[Reuters Analysis] Yuan may be cat among FX pigeons: Mike Dolan

By Mike Dolan

LONDON, April 9 (Reuters) - Currency markets have struggled all year to decide whether Washington's trade war is good or bad for the U.S dollar. Beijing may make up their minds for them.

Whatever President Donald Trump plans next in his worldwide 'reciprocal' tariff attack, the extreme targeting of Chinese imports and China's instant retaliation puts the Sino-America trade battle on a different plane.

Trump is now threatening 100%-plus tariffs on Chinese goods unless China backs down, while Beijing says it will fight to the end.

And even though the administration may try to engender optimism about negotiations with other countries, U.S. Trade Representative Jamieson Greer made it clear on Tuesday that China is considered a special case.

It's hard to imagine a scenario with 100% U.S. tariffs on China that does not involve some devaluation of the yuan akin to the 10% slide Beijing authorities engineered during Trump's first bilateral tariff war in 2018.

The opening salvos of this currency battle seemed to come on Tuesday as the People's Bank of China deliberately loosened its grip on its official yuan CNY= reference rate, causing a slide in the offshore rate CNH= to a record low overnight.

The yuan has now weakened 2.5% in less than three weeks.

The logic stacks up.

Even if China were to use ever more fiscal and monetary stimulus to protect its economy from the trade assault, that would only expand the yield gap between Chinese government debt and U.S. equivalents US10CN10=, especially if tariff-driven inflation keeps the Federal Reserve on hold and U.S. yields up.

One of the main reasons the PBOC was holding the yuan up at all was to avoid direct trade tariffs from Washington and encourage domestic demand rather than exports. But now that tariffs have been applied so brutally, it makes little sense to hold the line if the wider economy is at risk.

NO PLAZA II

A weaker yuan is then both defensive in nature and a shot across the bow at Washington, whose trade war is at least partly constructed to reduce an estimated 20% over-valuation of the dollar.

A weakening yuan would also likely have cascading effects, as it's hard to see how Europe could allow it to slide without responding.

After all, the euro's nominal trade-weighted index is still near an all-time high even though the euro zone economy is spluttering and facing its own Trump tariff barrage. Fears of a flood of U.S.-tariffed Chinese exports being re-directed to Europe at yuan-weakened prices only ups the ante.

A terms-of-trade threat and deflationary pulse from both the U.S. trade war and an inappropriately strong euro would heap pressure on the European Central Bank to cut interest rates to offset it.

And the cycle could just unravel from there. If the euro were to weaken sharply, pressure on sterling GBP= to follow it would increase too - or at least pressure would mount on the Bank of England to offset any unwanted pound appreciation.

Key 'China+1' trading countries - who have picked up much of the disrupted bilateral trade between America and China in recent years - would also feel the heat from a yuan fall. Mexico's peso MXN= and Asia's emerging market currencies would likely all be in the firing line.

And against all that, it's hard to imagine a trade-dependent economy like Japan standing idly by and allowing the yen to rise higher by default.

BOOMERANG

The boomerang then spins back into Washington's lap, as it would face the prospect of an even stronger dollar.

This would perhaps argue for Federal Reserve easing. But as Fed boss Jerome Powell made clear last week, the U.S. central bank is in no rush to do that. An op-ed from former New York Fed President Bill Dudley on Tuesday suggested market expectations of four Fed rate cuts this year may be overzealous.

It's tough to know how this will play out. Maybe China holds the line and props the yuan up eventually. Maybe the U.S. economy does crater in a way others avoid, or overseas flight from U.S. assets overwhelms American markets.

Any organized plan to weaken the greenback seems out of the question. Japan's former currency diplomat Naoyuki Shinohara threw water on the idea on Tuesday, telling Reuters that any U.S. attempt to pull off a 1985 Plaza Accord-type coordinated dollar depreciation just wouldn't work, as it would require the unlikely consent of China and Europe.

But if this week's events mark the start of a currency war to match the trade war, then the original thinking that U.S. tariff hikes would end up strengthening the dollar may well prove to have been correct all along.

And that's happening just as analysts across Wall Street are jettisoning that take and embracing the prospect of a falling greenback instead.

What were once considered long-term views now have a shelf-life of hours.

The opinions expressed here are those of the author, a columnist for Reuters

China's yuan throws cat among the FX pigeons

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