FX: Risk On Trades Could Lose Steam

FX: Risk On Trades Could Lose Steam

Kathy Lien  | May 29, 2020 04:33

U.S. equities extended their gains Thursday on the back of better-than-expected economic data. Durable goods fell less than anticipated, jobless claims hovered around 2 million and the market largely shrugged off downward revision to U.S. GDP. Currencies also rallied, with the euro, sterling the Australian and New Zealand dollars leading the gains. As U.S.-China tensions heat up, we are surprised by the nonchalant attitude in the markets. 
 
The relationship between the world’s two largest economies is expected to chill significantly over the next few days, and the ramifications could be significant. Beijing officially approved a new law that would significantly reduce Hong Kong’s autonomy. Activist groups would be banned and harsh penalties would be imposed on anyone violating national security laws. The U.S. State Department no longer sees Hong Kong as having significant autonomy, according to Secretary of State Mike Pompeo, paving the way for President Donald Trump to impose a new set of penalties. Trump is expected to make an announcement in the next 24 to 48 hours that could include taxing Hong Kong imports and imposing investment restrictions. This would be viewed as a direct jab at China that invites retaliation. Yet, markets are up with currencies holding steady.
 
Many investors may be wondering how the broader market can ignore the deepening rift between the U.S. and China. One argument is that Hong Kong and the U.S. do very little trade with each other, so the actual impact will be small. Secondly, relations have been chilling for weeks, with the Trump administration telegraphing potential penalties on Hong Kong/China. Third, China may talk of retaliation but could hold off doing anything meaningful until after the November election. Lastly, the biggest risk for the global economy right now is not a U.S.-China trade war but the economic and social impact of COVID-19. From that perspective, the good news continues to flow in with progress on vaccine development and the easing of more lockdown restrictions.   
 
Yet, risk appetite could wane as more U.S.-China headlines hit the wires. There are also a number of central bank meetings next week that could show policy-makers are still keen to ease. The Australian and New Zealand dollars rose strongly on Thursday but they are vulnerable to deep corrections if China tensions start to weigh on the markets. We are also looking for losses in the Canadian dollar. The current account deficit was worse than expected and tomorrow, first quarter and March GDP numbers are due for release with weaker numbers expected all around. 
 
The euro took out 1.1050 before the London close despite slightly disappointing Eurozone confidence numbers. This marked the third day of strength for the single currency, but with the European Central Bank expected to increase bond purchases next week and issue grim forecasts, we believe the rally will lose steam. Sterling also traded higher shrugging off dovish comments from Bank of England member Michael Saunders. On Friday, aside from Canadian GDP, Eurozone inflation data, revisions to the U.S. University of Michigan Consumer Sentiment Index will be released along with U.S. personal income and personal spending numbers.

Kathy Lien

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