Submitted by Michael Every of Rabobank
The 'Clause is Cause' Clause
As we had flagged repeatedly in recent days, US-China relations have suddenly deteriorated. US President Trump claims to have evidence that Covid-19 started in the Wuhan Institute of Virology. Moreover, he is allegedly considering an executive order to prevent an initial USD50bn of government retirement savings funds held by the Thrift Savings Plan being transferred to Chinese capital markets in line with the increased weighting China now has in the MSCI All Country World Index - something several members of Congress have been calling for. Other reports have it that trade advisor Navarro is pushing hard to onshore US manufacturing of key health goods as soon as possible by executive order - and is seeing ‘wait-and-see’ push-back from Treasury Secretary Steven Mnu-China. But recall this Thrift Savings Plan tug-of-war was being won by the doves until yesterday.
Meanwhile, the word “reparations” is actually being bandied about by some China hawks in DC, with one story even suggesting there were even White House plans to default on US debt to China as compensation. Larry Kudlow had to be wheeled out yesterday to deny that the US to do so. That’s like being in a dispute with your neighbour over the line of a fence and them calmly telling you “I can assure you that we don’t plan to burn your house down over this.” Is one reassured by that kind of thing or not? The hows and whys and ifs and maybes of what was once a crackpot leftfield is now out there actually being discussed on trading floors.
Beijing, and much of Asia, is out for the May Day holiday today so there is unlikely to be any kind of official Chinese reaction. However, where we have seen a knee-jerk response has been in USD/CNH, which at time of writing was at 7.1280 having been as low as 6.87 back in early January when the Phase One trade deal was on the table (and as we were saying “Don’t believe the hype”.) This is likely to put a serious dent in the head-scratching, math-defying risk-on rally we have seen for much of the week. Indeed, now month-end positioning is out of the way it has the potential to open up an entire new phase of USD buying vs. EM in particular – and this time CNY and CNH not being the exceptions.
This time last year, when we were all still going abroad regularly (right now just ‘outside’ is becoming a psychological barrier if I am honest) I was traveling with a presentation titled “Clause is Cause”. This argued that from a geostrategic ‘Von Clausewitz’ perspective, not a neoliberal “Let’s assume world peace” version, the US would at some point realise the USD/Eurodollar was a weapon it could wield vs. China, and when it did we would see three key strings cut: trade; tech; and then capital flows. The first was evident during the trade war – which has not been concluded is likely to get far worse soon; the second is also abundantly clear on a variety of fronts, much to Silicon Valley’s chagrin; and potentially, now we see the start of that third step – because if the US does block this first USD50bn going in, other such steps will follow, just as they did on the previously unthinkable idea of US tariffs on China.
CNH is right to be selling off, albeit in a traditionally limited fashion, because if you don’t buy from China and you don’t help China up the value-chain and you don’t invest in China then China is not going to be getting much USD liquidity at all. The US hawks probably don’t get the Eurodollar iron logic there; they are likely just pressing buttons in anger. The outcome would be the same nonetheless.
I can hear the market bulls and technocrats of the world saying “But China has USD3 trillion in reserves!” Perhaps. Most think it’s far lower than that. And not earning USD means you have to dig into that stockpile. And when you do, the PBOC either has to contract the local money supply (because every USD is backed by 7.xx CNY on the other side of the balance sheet) or it just creates new CNY anyway and supply-demand sees CNY move sharply lower – as we have been seeing in all other EM FX. Looking at the drop in BRL, ARS, ZAR, TRY, etc., or even THB, this would be how we would get to the ‘unthinkable’ 8 (9? 10?) handle in CNY. That would also crush those other EM crosses in tandem - and AUD and NZD, as the former tries to navigate its own geopolitical spat with Beijing.
I can also hear the market bulls and technocrats of the world saying “But the US relies on Chinese capital inflows!” Really? Really?! As the Fed is creating trillions of USD on its balance sheet with no end in sight, and with yields at historic lows, are you really going to try to peddle the myth that the US needs Chinese capital? It is flooded in cash – and has shown it can create it as needed. The only issue is how it is *distributed*. Do you seriously think US Treasuries are about to sell off from any Chinese action? In a risk-off geopolitical trade environment? With an activist Fed? Also, please recall the simple fact that Chinese (or any) capital inflows to the US are always the inverse of the export earnings they are getting from the US! If they don’t sell the exports, they don’t invest the capital. That was going to happen anyway in this downturn.
So that’s Von Clausewitz on the Eurodollar – but on good old fashioned US muscle, the picture is the same. It has been revealed by Reuters that Trump told Saudi Arabia that if they refused to sign up to a deal to cut oil production that he would not stand in the way of Congress voting to remove US military protection from the country after 75 years. Recall that the Petrodollar deal was always that the Middle East could sell as much oil to the US as desired, but had to recycle the USD earnings back into the US. It’s just that now the US has shale… So guess who blinked? Not that it is working – so prepare for round two shortly.
Folks, please disabuse yourself of the naïve belief that we live one giant happy world market where supply and demand and acronyms are all that matter and where politics and national security are dinosaur anachronisms, but in a bloc run by people who fall almost entirely into that camp, despite also relying on US military support, yesterday saw the ECB meeting.
As GDP is seen falling -5% to -12% in 2020 the ECB: left the deposit rate unchanged at -0.50%, while keeping the refi rate at 0.00%; the existing asset purchase programmes were left unchanged, APP at EUR 20bn/month plus an EUR 120bn envelope, and PEPP at a total of EUR 750bn in 2020; the temporary discount on TLTRO-III was increased by 25bp and will now be priced at -50bp under the benchmark rate (either the refi or depo rate, depending on loan growth); and a new set of 7 Pandemic Emergency LTROs (PELTROs) was launched. These are priced at MRO -25bp and will run (in a staggered manner) between May 2020 and September 2021. As our ECB team conclude, it remains to be seen whether EURIBOR-OIS spreads will ‘normalise’; the ECB is taking a very open-minded stance; and they believe further action is still necessary. I think the latter at least is clear to most readers.