MNI EXCLUSIVE: Yields To Support Yuan, Volatility Ahead

Relatively high Chinese yields and calmer trade relations between Beijing and Washington could still drive the yuan to as high as 6.2 to the dollar this year despite its recent weakness, but a declining yield differential with U.S. Treasuries and a recovering dollar index herald a period of greater volatility, Beijing policy advisors and traders told MNI.

The trend for yuan appreciation seen since last June was broken on March 5, when the currency fell through 6.5 to the greenback, touching 6.5799 on March 30, the weakest since Dec. 1.

The narrowing U.S.-China yield spread, which has eased to about 160bps from around 240bps for much of the second half of 2020, together with the broad improvement of the dollar index as the U.S. economy emerges from the pandemic, has combined with global market volatility to end the strengthening trend for the yuan seen since last year, said Guan Tao, a former senior official at China's foreign exchange administration. The yuan is approaching a reasonable and balanced level, he said, though he noted that U.S. Treasury yields are likely to continue to rise this year and that the dollar index's improvement may continue as the U.S. outperforms the eurozone.

Trade in the yuan could range between 6.2-6.7 in 2021, said Zhang Ming, deputy director of the Institute of Finance and Banking under Chinese Academy of Social Science.

The current China-U.S. yield spread is sufficient to support the currency, he said, although there is a risk of tightening by the Fed and the People's Bank of China could ease monetary policy moderately in the second half if the economy slows and financial risks build.

U.S.-CHINA RELATIONS

Ten-year Chinese government bonds should yield about 3.3% this year, said Zhang. This compares to about 3.22% now.

A strong currency will favour the continued internationalisation of the yuan, he noted, though he cautioned that the relaxation by the PBOC of controls on capital outflows could provide some downward pressure on the exchange rate. The PBOC's measures on relaxing restrictions on outflows last year, when the yuan was appreciating, came as it has moved away from regular intervention in foreign exchange markets since 2018, Guan Tao noted.

But the big market driver of the yuan will likely be the U.S.-China relationship. If Presidents Xi Jinping and Joe Biden meet this month, or the two countries open their borders to each other soon, that could boost flows into the currency, a trader at a big Chinese bank told MNI.

Conversely, a rise in the dollar index by another point to 94 could weaken the yuan to 6.60-6.65, with 6.60 the key technical level at present, said the trader, pointing to short-term interest rates such as Libor and the two-year U.S. Treasury yield rather than the 10-year Treasury yield as key gauges for Chinese market players.

China's exports are likely to slow in monthly terms in the second quarter, while foreign inflows into Chinese government bonds are weakening, said Zhang Ping, senior fellow of the CASS, who foresees the exchange rate trading between 6.30-6.80 for the year.

The PBOC set the CNY daily fixing at 6.5527 Tuesday compared with 6.5649 on Friday while USDCNY opened at 6.5550 as against the closing level of 6.5612 at 16:30 Beijing time Friday.