Daniel Zhang: The Speculation of Exchange Rate Narratives

Core Viewpoints

➤ The current mainstream narrative logic in the market regarding exchange rates has three obvious flaws: first, there is no necessary connection between the Federal Reserve's interest rate cuts and the movement of the US dollar; second, the correlation between the interest rate differential between China and the US and the exchange rate is extremely low; third, the claim that the appreciation of the RMB harms exports lacks empirical support.

➤ Recently, the appreciation of the RMB can be divided into two phases: the first phase was mainly supported by policy, while the second phase shifted to being driven by market supply and demand, with policies aimed at curbing excessive appreciation. In terms of foreign exchange settlement, the existing pressure has been partially released, and due to weak PMI, the fundamental support is still insufficient, so the exchange rate is expected to remain stable with fluctuations.

➤ In the next 1-2 years, the US dollar may present a neutral to strong pattern, for reasons including: the relative economic growth rate in the US is still high, the short positions on the dollar have reached their limit, and it is inappropriate to simply equate the increase in US debt ratio with a weakening dollar.

➤ If there is a long-term revaluation of the RMB, the key lies in whether the midstream manufacturing sector can achieve a breakthrough in globalization. Currently, the overseas gross profit margins of midstream manufacturing have surpassed those domestically, the industry supply and demand structure is healthy, and it is shifting towards manufacturing for global demand, which may drive changes in the surplus structure and foreign exchange settlement behavior, thereby promoting the internationalization of the RMB.

Main Text

I would like to briefly share my thoughts on the exchange rate issue, mainly divided into three parts:

First, I believe there are significant problems with the current mainstream narrative logic in the capital market regarding exchange rates.

Second, regarding the medium-term trend of the US dollar, I believe that in the next 1-2 years, we need to be wary of a neutral to strong pattern for the dollar, rather than a neutral to weak one.

Third, there is an important topic worth discussing regarding the RMB exchange rate in the next two to three years: if China's midstream manufacturing sector truly achieves a breakthrough in globalization and significantly changes the surplus structure, is it possible for the RMB exchange rate to experience a slight revaluation similar to that of 2005? This is a long-term issue that needs attention. In the short term, the exchange rate is expected to remain basically stable over the next year, and I will analyze this from both short-term and long-term dimensions.

Reflection on the Current Mainstream Narrative of the Exchange Rate Market

First, recently, from the end of 2025 to early 2026, the mainstream narrative in the capital market is: it is expected that the interest rate cuts in the US in 2026 will be greater than those in China, leading to a narrowing of the interest rate differential between China and the US, thereby driving the depreciation of the US dollar and the appreciation of the RMB. The market further worries that the appreciation of the RMB may weaken China's export competitiveness and even impact the currently emerging weak recovery trend.

However, by gradually dismantling this logical chain, we can find problems in each link:

First, there is no necessary connection between the Federal Reserve's interest rate cuts and the movement of the US dollar index. Data shows that from October 1982 to the present, the correlation coefficient between monthly adjustments in the Federal Reserve's policy interest rate and the monthly increase in the US dollar index is only 0.04. Moreover, the euro accounts for more than 50% of the weight of the US dollar index, and its movement reflects more of the relative differences between the US and Europe.

Second, even from the perspective of the interest rate differential between China and the US and the exchange rate, two distinctions need to be noted: on one hand, except for the period from 2018 to 2021 when the trade war and the pandemic disrupted the relationship between the ten-year government bond yield differential and the USD/CNY exchange rate, since the US entered a high interest rate phase in 2023, **the correlation coefficient between the ten-year government bond yield differential between China and the US and the USD/CNY exchange rate has remained as high as 70% over the past two to three years, indicating that there is still a good correlation between the two The long-term interest rate spread still has an impact on exchange rates, at least at the level of financial market trading.

According to observations, the correlation coefficient between the policy interest rate spread and the exchange rate is negligible, only 10%, indicating basically no correlation. I believe that predicting whether the U.S. and China will cut interest rates is fundamentally different from predicting the trend of the ten-year government bond yields in both countries. The former only involves monetary policy operations, while the latter encompasses comprehensive information such as inflation expectations, economic growth, and monetary policy. We can expect that the Federal Reserve's rate cuts by 2026 are likely to be greater than those in China, but this cannot be used to predict the direction of changes in the long-term interest rate spread between the U.S. and China, as they are two different levels of issues.

Third, the view that the appreciation of the Renminbi will harm export competitiveness lacks sufficient basis. Reviewing the historical relationship between China's cumulative export growth and the spot exchange rate of the Renminbi against the U.S. dollar, we can see that their correlation is unstable, and in certain periods, it is almost irrelevant. From an international comparison perspective, whether nominal or real exchange rates, there is almost no clear correlation with competitiveness indicators represented by export shares. This low statistical significance precisely illustrates the complexity of the relationship between the two. To clarify whether the exchange rate is a key variable for export competitiveness from an empirical perspective, a complex and rigorous analysis of control variables is required, rather than simple linear inferences.

