Trading the Trade War
On the first day of August 2019, President Donald Trump announced via twitter that his ongoing frustration with the slow pace of trade negotiations with the Chinese had forced him to consider raising tariffs against the world’s second-largest economy, yet again.
Set to take effect on Sept. 1, the latest round of tariffs would encompass any product exported from China to the United States that hasn’t previously been subject to tariffs. That represents roughly an additional $300 billion in goods that will now be subject to a 10% tariff upon entry into the United States.
The reaction in global markets to Trump’s latest trade war tactic was swift and decisive. The S&P 500, which had been trading at all-time highs after the most recent rate cut by the United States Federal Reserve, proceeded to drop more than 150 points in just two trading days.
The VIX, which is a widely followed barometer of stock market volatility, popped approximately 39% in a single day of trading. The VIX closed north of 24 on Aug. 5, which isn’t far from the highs seen this past winter when equity markets were cascading lower. Interestingly, that previous market correction was related to U.S.-China trade war tensions, as well.
Depending on one’s strategic approach, corrections such as these are often viewed as great trading opportunities. The chance to lower one’s cost basis in a favored long position, or to get short volatility when it spikes, are just a couple well-known avenues that active traders often pursue when corrective conditions materialize.
Periods of heightened stock market volatility are also usually associated with big moves in other global asset classes. Only days after Trump tweeted about the new tariffs, another big story emerged in the international marketplace—namely, the Chinese yuan (a.k.a. renminbi).
And this currency narrative serves as a good reminder that just like in the world of physics, the financial markets are also often susceptible to the famous axiom, “for every action, there is an equal and opposite reaction.”
The interconnected nature of the world’s financial markets cannot be denied, and after the United States took action—which arguably hindered the Chinese economy—the local currency in China also took a big hit.
Just two trading days after the tariff announcement, the Chinese yuan fell past what many had long-perceived as a psychological “line in the sand,” when it traded for more than 7 yuan per U.S. dollar. Looking at the history of the dollar/yuan exchange rate, one has to go back all the way to 2008 to find a time when more than 7 yuan were required to purchase a single dollar.
And while a portion of that move has to be attributed to shifting perceptions regarding the health of the underlying Chinese economy (and associated currency), many in the world of finance have also attributed the move to an intentional move by the Chinese to counteract the ongoing effects of the tariffs. A devalued yuan (versus the dollar) effectively makes Chinese produced goods cheaper for American buyers—which is critical when one considers that the tariffs are basically requiring American buyers of Chinese goods to pay more.
One might ask why China didn’t simply raise tariffs against the United States in tit-for-tat fashion, instead of intervening in the international foreign currency markets?
That’s where the huge imbalance between what the U.S. imports from China, and what China imports from the United States, becomes an even more important “piece” on the trade war chessboard. While the US was able to increase the pressure on China by tariffing another $300 billion in imports, China couldn’t respond in kind because that well is already mostly dry.
Thus, the devaluation of the yuan.
China also announced on Aug. 5 that they are basically suspending all purchases of U.S. farm production at this time. China purchased nearly $20 billion worth of American farm production in 2017, but has been throttled back to just over a billion in the first half of 2019. Based on the recent escalation in the trade war, that number will likely drop to zero in the second half of this year.
For traders, recent moves by the United States and China have certainly opened up a variety of new opportunities in the marketplace. Crude oil fell precipitously in the wake of Trump’s announcement regarding additional tariffs, dropping roughly 8% in less than a week. It should also come as no great surprise that agricultural commodities such as corn, soybeans and wheat are also trending lower.
In the foreign currency market, there’s been a lot of frenzied activity beyond just the devaluation of the yuan.
Roughly 8% of Australia’s annual GDP relies on Chinese purchases of Australian goods and services (mainly commodities). Due to these strong ties to the Chinese economy, the Australian dollar tends to share a relatively strong historical correlation with the Chinese yuan. And because the Chinese yuan isn’t easily accessible outside of China, some currency traders use the Australian dollar as a proxy.
Traders interested in learning more about the Australian Dollar, and potential pairs trades involving China-related financial products may want to review a recent installment of Closing the Gap: Futures Edition on the tastytrade financial network for more information. This particular episode outlines a pairs sample trade that utilizes the primary China ETF (FXI) as well as Australian dollar futures (/6A).More information on a wide range of tradable products and associated strategies is also available in the tastytrade LEARN CENTER.
Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to support@luckboxmagazine.com.
