Fundamental Forecast for the Yuan:Neutral

The USD/CNH set a higher low this week than the previous two weeks. The onshore Yuan, on the other hand, remained within a tight range for the third consecutive week. The two Dollar/Yuan pairs have been driven by different themes of recent: The Dollars strength weighted more on the offshore pair, while the onshore Yuan eyed more on moves from Chinas Central Bank. As the spread between the offshore Yuan and the PBOCs guided level narrows, this segregation could be eased over the following periods.

In terms of the offshore pair, the odds and timing of the U.S. Federal Reserve raising rates, as well as expectations on U.S. President Trumps tax cuts plan have been primary drivers to its trend and this likely continue to be the case. Fed Chair Yellens two-day testimony added mixed moves to Dollar pairs, including the USD/CNH. Next week, the U.S. economic calendar is dotted with housing and labor gauges, which are expected to add volatility to Dollar pairs.

On Chinas side, event risks would be low amid a light calendar; the major focus will be on Chinas Central Bank. The top policymaker has been reducing excessive Yuan liquidity since the Lunar New Year, targeting at bring monetary policy back to normal from slightly loose. However, this tweaked credit strategy did not bring much impact to the offshore Yuan over the past few weeks. Normally, a tighter policy would send the countys currency higher. Lets take a look first at why it did not work, as this may help us find out when it will.

The PBOC has been using open market operations as well as lending facilities to withdraw excessive cash from the financial market. Suspending and resuming liquidity injections through reverse repos and increasing target lending rates aim to delicately adjust liquidity to desirable levels. These moves are different from a hike in reserve requirement ratio which will have a long-lasting effect to the economy and in turn a greater impact to the Yuan.

More importantly, the offshore Yuan was already stronger than the guided level set by the PBOC. Since early January, the offshore Yuan has been both above the onshore Yuan and the Yuan fix (except during the Lunar New Year) until this week. This means that from the regulator point of view, the offshore Yuan might have been already overvalued.

However, as the spread between the offshore Yuan and the Yuan fix narrows, this could be changed. The PBOC has strengthened the Yuan fix for four consecutive days this past week. On Wednesday, the offshore Yuan dipped below the PBOCs guided level, the first time in two weeks. As of 1:40pm EST, the reversed spread has expanded to 50 pips. Traders will want to keep a close eye on the PBOCs guidance next week. If the policymaker continues to recognize levels of the offshore Yuan, the link between the onshore and offshore markets could strengthen again, and onshore policies may weigh more on the offshore pair.

Read this article:

Offshore Yuan Exposed to Onshore Risks as Spread Narrows - DailyFX