Yuan Outlook Bearish on Prospect of Increased Liquidity
Fundamental Forecast for the Yuan:Bearish
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With a light calendar over the past week, the offshore Yuan rate (CNH) extended losses against the US Dollar for the third consecutive week, testing a key support level at the 38.2% retracement level of the January decline. The onshore Yuan rate (CNY) dropped 0.36% against its US counterparty this week, following weakened daily reference rates set by the PBOC. The Central Bank has been injecting a significant amount of liquidity over the past week but the liquidity shortage remains unresolved. This further increases the probability of the Central Bank cutting the reserve requirement ratio (RRR) in the near term. A window will be opened for such rate cut after US Fed releases its benchmark rate on April 27th.
Two things that happened this week have significantly increased the odds of China’s Central Bank cutting reserve requirement ratios (RRR). One is that the Central Bank has injected a large amount of cash through the Medium-term Lending Facility (MLF) and reverse repurchase agreements (repos). The other is that despite this added liquidity, the overnight Shanghai Interbank Offered Rate (SHIBOR O/N) still remains above 2.0%, which was a major threshold for previous rate cuts.
From the four instances of the PBOC’s RRR cuts in 2015 (excluding the RRR cut on target institutions) and one instance in 2016, we can see a pattern: Phase 1) the SHIBOR O/N rate approached or went above 2%. Phase 2) The Central Bank started to significantly increase temporary liquidity through tools such as MLF and repos. Phase 3) the SHIBOR O/N was still above 2% or was approaching 2% with an upward trend. Phase 4) The Central Bank adopted the permanent tool to increase liquidity, which is to cut the RRR. Phase 5) the SHIBOR O/N dropped below 2% or the upward trend reversed. We have seen Phase 1 to Phase 3 over the past two weeks and therefore, the probability to see Phase 4 is has increased.
Also, these past instances can give us some clues as to how much the rate might be cut if it happens. The SHIBOR O/N on one trading day before the rate cuts on 2/4/2015, 4/20/2015 and 2/29/2016 was 2.9544%, 2.2680% and 2.0480% respectively; the cut in RRR was 0.5%, 1.0% and 0.5% respectively. This indicates that the next rate cut may be at least 0.5% as the recent SHIBORs O/N were above the 2% threshold. The other two instances of RRR cut was 0.25% on 8/26/2015 and 0.5% on 10/24/2015. The overnight borrowing rate one trading day before was 1.8790% and 1.9090% respectively, both below 2%. This sample size is small but it may still reveal the logic behind the moves: The bank needs a certain amount of rate cuts (0.5%) to generate enough liquidity to allow SHIBOR to drop below 2% in order to reverse the upward trend.
Liquidity shortage is not only seen in the interbank market but also in Chinese equity markets of recent. The Shanghai Composite Index slid 2.3% this past Wednesday, which is the largest loss in seven weeks. Liquidity risk and credit risk are investors’ major concerns according to local financial institutions. This also gives the Central Bank incentive to provide more liquidity over the following periods. The probability of the Fed raising rates on the April 27th meeting remains very low at 0%. Therefore, the period after Fed’s meeting could be an opportune time for China’s Central Bank to make its moves. In turn, the Chinese Yuan may move to lower levels, and we initiate a bearish forecast for the currency.
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