Remember how, earlier this month, the yuan staged a rally so large that it qualified as a 6+ standard deviation event going all the way back to the end of the dollar peg?
That “black swan” event came courtesy of hopes that Donald Trump’s tweet about a phone call he had with Xi signaled the beginning of the end of a trade conflict that, if there’s no resolution when the two leaders meet at the G-20, could find the U.S. slapping tariffs on the entirety of Chinese imports.
The good vibes surrounding Trump’s infamous “very long, very good” tweet were turbocharged about 12 hours later when Bloomberg reported that the President had instructed aides to draft a trade truce which, presumably, would be presented to Xi later this month.
That confluence of upbeat news sparked the best day for Hong Kong and South Korean shares in seven years on November 2, just as the yuan staged the above-mentioned two-day black swan rally.
Fast forward ten days and the yuan has retraced virtually the entirety of that move to trade back through 6.96 amid the dollar’s push to 18-month highs.
Overnight, traders observed “at least one” big Chinese bank buying up USDCNH forwards, driving 1M and 1Y forward points up sharply.
There’s obviously an ongoing debate about how much more yuan weakness the PBoC is willing to stomach. Back in August, Beijing implemented a variety of measures to stem the yuan’s depreciation including the reintroduction of the counter-cyclical adjustment factor, a mechanism the PBoC rolled out in the summer of 2017 in an (ultimately successful) effort to engineer a short squeeze. That effort amounted to a rolling back of whatever liberalization was ostensibly embedded in the “new” FX regime that went into effect in August 2015. Effectively, they went back to manipulating the fix to control the spot but they also retained the discretion to intervene in the spot market (and they subsequently did), which effectively meant that in June and July of 2017, they were manipulating the fix and the spot and because the latter informs the former, the whole thing was fixed.
This year, the PBoC countenanced yuan depreciation from June through mid-August in the interest of using the currency to preemptively cushion the blow from Trump’s tariffs, but that’s a dangerous game beyond a certain threshold. What China doesn’t want is capital flight and the worry is that if the yuan pushes through the psychological 7-handle, it’s trouble.
China’s reserves have held up reasonably well over the course of the trade conflict. The latest read (from last week) showed Beijing’s war chest falling $33.9 billion to $3.053 trillion in October. That was lower than consensus ($3.059 trillion), but the pace is a far cry from the 2015 panic liquidation.
That doesn’t tell the whole story, of course. “Chinese reserves declined again in October by around $8bn after adjusting for currency valuations [and] while the pace is lower than the $23bn decline in September, it nonetheless suggests the PBOC has continued to intervene to smooth the depreciation in the CNY during October”, JPMorgan wrote on Friday, adding that “this decline in reserves occurred against a backdrop of further weakening in demand for Chinese bonds, which contrasts with the strong demand for both bonds and equities earlier in the year.”
The bank goes on to say that when adjusted for valuation effects, foreign investors appear to have trimmed their holdings of Chinese bonds for the first time since February of 2017. The implication, obviously, is that further yuan depreciation could exacerbate the situation.
It’s against that backdrop that the PBoC dropped language in their Q3 monetary policy report referencing a willingness to let “market supply and demand play a bigger role in deciding the exchange rate.”
The report was published on Friday and as Bloomberg notes, “the last time that phrase wasn’t used was in the fall of 2013.” In other words, for the first time in five years, the PBoC has omitted a commitment to allowing the market to “play a bigger role” in dictating where the yuan trades.
Clearly, that tips nervousness at the prospect of the currency breaching the 7-handle, which is consistent with a number of reports out over the past several months that suggest Beijing isn’t enamored with the notion of a further rapid depreciation.
So here we are, right back asking the same questions. China will likely need to resort to more monetary policy loosening going forward (e.g., more RRR cuts) if the U.S. moves ahead with more tariffs. But against a backdrop of a Fed that continues to hike, the policy divergence will put more downward pressure on the currency than would already be playing out given the deceleration in the economic data. Further, the rate differentials pillar for China is about to vanish entirely, with the spread over USTs having narrowed to just 29bps from over 80bps back in August.
That’s going to put more pressure on the yuan.
Ultimately, it seems like just a matter of time before the PBoC has to start selling reserves in earnest, unless they want to lean even more heavily on the CCAF to prevent further depreciation in the currency, whose date with 7 is becoming more difficult to postpone.