The People’s Bank of China (PBOC) sets the daily midpoint for the yuan, also known as renminbi (RMB), against a basket of currencies, largely focusing on the US dollar. The PBOC manages a floating exchange rate system with the yuan’s value allowed to fluctuate within a band of +/- 2% around the central reference rate. This system takes into account market supply and demand, economic indicators, and international currency market fluctuations.
Yuan Trading Band
The midpoint serves as the reference point for daily trading, determining the permissible range of yuan valuation changes. The established trading band allows the yuan to appreciate or depreciate by a maximum of 2% from the central rate on any trading day. The PBOC may adjust this trading band according to shifting economic conditions and policy goals.
To ensure stability, if the yuan approaches the band limits or incurs excessive volatility, the PBOC might intervene by engaging in foreign exchange activities. This stabilises the currency’s value by buying or selling yuan, which facilitates a controlled and gradual adjustment of the currency’s value, maintaining market balance.
Given the central bank’s process, we see the daily reference rate not just as a number, but as a crucial policy signal. The key for traders is to observe the difference between the official setting and market estimates. This deviation reveals the institution’s true intentions for the currency’s direction.
We have observed a consistent pattern where the People’s Bank of China sets the fix significantly stronger than predictions. For instance, on June 7, 2024, the official midpoint was set at 7.1106, which was over 1,300 pips stronger than the Reuters estimate of 7.2455. This aggressive strengthening signals a clear policy to defend the yuan and prevent rapid depreciation.
This strong stance is likely a response to domestic economic challenges and a desire to curb capital outflows. By engineering a stronger-than-expected currency, the bank projects stability and confidence in its financial system. We believe this policy of a tightly managed currency will persist as long as economic uncertainties remain.
Impact On Derivative Traders
For derivative traders, this heavy-handed management effectively creates a ceiling for the USD/CNY exchange rate. We think selling call options or establishing bearish call spreads are prudent strategies, as they profit from the currency pair’s inability to break significantly higher. These positions align directly with the observed policy of capping upside momentum.
The bank’s actions also have a direct impact on market volatility, which has been noticeably suppressed. This makes strategies that rely on price swings, such as buying straddles or strangles, less appealing in the current environment. Instead, we see an opportunity in selling volatility, as the official interventions are likely to keep price action contained within a narrow range.
Historically, during periods of economic stress such as in 2018, the institution has used this exact playbook to guide the currency. Betting against this determined policy guidance was often a losing proposition in the short to medium term. We expect this historical precedent to hold true in the coming weeks.
We recommend monitoring the spread between the onshore yuan (CNY) and the more freely traded offshore yuan (CNH). A widening gap where the offshore rate is weaker indicates building market pressure for depreciation. This serves as our key gauge for how much stress the bank’s policy is under.
