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Yuan Volatility Eye On Equity Market Ahead of Holiday Season

Yuan Volatility Eye On Equity Market Ahead of Holiday Season

Renee Mu, Currency Analyst

Fundamental Forecast for the Yuan: Neutral

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The yuan offshore rate (CNH) gained slightly against the dollar this week as the Chinese central bank continued to slow the pace on devaluation in the yuan. PBOC set the reference rate for the currency (CNY) near 6.5580 this week and tightened yuan liquidity at yuan’s largest offshore market, Hong Kong, in order to stabilize the currency. It shows that yuan’s offshore rate is still very much controlled by onshore factors. Next week, the following three key themes will have mixed forces on the yuan: the Chinese stock market, the coming holiday season, and the bilateral floating regime.

The first factor is the Chinese stock market. As we discussed in previous weeks, when there is a fire at the equity market, it is less likely for the central bank to react by aggressively devaluing the yuan. Next week the equity market is likely to continue to see high volatility, though not necessarily via sharp drops. The main characteristic of Chinese equity market is that over 80% of transactions in the Chinese stock market are made by retail investors. A large number of them do not have enough professional knowledge about stocks to make independent decisions. They usually rely on news or rumors as well rather than on solid information or analysis. So when they see stock prices started to drop or others sell, they began to sell their holdings as well out of fear. When price falls too low for a sale to make financial sense, many stop selling temporarily.

Once the market pulls back above the breakeven point, they will start to sell their holdings again. This can explain a lot of the high volatility we saw this week: when the prices recovered a bit, a group of people felt (not necessarily calculated) they can accept the price and sell their holdings, and then the prices fell once again. And the cycle repeated. Thus, next week investors will want to continue to keep an eye on the equity market, especially on the volatility.

The second theme is the coming holiday season, which adds more positive sentiment into the Chinese economy as well as the currency. Chinese Lunar New Year holiday, from February 7 to February 13, is the most important Chinese holiday of the year. 1-2 weeks before the holiday is the biggest shopping season (Chinese version of Christmas) and short-term migration season. The seasonal spending has been significantly increasing the demand in the yuan. During the past week, Chinese central bank has injected 1.6 trillion yuan into the market to meet the increasing demand. The liquidity shortage issue is common during the Lunar New Year holiday. For example, in 2015, the central bank added 100 billion yuan to the market within one week before the holiday. In addition, the holiday mood may help Chinese to ease the tensions from slow economic growth, early losses at stock market and foreign exchange market. As we mentioned above, a large amount of retail investors are news-driven and market-sentiment-driven. Thus, positive sentiment is helpful to stabilize Chinese equity market and then give the yuan more flexibly to float.

The last driver to yuan is the bilateral floating regime itself. It leaves room for yuan to move lower. In the long-run, yuan still have depreciation pressure because of weaker Chinese fundamentals. The GDP report released this week shows that the growth rate in 2015 fell below 7% for the first time in 25 years. At the same time, China’s central bank has taken actions to curb speculations on yuan’s one-way movements after the USD/CNH broke its lowest level since 2009. In the past two weeks, the Chinese currency has stopped the earlier sharp losses and ended higher at each session end. This leaves room for yuan to move lower in the coming week if the equity market has no major crisis.

Here is a summary of the three themes to the yuan in next week: A) stock market volatile – yuan stable, B) holiday spending – greater demand in yuan – yuan higher; holiday sentiment – stock market stable – yuan lower, and C) bilateral floating regime – yuan lower. The first thing to look at and the center of all the relationships is still the equity market.

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