This week, the yuan broke above the 7.0000 handle against the dollar and continued to rise. Generally, the Chinese currency isn’t a popular trade because it’s officially kept within a trading band. The government allowed that band to drift above the technically and psychologically important level for the first time since late last year.
The weakness in the yuan is seen as another indicator that the expected boom following lifting of covid restrictions has not arrived. The currency initially gained against the dollar back in December because many traders were anticipating the Chinese economy to grow substantially. But, Q1 results have been lackluster, and the latest PMIs show the industrial sector is falling back into contraction. But, this appears to be a more global story.
The dollar is still king
The Chinese Ministry of Finance blamed the latest move in their currency to strength in the dollar. The greenback has been appreciating most of the week despite the ongoing political debate over raising the debt ceiling. While politicians make dire warnings about the US potentially falling into default, no one in the markets actually thinks that’s a real possibility. The possibility of economic uncertainty around how the debt ceiling issue is resolved might cause some weakness in the markets, however. Which, in turn, has raised demand for the dollar as a safe-haven.
The other factor is that more and more traders are coming around to the idea that the Fed might raise rates at the next meeting. At the start of the month, the narrative was a broad expectation that the FOMC would pause, but that view has now dropped to just 60%, from 85% just a week ago.
Beyond China
Turning to the inflation issue, a weaker yuan could contribute to lowering costs in most economies. As the largest manufacturing center in the world, the strength of the Chinese currency correlates with the cost of goods imported from China. If the currency weakens, it implies goods made in China become cheaper, which could help filter through to lower consumer prices. That would be particularly relevant for the US in Europe which import more from China.
On the other hand, a weaker yuan means it’s more expensive for Chinese firms to buy imported goods, such as from Japan, Australia, New Zealand and Germany. Those economies could feel a pinch if the yuan keeps trending in its current direction. Although the Euro has also weakened in the last few days as traders have speculated the ECB might not be as aggressive at the next meeting. But the latest data suggests that the RBNZ and RBA might be in line for more hikes, which could improve their currencies in the short term at the cost of lower economic performance in the long term.
Hiding a recession
But what could be the biggest worry for most market participants is that a weaker yuan implies weaker demand for Chinese exports. That would be one of the first expected signs of an impending global slowdown, if not outright recession.
Chinese state banks have been buying up yuan on the offshore market in an effort to prop up the currency. While this is in line with the domestic policies of the Chinese government, it means that had the yuan been left to its own, it might have become even weaker. That would be an even bigger sign that global demand was falling and mask a warning sign of just how much of a global recession could be coming.
