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Talking Points:

- The China-US trade war intensified today after another round of 'tit-for-tat' tariffs was announced by the two countries to the tune of $16 billion each way.

- We've previously suggested that Chinese policymakers are willing to use the Chinese Yuan as a weapon in the trade war, and recent FX reserves figures support that assertion.

- Expect the trade war to remain in the headlines throughout August, spilling into the fall ahead of the US midterm elections.

See the DailyFX Trade War Infographic for a visual history of the events that led to the US-China trade war.

The PBOC Doesn't Mind a Weakening Yuan

The latest round of FX reserves data for the People's Bank of China is out, and it would appear that a prominent theory about how Chinese policymakers are addressing the simmering trade war with the United States has gained credibility.

Two weeks ago, we asserted that the rampant appreciation by USD/CNH since the end of March was a sign that Chinese policymakers were willing to allow the Chinese Yuan to depreciate in order to blunt the impact of the Trump tariffs. Given the scale of the depreciation, we've argued that it is possible - even likely - that the impact of the tariffs would be negated simply by shifts in the USD/CNH exchange rate.

Earlier on Wednesday, the July batch of FX reserves figures for the PBOC showed a surprising lack of change. Typically, during times of stress on Chinese financial markets, the PBOC steps in to defend the Yuan from speculative forces from abroad. This translates into the PBOC burning through its FX reserve figures to 'defend' the currency.

But not this time around. During July, when USD/CNH appreciated by approximately +3%, Chinese FX reserves increased by $5.82 billion versus an expected drop of $12.1 billlion. This doesn't necessarily mean that the PBOC was actively adding to its reserves (selling Yuan and purchasing foreign currency); but it does suggest, at a minimum, that the PBOC wasn't standing in the way while USD/CNH was appreciating consistently throughout the month.

USD/CNH Daily Price Chart: Hourly Timeframe (July to August 2018) (Chart 1)

USD/CNH Appreciation Not a Problem for China, Reserves Figures Show

The US-China Trade War Will Grind On

Of course, the question is, why does this matter for traders? Speaking tactically, the fact that the PBOC was willing to stand by idly while the Chinese Yuan lost value serves as a significant piece of evidence confirming the prior belief that Chinese policymakers would use the exchange rate to offset the impact of the Trump tariffs.

To this end, it also means that the PBOC has a lot of dry powder available should it need to actively engage in depreciation efforts to further diminish the potential damage of a prolonged US-China trade war. Headlines like today, where China and the US are exchanging 'tit-for-tat' tariffs, will remain commonplace.

Furthermore, it seems almost certain that the US-China trade war will continue on through the summer and into the fall, which would add the dimension of the US midterm elections into the political calculus - which would promise a return of volatility over the coming weeks.

Read more: US-China Trade War Enters New Phase amid Yuan Depreciation

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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist

To contact Christopher, email him at cvecchio@dailyfx.com.

Follow him in the DailyFX Real Time News feed and Twitter at @CVecchioFX.