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The news should excite currency traders who have sought to profit from increased volatility in the normally stable yuan this year. As a currency based on a fixed exchange rate controlled by the steady hand of the Chinese central bank, the Yuan has not heretofore received a lot of attention from traders. But traders should be aware that China has drawn a currency weapon to help prop up the Yuan.

The USD/CNY fell slightly to 6.8688 in early morning European trading but is still stable. The small bounce up seemed like a tepid response to evidence the US trade tactics are taking a toll on China’s manufacturing sector. But traders should take into account a heavier government price setting hand when estimating Yuan price moves.

In September, the South China Morning Post reported that the People’s Bank of China (PBOC) has reintroduced the ‘counter-cyclical factor mechanism’—described as a ‘black box’ used by market makers when setting the Yuan fixed exchange rate to protect against depreciation. Typically, the fixed rate is determined based on the previous day’s close and overnight changes in the basket of currencies the Yuan tracks. This rate is allowed to fluctuate up to 2 percent in the forex markets. Just before the trade war began in January, as the Yuan stabilized, China had withdrawn the mechanism but as the trade war puts downward pressure on the Yuan, the PBOC has decided to reinstate it.

For many market observers, such Chinese government interference to prop up its currency has turned the trade war into a currency war. For traders, trading on the news alone without taking the additional fixing mechanism into account could lead to overestimations of price movements in the Yuan.

Though when the US markets open, a more enthusiastic response to the decline in Chinese exports and manufacturing in the ongoing trade wars is expected. After 15 months of expansion and eight months after President Donald Trump started imposing tariffs on Chinese goods, China’s factory orders have slowed. The Purchasing Managers’ Index (PMI) for September declined to 50.8 from 51.3 in August. Officially, the 50-mark would indicate a contraction. Growth in new export orders, meanwhile, declined for the fourth consecutive month to 48.0 from 49.4 in August. Companies attribute the slowdown in exports to the US trade tariffs, according to the Caixin/Markit Manufacturing Purchasing Managers’ Index (PMI), which reported a similar decline in September orders.

The currency war is now expected to escalate the trade war. President Trump has threatened China with more tariffs if it engaged in manipulation of the Yuan. In July and August, the USD was strengthening against the Yuan, which no doubt triggered China’s decision to reintroduce the counter-cyclical mechanism. Additionally, China is lowering taxes and fees to increase business competitiveness. The Services sector performed better, increasing from 54 to 54.9.

Manufacturing accounts for 30 percent and the services sector 54 percent of the Chinese economy.

Thusly, the trade war is expected to continue to escalate and create volatility in the USD/CNY pair. The Yuan has become more sensitive to the trade war than the USD; most recently, rallying on rumors of new trade talks on September 13th and falling three days later on Trump’s announcement of intentions to impose 10 percent tariffs on another $200 billion in goods by the end of September, and that tariff is set to rise to 25 percent by the end of the year. Furthermore, if China retaliated, which it did with tariffs in $60 billion on US goods, the US has threatened tariffs on an additional $287 billion in Chinese goods.

 USD/CNY implied one-day volatility of 4.9527 is steadily declining to 4.5600 for two-month volatility, and then slowly but steadily rising over the next three years.[1] Could the year-end volatility rise coincide with President Trump’s next trade salvo? Other factors will make the Yuan a more interesting volatility play going forward. Notably, to further ease pressure on the Yuan from the trade wars, China is accelerating the opening up of its capital markets and efforts to allow full convertibility of the renminbi. The Yuan trades offshore as the Offshore Renminbi (CNH).

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