The EUR/USD Rate is Still a Sell says Goldman Sachs, as Trade War 2.0 Will Soon Weigh

Modified: Tuesday, 14 May 2019 07:37 BST
Written by: James Skinner

- Keep selling the EURUSD rate on rallies says Goldman Sachs.

- Recent strength is just emerging market bets being unwound.

- Soc Gen looks for CNY correlations to hold, boding ill for EUR.

The Euro was one of only three G10 currencies to best the Dollar Monday but observers risk being fooled by its strength because Goldman Sachs has told clients to keep selling the single currency, arguing that President Donald Trump's new offensive in the so-called trade war with China will soon hurt it.

All currencies in the G10 universe succumbed to the overtures of a safe-haven U.S. Dollar on Monday, other than the mighty Japanese Yen, the safe-haven Swiss Franc and the Euro. The Euro rose on Monday as well as on the Thursday and Friday just passed.

This is after President Trump said in a Twitter post the previous Sunday that tariffs on $200 bn of annual imports from China would rise from 10% to 25% on the Friday concerned due to Chinese backpeddling on commitments made earlier in trade negotiations.

This response from the Euro is controversial because it differs to that seen between March and July of 2018 when the original range of tariffs were placed on Chinese goods, and the Dollar strengthened broadly through those months, helping to put EUR/USD deep under water.

The Goldman Sachs currency team has an explanation for this.

"On Thursday EUR/USD jumped higher amidst significant weakness in risk assets. We suspect the move reflected an unwinding of EUR-funded carry trades in higher-yielding EM currencies," says Monday's morning currency briefing from Goldman Sachs.

Tariffs cause economic damage primarily by rendering one country's exports uncompetitive relative to those of others, but if China is going to be hurt in the tariff fight then it won't be long before the fallout hits Europe given the close economic relationship between the two.

Eurozone GDP growth fell by more than half in the third quarter of 2018, from 0.4% to 0.1%, which is when the previous U.S. tariffs on imports from China were actually implemented and began to take effect.

Above: Euro-to-Dollar rate shown at four-hour intervals.

Analysts at many of the banks have spent 2019 telling clients they should buy emerging market currencies like the Russian Rouble, South African Rand, Argentine Peso, Mexican Peso and a range of others. And those trades had done well until last week.

Their argument was based on the assumption that, with the Federal Reserve having said in January that it would be "patient" before lifting U.S. interest rates again, the rate hiking cycle that hoovered Dollars from the international financial system and put Dollar-exposed emerging market economies under pressure last year had ended.

That was supposed to provide relief for economies that had seen the cost of servicing existing Dollar-denomiated debts rise and capital inflows, which finance government fiscal deficits in developing nations, turn into outflows.

Appetites for emerging market currencies were further fuelled in March when President Trump suspended "indefinitely" the 10%-to-25% tariff increase that went ahead on Friday. But that suspension was always contingent on good faith negotiations resulting in a deal agreeable to the White House.

Many of those investors who'd bought emerging market currencies over recent months had done so only after borrowing Euros in order to finance their speculative bets, and now the investment case is falling apart they're having to buy back the single currency.

Investors will have chosen Euros to fund their trades with because, given the European Central Bank (ECB) deposit rate is at -0.4% and its main refinancing rate at 0%, it's a cheap currency to borrow.

"In light of renewed risks to the global economy due to the US-China trade conflict, EM FX carry trades could be on the back foot over the near-term, and we may see further EUR short covering," Goldman Sachs says.

Above: US. Dollar relative to Russian Roube in 2019, alongside EUR/RUB (blue).

The reversal of those speculative flows is what the Goldman Sachs team are saying is responsible for the Euro's strength on Thursday and Friday of last week, and presumably on Monday too. And there's no definitive way of telling how long this might go on for.

"We do not think the Euro will generally trade with a negative correlation to risky assets (like the Yen), in part because Euro area growth prospects depend importantly on Chinese activity. We therefore retain our 1.10 3m target for EUR/USD and recommend selling on rallies for now," Goldman concludes.

Trump said last week that he's set the ball rolling on a process that could ultimately result in another $325 bn of China's annual exports to the U.S. being subjected to a blanket tariff of 25%, although a formal notification of this is yet to be made by the U.S. Trade Representative.

China has said it will retaliate and financial markets are now bracing to see exactly what shape that response will take. Economists already expect U.S., Euro area and Chinese growth to slow in 2019, but anything that accelerates that slowdown would have fundamental implications for currency markets.

The White House imposed tariffs on imports of Chinese goods last year, prompting a retaliatory response from China and ultimately leading to a cease fire and negotiations that began in December but are still ongoing today. It cited "unfair trading practices" and alleged state theft of intellectual property.

Above: Euro-to-Dollar rate at daily intervals alongside USD/CNH rate (orange).

"The market reaction is one-dimensional. The CSI 300 has reversed half of Friday's bounce, and is down over 6% since the end of April. Month to date, 10year Note yields are 6bp lower and the yen is up 1½% against the dollar so far in May, while the Chinese yuan, Korean won and Swedish krona have all lost over 1 ½%," says Kit Juckes, chief FX strategist at Societe Generale. "With the market in this mood, there's no point looking for gains from NOK, AUD, SEK, NZD or CAD."

Juckes says the Yuan is a globally important currency and suggests that other currencies' correlations with it will hold. Those correlations exist for economic reasons and barring the odd temporary breakdown, are slow to change.

The USD/CNH rate that reflects the U.S.-China exchange rate has a negative correlation with the EUR/USD rate, although this broke down last week when both moved in exactly the same direction for the duration.

Juckes wrote last week of a possible rise from 6.90 for USD/CNH, to the physcologically important 7.0 level. If that plays out and Goldman is right about the Euro, while Juckes is right about the above correlations holding, then the Euro-to-Dollar rate could soon begin heading south.

However, Juckes recommended selling the Canadian Dollar last week, not the Euro. He then sent clients a note Monday suggesting he might be waiting for lower and more favourable levels at which he could buy the single currency.

"As China is not a local but a global actor, contagion risks generated by fast yuan depreciation won't be limited to Asia, especially in a context of a sharper S&P correction," Jukes warned. "The Canadian dollar is now probably the most at risk, since it has the highest yuan correlation within G10 but has recorded the smallest G10 volatility increase since mid-April, when the yuan started to fall."

Analysts appear to have differing ideas about what this new front in the trade war will mean for the Dollar and the Euro.

The greenback was expected by many to decline in 2019 as the growth boost provided by last year's tax cuts manifests as a high bar for the economy to clear this time around and brings the market's focus to bear on the Federal Reserve. And the Euro was meant to benefit from this but the market jury is now deliberating on the outlook for both, given the escalating trade war.

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