FX update USD/CNH: The only way is up?

Earlier this month, markets traded in panic mode when the US non-farm payrolls report and other labor market data showed a significant cooling of the US labor market, which spurred fears of a hard landing. A surprise hike from the Bank of Japan (BoJ) increasing its policy rate by 15 bp to 0.25% further upset markets.

The combination of an increase in anticipated rate cuts by the Fed and a rate hike by the BoJ resulted in hedge funds and other investors unwinding large parts of their USD/JPY carry trades. Given the positioning of the market (risk parity trades amongst others) and an increase in algorithmic trading, volatility spiked and resulted in sharp movements across all asset classes worldwide. We do not often see (USD/JPY) movements of this magnitude.

The value of USD/CNH also decreased sharply, mainly caused by USD weakness but also due to some unwinding of dollar/yuan carry trades. Moreover, the currency pair USD/CNH could see strong future downside movements if more carry trade positions are going to be unwound. Against this backdrop, USD/CNH nosedived from a level of 7.34 to 7.13 on August 5. At the time of writing, we observe a rate of 7.18.

Still, the size of the market for USD/CNY carry trades is far less significant than the market for USD/JPY. So in the absence of renewed volatility, “fundamentals” remain important.

Fundamentals still matter

Because the yuan is not fully convertible, there are limitations. The Chinese market is also less exposed to speculative positions of hedge funds and other asset managers. A large share of yuan carry trades are held by Chinese exporters, who choose to hold onto the USD they received from exports and some of whom have started to sell USD for yuan. Next to that, there are some foreign investors who borrow in yuan to invest in mainland China. However, these flows had already diminished as foreign direct investment (FDI) in China has slowed down significantly since 2022 and money has in fact been withdrawn from China (see figures 1 and 2).

Early in August, the rally in USD/CNH already showed some signs of fatigue and the pair dropped from above 7.30 to a level of 7.25. This was around the time that we published our Monthly, in which our USD/CNH view remained unchanged; we forecast renewed weakness and a gradual strengthening to 7.30. The rationale behind that was twofold. First, we hold slightly lower than consensus expectations regarding China’s economic prospects. Secondly, the assumption of a Trump victory in November causing higher tariffs on Chinese goods and higher inflation, which would lead to fewer Fed rate cuts than the market was expecting at the time.

So, while these assumptions still hold, the abovementioned current developments have led us to review our forecast. We now foresee an exchange rate of 7.25 at the end of Q3 and a level of 7.30 at the end of this year. For 2025, we still expect a gradual strengthening of USD/CNH from a level of 7.30 in Q1 to 7.25 in Q2 and levels of 7.20 in the second half of 2025. As such, we maintain our general view of a gradual strengthening of USD/CNH from current levels before another slight weakening. .

Asymmetric and symmetric risks

First, the China Foreign Exchange Trade System (CFETS), established under the People’s Bank of China (PBoC), continues to allow the USD/CNY fixing to creep up gradually. At the end of the first quarter of this year, the fixing was set at a level just below 7.10 but on August 13, it was already close to a level of 7.15. Furthermore, CFETS shows a certain level of tolerance in letting the market trade at levels above the upper bandwidth of 2% of the daily fixing (see figure 3).

We can also observe that there does not seem to be the same level of tolerance in letting USD/CNH cross the fixing, let alone fall to the lower bandwidth of the fixing/mid-rate. In other words, there is an asymmetric upside risk from the way CFETS has set the fixing in recent months and the one-sided way CFETS allows USD/CNH to breach important levels.

We also still expect “only” two fed rate cuts this year, in contrast to current market expectations of four rate cuts this year (although we acknowledge the downside risk to that view). At the same time, we expect the PBoC to cut the seven-day reserve requirement ratio and the one-year medium-term lending facility by ten bps this year. In other words, we expect a larger interest rate gap to remain for the rest of this year than the market is currently expecting. This should maintain upward pressure on USD/CNH.

Finally, we see risks to our three-month and six-month views as roughly balanced. Potential government demand stimulus, a change regarding our expectations of the US elections outcome, and/or more Fed rate cuts, all provide downside risks to our view. On the other hand, lower than expected exports and/or lower domestic demand for China (and lower economic growth more generally), or safe haven demand arising from geopolitical tensions could pose upside risks to our expectations of the USD/CNH rate.