China’s unexpected retaliation last week and the hasty US reaction means we can expect China to use other tools besides tariffs for future retaliation. The yuan is likely to be one of these, but the central bank probably wouldn't want one-way depreciation lest it triggers capital outflows. Therefore, we revise our USD/CNY forecast.. again 

Dollars surrounded by Chinese yuan

It's all kicking off again

Last Friday, China surprised markets by imposing new tariffs on more US goods imported into China. The retaliation in terms of the amount is small (simply because China exports more goods to the US than it imports), so in principle, this won't have much of an impact on the US. It could ignore this as, after all, it was retaliation.

The unexpected announcement hit a nerve

Another perspective on the entire situation is the flurry of tweets that came almost immediately from President Trump displaying his anger. The Chinese tariffs seem to have hit a nerve.

The wobbly stock market

This marginal increase in tariffs may not be a substantial issue for China as the initial tariffs should have already been enough of a hindrance for  Chinese businesses exporting to the US.

But the surprise increase in tariffs means that China pretty much had the desired impact on the stock market. 

Over to China

The ball is now firmly in China's court. We think imposing more tariffs isn't the most effective way to create more hurdles for a Trump Administration that will soon begin to campaign in earnest for the 2020 presidency. Instead, China could probably cause more disruption if it keeps catching US stock markets - and potential Trump voters - off guard.

There are two measures available to China:

1. Unreliable entity list
   Inclusion of any US companies in the list means that those companies cannot tap into the Chinese market. This is a very powerful tool that has the potential to lead to increased market volatility. The yuan could also well face periods of sudden weakness. 
   Talks without progress are more likely to provoke additional tariffs from the US. Even though this is expected, this could well weaken the yuan significantly. USD/CNY could cross 7.18 (the recent high) to near 7.20. This alone, without any retaliation from China, has the potential to create further market disruption.

Revising yuan forecasts

With both measures likely to end up with a weaker yuan, we revise our USD/CNY forecasts.

But we think the central bank won't want the market to believe that the yuan can only depreciate against the dollar. We expect that, in between these “unexpected” events, the yuan will see periods of strengthening against the dollar.

If we draw a monthly chart of USD/CNY, we should see increased USD/CNY volatility, even if we only see a  linear weakening yuan trend at every quarter-end.

Our range forecast of USD/CNY for the rest of 2019 is 7.05 - 7.50. Volatility should be high given that China's objective is to use the yuan as a surprise tool for the market. The spikes in USD/CNY may not be reflected in the quarter-end point forecasts. Our previous forecasts were 7.10, 7.00 and 6.90 for the end of 2019, 2020 and 2021, respectively.