In summary, the narrative logic that is widely circulated in the current market and sounds reasonable is actually untenable at every link.

Recent Exchange Rate Trends and Driving Factors Analysis

The appreciation of the Renminbi since April 2025 can be divided into two phases:

From April to November 25, 2025, the counter-cyclical factor was significantly negative, averaging around -313 pips per day. An important feature of this period is that the daily midpoint reading was usually lower than the previous trading day's closing price, indicating a tendency to guide towards appreciation, while the spot exchange rate operated above the midpoint reading, suggesting that the willingness of policy regulation was quite evident, and the market supply and demand itself did not support the appreciation of the Renminbi, thus the actual appreciation was relatively limited.

After November 26, 2025, the driving factors for appreciation underwent a significant change. Although data shows that the Renminbi has continued to appreciate since April, the nature of the appreciation from April to November and after the end of November is fundamentally different. Since November 26, the real market supply and demand began to drive the appreciation of the Renminbi, at which point the central bank instead suppressed excessive appreciation fluctuations through the counter-cyclical factor. The counter-cyclical factor turned positive (averaging about 272 pips since December 16, 2025), which historically represents a relatively large degree of appreciation suppression.

From this, we can draw the following conclusions about the exchange rate trends:

First Phase (April to November 2025): Policy support predominates, with the midpoint guiding the spot exchange rate towards appreciation.

Second Phase (End of November 2025 to present): Market supply and demand dominate, with the midpoint being driven by the market, but the central bank continuously adjusts towards depreciation through the midpoint to suppress excessive appreciation The driving factors in these two stages have essential differences, which are significant for our understanding of the current market situation.

Firstly, regarding policy regulation, it is clear from the daily changes in counter-cyclical factors that the current attitude of the central bank towards suppressing excessive appreciation fluctuations of the exchange rate is very explicit.

Secondly, the reasons for changes in market supply and demand factors can be understood from two levels: one is the stock level, and the other is the flow level.

From the stock perspective, there is an objective backlog of USD positions waiting to be settled in the market. Data shows that since the pandemic in 2020, although the trade surplus has significantly expanded, it has not fully translated into an increase in settlement, leading to export enterprises accumulating a considerable amount of unsettled funds. Between 2020 and 2025, the backlog of unsettled positions and their cost distribution may mainly concentrate in two ranges: the first wave of hoarding cost range is 7.2-7.5, corresponding to the backlog of settlements in 2024; the second wave of hoarding cost range is 6.9-7.2, corresponding to the backlog of settlements in 2022.

After the exchange rate broke through the 7.2 mark in May 2025, settlements significantly increased, which may have basically digested the backlog of unsettled positions from 2024. Recently, the midpoint has risen above 7.0, which may accelerate the settlement of the second wave of hoarding positions in the 6.9-7.2 range, amplifying the fluctuations in the appreciation of the RMB, which belongs to the pulse effect at the stock level. Data shows that net settlements in December 2025 reached as high as 99.9 billion USD, setting a historical record, which may be influenced by the release of stock settlements.

However, what is more critical for the trend of the exchange rate is the flow level. The current issue is that the momentum for net settlements driven by the trend rebound of PMI may still need further accumulation and verification. Flow refers to the net settlements converted from monthly trade surpluses, which is the fundamental basis affecting the trend of the exchange rate. Historical experience shows that before the RMB begins a trend of appreciation, it is often accompanied by an improvement in net settlements, that is, the narrowing of the settlement deficit gradually turning into a surplus, driven by the upward trend of the net settlement rate. To maintain a high net settlement rate and ensure that the monthly surplus can be efficiently converted into settlements, PMI usually needs to remain in the prosperous range.

PMI reflects the activity level of domestic orders. The more active the orders, the more motivation enterprises have to convert USD settlements to supplement RMB liquidity, thereby expanding capital expenditures, increasing production, and replenishing inventory; otherwise, the motivation for enterprises to settle may be insufficient.

We infer that the current rise in the net settlement rate may largely be disturbed by the release of stock settlements; from the flow perspective, the endogenous momentum driven by the trend rebound of PMI leading to the rise in the settlement rate may still need further accumulation.

Outlook on USD and RMB Exchange Rate

Regarding the outlook for future exchange rates, I believe it is essential to clarify one point: although the pricing of the RMB is theoretically very complex, from the front-end perspective of market transactions, in the absence of significant changes in economic structure, assessing the main trend of the RMB over one or two years or two to three years can focus on two valuation perspectives:

First, the single exchange rate perspective, based on the yield spread of ten-year government bonds between China and the United States, to evaluate the deviation of the USD/CNY exchange rate from its equilibrium level. Second, from the perspective of a basket of exchange rates, assess whether the CFETS RMB exchange rate index deviates from its pricing center based on China's export share. Given that the CFETS index is essentially a weighted average exchange rate compiled based on trade weights, there is a good fitting relationship between it and export shares.

