USDCNH The final frontier in the USChina trade war

Modern wars are fought with precision tactics and tools like drones, targeted strikes, and heavy reconnaissance to identify where the enemy is weakest. But, as any military historian will tell you, wars used to involve far more blunt tools, like catapults and trebuchets, to inflict maximum damage on the enemy; friendly fire be damned.

With the growing US-China trade spat increasingly dominating the headlines (see “AUD/JPY: How FX traders will know that the “trade war” has started in earnest” and “USD: How does the Escalating Trade War Impact the Greenback?” for more on the topic), the markets have belatedly turned their focus to one of the original, blunt weapons of trade warfare: currency devaluation.

Over the last two weeks, the US dollar has rallied sharply against the Chinese yuan (here represented by CNH, the more liberally-traded “offshore” version of China’s currency). Framed another way, as certain US policymakers will no doubt play up, the CNH is now trading at its lowest level against the greenback of the year.

Indeed, the pair has now fallen for eleven consecutive sessions and is in the midst of its largest single-week rally since China’s devaluation of the yuan back in Q3 2015! From a trading perspective, today’s big rally may have bulls looking to target the 61.8% (6.7000) or 78.6% (6.8260) Fibonacci retracements next, though we hesitate to put too much stock into technical analysis on a currency that is not yet completely free-floating:

Source: TradingView, FOREX.com

So is this just the Chinese government’s attempt to make its exports more attractive and offset the looming round of US tariffs? While it’s tempting to believe so, there are multiple reasons why the notoriously measured and intentional Xi Regime would be hesitant to use the blunt “catapult” of currency devaluation unless it was absolutely necessary.

The first factor to note is that it’s not just the yuan falling against the greenback; indeed, every major and emerging currency is trading lower against the US dollar over the last week and month, so it would be a surprise in USD/CNH hadn’t rallied to some extent of late.

Furthermore, there is a clear monetary policy divergence between the US and China: while the Federal Reserve continues to hike interest rates at a consistent pace and gradually reduce its balance sheet, the People’s Bank of China has recently cut reserve requirements. Finally, intentionally weakening the yuan would risk the vicious cycle of capital outflows (and therefore further currency weakness) as wealthy Chinese citizens move their assets to more stable markets.

 For these reasons, it’s not yet clear that China has brought (or will bring) out the proverbial “catapault” of currency devaluation as the next step its simmering trade war with the US. Instead, the Red Dragon may make it more difficult for US companies to invest in China and/or become more tepid in its support for US policies regarding other countries such as North Korea and Iran. Needless to say, traders will stay looped in to comments from policymakers on both sides of the Pacific in the coming weeks in any event!