Should you worry about the yuan?

The Chinese yuan (CNY) has fallen by around 3% this year against the US dollar, making it the worst-performing currency within the Asia Pacific region. My team and I believe the USDCNY will weaken further to 6.80 in the next three to six months. Despite a slower anticipated pace to US Federal Reserve interest rate hikes, the ongoing deceleration of the Chinese economy will necessitate a prolonged accommodative monetary policy, which should keep the yuan under pressure, in our view.

The yuan’s slide this year has not concerned global financial markets, in stark contrast to last summer, when a sudden CNY devaluation triggered a sell-off.

Should investors still worry about the yuan and its spillover effect on global financial markets? In our view, there are two key differences between now and last summer that explain the market’s relaxed attitude to the risk of further yuan depreciation:

First, Chinese authorities have taken pains to improve their communication with market participants with regard to their policy intentions. Last summer’s abrupt CNY devaluation caught markets by surprise, and raised concerns about whether further rounds of devaluation might be in the making. This shroud of uncertainty fueled capital outflows last summer.

Since then, top Chinese officials, including President Xi Jinping and People’s Bank of China Governor Zhou Xiaochuan, have repeatedly stressed that a one-off CNY depreciation should not be expected. Calmer nerves, coupled with stricter restrictions on capital movements, have helped slow capital outflows from a peak of USD 170bn last December to a manageable pace of around USD 50bn in the last few months.

Second, proponents of a sharp CNY devaluation against the USD have also been caught by the change in Fed policy signals. Fed Chair Janet Yellen has conveyed that excessive USD strength is unwelcome, saying in early June that “as long as…the dollar does not rise substantially further, my expectation is that inflation will move up to 2% over the next one to two years.” This implies that a much weaker yuan (which pushes up the USD in tradeweighted terms) will make the Fed dial back on its hawkish rhetoric.

Moreover, the Fed has consistently emphasized that rate hikes will be gradual; at the June Federal Open Market Committee meeting, the dot plot for staff projections on the fed funds rate showed a reduced pace of rate hikes (to a total of 75 basis points by the end of 2017, down from 100bps in March). With the Fed likely to move slowly and inflation likely to rise, real interest rates could become less attractive and constrain further USD strength.

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