As the Federal Reserve gears up for what appears to be an inevitable interest rate cut in September, the markets have already factored in nearly 200 basis points (BP) of decreases before the end of next year. This anticipation has led the dollar index to retreat to levels not seen since early in the year, inching precariously close to the psychologically significant threshold of 100.

On the flip side, non-dollar currencies have mounted a vigorous comeback, with both the euro and the British pound reaching new highs against the U.S. dollar within the year. A notable highlight has been the robust performance of the Japanese yen, which surged more than 12% against the dollar earlier in August and has maintained its strength, hovering near 2023's zenith. As of the latest figures, the euro/dollar exchange stands at 1.114, the pound at 1.323, and the dollar/yen at 144.2, while the dollar index itself rests at 100.75, indicating a prevailing consensus among major institutions that the dollar's weakening trend is set to continue.

When it comes to the Chinese yuan, while its appreciation may not match that of certain other non-dollar currencies, a lift of nearly 2000 basis points certainly commands attention. The convergence of spot rates, midpoint rates, and offshore rates suggests a stark drop in depreciation expectations. Many traders and analysts from both domestic and foreign institutions believe that the yuan may have further potential for strengthening this year. Importantly, a potential "rush for settlement" has yet to materialize, giving exporters who previously missed the boat on high-rate settlements hope for future opportunities. Nonetheless, the extent of appreciation will ultimately hinge upon the improvements in economic fundamentals; a glance at the recent midpoint rates indicates that the central bank is not currently inclined to press the yuan’s appreciation further.

Advertisement

Eric Robertsen, Barclays' head of foreign exchange and rates strategy, estimates that Chinese enterprises hold about $500 billion in deposits, of which only $100 to $200 billion could be converted into yuan if the offshore yuan were to fall below 7.1 against the dollar.

The signal of potential interest rate cuts has ignited what is being termed the "weak dollar trade." Fed Chair Jerome Powell highlighted a pivot from a focus on inflation to concern over employment during the recent global central banking conference in Jackson Hole, stating that “the time for policy adjustment has arrived.” The only remaining points for discussion seem to be whether a 50 basis point cut will take place in September and by how much rates will decrease throughout the rest of the year.

Traders quickly absorbed this signal, resulting in a significant sell-off of the dollar, with both the dollar index and U.S. Treasury yields experiencing a sharp dip. Eric Robertsen further shared insights that suggest they predict a drop of 25 basis points at all three remaining meetings in 2024, but if the American economy deteriorates significantly, a 50 basis point cut could become a realistic possibility. Core PCE inflation has already decreased to 2.6% year-over-year, while the unemployment rate has risen from 3.7% to 4.3% since the beginning of the year. Should these trends accelerate, the Fed would be inclined to consider a sharper reduction.

Since August, the dollar index has consistently weakened, and non-dollar currencies have achieved new highs during this period. According to David Scutt, a senior strategist at IG, “The dollar index plummeted following the breach of a crucial upward trend support level, hitting lows around 100.6. With technical indicators like RSI and MACD issuing bearish signals, the 50-day moving average has crossed below the 200-day moving average, indicating a potential death cross. With key economic data due later in the week, the momentum currently favors short positions.”

Scutt remarks that if expectations for further rate cuts fail to materialize, the dollar index could find support around the 100 mark, which is also the site of earlier lows and the 200-week moving average. However, if it falls below this critical support, it could test levels around 96.

That said, numerous institutions have also cautioned against potential overpricing regarding rate cuts, warning of a possible rebound in the dollar in the near future.

Scott observes that the market has priced in 'hard landing' risks, anticipating total rate cuts of over 100 basis points in the upcoming three meetings. This implies at least one 50 basis point cut this year, with a small chance for two such cuts. Market forecasts suggest that, before September of next year, every meeting may well see a 25 basis point reduction, representing a balancing act between strategies for both hard and soft landings. How these expectations evolve will deeply impact the broader foreign exchange market performance in the coming year.

Salman Ahmed, head of global macro and strategic asset allocation at Fidelity International, expressed that "unless U.S. unemployment spiked significantly in August, the initial move should be a 25 basis point cut. Our assessment suggests that while the U.S. labor market has been slowing down, it has not entered a rapid cooling phase; we maintain our baseline assumption of a 25 basis point cut in September and another in December."

Leading up to the September meeting, critical data releases including the August non-farm payrolls on September 6 and the PCE price index on August 30 will be crucial. However, major changes in Powell's newly set dovish tone are unlikely unless core PCE significantly jumps from 2.6% to roughly 3%.

