Will 6.80 become a Hurdle for USD-CNY?

CNY strengthens on the hope of strong recoveryin 2023 

For thewhole year of 2022, the Chinese currency depreciated by 7.86% against the USD,ranking it in the middle of the major Asian currencies. For the coming year, weexpect the Chinese currency to strengthen. Our conviction is that 6.80 will notbecome a hurdle for USD-CNY, and the USD-CNY swap curve will shift higher inthe first quarter of 2023.

As theFederal Reserve (Fed)’s tightening draws to a close, overall dollar softnesswill be extended at least through the first half of 2023. The downside risks tothe US dollar have intensified as the Bank of Japan (BOJ) might surprise withaccelerating policy tightening.

However,the most important driving factor for the CNY is actually from the domesticfront. The Chinese economy will embrace a strong recovery in 2023 with a fullCovid reopening in sight. In the meantime, the policy tones have been lesshesitant in supporting growth with a focus on domestic consumption. We believethat the CNY will continue its stellar ride over the foreseeable future witheconomic activities recovering rapidly and with Covid reopening accelerating.

Ourbase case is that USD-CNY will touch 6.80, and further downside cannot bediscounted if economic indicators arrive in stronger than expected.

ForUSD-CNY swap points, we think it will move significantly higher in the comingmonths. the CNY funding could be tightened in the coming weeks or even months.The Chinese New Year falls on the last week of January, and the creditextension in the first month of 2023 is likely to be strong thanks to policysupport – both of these factors could result in a short-term funding squeeze inthe CNY. As such, the USD-CNY forward curve is likely to shift higher,particularly on the short-term tenor.

TheUSD-CNY experienced a fast and furious session over the last month of 2022 –while the market expected the Chinese currency to remain soft, the CNY hassurprisingly been outperforming. The USD-CNY closed below the 6.90 mark by theend of 2022. For the whole year, the Chinese currency depreciated by 7.86%against the USD, ranking it in the middle of the major Asian currencies. Forthe coming year, we expect the Chinese currency to strengthen. Our convictionis that 6.80 will not become a hurdle for the USD-CNY, and the USD-CNY swapcurve will shift higher in the first quarter of 2023.

Overalldollar softness will be extended at least through the first half of 2023. TheFed is expected to pause interest rate hikes by the end of Q2 2023. Inflationis likely to ease significantly over the next two quarters. In addition, economicactivity will be weighed on by the tightening monetary policy. Balancing thesefactors, the Fed is likely to enter a policy watch window after the policy ratetouches 5.0-5.25%. As the Fed’s policy actions are more or less priced in bythe markets, the US dollar has started to weaken since November 2022. Hence,the dollar weakness is likely to continue, if the Fed follows its currenttightening trajectory.

Thedownside risks to the US dollar have intensified as the Bank of Japan mightsurprise with accelerating policy tightening. After the BOJ surprisinglytweaked the YCC policy at its last monetary policy meeting in 2022, theJapanese central bank has emerged as one of the biggest uncertainties for theglobal markets in 2023. The uncertainties are mainly from two fronts: First,CPI inflation is likely to remain elevated due to rising wage pressures, whichmakes it difficult to judge the BOJ’s next step. While the BOJ continues tostress the necessity of easing mode, it is also difficult for the central bankto commit to a full-scale supportive manner as they did in the past. Second,the long-served BOJ Governor Haruhiko Kuroda is scheduled to step down in March2023 with no obvious successor, which would add policy uncertainty as well.

However,the most important driving factor for the CNY is actually from the domesticfront. The Chinese economy will embrace a strong recovery in 2023 with a fullCovid reopening in sight. In the meantime, the policy tones have been lesshesitant in supporting growth with a focus on domestic consumption. There islittle doubt that currency performance is a reflection of economicfundamentals. Hence, we believe that the CNY will continue its stellar rideover the foreseeable future as economic activities recover rapidly as Covidreopening accelerates.

Ourbase case is that the USD-CNY will touch 6.80, and further downside cannot bediscounted if economic indicators arrive in stronger than expected. It does notmake too much sense to project a monthly or quarterly trajectory for onecurrency as the markets move ahead of the economic activities. Nonetheless, anoverall appreciation trend of the CNY can be largely warranted given bothexternal and domestic dynamics.

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ForUSD-CNY swap points, we think it will move significantly higher in the comingmonths. On the one hand, the short-term funding costs for the US dollar arelikely to peak with the end of Fed tightening looming. On the other hand, theCNY funding could be tightened in the coming weeks or even months. The ChineseNew Year falls on the last week of January, and the credit extension in thefirst month of 2023 is likely to be strong thanks to policy support – both ofthese factors could result in a short-term funding squeeze in the CNY. As such,the USD-CNY forward curve is likely to shift higher, particularly on theshort-term tenor. With economic activities further warming up in the next fewquarters, which would further lift up CNY funding costs, we think the one-yearUSD-CNY swap points will narrow massively as a result.

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