While the State of the Union address is rarely if ever an FX market-moving event, in light of recent comments by both President Trump and Treasury Secretary Mnuchin and with global trade suddenly on everyone's radar, if there is one market-sensitive topic that may get a kick start on January 31, it is US trade relations with China.

For readers who want to get a head start on the topic, Deutsche Bank's Alan Ruskin suggests reading the United States Trade Representative 161 page primer on the "Report to Congress on China's WTO compliance", (it can be found here). According to the DB FX strategist, "the report is extraordinary, and at a minimum page 2 to 25 of the report deserve a read to understand the extent to which the US believes they have valid grievances on an array of perceived China WTO transgressions."

In fact, he claims that this is a story that extends way beyond the recent headlines discussed in the press on steel, aluminium and intellectual property. The topic headlines to the summary, highlight the breadth of issues and a panoply of perceived legal violations including as they relate to:

China's Industrial policies;

technology transfer;

Investment restrictions;

subsidies;

excess capacity;

reexport restraints;

Import bans on remanufactured products;

import ban of recoverable products;

government procurement;

Intellectual property rights, trade secrets;

bad faith trademark registration;

pharmaceuticals;

online infringements;

counterfeit goods;

electronic payment services;

theatrical films; banking services;

insurance services;

securities and asset management services;

telecom services;

internet services;

audio visual services;

legal services;

beef, pork and poultry;

biotechnology;

agricultural support;

publication of trade law transparency;

administrative licensing;

and competition policy

And below, DB notes, is the "it will not be business as usual" conclusion from the USTR report:

"For more than 15 years, the United States has relied on cooperative highlevel dialogues to effect meaningful and fundamental changes in China’s stateled, mercantilist trade regime. These efforts have largely failed. Accordingly, the United States intends to focus its efforts on enforcement going forward. These efforts will include not only use of the WTO’s dispute settlement mechanism to hold China strictly accountable for adherence to its WTO obligations, but also other needed mechanisms, including mechanisms available under U.S. trade laws. The United States is determined to use every tool available to address harmful Chinese policies and practices, regardless of whether they are directly disciplined by WTO rules or the additional commitments that China made in its Protocol of Accession to the WTO. The United States will not accept any Chinese policies or practices that are unfair, discriminatory or mercantilist and harm U.S. manufacturers, farmers, services suppliers, innovators, workers or consumers. Americans have waited long enough. The time has come for China to stop its market-distorting policies and practices and finally become a responsible member of the WTO."

What does this mean for traders? Well, those who have been begging for FX vol (a precursor to all other volatility) will soon get their wish, because according to Ruskin, the likely upcoming US attack on China trade policies is apt to have broader bipartsian support than many other US trade measures.

Whether or not it will transition into a full-blown trade war remains to be seen, but in the immediate future a trade dispute with China has the capacity to impact markets through a variety of channels that includes:

i) choking global supply channels;

ii) inflating prices;

iii) influencing China's global asset allocation, that could impact all of US bonds, equities and the USD negatively.



Of course, China knows all of this and explains the recent trial balloons by China and Bloomberg that Beijing may slow down, or even reverse, its purchases of US Treasurys.

What could stop a collapse in trade relations? Why, a market crash of course: as Deutsche predicts, a sharp uptick in US equity volatility is one of the few factors that could put a brake on this US push forward to change trade relations with China, and the above fits with a world of greater equity vol.

Focusing only on the currency side, the USTR report's recommendations have the capacity to go way beyond calling China a currency manipulator. While in the initial instance, US attacking China's WTO transgressions could be seen as encouraging of more CNY appreciation, in the longer-term this could prove both CNY negative and negative for most Asia EM FX. Short CNY/JPY would work under a risk-off environment, and has the added bonus that it offers some protection against a China official exodus from US bonds (if the politics turns unexpectedly ugly), with the yen one alternative reserve asset destination.