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Analysts at TD Securities explained that the trade war theme has shifted back onto the market’s radar screen following the implementation of tariffs on China and the rise in rhetoric that suggests further actions may be forthcoming.

Key Quotes:

“US assets have thus far received a pass, reflecting a mix of perceived insulation and fiscal support. This has probably raised Trump’s risk tolerance in regards to his negotiating strategy, which increases room for a miscalculation.”

“We doubt that US assets will maintain their immunity if the trade wars escalate from here. The market has upgraded its views on US growth and downgraded the rest of the majors, helping pave the way for the recent USD wave. Still, the flattening of the US yield curve (2s10s) argues that the market thinks that either 1) the fiscal impact is fleeting or 2) the Fed endgame is near, leaving us selling USD rallies into the fall. Our year-end forecasts show that most European currencies should outperform forward pricing, offsetting the negative carry.”

“We continue to highlight that protectionism is a process rather than an event, leading to different impacts over time. In the immediate future, an escalation in the trade wars would reinforce the strength in the USD against the high-beta complex, especially the currencies of small, open G10 countries. Improving growth could insulate the EUR and we still think a pickup in cross-asset stress favors the JPY against the dollar bloc.”

“Over time (quarters not days) a whittling away of the global supply chain and the international trade order would reinforce a weaker medium-term backdrop in the USD next year, especially against other reserve currencies like the EUR and JPY. Indeed, as the twin deficit is set to hit nearly 9% of GDP by the end of the decade, the US will require investment from the rest of the world to maintain support for the buck.”

“Against the global trade theme, we think AUD/JPY remains the best proxy trade. We prefer options to cash and like the optics of buying a 2-month 81.50 vs. 78.50 AUDJPY put spread that costs around 54 JPY pips.”