Goldman: Currency War Has Erupted

A few months ago, most of the so-called experts predicted that China would almost certainly not use its semi-nuclear options, currency devaluation, to respond to Trump's escalating trade war. However, as events from the past month have shown, not only is China not shy to use every weapon in its retaliatory arsenal, but the recent yuan devaluation has been the fastest on record, and even prompted Trump to intervene by warning the Fed to become more activist in response to the Chinese currency that is "dropping like a rock", even halting rate hikes if that's what it takes.

Bloomberg adds that as the world’s two largest economies open up a new front in their increasingly acrimonious game of brinkmanship, the consequences could be dire - and ripple far beyond the U.S. and Chinese currencies. Everything from equities to oil to emerging-market assets are in danger of becoming collateral damage as Beijing and Washington threaten the current global financial order.

“The real risk is that we have broad-based unravelling of global trade and currency cooperation, and that is not going to be pretty,” said Jens Nordvig, Wall Street’s top-ranked currency strategist for five years running before founding Exante Data LLC in 2016. “Trump’s rhetoric over the last 24 hours is certainly shifting this from a trade war to a currency war.”

Picking up on our discussion from earlier, Bloomberg then notes that China’s shock yuan devaluation in 2015 "provides a good template for what the contagion might look like" according to former Goldman head FX strategist, Robin Brooks, who is currently chief economist at the Institute of International Finance.

Risk assets and oil prices would likely tumble as worries about growth arise, hitting currencies of commodity-exporting countries particularly hard -- namely, the Russian ruble, Colombian peso and Malaysian ringgit -- before taking down the rest of Asia.

“Asian central banks will initially try to stem currency weakness through intervention,” Brooks said. “But then Asian central banks will step back, and in my mind, the big underperformer on a six-month horizon could be EM Asia.”

Of course, as BofA also explained earlier, this has not happened due to the market's belief that the global economy is strong enough - for now - to deflect the deflationary wave set to emerge from China, although that particular assumption could very quickly be put to the test with dire consequences.

Now the latest to admit that currency war has erupted is none other than Goldman Sachs, which writes in a note released on Friday afternoon that "trade war is evolving into currency war." Goldman economist Zach Pandl explains why:

President Trump this week brought currency matters to the center of ongoing trade disputes between the US and other economies, stating in a CNBC interview that Dollar strength puts the US at a “disadvantage”, and then commenting on Twitter that the US “should be allowed to recapture what was lost due to illegal currency manipulation”.

Goldman then discusses how Trump's jawboning of the Fed will impact both the Fed's outlook on the global economy, and negotiations with foreign nations:

The evolution of the conflict to more directly focus on FX would be consistent with how major trade disputes have played out in the past—often involving negotiated Dollar weakness—as well as the Administration’s goal of reducing the US trade deficit. We do not think the President’s comments on the Fed affect the outlook for US monetary policy. However, they could impact how other countries are approaching trade disputes, either by bringing them to the negotiating table or affecting currency policy directly.

There are three direct consequences of this posture, which Goldman thinks could lead to two direct outcomes: a weaker USD (offset by strong EUR and JPY), and a more stable Yuan as "the US could interpret further depreciation as a form of retaliation."

  1. that the correlation between trade tensions and FX will change, such that an escalating conflict may not result in consistent USD gains;
  2. that other reserve currencies, particularly EUR and JPY, should find support, and
  3. that CNY will be more stable, as the US could interpret further depreciation as a form of retaliation.

Finally, when analyzing the currency war from the perspective of China, Goldman writes that while "it is unclear how Chinese policymakers will respond to the latest comments from the White House", it believes there are two key reasons why any further CNY depreciation would likely be limited and gradual, and why chasing USD/CNY higher is probably the wrong trade:

  • First, capital controls look effective, as the 4% depreciation in the Yuan vs the Dollar in June only resulted in limited outflow pressures.
  • Second, although copper prices have declined sharply, direct measures of China activity growth are still solid (with our June CAI tracking 7.5%), and Chinese policymakers have taken actions to support growth.

Of course, if Trump's calculus is correct and the trade war inflicts far greater pain on China's economy than most expect, then Beijing will have no choice but the aggressively expand its devaluation, pushing the USDCNY beyond 7.0 (especially if as Goldman claims, the capital controls firewall is solid and impermeable) to stabilize its rapidly decelerating economy...

... eventually converging with the market shock scenario of 2015.

Because, as Goldman also wrote some time ago, the only way for Trump to realize if he is winning or losing the trade war is for the US stock market to crash, a fact which is all too clear to China.