Why traders should watch the CNH/CNY spread

February 23, 2016 09:00 AM

Chinese New Year officially takes place on Feb. 8, but for traders, the traditional Jan. 1 New Year had a distinct Chinese component to it. It was around that period that concerns about slowing manufacturing activity and a weakening Chinese currency threw global markets into chaos, leading to a nearly 20% drop in the Shanghai composite index and the worst first week of the year for U.S. equities on record. Of course, slowing manufacturing activity in the world’s second-largest economy is nothing new – China’s Caixin manufacturing PMI report was in positive territory only once in 2015 – so the fall in the value of China’s currency was seen as the proximate cause for the turmoil.

Though China has reformed its currency policy to allow a more market-determined exchange rate over the last few years, policymakers still have significant influence over the yuan’s value. Many traders speculate that the People’s Bank of China (PBOC) kept its currency unsustainably high in the first half of last year to gain entry into the International Monetary Fund’s (IMF) prestigious basket of currencies included in Special Drawing Rights (SDRs). Now that that goal has been achieved, Chinese authorities are intentionally guiding the currency lower in an effort to stimulate exports. With fears of a destabilizing currency war growing far faster than China’s sputtering economy, it’s more important than ever to understand the dynamics behind the yuan and how to analyze investor sentiment toward China’s currency. 

In case you’re unfamiliar, there are actually two markets for the yuan: An onshore rate that is heavily influenced by Chinese policymakers (CNY) and the offshore rate that is traded in Hong Kong and more subject to the free market whims of international investors (CNH). Chinese authorities first established offshore markets for the yuan in 2010 in an effort to promote international use of its currency, and trading volume in the instrument has grown consistently since. 

Through an opaque (and some would argue subjective or politically-motivated) process, the PBOC sets a daily reference rate for the CNY and allows traders to push the currency up or down by only 2% from the daily fix. By contrast, the CNH is not subject to a trading band, though the PBOC does regulate flows between the onshore and offshore accounts and can therefore influence its liquidity. In simple terms, the CNH can be viewed as a sort of “black market” for the country’s currency relative to the onshore rate that most Chinese citizens deal with on a day-to-day basis.

By looking at the spread between the offshore and onshore rates, traders can gauge the market’s sentiment toward the currency and its confidence in the PBOC’s policies (see “A tale of one currency”). During the start-of-the-year market fireworks, that spread expanded to a record high of 2% on Jan. 5, signaling that investors were worried about Chinese economic data and anticipated the PBOC would continue to weaken its currency. It’s worth noting that the surge in the spread preceded the worst of the global stock market turmoil, much as it did the last time the spread rocketed higher in Q2 2011, when U.S. equity bourses dropped by nearly 20%.

As we move through the “Year of the Monkey” in the Chinese Zodiac, the CNH-CNY spread will be a critical tool for traders to handicap whether it will be “The Year of the Bull” or “The Year of the Bear” for traders.

About the Author

Senior Technical Analyst for FaradayResearch. Matt has actively traded various financial instruments including stocks, options, and forex since 2005. Each day, he creates research reports focusing on technical analysis of the forex, equity, and commodity markets. In his research, he utilizes candlestick patterns, classic technical indicators, and Fibonacci analysis to predict market moves. Weller is a Chartered Market Technician (CMT) and a member of the Market Technicians Association.