US-China trade showdown: Semi-stable tension or far worse?

Tuesday 14 May 2019
John Hardy

By John Hardy, Head of FX Strategy at Saxo Bank

Risk appetite has cratered once again as this weekend’s news flow left investors wondering whether the US and China can reverse the downward spiraling trajectory of trade talks. The latest Trump tweets and defiant Chinese rhetoric don’t look encouraging. The next test is China’s inevitable response to Trump’s move to tariff all Chinese imports.

Given the risk of loss of face on both sides of the fraught US-China trade talks, our CIO Steen Jakobsen argued in a recent podcast that it may be useful for both sides for a while to test the waters of maintaining a “non-solution” before the talks might have a chance of recovering, possibly as soon as at the G20 meeting in late June in Osaka, Japan. 

In the end, both sides may find motivation to avoid a dramatic escalation to avoid ugly economic – and in Donald Trump’s case, ugly financial market outcomes (many have argued that Trump only had the luxury of taking such an aggressive response due to US stocks having recently hit all-time highs again). But the question in the meantime is whether the market remains over-confident that we can avoid an ugly misstep or worse in the interim. The stakes are high for global investors and  the market is rather poorly positioned after “stockpiling complacency” in the wake of the Fed’s dovish policy pivot since the beginning of the year.

Traders should beware that the tactical situation is very fluid and trading ranges could expand dramatically across asset classes – particularly in the recently moribund currency market if China chooses to allow its currency to adjust lower versus the US dollar. Some thoughts.

As we are awaiting China’s response: 

• China’s three demands (Liu He at the weekend): US must first end the additional tariffs (JJH: This looks an impossible ask in the nearest term), targets set by US for Chinese purchases should be in line with real demand, text of deal should be “balanced” to ensure the “dignity of both nations". 

• Foreign ministry spokesman Geng Shuang on coming Chinese response: "As for the details, please continue to pay attention. Copying a U.S. expression - wait and see.”

• China press: "At no time will China forfeit the country's respect, and no one should expect China to swallow bitter fruit that harms its core interests," China's top newspaper, the ruling Communist Party's official People's Daily, said in a commentary.

• More defiant language from official Chinese sources: “At no time will China forfeit the country’s respect, and no one should expect China to swallow bitter fruit that harms its core interests,” China’s top newspaper, the ruling Communist Party’s official People’s Daily, said in a commentary. 

• Trump directly warns, as you point out, “You backed out!” within last hour in tweets that China better not retaliate on tariffs and blaming them for the failed talks.
Is China “weaponizing” the currency: arguably, it was only keeping it artificially strong as a good-will measure as long as bilateral talks were ongoing. 

• Given the asymmetric trade relationship, China could move on its currency and they can argue it fits with market forces anyway and a move toward a freer float, as well they can rightly bemoan the dysfunction of having the USD as the global reserve currency. A bit surprised to see, as we are writing this article that China going straight after Trump-land (soy, cotton, etc…) with $60 billion of Tariffs on US imports as of June 1. It represents an escalation that Trump tweets that they better not retaliate and then they do precisely that.

• Range expansion in CNY today (closing in on 1% from yesterday’s close in USDCNY) is arguably the largest since episodes last summer when USDCNY coming off much lower levels. 

• Bitcoin exploding higher could be a speculative link to concerns that CNY set to “devalue”.
On CNY: I have seen the argument that China may only take it to USDCNY 7.25 or thereabouts to make a point. I’m not sure I buy this line unless there is a plan to announce something to counter that move. It is easier to keep something under control with show of strength than to tease with weakness and then move to clean up  later. The risk is that letting CNY go is letting CNY go, though I still have a hard time seeing China allowing a potentially market-stabilizing “float” or semi-float of its currency already now. Regardless, we are into the event horizon of a black hole of the unknown if USDCNY sustains a move above 7.00. Ultimately, we have argued that the level of USDCNY determines the likelihood of a trade deal. 

Risk metrics are very subdued – market feels clueless on the potential impact of all of this – corporate credit spreads, EM spreads, have hardly picked up in recent session.  BUT Asian FX beginning to move a bit more – and select Asian markets – KRW and KOSPI, USDSGD ramping up above  200-day moving average, etc…

This from our Quant Strategist on VIX:

The VIX Index is higher again this afternoon trading just below 20 and getting more nervous as we get closer to US session open and China’s retaliation putting tariffs on additional $60bn of US goods. South Korea equities are a good proxy on US-China trade war and China macro and this market is sending out stress signals with all of 2019 gains almost erased as of today.

The 22 level on the VIX Index is the turning point between bull markets and bear, and also commonly believed to be the long-term equilibrium in the VIX term structure. So investors should carefully watch this index for guidance on downside dynamics. In addition data suggest S&P 500 futures depth (limit order book) is thin, so system is fragile to shocks.

And on VIX positioning in the futures market from Ole S Hansen:

• Plenty of unwinding of short positions still to be seen on renewed stock market weakness.
• Since the through at 14.25% on the May VIX future at the beginning of the month the subsequent spike and retracement has only triggered a 10% reduction in the Open Interest to 399,000 lots.

As of last Tuesday the speculative record short had been cut by 17% to 150,000 lots (COT report):


Increased risk of additional short covering still to be done as the market has made a dramatic shift into backwardation since Friday. Short positions are being hurt not only on the rise in volatility but also to the increased cost of rolling positions further out the curve. The May to June spread has jumped from 0.65% contango on Friday to a current backwardation of  -0.55%.

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