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

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.