US dollar-yuan divergence trade could spin out of control without intervention from China soon

The more the US tightens policy and the more that China eases, the more a green light emerges for increased pressure on the yuan from the US dollar, with the rising spread of US bond yields over China adding momentum
Does China want a weaker currency to boost exports or a stable currency?

David Brown

Published: 6:15am, 20 Jun 2023

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The US dollar-China yuan currency divergence trade is in full flow. Unless Beijing gets a grip on the exchange rate soon, the yuan could hit 15-year lows very soon.

It’s a dilemma for the government as a weaker yuan might be good news for China’s hard-pressed exporters, but it could also open Beijing up to fresh accusations from Washington of currency manipulation. This would be bad timing, especially after US Secretary of State Antony Blinken’s visit to China this week for talks to help stabilise the fraught relationship between the two nations.

It’s the divergence between rising US interest rates and lower rates in China which is the problem, while the rising spread of US bond yields over China is giving added momentum to the stronger dollar-weaker yuan trade. The worry is there is no end in sight with the US Federal Reserve fretting over inflation while Beijing is more concerned about hitting its 5 per cent growth target for 2023. The dollar-yuan divergence trade could get out of hand quickly without intervention soon.

Last week was a tale of two diverging economies. As expected, the Fed paused its relentless 14-month campaign to stamp out excessive inflation with tougher monetary policy, although it made it clear that it was a hawkish break with the intention of raising interest rates again in the coming months.

On the other side of the equation, Beijing cut one of its benchmark lending rates by 10 basis points to help shore up domestic demand and get the economy back on target for growth of 5 per cent this year. With interest rate expectations heading in different directions, US dollar bulls hardly needed any encouragement. Relative interest rate prospects moving apart means that it’s just a question of how high the dollar-yuan trade can go before the Beijing calls a halt.

US money market futures suggest the Fed has at least one further increase up its sleeve, with the CME Group’s FedWatch tool suggesting a 74 per cent chance of a quarter-point raise in the Fed funds rate at the next Federal Open Markets Committee meeting on July 26. How much more tightening is in the pipeline depends on how quickly headline and core US inflation rates slow down. There is little chance of an easing in sight this year as inflation is unlikely to hit the Fed’s 2 per cent target before the end of 2023.

In the meantime, there is every reason to expect Beijing will ease interest rates again. China’s economy looks likely to fall short of hitting 5 per cent growth this year and will need much more of a helping hand while global growth prospects are stuck in the doldrums. There is plenty of scope for lower interest rates considering China has few issues with inflation, with the latest consumer prices data for May showing a subdued year-on-year rate of 0.2 per cent.

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The more the US tightens policy and the more that China eases, the more a green light emerges for increased pressure from the US dollar on the yuan. It might even be a blessing for Beijing considering China’s exporters are struggling, with May’s export sales down 7.5 per cent from a year ago.

With world trade growth suffering from the cost-of-living crisis and central bank tightening, the chances of global recession are rising. A weaker yuan would be a welcome bonus, but increased export competitiveness for China’s manufacturers would be badly received by the United States and Europe.

The divergence in government yield spreads between US and China compounds the problem of dollar strength over the yuan drawing in investors attracted by higher yields. With the 10-year US-China government bond spread moving from negative territory in 2022 to a yield premium of around 1 per cent currently, it’s a good enough reason for investors to keep buying US dollars over yuan.

Without short-term intervention, the US dollar could easily break through last year’s high of 7.33 yuan to the dollar to upwards of 7.5, a rate not seen since 2007. It’s really a question of what the authorities want.

Is it a weaker currency to boost exports or a stable currency to maintain stability? Beijing’s dual circulation strategy is not inconsistent with a weaker yuan if it means getting the most out of the external economy to boost domestic growth.

In the currency markets, it’s often said that policymakers generally tend to get what they want. It really boils down to whether benign neglect is allowed to get the better of the yuan.

David Brown is the chief executive of New View Economics