The People’s Bank of China (PBOC), the country’s central bank, determines the daily midpoint for the yuan, also called renminbi or RMB. This process is part of a managed floating exchange rate system, which allows the yuan to vary within a specific range around a central reference rate. Currently, the fluctuation band is set at +/- 2%. Today, the PBOC established the USD/CNY reference rate at 7.1345, compared to an estimate of 7.1709. This rate is the strongest for the yuan against the US dollar since November 6 of last year. The previous closing rate was 7.1836.

Challenging Market Expectations

Today’s strong signal from the central bank goes against the market’s expectations of a weaker yuan. Derivative traders who anticipated a higher USD/CNY rate might need to rethink their strategies. This move appears aimed at reducing speculation and creating more balanced risks for the currency. Implied volatility for yuan options is expected to increase in the coming days due to this unexpected change. The notable gap between the official rate and market estimates creates uncertainty, which option sellers can leverage by asking for higher premiums. We saw a similar pattern during the policy adjustments in August 2015, which led to a period of increased volatility. This action suggests that the PBOC is possibly setting a new, lower ceiling for the USD/CNY rate, with a firmer defense around the 7.20 level. Traders should consider strategies that profit from limited upside, like selling out-of-the-money call spreads. The previous closing rate of 7.1836 now seems to be a near-term peak rather than a pathway to further decline.

Implications for Global Markets

We believe this development will benefit the currencies of China’s key trading partners. The Australian dollar, often seen as a barometer for Chinese economic health, may strengthen against the US dollar. So far this quarter, Australia’s exports to China have already increased by 5% compared to last year, and a stronger yuan supports this trend. A stronger yuan also boosts China’s ability to purchase dollar-priced commodities. This could provide a lift for assets like crude oil and copper, which have seen stagnant prices recently due to global growth concerns. We expect renewed interest in call options for these commodities as traders anticipate stronger Chinese demand. This policy change seems well-timed with recent data showing signs of slight economic recovery, including an unexpected 2.1% month-over-month rise in July industrial production. The PBOC likely feels more confident in guiding the currency stronger without disrupting this fragile recovery. This lessens the risk of a sudden, uncontrolled depreciation that many had been preparing for. Create your live VT Markets account and start trading now.

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