FX Focus - CNYJPY – Same Trajectory Now, Divergence Later

Following the recent volatility in global asset markets caused by US recession fears and exacerbated by investors unwinding yen carry trades, JPY has strengthened by a massive 20 big figures (12.5%) against USD in a little over one month starting July 11th. But the yen is not the only currency to display such strength as it seems that the unwinding of the carry trade has spread to other low yielding currencies such as CNY and CHF that have also been used to fund carry trades. The unwinding of the carry trade has also seen CNY strengthen almost 1.5% against USD during the same period, far less than JPY but a significant move nevertheless relative to its history.
 

But the risk aversion spike that led to a global unwinding of carry trades in which funding currencies have strengthened so sharply, is already starting to moderate, a strong signal that the recent turmoil does not represent a new global economic collapse. This leaves CNY facing the same headwinds as before - a  wide rate differential with USD with the PBoC retaining an easing bias amid a faltering recovery in China that includes its exports and looming trade tensions with the US.
 

There is also little to cheer about from China’s recent seasonal beat in CPI and PPI - China’s inflation readings beating expectations in July are mostly still driven by supply-side factors and vulnerable to downside risks from commodity prices in the months ahead as well as overcapacity and insufficient demand. China’s slowing export momentum in July is more worrisome as slowing export growth follows the weakest quarterly GDP in five quarters in Q2 and suggests China’s export-driven growth strategy will be more difficult to achieve this year given the slowing US economy, threats of additional tariffs and ongoing technological decoupling.
 

The recent risk-off episode falls into the camp of a technical/positioning driven VAR shock rather and has little in common with the GFC/COVID episodes, which were true economic sudden-stops during which carry trade unwinds  were substantially larger. Therefore, it is difficult to see such the selloff in USDCNY being sustained as China’s currency remains the primary release valve to help ease domestic conditions especially when there is now a greater reliance on exports than has been the case for a number of years and the export momentum itself is slowing.
 

While CNY and JPY have gone down the same trajectory in the unwinding frenzy of the carry trade, fundamentals of CNY are completely opposite to that of JPY with the PBoC retaining its monetary easing bias whereas the BoJ is expected to continue on a path towards further tightening of financial conditions as part of the process of rate normalization. This is likely to see the paths of CNY and JPY diverge over the medium term.