Yesterday, we suggested that the most important question wasn’t whether the Fed would put a dovish spin on the June hike, but rather whether China would follow up with their own hike hours later.

The risk, you’re reminded, is that if China doesn’t effectively “call” the Fed (like they did in March), then rate differentials compress, sparking a weaker yuan and capital flight.

Seen in that light, the move to add a counter-cyclical adjustment factor to the yuan fix last month (and the attendant short squeeze it triggered), might have been an effort to get out ahead of the Fed.

The risk on the other side (i.e. the risk of hiking OMO and MLF rates) is that you exacerbate the shadow unwind with God only knows what consequences.

Overnight, China did indeed refrain from hiking and the rationale seems to be precisely what we discussed on Wednesday: rate differentials and the stronger yuan.

“The People’s Bank of China kept rates unchanged in its open- market operations on Thursday,” Bloomberg writes, adding that “the yield gap between U.S. and Chinese 10-year sovereign bonds widened to a two-year high of 150 basis points on June 6, compared with less than 90 on March 15.”

That said, the PBoC probably shouldn’t get too comfortable because the yuan is falling fast both onshore and offshore where USDCNH has recovered almost all of its post-short squeeze losses:

More color below…

Via Bloomberg

China’s central bank refrained from following the Federal Reserve in raising money-market loan costs amid talk that policy makers consider the existing interest-rate gap to be enough to dissuade outflows and the yuan to be stable.

• First Capital Securities (Shen Bifan, fixed-income analyst)
  • Considering that the interest-rate gap is already quite large, keeping costs steady shouldn’t lead to capital outflows
  • There’s less pressure on the PBOC to use rates to lend support to the currency because the introduction of a counter- cyclical factor to the yuan’s fixing has led to a strengthening exchange rate
  • NOTE: The onshore yuan has surged 0.9% against the dollar — the most in emerging Asia — since May 26, when the government said it was considering the fixing tweak
  • Also, as the economy is flashing signs of cooling and June is a month which usually faces liquidity stress, the PBOC may not want to bring additional pressure to the market
  • Even if the PBOC tightens, it probably won’t have any material impact on markets as expectations of credit and supervisory tightening are already priced in

• Citic Securities (Ming Ming, head of fixed-income research)
  • The PBOC raised rates in March because it wanted to curb financial leverage, and now it doesn’t have that intention as previous measures have already been quite effective
  • Optimistic about bonds as market conditions will improve in June and in the third quarter

• ABCI Securities (Yao Shaohua, economist in Hong Kong)
  • The PBOC remains on hold so far as the yuan stays relatively strong against the dollar and outflows ease
  • Capital control measures also help put an extra buffer; as long as the economy and the currency keep stable, the Fed is unlikely to cast a big influence over the PBOC

• AXA Investment Managers Asia (Aidan Yao, senior economist)
  • Don’t have a very strong internal or external justification for the PBOC to follow the Fed now
  • The yuan depreciation pressure is no longer as intense as in the past and, if anything, the currency has been appreciating in the past two weeks