DBS FX/Rates: Risk-off amid trade tensions

Philip Wee, FX Strategist, DBS Bank and Eugene Leow, Rates Strategist, DBS Bank

Risk aversion is likely to persist in the markets on US-China trade tensions. As long as Washington and Beijing keep up their tit-for-tat trade war rhetoric and actions, safe haven play is likely to drive the Japanese yen stronger against the euro and the Australian dollar. Asian (ex-Japan) currencies, understandably, are on the defensive. After all, the stronger-than-expected cyclical upturn in the external sector had been a key factor for the upside growth surprises that fueled the global reflation trade in the past half year into January. The risk remains for China to step up its response, for example by targeting US agricultural imports. The Oz is more vulnerable than the euro because most of Australia's exports head to Asia, in addition to the fact that the Fed Funds Rate has just risen above the Reserve Bank of Australia's cash rate. Similarly, the combination of trade worries and rising US rates would undermine currencies with twin deficits such as the Philippine peso, Indian rupee and the Indonesian rupiah.

Excluding Hong Kong, the three Asian (ex-Japan) countries with exports most vulnerable to a US-China trade war are Taiwan, Vietnam and South Korea. The Korean won depreciated the most (by 1.5%) last week; Washington is seeking a better deal from Seoul in its renegotiations to update the Korea-US Free Trade Agreement. The Vietnam dong has depreciated to 22795 last Friday, its weakest level since March 2017. Effectively, the dong has broken out of its six-month stable range. In contrast to 2017, the spot dong rate has been depreciating faster than its official mid-rate, and not vice versa this year. Korean companies that set up factories in Vietnam account for a significant share of Vietnam's exports to the world. As for the rest of the region, the room for complacency will lessen when equities start to push lower. Unlike January, when all AXJ stock markets rose on hopes for the global reflation trade to extend into this year, five have already fallen year-to-date by last Friday. The score for AXJ currencies was worse; six out of the eleven AXJ currencies that we monitor have depreciated for the year. Trading is likely to become more volatile as markets swing between hope and fears that Trump's strategy to deploy brinksmanship in trade negotiations would not be prolonged, overly quarrelsome, or worse, backfire with China.

As trade tensions dominate, weak sentiment is supporting USTs with 10Y yields hovering just above 2.80% (from 2.95% a month ago). However, we reckon that downside to yields from current levels may be limited. Increased Treasury issuances and nagging inflation fears appear to have put a floor to USD rates even as the VIX closed above 20 last week. Data wise, final GDP and PCE deflator numbers are due on 28 March. Consensus is looking for a slight upgrade in growth numbers (2.7% QoQ saar compared to 2.5% previously) while expecting the core PCE deflator to be unchanged (1.9% QoQ saar).

If trade friction heats up between US and China, the probability of China using their UST holdings as a point of negotiation becomes non-negligible. On the surface, US yields are likely to go up if China reduces their USD1.2tn holdings by a fraction. With the private sector barely able to digest the supply of US issuances, the US government may have to deal with increased funding costs. Optically, the relationship (China selling and higher UST yields) appears to be intact over the past two years. However, this correlation breaks down when viewed over a longer time horizon.

If China decides to diversify away from USD assets, it would probably have to take on assets in the other G10 economies. Realistically, there are not many markets deep enough to absorb Chinese buying other than the Eurozone and to a smaller extent, Japan, the UK and Australia. In any case, this complicates the trajectory of US yields. We think US Treasuries (and assets in general) would react negatively if this threat gets seriously considered.

Source : Equity Bulls

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