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Yuan at Risk amid Liquidity, Econ Data and Commodity Volatility

Yuan at Risk amid Liquidity, Econ Data and Commodity Volatility

Renee Mu, Currency Analyst


Fundamental Forecast for the Yuan: Bearish

Both the onshore (CNY) and offshore Yuan (CNH) closed at a slightly higher levels against the US Dollar on Friday, following the biggest move in Yuan’s daily reference rate set by China’s Central Bank in over 10 years. The daily fixing was lifted by 365 pips to 6.4589 on Friday. Next week, a couple of major themes are likely to add volatility to Yuan rates: Both the Federal Reserve and the Bank of Japan announced that they will hold their monetary policy this past week, which cleared barriers for China’s Central Bank to make its own moves. The daily reference will not be released on May 2 as the onshore market will be closed for a national holiday, and in-turn, market factors could weigh more heavily on Yuan rates. Key Chinese economic data that normally drives Yuan moves will be released next week, such as the state-issued Manufacturing PMI and Caixin PMI gauges. Also, sharply increased speculation in the Chinese commodity markets have added risks to the economy, as well as to its currency.

The upcoming period will be an opportune time for China’s Central Bank to cut the reserve requirement ratio (RRR). The Federal Reserve left interest rates unchanged on Wednesday, which eased the capital outflow pressure on China and devaluation pressure on its currency. Yet, such a favorable environment for China is not unlimited, as Fed leaves the door open to a rate hike in June. This means if PBOC waits to cut RRR after the June meeting, it may face even heavier risks of uncertainty. Also, the liquidity shortage has not yet been fully resolved even though the PBOC continued to add liquidity through the Medium-term Lending Facility this past week. The growth of major interest rates shows slowdown, but they are still in up-trends. And the short-term rates are higher than long-term rates. For instance, the key threshold, SHIBOR O/N, remains in an upward trend above 2% and it is higher than SHIBOR 1W, 2W and 1M. With the unmet liquidity demand and favorable global environment, the probability of a RRR cut remains high. In turn, the outlook for Yuan remains bearish over the following periods.

In addition to the main theme of an expected RRR cut, high volatility driven by key economic reports is likely to be seen next week. On China’s side, April manufacturing PMI figures will be released on Saturday with the Caixin numbers on Monday and Wednesday. The March data showed some improvement in the manufacturing sectors from February, which is not uncommon. Factories reopen after the 7-day Lunar New Year holiday in February and normally have a higher production levels in March. Thus, the April data will help us to figure out whether the fundamentals of manufacturing firms have really improved, either led by their own reforms or government’s supports. So far, Chinese manufacturing firms are still facing a series of challenging issues. For example, Dongbei Special Steel, a major steel producer, defaulted on its debt. Another steel producer, Xining Special Steels is likely to default as well. There is also the low growth issue: China’s largest oil producer, PetroChina, reported over a 50% cut in profits in 2015. In the first quarter, profits of state-owned enterprises dropped by -13.8%. This means that it is likely to take a longer time for Chinese manufacturing sectors to fully recover. However, we may still see some improvements in the short-term. A better-than-expected PMI ratio could drive the Yuan higher.

Another theme that has been attracting a lot of investors and regulators’ attention of recent are the moves at the Chinese commodity markets. Commodity trading is relatively new to Chinese retail investors. However, over the past few weeks, a large amount of speculators have flowed into the market and this has sent commodity prices to new highs. This might be a temporary benefit for the Chinese Yuan, as capitals flow into this market and remains in China rather than flowing out of the country. However, such fast increases in prices that are inconsistent with fundamentals may become ‘price bubbles.’ And when a bubble breaks, the consequences could be catastrophic, which was seen in the Chinese equity market less than a year ago, and in US real estate sector in 2008. Therefore, Chinese regulators have introduced tightened rules on commodity trading this past Wednesday in the effort of curbing excess speculation. Following the introduction of the new rules, the upward trend for major commodities had temporarily stopped. Yet, two days after those policies were rolled out commodities began to regain its earlier momentum. Cooking coal and iron ore hit the increased limit-up levels under the new rule while other commodities saw significant increase as well. With this aggressive price action, traders will want to keep a close eye on the commodity market in case of any major change in capital flows..

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.