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7 per USD mark looks safe now, but pressure lingers

The biggest news for the Chinese yuan in the past week is that the People’s Bank of China (PBOC) said it had reintroduced the counter-cyclical factor to the yuan’s fixing mechanism, as the latest move to curb the sharp depreciation since June this year.

“As the foreign exchange market has seen pro-cyclical behaviours with a stronger US dollar and trade frictions, we have adjusted the counter-cyclical factor in setting yuan’s daily fixing to ease the pro-cyclical sentiment,” according to a statement released by the China Foreign Exchange Trade System (CFETS) under the PBOC last Friday.

The yuan jumped after the announcement, with the offshore yuan surging nearly 900 pips or 1.3 per cent to close at 6.8055 per USD on Friday, making it 0.4 per cent higher than a week earlier.

The counter-cyclical factor was first introduced in May 2017 in what regulators said was an effort to better reflect supply and demand, lessen possible “herd behaviours” and guide the foreign exchange market to focus more on macroeconomic fundamentals. The move curbed the yuan’s depreciation and was followed by about 6.7 per cent strengthening until it’s removed in January 2018.

The move comes as part of a series of measures recently to support the currency including raising forward foreign exchange risk reserve requirement ratio to 20 per cent from previous zero and banning banks from using interbank accounts to deposit or lend yuan offshore through free trade zone schemes to tighten offshore yuan liquidity and making it more expensive to short the yuan.

The measures were prompted by continued depreciation of the yuan, with the offshore yuan hitting 6.9580/USD, the weakest level since January 2017, fuelling a higher expectations that the currency will break the psychologically critical 7 mark.

“The reuse of the counter-cyclical factor is to help stabilise the expectation in the market”, said Zhao Qingming, chief economist at China Financial Futures Exchange.

Analysts say the move helps to maintain yuan’s stability when policymakers shift to easier credit policies and fiscal stimulus to support the cooling economy.

“Given the clear message from the authority’s measure, the yuan is unlikely to break 7 mark this year,” said Shen Jianguang, chief economist at JD Finance.

While 7 mark looks safe now, pessimism lingers, as a trade war between the world’s two biggest economies is primed to escalate after officials failed to make progress in two days of negotiations in Washington last week.

The US dollar is expected to stay relatively strong in the short term as the Federal Reserve’s latest remarks made an interest rate hike at the FOMC meeting on September 26 is more or less a done deal, with CME Fed Funds Futures pricing in a 25-bps rate hike with a 98.4 per cent probability.

The spreads between 2-year, 5-year and 10-year Chinese government bond yields and their US equivalents continued to narrow to 51 bp, 76 bp and 79 bp respectively. The convergence will continue to pressure the yuan, said Shen.

Depreciation pressure for the mid-term is reduced. Offshore one-year non-deliverable forwards contracts (NDFs), considered the best available proxy for forward-looking market expectations of the yuan’s value, traded at  1 percent weaker than the fixing.

The yuan is expected to maintain two-way fluctuation around 6.8 per USD in the short time, said Zhu Chaoping, strategist at JP Morgan Asset Management.

The strengthening of the USD index, the key factor for the yuan’s future movement, is only temporary and the US dollar is expected to see continued depreciation in the next 2-3 years, easing depreciation pressure on the yuan, said Zhu.

The USD index dropped 0.48 per cent to 95.1737 on Friday, bringing its weekly loss to 0.99 per cent, after the chairman of the Federal Reserve said that there was no sign that the US inflation will increase above 2 per cent target.

In the medium to long term, the US dollar face increasing uncertainties as the support from the tax reform subdues, said Shen Jianguang.

The probability of an additional rate hike before the end of the year at the Fed’s December 19 meeting is only at 65.6 per cent which is unchanged from last month, and an underestimation of the FOMC’s projections.

Earlier this month, Goldman Sachs said it expected the greenback to weaken by 7 per cent over the next 12 months and urged investors to factor that outlook into their equity positions.

DXY has gained 4.5 per cent in the year to date, thanks to supportive US economic data, continued tightening by the Federal Reserve policy that put U.S. interest rates further above their peers, waning global growth, and escalating trade tensions that have weighed on the dollar’s rivals.

The  dollar’s fundamental advantages could be due to diminish and the growth differential could narrow: economists’ global leading current activity indicator measured 4.1 per cent in August compared to 3.7 per cent in June, suggesting a nascent improvement in global economic growth,Goldman Sachs said.

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