Yuan is Heading Lower – How Fast Depends on Next Move in StocksYuan is Heading Lower – How Fast Depends on Next Move in Stocks

Fundamental Forecast for the Yuan: Bearish

The yuan rates have broken a lot of records this week. The offshore yuan rate (CNH) broke to its lowest level since 2009 and the spread between the offshore and onshore (CNY) rates hit its widest level in more than four years. This is partly driven by PBOC which guided the yuan lower intentionally and set the reference rate to the weakest level since April 2011. On Friday, the central bank suspended its aggressive pace on lowering yuan after the Chinese stock market halted in trading in two days out of three. Combined with a bearish outlook for stocks and capital outflows, however, our outlook on the yuan remains negative through the coming week.

The stock market will still be the key issue, which could drive additional capital to flow out of China. The Chinese media itself shows a lot of concerns on how far the equity market can fall. If the New Yuan Loans data to be released next week comes out worse than expected, it can trigger a new round of panic in the stock market. In addition to the real fundamental issues, a more severe crisis in the market is investors’ diminishing confidence. They are like a group of rabbits, standing and shaking in the middle of the night. A piece of leaf falling on the floor may scare them enough to cause a big escape, which for the equity market, it will be another day of plunge. Such a scenario will make it hard for the central bank to react in a meaningful and productive way.

On one hand, market fears will drive more international capital to flow out of China to safe-haven assets, which will send yuan lower. On the other hand, in order to control the volatility at the equity market, the regulator has to stable the currency or China will have two fires in the house at the same time. Through all of this it should be noted that the Chinese government promised to let markets play a greater role in setting the CNY reference rate as a condition to join the IMF’s SDR basket. This will complicate any attempts to act aggressively.

There are two reasons that the Chinese central bank is sharply devaluing yuan recently and is likely to continue after the equity market crisis is over. First, PBOC is practicing the strategic change announced earlier, to de-peg the yuan against the dollar and refer to a broader basket of currencies. The US dollar strengthened against most currencies after the Fed raised interest rates in last December and is expected to continue to gain as the Fed raises rates. In order to maintain yuan’s relative stability to the basket of currencies, it has to devalue against the dollar as well. Second, the regulator has an agenda to let the yuan reach its natural level before yuan’s addition to SDR officially takes effect on October 1, 2016. Thus, if we see the stock market is getting better, the central bank may resume the pace on yuan’s devaluation.

Overall, yuan’s outlook is bearish in the coming week. The only difference lies on the degree of devaluation. For traders, keep a closer eye on Chinese stock market, as that is the indicator to tell you how much yuan will drop.