FX Traders Confront New Reality of Yuan Weaker Than 7 a Dollar

(Bloomberg) -- Yuan traders are now living without the line in the sand that has helped cushion the currency since its shock devaluation in 2015.

How low the yuan will go is the question on everyone’s lips after China allowed it to tumble below 7 per dollar. While the central bank vowed to keep the exchange rate steady, analysts are convinced further declines are ahead as officials look to offset the threat of additional U.S. tariffs. Positioning in the spot and derivatives markets suggests there’s plenty room for the yuan to weaken.

The 7-per-dollar support level finally succumbed Monday to an escalating trade war with the U.S. and months of worsening Chinese economic data. That spurred the most dramatic day of trading for China’s yuan in almost four years, roiling global markets and affecting the price of everything from gold to Japanese government bonds.

“A tsunami is coming -- the market implications of breaching 7 are tremendous,” said Zhou Hao, senior emerging market economist at Commerzbank AG. “The market will remain extremely volatile and the risk for both the economy and yuan are biased to the downside. We are in a messy market.”

Read more on how China is hitting back at the U.S.

For clues on where sentiment is on the yuan, look to the offshore rate. Its discount was as wide as 800 pips relative to the onshore rate on Monday, the largest gap since 2016. That suggests the onshore currency may have the room to weaken further, as the overseas rate is less influenced by Beijing. The spread was around 400 pips when the onshore yuan closed.

The offshore yuan can depreciate to 7.5 per dollar if President Donald Trump follows through with his threat to slap up to 25% tariffs on another $300 billion in Chinese goods, Citigroup Inc. analysts led by Sun Lu wrote in a note. That’s even as the People’s Bank of China may sell its foreign reserves to slow the declines.

The Trump administration formally labeled China a currency manipulator, further escalating its trade war with Beijing. This came after PBOC Governor Yi Gang said that his nation wouldn’t use the yuan as a tool to deal with trade disputes.

The onshore yuan is at the largest discount to the daily reference rate set by the PBOC since March 2015. This suggests officials, who base the rate on the previous day’s close, will have to issue a much weaker fixing on Tuesday. The yuan may slide to as low as 7.3 if the rate is fixed weaker than 7 in the coming days, said Tommy Xie, an economist at Oversea-Chinese Banking Corp.

The yuan will likely drop 5% versus a basket of other currencies if the trade war worsens, according to Citigroup. A Bloomberg replica of an index tracking the Chinese currency against 24 exchange rates fell the most since May 14 on Monday.

The extent of Monday’s slump caught most traders off guard: a gauge tracking expected swings in the offshore rate surged the most in nearly four years. A measure of demand to buy bearish options was at the highest since May 2016, a sign that traders are rushing to hedge against more declines.

Analysts and investors are now scrambling to come up with new targets and trading strategies. Some have already tweaked their forecasts for the yuan:

The offshore yuan fell 0.42% to 7.1289 per dollar as of 8:09 a.m. in Hong Kong.

--With assistance from Qizi Sun, Ran Li and Anooja Debnath.

To contact the reporters on this story: Tian Chen in Hong Kong at tchen259@bloomberg.net;Claire Che in Beijing at yche16@bloomberg.net

To contact the editors responsible for this story: Sofia Horta e Costa at shortaecosta@bloomberg.net, David Watkins

©2019 Bloomberg L.P.