Financial leaders from the world's biggest economies found common ground on foreign exchange at a G-20 meeting on Saturday but failed to agree on trade, highlighting a global shift towards protectionism and setting a cautious tone for financial markets next week.
The Group of 20 powers meeting in the German spa town of Baden-Baden reiterated their long-standing warnings against competitive devaluations and disorderly foreign exchange (FX) markets, allaying fears that the new U.S. administration might have opened up a chink in the G-20's united front on global currency policy.
For markets, no change to G-20's stance on FX is welcome news. Having the world's financial and economic powers on the same page should help keep FX volatility low, a cornerstone for stable markets and rising asset prices more broadly.
But failure to agree on a commitment to keep global trade free and open will have negative consequences for financial markets, even if not dramatically so immediately.
"We may open on Monday with modest dollar weakness thanks to the failure to agree on trade, but it would have been a lot worse if there were major changes to the FX language on top of that," Tim Graf, managing director and head of macro strategy EMEA at State Street in London, said.
The dollar has slipped recently even though the Federal Reserve has raised U.S. interest rates, because longer-term bond U.S. yields have eased back. The dollar had its biggest weekly fall for two months last week.
Similarly, the upward momentum on Wall Street has fizzled out this month after a string of record highs, although European markets have continued to advance.
The pullback in longer-term yields despite a rise in shorter-term yields suggests investors think growth and inflation are not strong enough for the Fed to lift rates much further. This so-called "flattening" of the yield curve has weighed on stocks and the dollar.
An initial draft of the G-20 communique earlier this month had removed almost all of the boilerplate language on FX from previous communiques. It had removed warnings against "excess volatility" and "disorderly" FX moves as well as a pledge to refrain from "competitive devaluations."
They were all reinstated.
G-20 and G-7 communiques have long stated that stable and strong growth is best fostered by stable and calm currency markets.
The level of implied volatility in the the exchange rate over the next month fell last week to 6.075 percent, its lowest in two and a half years. One-month the implied volatility hit its lowest in over a year.
According to economists at JP Morgan, one of the main reasons for the depressed volatility across financial markets currently is because volatility in global growth is now the lowest in at least half a century.
Yet one sentence from last year's G-20 communique — the shortest and one of the most important — was omitted: "We will resist all forms of protectionism."
This points to a fundamental disagreement between the U.S. administration and the other 19 participants, particularly the Europeans, who flatly rejected any form of protectionism.
U.S. Treasury Secretary Steven Mnuchin said that the previous communique was not necessarily relevant to the current global economic climate from his point of view. He said he favored "free" trade but some agreements might need to be renegotiated.
Yet despite the isolationist and anti-globalization rhetoric from the U.S. administration, the implementation of protectionist policies and reality of trade wars are not immediate concerns, analysts say.
"This G20 is not really a big deal for the market, partly because the language on FX was maintained," Kenneth Broux, head of corporate research, FX and rates at Societe Generale, said.
"The disagreement on trade and protectionism is new, but the meeting at a later date between U.S. President Donald Trump and Chinese premier Li could be more pertinent to where trade negotiations are headed," Broux said.
Washington may have signed up to the language on FX, but it is widely believed that it wants a weaker exchange rate. It blames the persistent U.S. trade deficit, manufacturing decline and lack of competitiveness on the dollar's strength.
In January a closely-watched measure of the dollar's trade-weighted value hit a 14-year high. President Trump and some of his key advisors have accused Germany, Japan and China — three of America's biggest trading partners — of exploiting weak exchange rates to their competitive advantage.
Some analysts warn that the U.S. administration will soon bring exchange rates back to the top of its economic policy agenda.
"The U.S. administration's team is not yet in place, so its foreign exchange policy is not yet settled. The signs don't look good ... and we need to be wary of discussions inside the U.S. administration as well as remarks by its key people," Tsuyoshi Ueno, senior economist at NLI Research Institute, said.