In the early days of 2016, volatility in China has dominated global markets.
That means to stay ahead, US traders have to start looking at something new when they wake up: the spread between the onshore and offshore yuan.
To recap, the onshore yuan, or CNY, is set by the government, while the offshore yuan, or CNH, is set by the market.
We know that understanding the yuan is crucial because weakness in the yuan led Chinese stocks — and subsequently global stocks — down all of last week.
It’s becoming increasingly clear that a depreciating yuan means volatility.
Global foreign exchange markets are now more correlated with the renminbi than with the dollar.
At the same time, though, understanding the fair value of the yuan has become more difficult over the last three months. The old relationship with the dollar is breaking down, and the Chinese government has been doing everything it can — in both word and deed — to make the yuan seem stable.
Watching the spread between the onshore (CNY) and offshore (CNH) yuan is one of the few ways left for traders to get an understanding of the free market value of the yuan.
“…one of the best risk indicators for markets is the spread between onshore and offshore CNY-CNH currencies in China. It helps investors measure the speed of the devaluation and as China starts to cheat, this warning sign can be seen in the spread,” Grant O’Connor, a Bear Traps analyst, said in a recent note.
“Meaningful increases in the CNY-CNH spread have occurred before every significant surge in US equity volatility in the last 9 months,” the note said.
In other words, this spread has turned it into something for the entire world to trade on.
The Vix has spiked whenever the CNY-CNH spread widens
Saw it coming
There are a bunch reasons why the government wants to keep the yuan stable, or least manage the pace of the devaluation.
Last fall, it became an official World Bank designated global reserve currency. For that, it needed stability. After it got the designation, the yuan started to slip down.
Chinese officials saw this turmoil coming. That’s why, at the end of last year, they announced that they would depeg the yuan from the dollar, which was appreciating against the yuan.
Instead, China said that it would start measuring the yuan against a basket of currencies — one with a lower value than the dollar. Consider this a kind of unofficial devaluation. Especially since we don’t know what is actually in the basket.
At the same time, in order to keep yuan-holders from selling as their currency loses value (outflows), the Chinese government has said that the yuan won’t fluctuate too much. In December it spent $108 billion of its around $3 trillion in reserves to make sure that it didn’t.
“Giving more consideration to a basket of currencies means the RMB’s [yuan] value will be kept basically stable against the whole basket,” said Ma Jun, chief economist of the People’s Bank of China’s research bureau.
“That will be the keynote of the yuan’s exchange rate formation mechanism in the foreseeable future,” he said.
So to review: The depreciating yuan has been depegged from the dollar and pegged to an unknown basket of currencies with an unknown value that reflects where the Chinese government should set the currency every day.
Not a lot of concrete answers there.
That is why the CNH has become so important to traders. It is more controlled by the market, and as such, reflects the outside world’s view of the value of the yuan.