BNY Mellon: The Aerial View: CNY: An Early Warning Indicator

Dec 18, 2018

By Simon Derrick, Chief Currency Strategist, BNY Mellon

•             Forward outrights have proved useful indicators of pressures in managed systems •             Gap between spot USD/CNY and the one-year NDF outright is narrowing rapidly •             NDF market has proved a useful leading indicator in the past

Through the 1980s and the early part of the 1990s one of the key indicators of mounting pressures within the European Exchange Rate Mechanism was the performance of forward outrights.

In normal circumstances, the movement of three month and longer forward outrights beyond the calculated range against the DEM would see the  currency that had come under pressure begin to be bought by investors until it moved back within the band. In contrast, when the three-month forward outright moved outside the band and stayed outside the band, this provided a key early warning of devaluation battles to come.

Why does this matter now?

Recent months have seen increased guidance from Beijing that 2019 will see a marked slowdown in Chinese growth. Recent examples include a comment from a spokesman for China’s statistics bureau late last week that the economy faces more external uncertainties next year as well as a statement earlier today from a researcher with the National Development and Reform Commission (see Newswatch).

This in turn has seen the CNY coming under - admittedly modest - renewed pressure against the USD.

However, what is interesting is that unlike the period between August 2015 and January 2016 or, again, in December 2016, there’s little sign of the NDF market becoming particularly excited about the prospect of a significant move higher in USD/CNY over the next 12 months.

Indeed, to put this into some kind of context, the spread between the one-year NDF forward outright and spot is currently at about the same level it stood at in October 2012 when the USD downtrend was starting to slow (see chart below).

This suggests that this is a market that collectively believes the PBOC will be able to carry out a very effective smoothing operation in the months ahead and that any move by the USD above CNY 7 will likely prove muted.

There is, however, a broader observation to be made. Since March 2012 - the point at which the seven-year rally in the CNY against the USD finally began to lose momentum - there has only been one very brief period when the one-year NDF points turned even briefly negative.

In other words, the past six years have been characterized by consistent expectations that the CNY would weaken over the subsequent 12 months from wherever spot was at the time.

Given this, it is therefore very interesting to note that one-year NDF points are rapidly moving towards zero. This then is a market that is beginning to consider the possibility that the CNY might actually strengthen against the USD in 2019.

While markets can most certainly be caught unawares by events - the depegging by the SNB in January 2015 being an excellent example - it should be noted that the NDF market has a history of getting trend shifts in spot CNY roughly right.