Fundamental Forecast for the Yuan: Neutral

The offshore Yuan (CNH) rose to the highest level in two months against the US Dollar last week thanks to a smaller-than-expected drop in China's foreign reserves combined with Chair Yellen's testimony saying that negative rates are not out of the question for the US economy. The rally in the Japanese Yen over the past two weeks has also helped to reduce pressure on the Yuan, despite of Bank of Japan's negative interest rate policy. On the coming Monday, China's onshore equity and foreign exchange markets will reopen. China's central bank will guide the onshore Yuan by issuing the daily reference rate again. Also, key Chinese data will be released including trade balance, CPI and PPI figures over the next week. All these factors will likely bring volatility to a global market that is already bursting at the seams with volatility.

We have discussed in the previous weeks that the regulator's controls of exchange rates are highly related to the performance of Chinese equity markets. After the global stocks began to face turbulence being driven by risk aversion, the outlook on Chinese stocks has become even uncertain. Specifically, Hong Kong's Hang Seng Index dropped 3.85% after the market reopened following the Lunar New Year earlier this week. Unlike the full-week holiday in mainland China, Hong Kong has three days off for the New Year so markets in HK re-opened earlier. Its performance can be seen as a leading indicator for the mainland market as the two share a close relationship; historical data shows that their indexes move along similar trends, especially over the past six months.

Moreover, Shanghai-Hong Kong Stock Connect program directly links the two markets. The channel could potentially transfer the turmoil from Hong Kong to mainland China. Under such a turbulent environment, combined with the Chinese stock market's own plunges in January, Monday's reopening may bring in heavy volatility to Chinese stocks. From regulator's point of view, relatively stable Yuan rates can help to maintain market confidence. Thus, the first reference rate after the 7-day holiday is likely to be set stronger, which would be consistent with Yuan-moves over the past week and could continue to reduce Yuan short speculation.