‘They Offset The Tariffs Before They Even Happened’: How To Lose A Trade War Before It Even Starts

Is Donald Trump “winning” his trade war with China?

Well, no.

And if you don’t believe me, just ask noted expert on all things Donald Trump, Donald Trump:

China, the European Union and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars gets stronger and stronger with each passing day – taking away our big competitive edge. As usual, not a level playing field…

— Donald J. Trump (@realDonaldTrump) July 20, 2018

….The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates – Really?

— Donald J. Trump (@realDonaldTrump) July 20, 2018

Those tweets are of course from Friday and they amount to a remix of the President’s smash hit “Not Thrilled“, a Jerome Powell diss track featuring background vocals and a guest verse from Joe Kernen.

Somewhere buried in all that egregious “covfefe” is a halfway accurate assessment of the extent to which the policy divergence between the Fed and the PBoC is effectively allowing China to negate the impact of the tariffs and as you can see, Trump is not amused.

Those tweets focused the trade war squarely on FX and put Jerome Powell in an extremely awkward position. In the event the yuan keeps weakening and spills over into other Asia EM FX on the way to tightening U.S. financial conditions, the Fed chair (just six months into his tenure) will have to choose between preserving Fed independence at the possible expense of the U.S. economy and U.S. equities, or else taking a pause (or even cutting rates) at the risk of being accused of politicizing monetary policy and actively entering the trade war.

Meanwhile, the only thing that stops China from encouraging (or at least “allowing”) more yuan weakness is capital flight which isn’t showing up yet in any real sense.

This is the context for a Deutsche Bank note out Sunday that poses the following question:

With the CNY weakening sharply in recent weeks, it is tempting to argue that the US is “winning” the trade war. But are things that bad?

The short answer is “no.”

For one thing, CNH implied vol. is still well off the levels seen in early 2016 when the world was on the brink of plunging into a deflationary spiral.

Beyond that, Deutsche also notes that “so far in July a synthetic Asia stock basket with a high exposure to US dollar revenues has rebounded”:

The most important point the bank makes in the short piece is this:

CNY is weakening because of, not in spite of, China policy.

The PBoC is not only letting this happen, but in fact encouraging it by, among other things, adopting a dizzying array of overt and covert measures to ensure domestic liquidity remains ample, keeping the counter-cyclical adjustment factor sidelined, and eschewing spot market intervention (for the most part).

Of course the most compelling evidence of all when it comes to the contention that Yi Gang is prepared to let the currency fall further (especially if he thinks Donald Trump is going to try and push the Fed to close the policy divergence), came on Friday when the PBoC weakened the fixing by the most in more than two years just hours after Trump’s CNBC interview.

Again, this is all contingent on capital flight not picking up. Here’s Deutsche Bank one more time:

So long as there are little signs of stress building into the system, there is little incentive for China to discourage FX weakness. After all, the nearly 10% USD/CNY move since March has almost completely offset the impact of Trump’s potential tariffs before they have even happened. Perhaps this is why the US President’s Twitter feed has turned back to talking down the dollar.

Yes, “perhaps” it is.