Why is the Renminbi appreciating? How sustainable is it?

Event: On July 25th, the offshore RMB exchange rate against the US dollar appreciated significantly by over 500 basis points to around 7.2117 (as of 19:00 Beijing time), reaching as high as 7.2035 intraday. Why did the RMB exchange rate surge?

1. Since July, overseas trading has indicated a recession in the US economy. The sharp decline in the US ISM non-manufacturing PMI in June, coupled with slowing employment and inflation data, along with the dovish stance of the Federal Reserve, has boosted expectations of interest rate cuts. On July 24-25, various assets, including gold, saw profit-taking at high levels. Despite the lack of multiple interest rate cuts reflected in US Treasuries, if data continues to weaken, the increasing certainty of a recession will inevitably lead to more rate cuts. The economic and even future interest rate differentials between the US and non-US economies will be weakened. 2) News on July 25th during trading hours raised expectations of a rate hike by the Bank of Japan next week, causing a reversal in carry trades and accelerating short covering of the Japanese yen as well as the RMB. In fact, in early May and early July this year, the RMB exchange rate saw increased elasticity due to the appreciation of the Japanese yen.

In the short term, the RMB exchange rate may experience a slight rebound under the resonance of "grabbing exports" and "overseas recession trading." However, it is still premature to anticipate a significant economic downturn in the US at present. The actual GDP growth rate for Q2 in the US announced on July 25th is still at 2.8% on a quarter-on-quarter annualized basis. Therefore, whether the Federal Reserve will continue to cut interest rates remains to be seen. In addition, the effects of domestic demand policies also need to be observed. A hasty appreciation of the RMB exchange rate will constrain exports in the future. Therefore, it is expected that the fluctuation range of the RMB exchange rate may widen, but it is still difficult to draw a conclusion of sustained appreciation.

The strengthening of expectations for a rate cut by the Federal Reserve reinforces overseas recession trading.

1. The sharp decline in the US ISM non-manufacturing PMI in early July, coupled with slowing employment and inflation data, has boosted expectations of a rate cut. The ISM non-manufacturing PMI for June announced on July 3rd plummeted to 48.8 (expected 52.5, previous value 53.8), the lowest level since 2011 (excluding the abnormal value in May 2020), with a mean value of 54.8 since 2008; the June unemployment rate announced on July 5th rose to 4.1% (expected 4.0%, previous value 4.0%), with a non-farm payroll increase of 206,000 (expected 190,000, previous value 272,000), but the data for April and May were revised down by a total of 111,000; the June US CPI announced on July 11th showed a month-on-month decrease of -0.1% (expected 0.1%, previous value 0.2%), with a year-on-year CPI of 3.0% (expected 3.1%, previous value 3.3%).

2. Statements from Federal Reserve officials turning dovish further strengthen expectations of a rate cut. On July 2nd, Powell first expressed considerable confidence in the results of inflation suppression, then after the cooling of June employment data, stated that inflation was no longer the only risk, and on July 10th hinted at a relaxation of the 2% inflation target with an emphasis on employment. On July 24th, New York Fed President Dudley wrote, "I have long been in the 'Higher for Longer' camp, but the changing situation has made me change my mind. The Fed should cut interest rates, preferably starting from the upcoming monetary policy meeting next week."

3. European PMI data falling short of expectations also triggered concerns about recession. On July 24th, the initial value of the Eurozone services PMI was 51.9 (expected 52.9, previous value 52.8), hitting a 4-month low; the Eurozone manufacturing PMI initial value was 45.6 (expected 46.1, previous value 45.8), hitting a 7-month low. On July 24th, the initial value of the German services PMI was 52.0 (expected 53.3, previous value 53.1); the initial value of the German manufacturing PMI was 42.6 (expected 44.0, previous value 43.5).

