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Dollar to be Dragged Higher on Trade War Escalation: "Chinese Yuan Really is the World's Most Important Currency" say Soc Gen

 Xi Jinping

Above: Chinese President Xi Jinping. File photo. © GovernmentZA, image Reproduced Under CC Licensing

The Dollar and Yen will be dragged higher while Asian currencies and global stocks will be pushed lower if the anchor that is the Chinese Yuan is dislodged by a full-blown U.S.-China trade war says a strategist at Société Générale.

Kit Juckes with Soc Gen in London says the "Chinese yuan really is the world's most important currency. It isn't the most traded, or the biggest component of central banks' reserves but has plenty of soft power."

Foreign exchange traders and investors have this week been primarily focussed on the evolution of China-U.S. trade negotiations, which have taken a decidedly negative turn.

Stocks and high-yielding assets are deep in the red on Thursday after Beijing vowed last night to retaliate if the U.S. moved forward with plans to impose fresh import tariffs on Chinese-made goods on Friday.

Officials from the world’s two largest economies will convene in Washington today, mere hours before both nations have threatened to intensify their trade war.

The Yuan is widely expected to suffer in the event of trade tensions escalating as markets anticipate a sizeable knock to already declining Chinese growth rates.

"The near-term risks around U.S.-China trade negotiations are substantial in that they could lead to significant moves in USD/CNH and impact on other global markets," says Lewis Alexander, an economist with Nomura in New York.

Nomura say the falling Yuan could lead the USD/CNH to possibly test 7.0, the exchange rate is presently quoted at 6.81.

Juckes says the Yuan remains an anchor of stability for all markets "and if that anchor is dislodged, it will lead the Dollar and Yen higher."

Juckes says if the exchange rate goes on to break 7.0 from here (even temporarily), EUR/USD is likely to break below 1.11 and test 1.10.

"But the biggest moves would be in EM, not just Asian EM, the big losers in the USD/CNH rally last year were ARS, TRY and ZAR," says Juckes.

Dollar Yen

Data shows that the Dollar index (DXY) - a broad measure of the Dollar's value - and the Yuan tend to move together.

This relationship is usually explained as China manages a currency basket to determine the value of their currency.

Analysis by Soc Gen suggests the strength in the Yuan (January), stability (February-April), and weakness (now) are all linked to trade negotiation factors.

However, over time the Dollar and Yuan should continue to move broadly in the same direction.

"The only question is who leads who?" asks says Jason Daw, an economist with Société Générale.

"The view years ago was that China (like most EM currencies) was a “follower” in the global FX cycle. That is changing and CNY is being increasingly viewed as a 'leader' in certain periods," says Daw. "The CNY was an anchor of stability for Asia FX until last week. If that anchor gets dislodged further, CNY will lead the Asia FX cycle weaker."

Soc Gen forecasts have assumed USD/CNH rising toward 6.95 by year-end, but not breaching 7.0 until quarter-one 2020.

"This was predicated on trade negotiations continuing. If the two sides walk away, the chance of USD/CNY breaking 7.0 earlier than we expected would increase," says Daw.

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