Forex trends: US and European political risks remain
The US dollar started to weaken earlier this year after President Trump said there needed to be a dollar correction. This bearish trend continued in February. The Chinese yuan, on the other hand, has mainly traded in a sideways range since February.
In economic terms, there have been no major change in growth trends in either the US or China. In China, recovery has continued, while the US economy has maintained a path of gradual expansion. The consensus view is that by the end of June, the US/China interest rate differential will narrow, with the yuan weakening against the dollar, although there are likely to be widespread reverberations from European and US politics. The yuan is forecast to trade in a range of 6.5-7.1 yuan against the dollar in the second quarter of the year.
Currency pair trends
The yuan peaked at 6.856 against the dollar in February – based on spot rates from the China Foreign Exchange Trading Center – and its trough was 6.887. It closed the month at 6.869, a marginal 0.3% increase against the dollar vs the previous month. The yuan’s reference rate also moved in a narrow range. The peak for the month was 6.846, and its trough was 6.890. It ended the month at 6.8750. Against the Japanese yen, the yuan strengthened slightly. The JPY/CNY exchange rate was 16.38 at the end of January, and 16.43 at the end of February (+0.6%).
Looking at world currencies, the euro fell against the US dollar in February, against the backdrop of a weaker dollar in general. With political debate heating up around the French presidential elections, the euro fell 1.7% against the US dollar over the month. The Japanese yen climbed 0.6% against the dollar, with the Russian ruble up 2.9%, the Korean won up 2.8%, and the Indian rupee up 1.7%.
The People's Bank of China has had controls in place on the yuan since early last year to stabilize it against key global currencies. It has diluted the role of the dollar within its currency basket and has upgraded the yuan’s correlation with the European euro (the second largest component of the currency basket after the US dollar). The yuan is not a particularly volatile currency. However, its movements have become more aligned with the euro in recent months. This trend was particularly evident in February.
Given the direction of the monetary policy in the US, and the fact that the economy continues to grow steadily, there appears to be ample scope for additional rate hikes during the current forecasting period.
Meanwhile, in China, the housing bubble remains an issue as the economy picks up. The government is taking steps to control this, and to manage a slowdown in the economy. However, the risk is that if the Chinese authorities were to raise rates to stop the renminbi decline, that could prompt a housing collapse. Therefore the likelihood that China raises rates in the near future seems minimal.
With the environment favoring a stronger dollar and weaker yuan, it seems reasonable to anticipate that the differential between US and Chinese interest rates narrows. Notwithstanding this, the possibility of action by the Trump administration to correct dollar strength remains, with the US government’s fiscal policy still uncertain. President Trump's administrative policy speech advocated the expansion of defense spending, higher infrastructure investment, and cuts to corporate taxes and personal income tax. These expectations have been discounted in the stock market. However, it is not yet clear how the government plans to secure the funds needed for this investment.
Although the more optimistic expectations about these spending promises have been tempered as the dollar has fallen, there is still a possibility that, as political divisions continue to emerge in the US Congress, the currency comes under further pressure.
In Europe, political risk remains a key factor. The outcomes of the recent elections in the Netherlands and in France may suggest that momentum behind populism is slowing, but the Euro remains highly sensitive to political sentiment. Any event which damages confidence in the Euro (for instance, adverse sentiment around the Brexit negotiations between the UK and the EU) could trigger a possible move to dollar parity with the Euro.
Political trends in the United States and Europe can have a wider impact on the Chinese currency.
In China, at the National People's Congress (NPC) in March, the authorities set their 2017 growth target at "around 6.5%, or higher if possible." The leadership’s focus is on mitigating risk and ensuring stability ahead of the five yearly leadership transition this year. This projection was a slight downgrade compared to last year’s growth projection of “6.5% to 7%”, but was broadly in line with economists’ expectations. Hence the impact on the Chinese currency was limited.