Guotai Junan: Exchange rate is a key variable for observing policy direction

1. At the end of August, foreign exchange reserves increased by USD 31.843 billion to USD 3,288.215 billion on a month-on-month basis, mainly due to the dual benefits of exchange rate and interest rate cuts leading to value appreciation.

On one hand, under the fermenting expectation of a Fed rate cut, non-US currencies appreciated, with the Japanese yen rising sharply by 4.85%, the euro by 0.96%, and the pound by 1.51%;

On the other hand, 10-year US Treasury yields fell by 18 basis points, Japanese government bond yields by 15 basis points, and Australian government bond yields by 14 basis points, resulting in asset appreciation effects.

We estimate that the valuation effects of exchange rate movements and asset price changes are approximately USD 32 billion and USD 45 billion, respectively. As central banks usually increase their holdings of foreign assets during periods of valuation appreciation, the combined effects of valuation and asset holdings may be close to USD 100 billion, indicating that the contribution of international balance factors to foreign reserves is around USD -70 billion.

2. A consensus expectation for exchange rate appreciation has not yet formed, and the policy stance on stabilizing the exchange rate remains firm. The spot trading volume of the USD against the RMB in August increased significantly compared to July, exceeding USD 60 billion by the end of the month, indicating that a consensus expectation for exchange rate appreciation has not yet formed in the market.

Foreign exchange data shows that net forward exchange sales fell to around zero in July, and the net spot exchange sales amount for the month approached a low point since early 2016;

Internally, in the current account, the trade surplus and net exchange sales difference continue to rise, indicating that hot money is still flowing out through trade channels; in the capital and financial account, net sales of direct investment and securities investment have reached a new high since 2016, and there is still a gap to be bridged with the net exchange sales difference of capital and financial projects, possibly influenced by enterprises or banks holding foreign exchange, leading to net sales in other investment projects as well.

In August, due to the increase in RMB appreciation, there were more exchange sales, forming a positive feedback loop of "appreciation ➔ exchange sales ➔ appreciation", but its sustainability depends on the various departments' expectations of the sustainability of exchange rate appreciation.

The extent of various departments' expectations for exchange rate appreciation has narrowed to some extent. In terms of the resident sector, although the Shanghai gold premium has significantly fallen, it is still positive, and has increased from August to early September, currently at 766 pips; for the corporate sector, the exchange rate is still in a downward channel; for overseas institutions, the NDF premium relative to USDCNH has narrowed, indicating a weakening expectation of RMB appreciation.

In August, with the RMB exchange rate appreciating, the forward premium rate significantly fell, but rose slightly at the beginning of September. At the same time, on September 5th, the central bank's special treasury bonds held in the interbank market were first seen with sell orders, breaking the market's expectation that the central bank would not sell special treasury bonds, indicating that the policy stance on stabilizing the exchange rate remains firm.

3. In the short term, the crowding in gold trading has significantly increased, but the main uptrend under the RMB exchange rate pricing framework is not yet over.

Gold experienced a main uptrend in Q3 catalyzed by both rate cut trades and recession trades. Since Q3, North American investors have replaced Europe and Asia as the largest source of net inflows into gold ETFs, with COMEX gold net long positions rising to the highest level in nearly 4 years, indicating a significant increase in crowding China's central bank continues to suspend gold purchases, while other central banks have not stopped their pace of gold buying. In July, global central banks' net gold purchases rebounded significantly from June, with Poland, Uzbekistan, and the Reserve Bank of India being the top three gold buyers, indicating that geopolitical concerns and the trend of de-dollarization are still ongoing.

In the systematic shift towards a gold pricing paradigm anchored by the RMB exchange rate, we believe that the primary uptrend in gold is not yet over, with exchange rate fluctuations around the midpoint price acting as a catalyst.

In an interview on August 15th, Governor Pan revealed that the central bank is "further planning new incremental policies," proposing to "achieve the dual goals of currency stability and financial stability." We believe that the exchange rate is a key variable for observing incremental policies.

The inconsistency between the decline in real financing interest rates and bond yields remains a core contradiction that monetary policy needs to address in the short term. Stock loan rates help guide expectations of risk-free rates, but their connection to policy rates is not as close as bond yields, leading to a situation where lowering policy rates only affects the decline in bond yields, making risk-free rates relatively higher. One concern comes from the pressure on banks' net interest margins. Looking at the interest rate spectrum on current bank balance sheets, an effective and side-effect-free way is to lower the cost of liabilities with higher costs, such as MLF and interbank CDs. In August, the central bank actually swapped 100 billion yuan of MLF by purchasing government bonds, but due to the limited extent of increasing government bond purchases in the short term, the next step may involve using reserve requirement cuts to replace banks' high-cost liabilities

Author: Han Zhaohui S0880523110001, Zhang Jianyu S0880124030031, Source: Guojun Macro Research, Original Title: "Exchange Rate is the Key Variable for Observing Policy Direction"