On August 5th, under the expectation of a Federal Reserve interest rate cut, the Chinese yuan continued to strengthen, with both onshore and offshore yuan exchange rates reaching a new high for the year at 7.1160 and 7.0838, respectively. On August 6th, the onshore and offshore yuan closed at 7.1506 and 7.1461.
Even market veterans would be astonished by the flickering numbers on the trading screens recently. On one hand, "Black Monday" led to a $6.4 trillion evaporation in global stock markets. On the other hand, stock markets in Japan and other places surged the next day. On August 6th, the Nikkei 225 index opened high and quickly rose by 8%, triggering an upward circuit breaker mechanism. That day, the index closed up by 10.23%, setting the largest increase in history. In terms of the Chinese market, the exchange rate is greatly influenced by the international market, as its price is pegged to currencies such as the US dollar. On August 5th, under the expectation of a Federal Reserve interest rate cut, the yuan continued to strengthen, with both onshore and offshore yuan exchange rates reaching a new high for the year at 7.1160 and 7.0838, respectively. On August 6th, the onshore and offshore yuan closed at 7.1506 and 7.1461. The appreciation of the yuan has been going on for some time, with the most recent instance traceable back to August 2nd. That day, influenced by the sharp appreciation of the Japanese yen, both onshore and offshore yuan exchange rates against the US dollar increased by more than 300 points, regaining the 7.20 yuan threshold during the session. Subsequently, following the release of the US non-farm data that fell short of expectations, the market began to price in the risk of a US recession. As a result, risk assets initiated a new round of selling, while the movement of safe-haven capital intensified the appreciation of the yen. As of the week ending August 3rd, the yen appreciated by more than 6% against the US dollar, and the yuan exchange rate against the US dollar increased by 1.4%.
According to Xing Zhaopeng, a senior China strategist at ANZ Bank, the sharp appreciation of many Asian currencies is mainly due to the expectation of a Federal Reserve interest rate cut and the unwinding of yen carry trades, with the latter being the main driver. "Recently, the yen has undergone multiple appreciations. The first wave was influenced by the 'fast money' from closing short yen positions, with the yen-to-US dollar exchange rate rising from 162 to 152. The second wave was influenced by recent real money transactions, with the yen-to-US dollar exchange rate rising from 152 to 142. Since the yuan, as a low-interest currency, has a high correlation with the yen, yuan carry positions have also been significantly unwound. In the future, the yen may still trigger some long-term capital leverage unwinding, but the yuan exchange rate may have fully priced in external factors, and will return to be dominated by the differences in fundamentals between China and the US," he said.
Regarding the future direction of the Japanese market, Ding Rui, head of Japan research at the International Group of the Research Department of CICC, believes that although the Bank of Japan's interest rate hike has impacted the global market, there is currently no evidence of liquidity issues in the yen. Based on the current economic fundamentals of Japan, the Bank of Japan may still raise interest rates to 0.50% by the end of the year. However, considering the significant market volatility recently, there is no need for the Bank of Japan to show a hawkish stance in the short term.
Yen carry trade unwinding reflects changes in monetary policy. Over the past 18 months, as the Federal Reserve raised interest rates and the Bank of Japan remained on hold, the "carry trade" of shorting the yen has been prevalent. The so-called "carry trade" refers to investors borrowing currencies from countries with lower interest rates, such as Japan or China, and then using these funds to invest in currencies from countries with higher interest rates, such as Mexico. However, as the US and Japanese monetary policies turn, short yen positions are also facing unwinding. "The logic of the 'carry trade' has changed," said Wang Ju, head of foreign exchange and interest rate strategy for Greater China at BNP Paribas. "On August 5th, we just took profits on selling the US dollar/CNH currency pair because the spot rate has returned to the midpoint, but we expect there is still room for the yuan exchange rate to appreciate before the end of the year." On July 31st, the Bank of Japan raised the benchmark interest rate from around 0.1% to near 0.25%. In contrast, on August 2nd, after the release of the US employment report, the market's expectation of a Federal Reserve interest rate cut increased. The report showed that in July, the US added 114,000 jobs, which was not only lower than the market's expectation of 175,000 but also a new low for the year. The reversal of speculative capital has amplified the fluctuation of the Japan-US interest rate differential. Data from the US Commodity Futures Trading Commission shows that as of early July, hedge funds and other speculative investors held more than 180,000 net contracts betting on the yen's depreciation, worth more than $14 billion. In the week ending August 3rd, such positions had dropped to about $6 billion. Moreover, there is an even larger amount of yen carry capital in the market—overseas loans from Japanese banks. As of March, such loans reached $1 trillion. Data from the Bank for International Settlements shows that this is a 21% increase from the level in 2021. The recent growth in cross-border yen loans has mainly occurred in the interbank market for bank-to-bank lending, and another direction is non-bank financial institutions such as asset management companies. As the yen exchange rate rises, carry trade investors are currently suffering heavy losses. Investors who borrowed yen are being asked to add margin, and banks insist that they provide more collateral. These investors are forced to buy yen to close their previous positions, which further pushes up the yen exchange rate and triggers further margin calls.
