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Currency traders poised to pounce as US trade war keeps the Chinese yuan weaker

For participants in the currency market, trade wars offer plenty of moneymaking opportunities. The decision of the Trump administration to raise the stakes in the China-US trade war is one such opportunity.

Given reignited China-US trade tensions, the foreign exchange market may logically expect renewed and sustained yuan weakness, and that Beijing might well be inclined to tolerate some decline in the renminbi’s value to partially counter the effect of Washington’s tariff hikes on Chinese exporters.

“With tariffs rising to 25 per cent for now but ongoing discussions likely to continue”, HSBC expects that “heightened [yuan] volatility should occur”. HSBC has revised its second- and third-quarter expectations for the US-dollar-to-yuan exchange rate to 6.95 in both cases, as opposed to prior forecasts of 6.70 and 6.75 respectively. However, the firm sees China-US trade tensions moderating and has kept its year-end forecast at 6.75.

By the same logic, if markets sense that the US-imposed tariff hikes might be reversed, the yuan might react positively.

But currency traders should not just be focusing on the daily moves in the spot price when seeking to gauge whether the market as a whole has a real conviction that sustained yuan weakening is a real possibility.

The yuan may not necessarily trade against the US dollar in a band that has parameters pre-agreed on by Beijing and Washington which both sides would defend, but it is probably fair to say that for the dollar-yuan exchange rate, the 7.00 level has become totemic.

Simon Derrick, chief currency strategist at BNY Mellon, noted last week that in recent years, for the dollar-yuan currency pair, the non-deliverable forward market had been “getting trend shifts in the spot market roughly right”. Non-deliverable forward contracts, or NDFs, differ from standard forward contracts in that, instead of buying or selling the currency at the agreed price at the specified date, both sides settle the trade’s loss or profit instead.

At the tail end of 2018 when there was a lot of talk of the yuan weakening beyond 7.00 to the US dollar, there was a noticeable degree of equanimity in the NDF market, Derrick wrote, that suggested traders felt China’s central bank would ensure that any weakening of the renminbi beyond that level would “likely prove muted”.

Through 2019, the difference – or spread – between the spot dollar-yuan rate and “one-month, three-month and six-month NDF outrights has been pretty well zero”, Derrick added. But since the start of May, “these spreads have begun to widen out rapidly (albeit to still modest levels when compared to most points in the past three years)”.

This suggests that the currency market envisages that renewed yuan weakness will be sustained rather than fleeting.

But the dollar-yuan rate will not be the currency market’s only focus. Other currencies will also get caught in the slipstream of heightened China-US trade tensions. The yuan’s slide against the Japanese yen in recent days is just one example.

Tokyo will not be overly impressed by a show of yen strength, eroding the export competitiveness of Japanese manufacturers at a time when Japan has its own economic challenges and with Japan-US trade relations a little sticky. But in truth there is not much that Japanese policymakers can do about it.

The bottom line is quite simple. At times of international tension, the foreign exchange market tends to seek out what it perceives as safe havens, such as the yen.

Equally, in the currency space, the yuan will not be the only fall guy following the reigniting of China-US trade tensions.

Having experienced an economic contraction in the first quarter of 2019, the exposure of South Korea’s economy to China leaves the Korean won vulnerable. Purported sales of US dollars by the Bank of Korea on Friday, to stem a slide in the value of the won versus the greenback not seen since January 2017, is not likely to deter markets if China-US trade tensions continue to ratchet up.

A material setback has occurred in China-US negotiations aimed at resolving the current trade war. The currency market will respond accordingly.
Source: South China Morning Post

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