Why PBOC’s New Fixing Rule Could Be Good News to Dollar?

May 29, 2017

| Fullerton Markets

Why PBOC’s New Fixing Rule Could Be Good News to Dollar?

U.S. to release NFP this week, long USD/JPY?

Are you ready for a strong dollar in second half of the year?

Bloomberg reported last week that China is considering changes to the way it calculates the yuan’s daily reference rate against the dollar, as policy makers may add a “counter-cyclical factor” to the yuan’s daily fixing. China’s foreign-exchange market can be driven by irrational expectations, resulting in "unreal" supply and demand that increases the risk of overshooting, according to an official statement on Chinamoney.com, run by China Foreign Exchange Trade System. The counter-cyclical factor may ease "herd actions" and help guide investors to pay more attention to economic fundamentals, according to the statement.

Some market participants view the change would give authorities more control over the fixing and restrain the influence of market pricing. We think this move reveal some of the attentions behind the Chinese central bank, which has been communicating with the Federal Reserve in the past few years.

Strong dollar fears

Dollar has been in a soft trend since beginning of the year, largely due to Trump policy disappointing and priced-in Fed’s rate hikes. But no one knows the Fed’s tone and plans in second half of the year. There is some rumour in the market recently that “Fed would be much more hawkish than most people think in the fourth quarter”, and definitely markets are not preparing for that. So this counter cyclical factor introduced by the PBOC could be considered as a pre-emptive move in case domestic capital flows accelerate when dollar gets firm later on. If one of the biggest central banks in Asia stands by for a stronger dollar to emerge, that is an important signal for the rest of the markets.

Spillover effect

The new “counter-cyclical factor” is a component that potentially drives the yuan lower versus basket of currencies, which could induce other currencies to follow the yuan. China CFETS yuan index has been digging into another fresh low after the index was introduced in 2015. A chart below shows that CNY has been in depreciation trend versus SGD, EUR.

It is widely recognised by the market that PBOC is targeting the dollar and a basket of currencies in its favour. When dollar is in uptrend, PBOC will anchor yuan stability versus a basket of currencies; but when dollar is in downtrend, PBOC would anchor dollar stability, which means yuan will fall versus non-dollar currencies. In such fixing mechanism, there is a rare chance that yuan will appreciate against a basket of currencies in sustainable period. Once this “counter-cyclical factor” kicked in, the central bank will have increased room to engineer the flexibility of the index.

Yuan Index Keeps Edging Lower

As the world’s second largest economy, its currency moves could easily affect the rest of the currencies, especially to those who have close trading relationship with China. In an extreme scenario, if many of these currencies set yuan as the target, it could add increasing appreciation pressure on dollar.

Friday’s US non-farm payrolls report for May can offer some clue of the Fed’s upcoming decision on monetary tightening. Leading employment indicators like declining initial jobless claims point to a 180k increase in non-farm payrolls. With the US economy near full employment, average hourly earnings growth will be a bigger driver of near term US interest rate expectations and the USD than the pace of job gains.

Our Picks

EUR/USD – Slightly bearish. It’s uptrend showing a bit exhausted in near term. This pair may move towards 1.11 in coming days.

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