Offshore Yuan Dips Below 7.3 as Yen Hits Record Low

The recent fluctuations in the foreign exchange markets have sent ripples across global economies, particularly as the USD/CNY offshore exchange rate broke through the 7.3 mark, representing a significant depreciation of the Chinese yuan. As of June 26, the yuan reached its lowest point since November of the previous year, showing a consistent weakening trend over the past two weeks. This situation unfolds amidst a backdrop of a resurgent strong dollar, exerting pressure on Asian currencies, with the Japanese yen also hitting a historic low against the dollar.

According to Wang Ju, the head of currency and rate strategy for Greater China at BNP Paribas, despite the central bank's ongoing efforts to maintain an exchange rate stability, the yuan faces challenges in the upcoming quarter. Factors contributing to this outlook include the approaching dividend season, trade tariff risks, and a significant interest rate differential between China and the United States. Wang emphasized that these elements could apply continuous pressure on the currency.

In the short term, market participants are closely monitoring the upcoming Personal Consumption Expenditures (PCE) report. The PCE index is greatly valued by the Federal Reserve as an inflation gauge; a decrease in PCE, if observed, could alleviate pressure on Asian currencies as a whole. The anticipation surrounding this data adds to the current sentiment in the market, as traders prepare for what it might reveal.

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Considering the yuan's performance from June 17 to June 21, it exhibited a continued weakening trend, depreciating slightly across these five days. The decline was marked particularly from June 20, with significant falls in the offshore market leading to adjustments in the onshore market, resulting in an overall depreciation rate of 0.09% for that week.

This week has seen the weakness of Asian currencies continue, with the yen remaining under strain and again setting fresh records low against the dollar. Traders are awaiting the PCE data announcement with considerable interest, as its results could redirect current market dynamics. Wang attributed the recent weakness in the yuan to several underlying reasons: recent high-frequency indicators suggest uneven improvements in industrial production during the first half of June, a continued weakness in credit demand from the real economy, and government-led growth being the primary contributor to economic momentum. Moreover, the central bank has been progressively raising the yuan's mid-point exchange rate, which recently surpassed 7.12. BNP Paribas anticipates that the central bank will adopt a measured approach towards yuan devaluation moving forward.

From the data perspective, economic indicators signal a weakening trend in May compared to April; the total social financing figures continued to "de-water" the economy, with a drop in M1 growth and subdued private sector funding. That said, social financing did improve slightly, rising by ¥2.06 trillion in May after a previous period of negative growth, primarily driven by government bond issuance, which accounted for 59.2% of May's total increase in financing. Demand from the real estate sector remains on a downward trajectory, while consumption of durable goods such as automobiles also remains anemic, although both exports and manufacturing investment show resilience.

Nonetheless, there have also been some positive developments for the yuan since May. The current account has finally turned positive, with exports emerging as a strong growth engine for China and productivity continuously improving. Foreign direct investment outflow pressures also eased slightly, attributed mainly to a minor decline in outbound direct investment compared to April. Year-on-year, however, outbound direct investment surged by 25%, while foreign direct investment increased by 9%. With China's goal of internationalizing the yuan, institutions expect the trend of increasing outbound investment to persist in the short term. Moreover, net inflows into portfolio investments have risen significantly, aided primarily by inflows related to bond asset swap transactions.

According to Wang, strong export inflows are instrumental in maintaining currency stability. However, investors must remain vigilant during the summer dividend season, which could generate capital outflow pressures. Concurrently, the high interest rate differential between the U.S. and China has led some exporters to prefer holding dollar assets rather than converting back to yuan.

Despite these challenges, institutions predict that the central bank's approach to stabilizing the currency market will not undergo substantial changes. "The People's Bank of China has shown some shifts in its operational approach to maintain market stability, such as moving a portion of its onshore forward interventions to the offshore market, but we believe the central bank will continue to engage in smoothing operations to manage the pace of depreciation," Wang commented.

In the short term, the PCE data is set to dominate market sentiment. Given the series of extreme events that have resulted in a stronger dollar, a potential reversal could significantly alter the current dynamics. David Scutt, a senior strategist with StoneX, provided insights on the situation, stating, "I don't believe that the upward momentum of the dollar index observed last Friday is sustainable. It was driven by a surprising strengthening in the S&P Global U.S. Composite PMI, which contradicts bearish signals from most other recent U.S. economic data. The PCE may indicate a notable slowing of inflation pressures compared to earlier this year, which could raise the risk of revised expectations for rate cuts by the Federal Reserve." With the French elections looming, uncertainties have also added to the bearish sentiment around the euro, further bolstering the dollar's position.

The anticipation surrounding Friday’s PCE report is palpable, as market analysts predict both overall and core PCE to dip to 2.6%, down from previous readings of 2.7% and 2.8%, respectively. Scutt noted that if the data exceeds expectations, it could solidify the Fed's rate cut expectations for the year, which would favor the dollar. Conversely, if inflation data falls short—such as a month-on-month rate below zero—there could be a softening of the dollar, potentially aiding a resurgence in gold prices. However, historical trends indicate that prior readings have often surpassed expectations.

The Federal Reserve has adjusted its rate-cut predictions for the year down to once, while the market anticipates as many as two cuts, with a 61% probability of a 25 basis points reduction in September, though significant divisions in projections remain evident. Notably, Fed official Michelle Bowman has suggested she does not foresee any rate cuts occurring this year.

Political uncertainties combined with concerns over the eurozone's economic outlook have exerted pressure on the euro/dollar exchange rate, which has fueled the dollar index's rise recently. Scutt elaborated, stating, "The upcoming French elections on June 30 have stirred fears of political instability and spending plan uncertainties, weighing down the euro. Moreover, the latest data release revealed a surprising downturn in German business confidence, raising alarms about the waning momentum of economic recovery."

In summary, short-term dynamics point towards a potential easing in the dollar's strength, which, if materialized, could positively impact both the yen and the yuan in the currency markets. Close monitoring of the USD/CNY exchange rate is crucial, as it has not only led recent buying interest in USD/JPY but has also exhibited strong correlations with it over the past month. Although the recent performance of the USD/CNY has been somewhat lackluster, its relationship with AUS/USD and NZD/USD has showcased significant negative correlation over most of this year. The global currency markets clearly remain in a state of watchfulness and uncertainty as they orbit around these critical indicators.