In the last two months, the Chinese Yuan has soared by nearly .6% against the USD. Compare that with the 1.2% that the Yuan appreciated in the prior 10 months, and an interesting picture begins to emerge: is China finally relaxing its control over the Yuan, allowing its value to be determined by market forces? The short answer is ‘no,’ but the long answer is ‘yes.’ Specifically, the last two months represent a sop to international economists and western politicians, who have hinted that China’s failure to continue ‘revaluing’ its currency would bring about negative consequences for its economy. While China is nowhere near letting the Yuan float freely against the basket of currencies it is currently pegged to, the last two months were certainly a small step in that direction. The Shanghai Daily News reports:

“The central bank is likely to follow up with …faster yuan appreciation through widening the yuan/dollar trading band, said the chief economist at Goldman Sachs Asia.

Read More: Yuan growth picks up in time to tackle trouble

A slew of economic data was released yesterday, each with the potential to exert pressure on the USD. Traders and economists were eyeing the data closely, in order to gauge the likelihood of a Fed rate hike next month. The first two pieces of data to be released were new home sales and durable goods orders, both of which came in below analysts’ expectations. Quarterly GDP data was next to be released, indicating the US economy has slowed considerably since last quarter, when GDP grew at an astounding 5.3%. The new consensus is that inflation appears to be easing, and hence, the likelihood of another quick rate hike is waning. It seems traders have been bracing for the end of monetary tightening for quite some time, because the net effect of the economic data on the USD was neutral. The Star Tribune reports:

The uncertainty has caused volatility in the markets, although the dollar has remained in very tight ranges with traders reluctant to push currencies in any one direction without further guidance from the Fed.

Read More: Dollar Little Changed

In a recent white paper, the American Enterprise Institute (AEI), a think-tank with a conservative bend, examined the sustainability of the US current account deficit. The AEI focused its analysis on the net savings and investment side of the account balance equation in its attempt to ascertain the factors that influence capital flows. They concluded that the deficit is ultimately sustainable because of the variety of “wealth storage” opportunities available in the US. In other words, foreigners will continue to park their savings in US-denominated assets because of the inherent liquidity, diversity, and stability afforded by such assets. Further, the AEI argues that while high oil prices have driven vast increases in the value of oil imports, the net effect on the US current account balances may be positive because oil exporters often immediately turn around and reinvest oil profits in US securities. The AEI reports:

Today, the real trade-weighted dollar is virtually at its average level for the past sixteen years and is slightly stronger than it was in 1991, when the U.S. current account deficit stood virtually at zero.

Read More: America’s External Balances

China’s foreign exchange reserves are currently the largest in the world; analysts are predicting they may soon surpass one trillion dollars. The majority of the reserves have long been parked in USD-denominated assets, mostly Treasury securities. Because the RMB is slowly appreciating against the USD, when China converts these securities back into Yuan, it will incur massive losses. Further, the longer it waits-assuming the Yuan continues to appreciate in value-the larger China’s losses will be. For this reason, China’s National Bureau of Statistics is recommending for it to begin transferring some of its holdings into assets denominated in other currencies and mitigate its foreign exchange risk. Since China’s reserves are so large, any move away from the USD would have significant fallout in forex markets.

The National Bureau of Statistics warned against the exchange risk associated with tying too much money up in assets denominated in a single currency which threatens to steadily decrease the value of the reserves

Read More: China urged to switch out of dollars

In the days leading up to Ben Bernake’s semi-annual testimony before Congress, financial markets ratcheted up their expectations of an August rate hike to 90%, signaling that it was nearly certain to happen. After Bernanke’s testimony, the expectation of an August rate hike-proxied by interest rate futures-declined sharply. Now, investors have two conflicting sources on which to predicate their interest rate expectations: Bernanke, himself, and actual inflation data. Depending on which products and services are included in the calculation, inflation is hovering between 2.5% and 4%, which is higher than many economists would like to see. Meanwhile, Bernanke has indicated that he is essentially unconcerned with current inflation levels, and is not in any hurry to raise rates, which is bad news for dollar bulls. The Economist reports:

If the economy is slowing only modestly, as his words suggested, his relaxed attitude to inflation seems odd, especially after recent months’ inflation figures.

Read More: Making Sense of Bernanke

After a two month hiatus, Adam Kritzer has returned to his desk at the ForexBlog. Beginning this week, he will supplement his regular news posting with a weekly commentary on forex markets. If there is a specific topic that you would like to see him address, please post a comment on the website.

This month marks the one-year anniversary of China’s revaluation of its currency. At the time, commentators and economists predicted China would continue to incrementally revalue its currency, and gradually move towards a market-based exchange rate. In reality, the Yuan has appreciated by less than 1.5% against the USD, and American business interests are once again calling for blood. The American political establishment has responded by introducing a new strategy, one that involves offering China a greater role on the geopolitical stage in return for dismantling the de facto peg to the USD. Specifically, the US may help China negotiate a larger share in the International Monetary Fund (IMF), so that it will have a greater ability to influence decision making. The Wall Street Journal reports:

The IMF has been trying to get China-and by extension South Korea, Taiwan, and some other Asian nations that track China’s exchange rate- to reduce their reliance on weak-currency driven exports.

Read More: U.S. Plots Deal Over Yuan Revaluation

Earlier today, China announced that the minimum amount that banks must place with the central bank will be increased by 0.5% beginning August 15. This reserve requirement increase caused the yen to reach its one-week high against the USD. It came as a disappointment to Washington however that there was no further discussion of yuan flexibility, but it is likely that this debate will heat up in the coming weeks and months. Forbes reports:

Bank of New York currency analyst Neil Mellor noted that Ba Shusong, an influential government economist said today that China needs to widen the yuan’s trading band to help control excess liquidity.

A further widening of the trading band ‘could easily come within the next few weeks,’ Mellor reckoned.

Read more: Yen gains against dollar as China raises reserve requirement

Tomorrow, the Bank of Japan will meet, and it is expected that they will raise the interest rate in Japan to 0.25%. Such an occurence would mark the first time in five years that the interest rate was above zero. Yesterday, the US dollar rose to a six-day high of 115.73 yen in response to the expected rate hike. According to Life Style Extra:

‘The recent spike higher in dollar/yen provides a new opportunity for playing future yen strength as interest rate differentials narrow, the economy remains strong and the current account surplus provides a happy contrast to structural deficiencies in the US,’ [Daragh Maher of CALYON] said.

Read more: Yen rises ahead of BoJ meeting tomorrow

A year ago, China adjusted the yuan by 2.1% versus the dollar and allowed it to float within tight bands. Still, US economists believe that the yuan remains grossly undervalued and want it to be able to float more freely. The US trade deficit with China hit $202 billion last year, perhaps largely due to the yuan being so undervalued. Wei Benhua spoke at a press conference in Paris earlier today and indicated that China still needs more time to assess the yuan reform. According to Wei, via the Gulf Times, the management of forex reserves are carried out under three guidelines:

First is to maintain the liquidity of reserves. We need to have liquid reserves. The second principle is the safety of our reserves — we want to be very secure. The third is profitability. After you meet the first requirements, you want as much profit as possible.

Read more: China needs time to assess forex reform, official says