By Bannockburn Global Forex, LLC
March saw the USD fall back a little against most currencies, though there were modest gains against the CAD and some of the other more risk positive currencies. Although there was significant monetary policy news with the Fed raising rates and the ECB shifting their stance to be very slightly less dovish, the main market focus in March was on the Trump proposal to introduce tariffs on steel and aluminum and a large selection of Chinese imports.
The impact on the USD from these announcements was generally USD negative, though this was more clear-cut against safe haven currencies than the more risk positive currencies. However, by the end of the March there was some easing in trade tensions allowing many of the USD moves seen earlier in the month to be largely reversed, although equity markets remained some way below their levels seen at the beginning of the month. April has now opened with heightened trade tensions and most recently, Chinese retaliation with proposed tariffs on a range of high value US exports.
Outlook for April
1) US Trade Tensions
Trade tensions triggered by Trump’s proposed tariffs led to a sharp selloff in equity markets in March, but there was a modest recovery towards the end of the month as markets started to take the view that a global trade war was unlikely. Early April has been volatile as tensions continue to ratchet up and markets handicap renewed prospects of a trade war with China. Trump’s proposals may well not get put into action, and may never have been intended to. The motivation may have been partly aimed at political popularity, partly at getting improved trade terms. As the author of “The Art of the Deal” Trump is aware that it is often favorable to appear extreme at the beginning of negotiations. As it stands, it appears that the retaliation to the steel and aluminum tariffs in the original proposal (if they are imposed) are unlikely to be large, and the impact will be small, as these commodities make up a very small part of US trade. Canada would be the most affected country, but the ongoing NAFTA negotiations are more important for Canada and it appears that there has been some progress on these in March, with the US dropping demands for a 50% US content for all autos made in NAFTA nations. There are reports of a generally more flexible stance from US negotiators. China relations on the other hand are far more complex. The Chinese dynamic remains uncertain and with early April escalations there is clearly potential for trade tensions to increase again if Trump overplays his hand or other nations start to respond more aggressively.
2) UK-EU Trade Talks
The UK and EU agreed to a transition deal in March which meant the existing trade relationships would extend for 21 months beyond the official UK exit from the EU scheduled for March 2019. This was seen as good news, but there is a big caveat. The transition deal will only be effective if the full withdrawal agreement is agreed to by March 2019. If there is no agreement on this – including the vexatious problem of the Irish border – the transition deal will be null and void. This seems to give the EU the whip hand in the trade negotiations which begin this month, as the UK has more to lose from a “cliff-edge” Brexit than the EU, although such an outcome would be bad for both parties. While a free trade agreement looks achievable, there are a lot of potential sticking points, with financial services being a major issue. The UK want to include financial services in a trade deal, while at this stage the EU is saying this is not in
the cards. It is unlikely that anything will be decided in April, but it seems likely that we will see some noise from the negotiations which is likely to be negative, as in the early stages both sides will be emphasizing their aggressive negotiating positions rather than attempting to achieve a compromise.
3) Italian Government Formation
Although the Italian election was conducted at the beginning of March, we have yet to see a government formed. The markets have been relatively sanguine about the result, even though the populist M5S were the biggest winners and a coalition between them and the right wing “League” looks the most likely result. This could be problematic as it seems likely to mean higher government spending and an expansion in Italy’s already large public debt, in contravention of the EU deficit policies. However, there is no real concern at this stage about an Italian version of Brexit, although both M5S and the League are quite hostile to EU institutions, they stop short of calling for EU or euro exit. Nevertheless, if we do see a formal M5S/League coalition, the markets may react negatively. However, there are still other possibilities, potentially involving Berlusconi’s Forza Italia or even a coalition between M5S and the center-left former governing PD.
After starting March on the back foot, the EUR enjoyed a rally helped by the initial market response to the Trump proposals for tariffs on steel and aluminum. It also benefitted slightly from the SPD vote allowing a Grand coalition in Germany. The Italian election result was unclear in its market implications, being more favorable to the populists than expected but less clearly favorable to the right wing anti-Europe lobby, but this may become a factor again in April. For the moment, the 1.2150-1.25 range looks hard to break. Yield spreads continue to suggest that we may see a break to the downside, although the ECB have slightly moderated their dovishness, the lack of any real prospect of higher Eurozone rates until well into 2019 compared with the expectation of continuing rate rises from the Fed through this year underline the US yield advantage. The futures data also still show a heavy speculative long EUR position which could be vulnerable to a clear change of momentum.
Through March market uncertainty about trade seemed to be the primary factor preventing a USD rally, but if tension fades through April the EUR could well prove vulnerable and a test of 1.20 looks possible in this scenario. It would require intensifying trade concerns to test the top side of the range, though such concerns around Brexit could prove USD positive.
GBP/USD benefitted in March from the transition agreement on Brexit with the EU, which means current trading conditions will remain in place for 21 months after the official Brexit date of March 2019. While this is still conditional on a full withdrawal agreement being concluded by the March 2019 date, it maintained the optimistic Brexit tone that has held GBP up in recent months. GBP may also have enjoyed some seasonal strength – March has been a consistently strong month for GBP in recent years. GBP/USD also got some benefit from the USD’s weakness in the immediate aftermath of the Trump announcement of trade tariffs. Trade talks proper on post-Brexit arrangements start between the UK and EU in April. Given that both sides will be presenting their initial negotiating positions, the risks seem to be towards a more negative market response. However, with most also expecting a Bank of England rate rise in May, the downside for GBP/USD may not be too substantial.
The CAD was the biggest initial victim of the Trump announcement of tariffs on steel and aluminum. Not only is Canada the largest single exporter of these commodities to the US, the CAD also tends to suffer from any general decline in risk appetite, and the impact on the equity market of concerns about a possible trade war compounded the initial reaction to the announcement of tariffs. However, towards the end of the month the news of progress in NAFTA negotiations helped the CAD rally. There may yet be more potential for CAD gains if trade tensions recede further, especially if there is more evidence of NAFTA progress or indications that Canada will get exemptions from any of the US tariffs. There could be scope to the 1.25 area on positive news.
The MXN was one of the best performers in March, performing much better than might have been expected in reaction to the US tariff news. The positive news on NAFTA helped the MXN even more than the CAD, perhaps aided by reports that the US wanted to make more progress on negotiations ahead of the Mexican elections in July. USD/MXN hit its lowest level since September 2017 as trade tensions faded at the end of the month. The MXN remains excellent long term value at these levels and although there are nerves about the potential impact of the July election, the market may now well focus on the potential to reach the 2017 lows at 17.45, as long as trade tensions do not reignite.