Despite uncertainties, the market is betting that the dollar's weakening trend is ongoing. Over the past month, the dollar has depreciated nearly 3% against the euro to reach a new low not seen in over a year; with the pound surpassing 1.32 against the dollar, reaching its highest level since March 2022. In the last three weeks, the Australian dollar has rebounded 7% from its low, climbing from year-to-date lows to new highs, while the yen has appreciated more than 7% against the dollar in the month. Additionally, gold prices have set new heights, reaching $2531 per ounce earlier this week.

The trajectory of the yen remains a focal point of market attention. The dollar/yen pair peaked at 162 but sharply reversed course due to unexpected rate increases and balance sheet tightening signals from the Bank of Japan. This led to a significant position covering, driving dollar/yen to around 140, where it currently sits near 144. However, expectations for further yen appreciation remain strong.

The trend of the yen also influences the exchange rate of the yuan, as both currencies are subject to similar factors as low-yielding Asian currencies and are easily influenced by speculative trading. Data signals indicate a likelihood of continued monetary policy tightening in Japan. According to the Ministry of Internal Affairs, July's CPI, excluding fresh food, rose by 2.7% year-over-year, surpassing June's rate of 2.6%, indicating a continued rise in the cost of living. Consequently, after the Bank of Japan's Governor Kazuo Ueda suggested a willingness to continue adjusting rates if inflation trends align with forecasts, the yen reacted quickly with a bounce back.

Oxford Economics predicts an additional rate hike from the Bank of Japan in October, following the release of hawkish forward guidance at the July meeting.

“After another rate hike, we expect the Bank of Japan to tread cautiously, raising rates just once in each of 2025 and 2026 to achieve a final target rate of 1%.” The institution also notes that the political situation surrounding the next prime minister, going beyond what Prime Minister Fumio Kishida currently faces, could alter the increasing pressure on rate hikes. Although the currently unpopular weakness of the yen has experienced some recovery, concerns linger about potential stock market corrections and the ensuing effects on vulnerable groups, including low-income households and microenterprises.

Scutt shares his views, predicting that if the dollar/yen breaches the support level of 143.63, it opens the door for a retest of the low of 141.70 set on August 5. Other important lower targets include 140.27 and 138.

UBS projects the dollar/yen exchange rate will hover around 147 in September and December and gradually slip to 143 and 140 by March and June 2025, respectively.

Another critical aspect beyond movements in the dollar, yen, and other international factors for the yuan lies within the behavior of exporters. Over the past two years, Chinese businesses have kept a significant amount of dollar deposits that earn higher interest.

J.P. Morgan estimates that unconverted dollar amounts held by Chinese enterprises stand between $300 billion and $600 billion. Should the dollar decline and exchange rates slip lower, these businesses might focus on converting their currency in a concentrated manner, thus significantly impacting the market.

“From what we understand, exporting enterprises have been slow to convert their earnings, with most yet to engage. A previous wave of settlements was missed, and the current activity still primarily involves bank positions,” reported a head of foreign trade finance at an enterprise.

Barclays estimates that Chinese exporters hold around $500 billion; if the dollar and offshore yuan continue to weaken below 7.1, it is projected that $100 billion to $200 billion might be converted into yuan.

“For the past two years, Chinese exporters have refrained from liquidating their dollar earnings. Unlike businesses in South Korea and Taiwan, which engaged in settlements at currency highs against their shadowy counterparts, these exporters have retained their dollars due to their pessimistic attitude towards the yuan,” stated Zhang Meng, a strategist.

According to China's foreign exchange settlement and trading data, Zhang estimates that from 2020 to 2022, the average ratio of net foreign exchange settlements (representing customer accounts) to China's annual trade surplus was 0.29. However, this ratio plummeted to -0.17 in the first half of 2023, suggesting that the "missing" settlement flows are primarily linked to exporters' dollar retention. Rough estimates indicate that since 2023, exporters have maintained around $538 billion in dollars. Furthermore, according to the foreign exchange derivative trading and spot transaction ratio released by the State Administration of Foreign Exchange, the average forex hedging ratio for Chinese enterprises stands at 27.1% for the first half of 2024, slightly higher than last year’s 24.2% and the previous year’s 25.8%, yet overall still relatively low, signifying the vulnerability of exporters in light of substantial forex volatility.

Institutional sources concur that unless the Fed initiates an aggressive rate-cutting cycle, Chinese enterprises will likely continue holding onto dollars. Given the rising volatility in exchange rates, major Chinese enterprises are negotiating with global partners to mitigate foreign exchange risk, while small- to medium-sized enterprises are redistributing resources through heightened overseas investments to buffer the impact of yuan fluctuations.