Historically, significant trend inflection points for the RMB often correspond to deep pricing deviations occurring in the aforementioned two dimensions. For example, before the substantial devaluation of the RMB in August 2015, both the RMB central parity and the CFETS index exhibited clear overvaluation characteristics, deviating from the valuation center by 5%-10%. At that time, the trend of the China-U.S. interest rate differential had already reversed, and the performance of China's export share did not support a strong basket of exchange rates, leading to significant devaluation pressure on the RMB due to the valuation divergence.

Looking at the RMB appreciation cycle in 2020, China's export share had significantly increased, but the exchange rate failed to reflect this change in a timely manner, resulting in clear undervaluation. The CFETS index was once undervalued by more than 10% compared to the fitting center of export shares. Based on the severe divergence between the exchange rate and fundamentals, coupled with support from the China-U.S. interest rate differential, we anticipated at that time that the RMB would begin an annual appreciation trend.

Overall, significant trend fluctuations in exchange rates usually stem from notable deviations between pricing and fundamentals. At present, while it cannot be asserted that the current exchange rate pricing is absolutely reasonable, at least no extreme pricing deviations similar to those in 2015 or 2020 have been observed. Whether from a single exchange rate perspective or a basket of exchange rates, the deviation in pricing is within 3%.

Combining the previously analyzed stock and flow factors: in terms of stock, although there are still positions waiting to be settled (mainly in the 6.9-7.2 range), their impact is more of a pulse disturbance; in terms of flow, the trend recovery of PMI may still need further accumulation of momentum for net settlement rates, and the current economic fundamentals are insufficient to support sustained and strong settlement inflows from enterprises. Therefore, overall, the RMB exchange rate is expected to maintain a pattern of stable fluctuations.

Regarding the trend of the U.S. dollar, I have three main views:

First, the difference in nominal GDP growth rates between the U.S. and Europe/Japan is expected to remain high in 2026, which means that the relative nominal returns of U.S. assets still have attractiveness.

Second, the current short positions on the dollar have reached historical extremes, and from a trading structure perspective, the momentum for further shorting the dollar has become insufficient, unless a new and strong bearish narrative emerges.

Third, I do not agree with the view that the high proportion of U.S. Treasury debt to U.S. GDP indicates a decline in U.S. national strength. If we follow this logic, the high proportion of U.S. stocks to U.S. GDP also sets a historical high; does that mean U.S. strength is increasing?

The true status of U.S. Treasury debt needs to be viewed within the context of the global financial market, as the dollar is the dominant international reserve currency, and U.S. Treasury debt possesses global safe asset attributes, serving as an important vehicle for international transactions and capital accumulation. If we look at the ratio of U.S. Treasury debt stock to the total market size of stocks and bonds in major global economies, this ratio has actually remained stable over the long term, consistently within a relatively fixed range over the past decade Therefore, regarding the statement that "the rising proportion of U.S. debt necessarily means a weakening dollar," I believe it should be viewed with caution.

In addition, we must be vigilant that a major power that is beginning to see a turning point in its national strength typically will not allow such changes in strength to be priced linearly and smoothly in the financial markets. The United States will not actively provide positive incentives for shorting the dollar. On the contrary, during this sensitive phase, it may strive to maintain the credibility of the dollar and thwart the confirmation of a trend reversal. Therefore, in the next 1-2 years, I believe the dollar is more likely to present a relatively strong narrative tone.

Long-term Structural Opportunities for the Renminbi

Finally, regarding the long-term structural issues of the Renminbi, I would like to share a perspective worth noting.

The claim that the purchasing power parity of the Renminbi is undervalued, although frequently mentioned in many analyses this year, is not a short-term phenomenon. Against the backdrop of significant changes in the current economic structure, whether this undervalued purchasing power can be released in the next two to three years, I believe a key observation point lies in whether China's midstream manufacturing can enter a new stage of development.

At the macro level, we decompose retail sales, exports, and fixed asset investment into corresponding demand for the upper, middle, and lower reaches of manufacturing (viewed as indicators of economic performance), and break down corporate spending, government spending, and direct and indirect financing of the real economy into support for the upper, middle, and lower reaches (viewed as indicators of growth potential). The results show that both the performance indicators and potential indicators of the midstream are leading.

At the same time, the capital market perspective has also observed new changes that resonate with this. The changes in economic structure correspond well with the evolution of the market capitalization structure of A-shares. Although it is difficult to predict A-shares in the short term (such as a week or a month), the capital market's reflection of economic structure remains relatively accurate over a period of about two to three years.

