Last week’s price action was dominated by speculation over global policy rates following a dovish turn by the Federal Reserve.
While markets have increased their bets on how much the Fed will cut rates, with pricing currently suggesting 78 basis points by January 2020, this week’s geopolitical events are beginning to take the mantle in dominating market focus and sentiment in the run-up to a pivotal G20 meeting.
Tensions between the US and Iran continue to simmer after Revolutionary Guard forces shot down a $100m US navy surveillance drone over Iranian airspace.
Yesterday saw the release of the White House’s response, following an aborted missile strike last week. Last night Trump announced the first stage of sanctions on Iran as the US will aim to freeze the assets of leader Ali Khamenei along with other Iranian military commanders.
The President suggested further sanctions will be imposed on Foreign Minister Zarif later this week. By turning the screw the Trump administration is sustaining maximum pressure on Iran to bring them to the negotiating table. However, the potential backlash from Iran, who have repeatedly threatened to close the key shipping chokehold that is the Strait of Hormuz, has kept markets on edge this week.
Tensions between the US and Turkey continue to simmer in the background following Turkey’s pledge to purchase the Russian built S-400 missile system.
The purchase of the Russian defence system puts a spanner in the works for the NATO defence network and prompted the Pentagon to halt the training of Turkish pilots for the upcoming F-35 fighter jets.
The Russian defence system is expected to be delivered in July, and recent rhetoric by Turkish officials suggests that the $2.5bn deal between Turkey and Russia will not be reversed regardless of the level of sanctions imposed by the US.
Under the 2017 Countering America’s Adversaries Through Sanctions Act (CAATSA) the US could levy further sanctions on Turkish officials and defence companies such as restricting their access to US financial markets.
This would reignite tensions between the two NATO members which have only recently subdued following the Pastor Brunson imprisonment and adds to an increasingly tense political landscape.
That said, market’s aren’t anticipating sanctions to be levied prior to the G20 meeting between Presidents Trump and Erdogan, but rhetoric from Istanbul and Washington continues to dominate EM sentiment.
This was highlighted by the Turkish lira retracing its rally after the release of the Istanbul vote due to Turkish officials voicing their willingness to swallow US sanctions. The move also filtered through into other EM currencies such as ZAR.
Chart 1: USDTRY leads EM sentiment yesterday as evidenced in USDZAR
The G20 summit is not only pivotal for US-Turkey relations but also the headline US-China trade war. Both Trump and President Xi are expected to hold an “extended meeting” after dialogue broke down and further tariffs were levied back on May 10th.
As things stand, channels of communication are open in the run up to the lengthy meeting in Osaka, but a threat of imposing tariffs on a further $300bn of Chinese goods still lingers over the negotiation table.
The new tariffs extends to an array of consumer products including electrical items and have already been written into legislation of which is set the period of public consultation is set to end on July 2nd. Most recently the US Commerce Department added five new Chinese entities to its exclusion list which bars them from buying US components without prior state approval.
Both parties have economic and political incentives to build bridges and cool tensions for a second time at the G20 summit.
However, with substantial sticking points such as Intellectual Property theft yet to see any traction, the markets expectations are dramatically low for any further progress between the two economic powerhouses.
Chart 2: USDCNY is far from recent highs (6.9311) however the yuan is at its weakest level since January against a basket of its closest trading partners
This suggests that a ramping up in trade tensions will weaken the yuan but the effect may not be channelled through USDCNY. This is due to the Fed having to cut rates as aggressively as fixed income markets suggest due to downside risks materialising.
The PBOC may be willing to hold the USDCNY rate steady and watch the yuan weaken against its closest trading partners (EUR, JPY, KRW, HKD, AUD)
For now, US protectionism and the rise of geopolitical tensions is currently the overwhelming force that is dictating financial markets, central banks and the global economy alike, and shows no signs of abating. However, if it does, the turning point may be the upcoming G20 meeting.