"Previously, investors borrowed yen to buy Australian dollars, US stocks, and commodities, so behind this round of yen appreciation, the prices of these assets have also fallen accordingly, which is a process of deleveraging," said Xing Zhaopeng. "Relative to the US dollar, the yuan is also a low-interest currency and is naturally affected by the appreciation of the yen. The logic of the yuan 'carry trade' has also changed, and as a result, the yuan exchange rate has risen." However, Ding Rui warned that although the Bank of Japan's interest rate hike has impacted the global market, there is currently no evidence of liquidity issues in the yen. "The sharp rise in the yen is mainly driven by the reversal of 'carry trades' borrowing yen and buying US dollars, the reversal of yen net short positions, and the US recession trade, among other factors. In addition, the sharp depreciation of the yen in the first half of the year does not conform to the fundamental trend of the yen exchange rate, so the yen has appreciated significantly recently," he said. Pricing in the US recession has amplified the impact of yen carry trade unwinding. However, in the view of many market participants, it is still too early to trade "US recession." In its latest research report, Goldman Sachs said that the US employment data for July is not a "new trend." First, more than 70% of the US unemployment rate in July came from temporary layoffs; second, the permanent layoff rate is still very low, which reduces the risk of a vicious cycle of income loss and spending reduction; third, some of the increase in the unemployment rate, including in July, reflects temporary frictions in the labor market, including the job search challenges of new immigrants. Goldman Sachs has raised the likelihood of a US economic recession in the next 12 months from 10% to 25%. The bank believes that although US corporate earnings have slowed down, they are still growing at a healthy pace. In this process, although there are unexpected economic data releases, the overall trend is still positive.The Trend of the Renminbi Depends on Fundamentals
Against the backdrop of unwinding carry trades and expectations of interest rate cuts by the Federal Reserve, many analysts believe that the Renminbi may enter an appreciation cycle. "Influenced by the appreciation of carry currencies such as the Japanese Yen, the exchange rate of the Renminbi is also expected to rise," said Wang Ju. However, in the view of Zhang Jiantai, the Chief Foreign Exchange Strategist for Asia at Mizuho Bank, the current appreciation of the Renminbi is mainly driven by external factors like the US Dollar, and the future trend of the Renminbi exchange rate will still return to fundamentals. At present, the significant recovery of China's economy still requires time, and the Renminbi exchange rate may not continue to appreciate. Xing Zhaopeng also holds this view. In his opinion, within the next 1 to 3 months, the exchange rate of the Renminbi against the US Dollar may hover around 7.2. Goldman Sachs predicts that within the next three months, the onshore Renminbi exchange rate against the US Dollar may reach 7.35. Looking at the fundamentals of China's economy, Xing believes that it will still take time for Chinese residents' consumption expectations to rise. In addition, in terms of external demand, although the global semiconductor cycle is on an upward trend, the global commodity cycle is on a downward trend, and these two factors may offset each other. It is expected that after the third quarter, China's external demand will face pressure. Consumer goods companies have felt this deeply. Pepsi CEO Ramon Laguarta said in a conference call with analysts on July 11, "Consumers are obviously saving money, saving more than they are spending." Procter & Gamble indicated that the sales situation during China's "6.18" shopping festival showed that even with significant discounts offered by retailers, Chinese consumers still reduced their spending. In June, the total retail sales of consumer goods in China, a measure of consumption levels, grew by 2% year-on-year, lower than the 3.7% in May. However, Xing also said that with the improvement of the "rent-to-price ratio" in housing, the "rent-to-support-loan" model is gradually becoming feasible, and the investment value of China's real estate is increasing. Moreover, due to the lower base in the second half of 2023, the sales and investment data of China's real estate in the second half of 2024 will improve on a year-on-year basis. Therefore, in 2024, the drag of real estate on China's economy may decrease. Another factor affecting the Renminbi exchange rate is the interest rate differential between China and the United States. In Zhang Jiantai's view, within the scope of interest rate cuts by the Federal Reserve in the future, the People's Bank of China (hereinafter referred to as "PBOC") will also cut interest rates, which will support the domestic economy. This means that the interest rate differential between China and the United States will not narrow significantly. In addition, the PBOC will not pursue the appreciation of the Renminbi, as it is not conducive to exports. It is expected that the PBOC will aim to stabilize the Renminbi. Xing also said that the future trend of the Yen and the Renminbi may be different because the interest rate differential between the US and Japan may narrow, but the interest rate differential between China and the United States may not narrow significantly, which will put pressure on the Renminbi exchange rate. Goldman Sachs believes that after the recent reduction of the People's Bank of China's 7-day reverse repo operation (OMO) rate in the open market, the 1-year Medium-Term Lending Facility (MLF) rate was also lowered by 20 basis points. This round of monetary policy easing and the recent slight strengthening tendency of counter-cyclical factors indicate that the Chinese government is only trying to limit the weakness of the Renminbi exchange rate. As the US election and tariff negotiations approach, the Renminbi exchange rate may still be weak. In addition, Wang Ju also said that the current sentiment of many traders waiting for settlement of exchange needs will be released, which will put pressure on the Renminbi exchange rate. In June, China set a historical high of nearly 100 billion US Dollars in trade surplus. According to data from the State Administration of Foreign Exchange, in the same month, the bank's foreign exchange settlement and sale deficit was 39.65 billion US Dollars, the largest since December 2016. The exchange rate in the same month was 71.75%, also the highest since the end of 2016, indicating a strong willingness of traders to buy foreign exchange, while the settlement rate fell to the lowest since February 2022.
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