Understanding the appreciation of the Renminbi in three charts

The offshore RMB exchange rate once broke through 7.09 overnight, while at the same time, the US dollar index even showed some increase. Such a scene has raised some doubts in the market, what exactly is driving the appreciation of the RMB? We will use the following three charts to explain the changes in the foreign exchange market.

First, the overnight appreciation of the RMB seems to be an independent phenomenon, but the US dollar index has shown a significant decline in the past two months, mainly due to the market actively trading on the possibility of the Fed opening an interest rate cut process. In July, the US dollar index fell by 1.67%, and in August it fell by 2.63%. Based on the experience of the past 5 years, the US dollar index is likely to fall in July, but consecutive declines in August only occurred during the COVID-19 outbreak in 2020 - clearly, at that time, the market's expectations of dual easing in monetary and fiscal policies hit the US dollar exchange rate. This year's situation is focused on monetary policy easing (i.e. interest rate cuts), from this perspective, understanding the RMB exchange rate, we will find that the appreciation of the RMB against the US dollar is not an isolated event. In fact, compared to the significant decline in the US dollar index in the past two months, the performance of the RMB index remains relatively stable. In this sense, the appreciation of the RMB is mainly influenced by the decline of the US dollar.

Another phenomenon worth noting is the recent narrowing of the China-US interest rate differential. As mentioned above, the market is focused on trading the Fed's interest rate cuts, one result is the downward trend of US Treasury bond yields. Due to the relatively stable Chinese government bond yields recently, the result is a rapid narrowing of the China-US interest rate differential. Taking the 10-year China-US bond yield differential as an example, the recent level is maintained at around 170 basis points, while in July it was around 200 basis points. The peak this year occurred at the end of April, when the yield differential was around 240 basis points. From this perspective, there is a significant correlation between the appreciation of the RMB and the narrowing of the China-US interest rate differential. Understanding exchange rates from an interest rate perspective also helps avoid falling into the trap of "conspiracy theories".

In the third chart, let's look at the forward points of offshore and onshore RMB against the US dollar. Taking 1 year as an example, the forward points of CNH have been relatively stable recently, but the 1-year forward points of CNY have shown a rapid increase and are approaching the offshore level. This situation indicates that onshore RMB interest rates have risen rapidly, or onshore US dollar interest rates have fallen rapidly. To some extent, this seems to have some similarity to the unwinding of carry trades in the Japanese yen. The closure of arbitrage trades is often caused by two reasons, one is the expectation of rising interest rates for originally low-interest liabilities; Another factor is the volatility on the asset side. Taking the yen carry trade as an example, when the Bank of Japan starts raising interest rates and the US stock market experiences volatility, there is a risk of being squeezed by both the liability side and the asset side in carry trades, which may lead to significant reverse closing positions.

Looking ahead, interest rates and the spread between China and the US still remain the dominant factors determining the RMB exchange rate. From this perspective, after the Fed's rate cut in September, the market may reprice the future US dollar rates. This also means that the downside risk for the RMB in the short term is relatively limited.

Authors: Zhou Hao, Sun Yingchao; Source: Guojun Overseas Macro Research; Original Title: "Understanding RMB Appreciation in Three Charts"