4. The reflexivity of global financial markets strengthened rate cut and even recession trades. On July 23-24, the S&P 500, Nasdaq, Dow Jones, Germany's DAX, France's CAC40, and the UK's FTSE 100 indices fell by 2.3%, 3.6%, 1.2%, 0.9%, 1.1%, 0.2% respectively. During trading on July 25th (as of 19:00 Beijing time), COMEX gold, WTI crude oil, and LME copper all fell by over 1%, with various assets including gold showing profit-taking at high levels, indicating the market is pricing in a hard landing. Meanwhile, the US dollar index fell by 0.16%, and the USD to JPY and USD to offshore RMB exchange rates rose by 1.08% and 0.74% respectively.

The unwinding of the yen carry trade pushed up the yen and also boosted the RMB exchange rate. 1) Expectations of a rate hike by the Bank of Japan boosted the yen. Sources indicated on July 25th that "the Bank of Japan will consider raising interest rates next week and plans to halve its bond purchases in the coming years. The majority of the Bank of Japan's committee members agree on the necessity of raising interest rates in the near future, but a final decision has not been made on whether to raise rates next week or later this year.

It is obvious that the Bank of Japan will raise interest rates in the coming months, it's just a matter of time." As of July 24th, Bloomberg OIS swap pricing showed a 58% probability of a 15 basis point rate hike by the Bank of Japan at the July meeting, while CME tools showed probabilities of 8.8% and 80.3% for rate cuts by the Fed in July and September respectively. The policy expectation spread between Japan and the US led to the unwinding of the yen carry trade, forcing yen shorts to cover. 2) This year, the USD to RMB and USD to JPY exchange rates not only show a high degree of consistency in trends but also move bidirectionally at key points. For example, after the USD to JPY exchange rate broke below 160 on April 29th, it quickly rebounded by 5 yen to 155, with the Japanese Ministry of Finance admitting to intervening in the forex market with 9.8 trillion yen in April-May, causing the offshore RMB exchange rate to drop from 7.25 to below 7.20. Similarly, on July 11th, after the USD to JPY exchange rate rose above 161.75, the Bank of Japan was suspected to intervene again with 3.5 trillion yen in forex, causing the offshore RMB exchange rate to rise from 7.29 to 7.26 on the same day. The similarity lies in the fact that the yen and RMB are currently both low-yielding funding currencies, and under the unwinding of the carry trade, yen shorts covering also accelerates RMB shorts covering The core variable for the current rebound of the Renminbi is not internal factors, but the central bank can take advantage of the situation. Since July 22, the central bank has implemented a "combination punch" of monetary policy adjustments, simultaneously lowering the 7-day reverse repurchase rate, 1-year and 5-year LPR rates, MLF rate, and SLF rate by 10 basis points each. During the same period, the 10-year US Treasury yield dropped by about 4 basis points due to interest rate cut expectations. From the perspective of the China-US interest rate differential, it seems that it does not support a significant strengthening of the Renminbi exchange rate. Looking at recent total and high-frequency economic data, domestic economic growth continues to slow down. So why has the Renminbi rebounded significantly in this round? We believe that due to the higher elasticity of Renminbi exchange rate appreciation driven by the appreciation of the Japanese Yen in early May and early July, the central bank took advantage of the situation on July 25 when the Yen strengthened and the US Dollar weakened, resulting in a synergistic effect, making the exchange rate stabilization more effective.

Looking ahead, in the short term, the Renminbi exchange rate may slightly rebound under the resonance of "grabbing exports" and "overseas recession trade". However, it is still premature to foresee a significant economic downturn in the US. The actual GDP growth rate for Q2 in the US, announced on July 25, is still at 2.8% on a quarter-on-quarter basis, so it remains to be seen whether the Federal Reserve will continue to cut interest rates. In addition, the effectiveness of domestic demand policies also needs to be observed. A hasty appreciation of the Renminbi exchange rate will constrain exports in the future. Therefore, it is expected that the fluctuation range of the Renminbi exchange rate may widen, but it is still difficult to draw a conclusion of sustained appreciation.

Author: Zhang Jingjing, Wang Hebin from CMB Macro, Source: Jingguan Finance, Original Title: "CMB Macro | Why is the Renminbi Appreciating? How Sustainable is it?" Analysts

Chief Analyst Zhang Jingjing S1090522050003

Team Leader Wang Lebin S1090523070007