The value of Chinese yuan traded in offshore markets fell 1.3% against the U.S. dollar this week, marking the currency's biggest weekly decline since 2011. A large portion of the move came on Friday, following the People's Bank of China's decision to set a lower fixing against the dollar in onshore markets for the fourth straight session.
The PBoC sets a daily reference rate from which the spot value of the yuan in onshore markets is not allowed to deviate more than 1% in either direction. Yuan traded in offshore markets are not subject to this trading band, and the popularity of the long-China carry trade among investors looking for continued appreciation of the yuan against the dollar has caused offshore yuan to trade at a premium to onshore yuan.
This week, however, the PBoC appears to be squeezing traders out of these positions, causing the offshore yuan to plunge as carry trades unwind, thereby erasing the premium in the offshore market.
According to Sacha Tihanyi, a senior currency strategist at Scotiabank, today's swift decline in the value of offshore yuan is indicative of a "panicked unwind" of the carry trade, as violent price action fed on itself throughout the session.
Dollar-yuan options trades accounted for 72% of total volume today, according to DTCC — three times the currency pair's average over the last five sessions — as traders scrambled to hedge their long-yuan positions.
Ju Wang, a senior FX strategist at HSBC, says the PBoC has been setting weaker fixings following the Lunar New Year holiday despite the dollar's weakness against other global currencies, suggesting it wants to take advantage of relative calm in market to reduce yuan appreciation expectations.
However, given the disappearance of the premium in the offshore yuan market, the squeeze may be coming to an end.
Mirza Baig, head of foreign exchange and interest rates strategy at BNP Paribas, points out that the PBoC is has been buying dollars in recent sessions as the yuan has declined, and suggests that when the PBOC turns around and starts selling dollars, it would be a signal that they are done squeezing the market.
Nonetheless, traders are watching this market carefully.
"Protracted yuan weakness would have potentially profound implications for developed markets, in particular because China would be exporting disinflation," says Vincent Chaigneau, global head of rates and FX strategy at Société Générale.
"That would undermine our fundamentally bearish bond views. Stay tuned."
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