Dollar, Yen Tipped to Lose on North Korea Boost to Global Risk Sentiment

“The market is now getting rinsed on the Italy trades (short EURJPY etc.) and repricing to remove the tail risk of a nuclear conflagration on the Korean Peninsula.” - Spot FX trader, HSBC. 

The US Dollar returned to the dogbox Tuesday as currency markets rediscovered their appetite for risk.

Price action was driven by investor and trader responses to signs of a possible detente between North and South Korea which could provide an easing of tensions in what is a key source of global risk sentiment.

The Japanese Yen fell as the news bodes particularly well for Japan; Japanese investors would typically sell the Yen as they pare back currency hedges on their investments. America’s greenback, which has racked up a double digit loss against a basket of currencies in the last 12 months, was offered lower and then lower still against all of its G10 rivals Tuesday.

This reverses much of the gains made by the currency over the last two weeks, a period dogged by caution among traders, many of whom may have been burned by the global financial market rout of February 06. 

“The USD losses have picked up speed in early North American trading as risk appetite improves,” says Shaun Osborne, chief FX strategist at Scotiabank. “Markets continue to mull the risk of the US imposing tariffs on foreign steel and aluminum but sentiment has been supported perhaps by signs of last ditch efforts to talk the president out of the measures and by signs of détente between North and South Korea.”

Both Sterling and the Euro notched up gains over their North American rival, with the Pound-to-Dollar rate rising 0.19% to 1.3874 while the Euro-to-Dollar rate gained 0.56% to 1.2404.

"The bigger and more significant development in the two Koreas is that North Korea’s leader is reported to have agreed to halt nuclear weapons testing following talks with his counterpart from the South. This, plus the resignation of Gary Cohn, prompted a renewed sell-off in the US dollar, with the EUR/USD trending towards 1.24 from 1.22 a few days ago," says Isaah Mhlanga, an analyst with RMB in Johannesburg..

Possible progress being made in talks with North Korea. For the first time in many years, a serious effort is being made by all parties concerned. The World is watching and waiting! May be false hope, but the U.S. is ready to go hard in either direction!

— Donald J. Trump (@realDonaldTrump) March 6, 2018

Both North and South Korea have agreed to meet at a summit in April where they will discuss future relations in a formal setting for the first time in more than a decade, according to a Reuters report.

“The North also said it can have frank talks with the United States on denuclearization and the normalisation of ties between North Korea and the United States,” the agency quoted a South Korean diplomat as saying.

Crucially for markets, which were buffeted by North Korea’s frequent nuclear weapons tests in 2017, the North is reportedly open to the idea of nuclear disarmament if its security can be guaranteed.

“The North Korea story was always a massive tail risk with a tiny probability. Kind of like Pascal’s Wager in reverse, where you had to worry about it a bit even though the odds of something happening were small because the negative outcome was so catastrophic,” says Brent Donnelly, an FX spot trader at HSBC.

“The market is now getting rinsed on the Italy trades (short EURJPY etc.) and repricing to remove the tail risk of a nuclear conflagration on the Korean Peninsula.”

The talk of denuclearisation on the Korean peninsula is significant given last year’s increase in nuclear missile tests, which drew harsh rhetoric from President Donald Trump, as well as threats to “rain fire and fury” on the hermit state if it continued to threaten America or its territories.

“The moves do not seem like an overreaction to me as a trend toward peace and maybe a path to eventual unification one day is potentially gigantic news. Hours before the denuclearization headline hit, there was already some good stuff happening,” Donnelly adds.

It remains to be seen how long the risk-on attitude across markets will endure given Thursday is expected to herald a formal announcement of new US tariffs on aluminium and iron ore imports, threats of which have to led to mounting fears of a possible trade war over recent days.

The White House could abandon its threat to impose new tariffs before Thursday, if international pressure and threats of retaliation win out, although this looks unlikely.

“White House economic adviser Gary Cohn is summoning executives from US companies that depend on aluminium and steel to meet with President Trump this week in a last ditch effort to halt the imposition of import tariffs,” says Lee Hardman, a currency analyst at MUFG.

"Top Republicans, such as House speaker Paul Ryan, have also expressed concern. Yet, President Trump has stated clearly that 'we’re not backing down'."

Analysts and economists are divided over the likely effect that new tariffs would have on the US Dollar given its role as the world’s reserve currency, the large size of the US market and scope for retaliation from other countries to lead various parts of the global economy into an all out trade war.

“While the economic literature is inconclusive on the effects of tariffs on FX, under our framework the depressing effects of taxes on trade on productivity and economic growth, and thus returns to capital, imply a net negative impact for the imposing country’s currency, at least in the long run,” writes Marvin Barth, head of FX strategy at Barclays, in a note Monday.

“As the currency of the world’s largest economy and consistent leader and instigator of the global movement towards freer trade for more than half a century, the USD ultimately may be the beneficiary of a trade war, ironically.”

“As a large, largely domestically oriented economy, the US is better insulated than most economies from global trade shocks, even if it is the instigator.”

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