China GDP slumps, but it's inflation which could help drive USD/CNH higher

Chinese growth prospects slow

Chinese growth prospects have been dented through the nation’s zero-Covid policy that has restricted economic activity.

A raft of data points seen this morning served up a relatively mixed theme, with the second quarter (Q2) growth rate of 0.4% grabbing the headlines.

Undoubtedly, we are seeing the impact felt by the Chinese zero-Covid policy which has significantly dampened business and consumer activity in a bid to restrict the spread of the virus.

Thankfully for markets, there are some signs that this restrictive policy could ease somewhat.

For example, we have seen the quarantine period for arrivals halved, bringing hope that the country will begin to push towards a more normalised environment.

Certainly, this week’s trade data did highlight how easing restrictions have benefitted the economic picture, with June exports growing at the fastest clip in five years.

Meanwhile, the retail sales (3.1%), and industrial production (3.9%) data provide greater confidence that we are seeing the Chinese economy turn a corner.

However, there are fears that we could see elements of this so-called zero-Covid policy continue until at least until the 20th Party Congress in the fourth quarter.

While cases remain depressed for the time being, there is always a risk that we will see further lockdowns to stem any flare up in a particular region.

China stands out from the pack for a number of reasons, with their current approach to Covid representing just one of them.

Another significant reason to view China in a different light to other major economies is the fact that they are largely devoid of any above-target inflation.

While the US and Europe struggle to contain rampant inflationary pressures, China have access to cheap Russian oil and an inflation rate of just 2.5%. That provides the People's Bank of China (PBoC) with little reason to raise rates anytime soon, bringing the risk of yuan devaluation into play.

The chart below highlights how we have seen a sharp divergence between US and Chinese inflation.

Interestingly, we can see that the widespread appreciation in the dollar can be largely attributed to the growing disparity in monetary policies expected by the Federal Reserve (Fed) compared with their international counterparts.

One of the biggest outperformers over the course of this year has been USD/JPY, with the lack of inflation in Japan meaning that the Bank of Japan (BoJ) has little reason to raise rates like those in the West.

China has a similar situation, with economic struggles coupled with relatively contained inflation meaning that we will see a gulf appear between US and Chinese interest rates in the coming months.

With the US Fed expected to raise rates by 200 basis points over the next four meetings, could this drive further USD/CNH upside?

This serves to highlight how central banks will continue to drive movements in the FX market, with inflation the key determinant of future tightening.

Looking at daily USD/CNH chart, we can see that price has been largely trading within a holding pattern over the course of the past two months.

Coming off the back of a dramatic surge throughout April and May, there is a chance that we will see that uptrend kick back in before too long.

The past two weeks have seen price challenge the crucial 6.7859 resistance level, with a break above that point bringing a bullish signal for the pair.

The hourly chart highlights how price continues to struggle at resistance, with the recent uptrend struggling this morning. A convincing break through 6.7859 resistance would bring greater confidence of an extension to this current intraday uptrend.

Meanwhile a decline through 6.7477 swing-low support would bring an end to this recent rebound and point towards another period of consolidation as USD/CNH struggles to break key resistance.