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CHINA: Tariff Concerns Building, But CNH Downside Could be Limited

CHINA
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  • While the February 1st tariffs nominally target Canada and Mexico, CNH's weakness this week serves as another reminder that markets see China levies as following closely behind those set against USMCA. This leaves USD/CNH holding the entirety of the late Thursday rally, putting prices back through the 50-dma. A close above would be the first since October last year, again opening the cycle highs posted on Dec31 at 7.3695.
  • The reaction function of the Chinese authorities is key here. We wrote on January 17th that the PBOC will limit any sharp depreciation of the CNY in response to tariff uncertainties as sharp CNY depreciation will worsen capital outflows and impede monetary and fiscal policy coordination.
  • How would the Chinese authorities work against CNY weakness? USD liquidity and use of the counter-cyclical factor is likely the first line of defence, but tweaks to both the FX RRR (last used in 2023) and deposit requirements for FX forwards remain tools to be used should markets become disorderly. Markets will be on watch for these headlines should the tariff spat escalate in the coming weeks.
  • Any agreements made between China and the US will be taken in the context of the 'Phase One' agreement signed in Jan'20 which allowed for FX rate flexibility as a release valve for internal/external economic imbalances - and could limit criticism of fluctuation in FX rates over the medium-term.
  • As such, CNH downside could be limited over the short-term - price action that would work against options market pricing that increasingly favours USD/CNH calls. As such, collecting premiums via selling USD/CNH topside would stand to benefit.
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  • While the February 1st tariffs nominally target Canada and Mexico, CNH's weakness this week serves as another reminder that markets see China levies as following closely behind those set against USMCA. This leaves USD/CNH holding the entirety of the late Thursday rally, putting prices back through the 50-dma. A close above would be the first since October last year, again opening the cycle highs posted on Dec31 at 7.3695.
  • The reaction function of the Chinese authorities is key here. We wrote on January 17th that the PBOC will limit any sharp depreciation of the CNY in response to tariff uncertainties as sharp CNY depreciation will worsen capital outflows and impede monetary and fiscal policy coordination.
  • How would the Chinese authorities work against CNY weakness? USD liquidity and use of the counter-cyclical factor is likely the first line of defence, but tweaks to both the FX RRR (last used in 2023) and deposit requirements for FX forwards remain tools to be used should markets become disorderly. Markets will be on watch for these headlines should the tariff spat escalate in the coming weeks.
  • Any agreements made between China and the US will be taken in the context of the 'Phase One' agreement signed in Jan'20 which allowed for FX rate flexibility as a release valve for internal/external economic imbalances - and could limit criticism of fluctuation in FX rates over the medium-term.
  • As such, CNH downside could be limited over the short-term - price action that would work against options market pricing that increasingly favours USD/CNH calls. As such, collecting premiums via selling USD/CNH topside would stand to benefit.