As BofA’s rates strategist Ralf Preusser writes in a note this morning, “not even a month since the US election and markets seem unrecognizable” adding that the Trump election represented a paradigm shift. Fiscal easing would take over from monetary easing and would allow for the dollar and rates to rise in unison, a trend not seen for a while. The bank notes that whilst the direction of the moves since the election is in line with its expectations and forecasts, “the speed has come as a surprise.” and while fundamentally the repricing has further to go, especially in light of OPEC’s decision to end the price war within the cartel, there are red flags emerging among which vulnerability of EMs, and the reaction function of the PBOC, while warning that investors should not forget that premature tapering by the ECB risks exposing the Euro area’s fault lines again.
Below is a summary of what BofA’s Preusser lays out as the key risks to the “post-Trump” market:
EM, China and Europe remain risks to central scenario
With no additional clarity on the policies that President-elect Trump will pursue once in office, it is worth revisiting some of the risks to our central scenario. The vulnerability of EM, and in particular the reaction function of the PBOC, is a concern. At the same time, investors should not forget that Europe continues to dance to a different inflation tune, and that any premature tapering by the ECB risks exposing the Euro area’s fault lines again.
ECB to extend QE, removing Euro area risks to reflation sentiment
In Europe, we fear that investors are losing sight of the extent to which the recovery and inflation dynamics rely on ECB support. This makes this week’s ECB meeting by far the biggest upcoming risk event, and arguably of more importance to the rates market than the Italian referendum. Our economists’ central scenario of an EUR 80 bn extension for six months should be bullish both rates and spreads. We therefore reiterate our constructive stance on EUR rates vs the US.
More importantly, however, for US rates to be able to reprice higher, in turn providing support for the dollar, the market must not start questioning the integrity of the Euro area. Decisive action by the ECB on Thursday is therefore a necessary condition for a continuation of our year ahead themes.
OPEC decision and breakevens suggest EM could become a reflation trade
In EM: a deflation or reflation trade? we highlight that rising US rates are not inconsistent with rising EM, as we saw in the 2004-06 Fed hiking cycle. The OPEC decision (OPEC delivers at last) makes us comfortable reiterating our bullish, aboveforward oil price forecast. Crucially for EM, this implies a much higher chance of revisiting the positive correlation between commodity prices and US data surprises that characterized the positive correlation between US rates and EM returns in 2004-06.
Second, unlike the botched track relay handoff in 2013, fiscal policy will be stepping into any void left by monetary policy, pointing to a much smaller risk of breakevens treating tighter monetary policy as a mistake, again leaving room for EM as a reflation trade.
RMB devaluations in response to protectionism
Even if EM as a whole seems in a decent position as of now, questions over China’s vulnerabilities are unlikely to disappear anytime soon. In Trump’s policies and Asia, we discuss why we do not believe that US protections would trigger RMB devaluations. We do see continued downward pressure on RMB and remain long USD/CNH, but do not expect the kind of disorderly moves that would put the current reflation sentiment at risk.
Of the four, the last one is the one that has received the most attention in recent days, so here is some additional details on “Trump’s policies and Asia” per BofA’s Claudio Piron:
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Asia waits for clarity on Donald Trump’s trade policy as he fills his Cabinet. Trump’s Presidential election campaign website stated that one trade policy of a Trump administration is to reduce the US trade deficit1. In EM Asia, China and Korea accounted for 53% of the US trade deficit in 2015. Trump has publicly discussed asking the US Treasury Secretary to label China as a “currency manipulator”2; imposing a 45% tariff on imports from China; and criticised the South Korea-US Free Trade Agreement.
Whether or not a Trump administration seeks to label China a “currency manipulator” as suggested in Trump’s Presidential campaign, once in office as President, Trump could still impose tariffs on China directly on the basis of different legislation. There are five statutes that empower a President to impose tariffs on any economy (Table 4). This means a President does not need the Treasury to consider an economy a “currency manipulator” before he imposes tariffs. In practical terms, we believe only the Trade Act of 1974, Section 301 could be invoked eventually. In our opinion, the invocation of other Acts would not be applicable and could trigger strong court challenges.
We may get a signal from the Trump administration on how it will handle the US’s trade relationship with China in mid-December, when China expects to be given market economy status from 11 December 2016. We think a tough stance against China being granted market economy status would increase the likelihood of tariffs being imposed against China. It could also be a precursor to the US trade stance with South Korea. On his Presidential election campaign website, Trump stated that the trade deal with South Korea has reduced nearly 100,000 American jobs. As another trade policy of Trump is to “negotiate fair trade deals that create American jobs”, we believe the Trump administration could consider seeking to renegotiate the South Korea-US FTA. We don’t see China and S. Korea devaluing their currency in reaction to US protectionism:
- It would be against China’s interest to engage in such currency devaluation practices. We think this could exacerbate RMB depreciation expectations and, in turn, capital outflows. We recently showed how USD appreciation can lead to capital outflows from China by Chinese residents. Furthermore, the effectiveness of China to contain capital outflows is arguably questionable given the persistent and negative net error and omissions in its balance of payments.
- South Korea’s capacity and willingness to competitively devalue its currency against the USD is limited. Korea would need to forego either monetary sovereignty or free capital flows. But neither option is palatable for Korea, in our view.
Protectionism in the US is an inherent risk for Asia. We think the likelihood of steep tariffs is low, as it would raise prices in the US and reduce disposable income, which would be politically costly. That would limit the magnitude of potential retaliatory tariffs from China. Ultimately, if the trade policies of a Trump administration were to successfully lower the US trade deficit, China and Korea would have a lower trade surplus than before, all other things being equal. But this would decrease the selling of USD, and purchase of local currencies, by Chinese and Korean exporters.
The potential trade policies of a Trump administration could cause the RMB and KRW to depreciate. This would be consistent with our end-2017 USD/CNY and USD/KRW forecasts of 7.25 and 1,270, respectively. A US trade policy-related risk to our view is that the Trump administration adopts tough trade policies that trigger strong response from China and Korea and fuel strong depreciation expectations of the RMB and KRW.
Chart 9 shows that Chinese exporters have become net sellers of fx since March 2016: selling fx and purchasing RMB. In this environment, a weaker trade surplus in China would reduce the net selling of FX and alleviate appreciation pressure on the RMB. We stay long 12M USD/CNH (current: 295bps, target: 373bps, stop: -116bps). Risks to this trade are a strong growth recovery in China and intense capital outflows.
In South Korea, we estimate corporates would sell their FX receipts when USD/KRW is above 1.144. When the KRW is weak, Korean corporates would want to sell their FX receipts to benefit from a favourable exchange rate (Chart 10). Therefore a reduction of the US trade deficit with South Korea could put depreciation pressure on the KRW.
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