Paul Volcker has died of cancer at 92, the New York Times reports.
Volcker led the Fed from 1979-1987 in a particularly difficult time characterized by runaway inflation and currency instability. He began working at the Treasury Department under JFK and was chairman of Obama’s Economic Recovery Advisory Board.
Late in his life he was known for the ‘Volcker rule’; a measure that prohibited banks from making risky trades with their own funds, something that contributed to the financial crisis and bank bailout of 2008.
However his defining legacy was tackling the persistent and runaway inflation of the 1970s and 1980s by raising interest rates as high as 20.0% in 1980. That triggered a recession the next year but ended the era of double digit inflation and kicked off the great moderation — a +30 year period of generally falling borrowing costs and interest rates.
Where the economies of US and China go, the rest of the world economies follow. Why is that? Well, around 40% of the world’s GDP comes from the combined economies of the US and China.
Take a look at the chart below from the World Economic Forum and you will see how a large proportion of the world’s $80 trillion GDP is made up by the US and China’s economies.
So, the market’s concern with the ongoing US-China trade dispute is really an ongoing concern about global growth. That is why a fall out between the US and China impact global financial markets.
The market wants the US-China trade dispute resolved as soon as possible. The markets have become used to a game of ‘ping-pong’ where some news prompts optimism about a US-China trade deal and then some other, conflicting news, encourages pessimism about the US-China trade deal. It’s truly a game of geo-political ping pong!
At the moment the market is digesting the latest news on Tuesday last week where US President Trump announced that it is probably better to wait until after the 2020 presidential election for a China deal and that there is no timeline on trade.
Then, on Wednesday, some sources quoted by Bloomberg said that a deal was much closer than the recent heated dialogue would otherwise indicate. Another game of ping pong! However, it is worth being aware that the US-China trade dispute could actually get much worse.
Two of the ways it could deteriorate would be if the US goes ahead with restricting US capital flows into China and if the impact of the Hong Kong riots spill over to further political moves from the US or China.
The impact of proposals to restrict US capital flows into China
One of the moves the US has suggested at the end of September this year in the ongoing trade war is a restriction of US capital flows into China. To literally turn off the tap of US capital. The impact of such restrictions could be:
A drag on Chinese firms listed on global stock exchanges. Chinese companies listed on the US stock exchanges have a market capitalization of $1.3 trillion and include names like Alibaba and Beijing Capital Airport ADR.
China may retaliate to the US restrictions and sell off some if it’s $1.2 trillion dollars of US debt. This would cause US bond prices to fall and yields to spike as an alarm response. This in turn would make it costlier for US companies and consumers to borrow. A complete selling of US debt would be enormously risky for China as they are the largest foreign creditors of debt.
There is a danger of a decoupling between the US and Chinese economies and that would cause a far greater impact than the tariffs already in place have.
Hong Kong turmoil adds to tensions
The relationship between Hong Kong and China is tense. There is a ‘one country, two system’s’ policy between Hong Kong and mainland china, but the relationship is under strain. The catalyst for the strain has been Hong Kong protests over a proposed Chinese law to allow the extradition of criminal suspects to mainland China.
This has been the source of all the problems and riots that have been taking place recently. To make matter worse, at the end of November, President Trump signed new human rights legislation authorising sanctions on Chinese and Hong King officials responsible for human rights abuses in Hong Kong.
In this way the US are signaling support for pro-democracy activists. China responded to this legislation by calling it an illegal interference in its own affairs. The current expectations are that this in itself is not enough to de-rail US-China trade talks and Donald Trump.
However, it is an added tension in an already difficult relationship. President Trump has tried to avoid antagonising the situation by signing the bill in private and not having a large press conference.
However, there are certain predictable responses that the market makes when it is concerned. These moves are called ‘risk off’ moves. In a risk off market we typically see gold strength, JPY and CHF strength, US oil weakness, bonds bid, AUD, JPY, and equity weakness.
A US-China trade war will make gold an attractive asset to buy. A world with central banks having low interest rates and risk being elevated makes gold a decent potential for investors seeking alpha. Also, with the month of January being an excellent time for gold, over the last decade, a breakdown in US-China trade relations would further encourage gold bulls.
The Japanese Yen is a traditional safe haven currency. Negative interest rates, like the Bank of Japan currently has, would typically discourage currency capital inflows. However, the debt structuring of Japan means that the currency is considered very stable and safe for uncertain times. As a result, when investors and speculators are fearful, there are sudden and marked inflows into the Japanese Yen.
The pair that stands out for particular downside in a fresh round of the ongoing US-China trade war would be the AUD/JPY pair. As around 30% of Australia’s economy is made up of trade with China it stands to lose out on a US-China trade war. Further trade strain would result in AUD weakness and JPY strength on safe haven flows.
In case you missed the news from earlier today, North Korea has set a year-end deadline for the US to change its policies or Kim Jong Un may “embark on a new path” as denuclearisation talks between the two countries appear to have broken down.
If you’ve been following our headlines over the past few months, it is clear that the two countries aren’t getting along well with how frequent North Korea has been conducting missile launches and tests during the period.
As things stand, they want the US to lift more sanctions before committing to any more “denuclearisation” projects but the US wants it to be the other way around. Hence, we have reached a bit of an impasse at the moment.
If anything else, keep an eye on this issue here as it could present a wild card risk for markets in 2020 – alongside the host of other issues.
The pound stays underpinned ahead of the UK election this week
Early bids have helped push the pound to a high of 1.3181, closing in on the May high of 1.3185 as we get into what will be a crucial week for the pound.
It is all about the election now and so far the polls are still suggestive of Boris Johnson coming out on top with traders holding out some hope for a majority outcome as well.
As for cable, looking at the weekly chart:
We can see that buyers are looking poised for a key upside break after closing last week above the 100 and 200-week moving averages. This week, the 50.0 retracement level @ 1.3168 will be a key level to watch out for but it all depends on the election outcome.
If we do see yet another hung parliament result, expect the pound to undo its good work since October as we go back to the drawing board in this whole Brexit debacle.