For example, from China's accession to the WTO in 2000 until 2014-2015, the Chinese economy primarily relied on urbanization and real estate for growth, with manufacturing essentially serving real estate development. During this period, upstream demand was the strongest. At that time, star fund managers or companies that achieved outstanding returns in A-shares were mostly adept at investing in real estate, construction materials, and commodities. There was even a saying: if you did not understand the commodity and real estate supply chains, it was difficult to succeed in the A-share market.

With the arrival of the Lewis turning point in 2014-2015, the real estate cycle gradually peaked, and the issue of overcapacity became apparent. From 2014 to 2021, China's per capita GDP rose from four to five thousand dollars to about ten thousand dollars, and asset prices experienced a decade-long appreciation process. During this stage, Chinese manufacturing began to shift to serve consumption upgrades. During this period, downstream consumer demand continued to perform well—since 2016, the year-on-year growth rate of total retail sales of consumer goods has consistently exceeded the growth rate of fixed asset investment. In those five years, the Chinese consumption sector experienced a significant boom, and it was against this backdrop that giant market capitalization companies like Moutai emerged.

I would like to point out that from the data for 2024 to 2025, it seems that China's midstream manufacturing is beginning a new round of structural transformation, which is likely to become the most promising direction in the next two to three years It is foreseeable that the proportion of the midstream manufacturing industry in the A-share market value will significantly increase, and it is expected to give birth to "Moutai" level enterprises in this field, triggering a major change in the market value structure. This judgment is mainly based on the following two points:

First, in 2025, the overseas gross profit margin of midstream manufacturing listed companies will systematically surpass that of domestic for the first time. Specifically, midstream manufacturing includes eight industries: general equipment, specialized equipment, electronics, electrical, automobiles, transportation equipment, instruments and meters, and metal products, all of which correspond to the basic exports of Chinese electromechanical products. The overseas gross profit margin of these enterprises has historically surpassed that of domestic for the first time, indicating that Chinese manufacturing is truly achieving better profitability in overseas markets.

Looking back from 2000 to 2020, although China's export scale continued to expand, the overseas gross profit margin of midstream enterprises was long lower than that of domestic, mainly constrained by two factors: first, at that time, Chinese manufacturing products were mostly in the mid-to-low end, primarily relying on labor-intensive and OEM/ODM models, lacking brand premium and having limited profit margins; second, in most previous periods, China's economic growth and inflation levels were higher than those overseas, making domestic market profitability relatively stronger.

The reversal of this situation in the past two years is, in my opinion, partly due to the tariffs imposed during the Trump era, which objectively promoted Chinese enterprises to enhance product competitiveness and brand awareness. At the same time, the disruption of the global supply chain during the pandemic also provided opportunities for Chinese enterprises to penetrate more core international supply chain systems. On the other hand, the economic growth and inflation levels in overseas markets (represented by the United States) are relatively higher than those domestically, and the price elasticity brought about by nominal growth is more favorable for corporate profitability.

Currently, the overseas gross profit of midstream manufacturing accounts for about 25% of the overall gross profit of listed companies, with a high proportion of overseas profit weight and significant improvement in gross profit margin. This means that even if the Chinese real estate market continues to be under pressure, the profits of midstream manufacturing are still expected to rebound, which is distinctly different from the past situation where A-share profits were highly dependent on the real estate cycle.

Second, against the backdrop of widespread "involution" in the industry, the supply-demand balance of midstream manufacturing is showing a relatively optimal state, which can be described as "diamonds in the sand." If we peel back the surface of the total data, its structural advantages are very prominent. We find that the current midstream manufacturing industry may replicate the rise path of the consumer sector in 2015, with the essence being the question of "who is Chinese manufacturing really for."

Currently, Chinese manufacturing may be facing urgent demands from three global dimensions: America's technological anxiety, Europe's and Japan's security anxiety, and the developmental anxiety of emerging markets in Asia, Africa, and Latin America. These anxieties need to seek solutions in industrialization, military industry, and power investment, thus bringing new growth space for China's midstream manufacturing.

This gives rise to two thought-provoking questions: First, if the prosperity of midstream manufacturing continues in the future, the behavior of related enterprises in earning surpluses through exports and their subsequent foreign exchange settlement will differ from the past, which may lead to significant narrative changes in the international balance of payments structure; second, as enterprises deepen their global layout, GDP will be more transformed into GNP, thereby promoting China's financial output, financial order construction, and the process of RMB internationalization. Compared to the relatively static "Belt and Road" initiative in the past, this change will contain stronger endogenous motivation and the possibility of qualitative change, and is expected to significantly accelerate the relevant processes Risk Warning and Disclaimer

The market has risks, and investment should be cautious. This article does not constitute personal investment advice and does not take into account the specific investment goals, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Investment based on this is at one's own risk