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Yuan drives Australian dollar to three-week low

The Australian dollar set a fresh three-week low against the greenback on Wednesday as Chinese currency devaluation added to commodity price weakness and related jitters about China's growth to drive selling.

In late-afternoon trade, the local unit was buying US71.25¢, after earlier hitting a new 20-day low of US71.07¢. This was the lowest point since December 17, when it touched US70.97¢.

Wednesday's dive, from as high as US71.72¢, followed the latest devaluation from the People's Bank of China (PBoC), which fixes the yuan daily in line with the previous day's offshore trading.

The 0.22 per cent depreciation, to 6.531 to the US dollar, surprised the market, said Westpac foreign exchange strategist Sean Callow.

Market caught off guard

"The market was very much caught off guard; it was a big surprise," he told Bloomberg.

"The impression is that upside risks on the dollar-yuan rate have grown further, but that investors will be kept on their toes day to day."

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With the offshore yuan still trading about 2 per cent lower, at 6.665 to the dollar, further devaluation looks likely this week.

Although making the world's second-biggest economy a more competitive exporter, a softer yuan makes imports more expensive, potentially hurting big trade partners such as Australia.

"This isn't good for the rest of the world," said Koichi Kurose, chief market strategist at Resona Bank.

"Until China stops weakening the yuan, global markets will struggle to stabilise. The Chinese authorities may be trying to prop up the economy by boosting exports, but while that'll help one part of China's economy, it comes at the sacrifice of someone else."

More aggressive monetary policy

Foreign exchange experts last year flagged more aggressive monetary and currency easing from China in 2016 as authorities loosen the yuan's traditional peg from the greenback and the US Federal Reserve continues to lift interest rates.

Societe Generale's global fixed income strategist, Kit Juckes, last month forecast a gradual fall to around 6.8 to the US dollar, although he said an overshoot to 7.5 wasn't out of the question.

The latest PBoC move comes amid renewed greenback strength against most monetary units, but in particular against the euro – following a weak inflation reading in the eurozone – as well as pounds sterling and commodity currencies such as the Australian, New Zealand and Canadian dollars.

Despite an earlier boost from Middle East tensions, the price of oil and base metals such as iron ore and copper have begun to slip again as investors bet demand from China for industrial inputs will continue to soften this year. The latest sign of this was a weaker-than-expected result on a private sector purchasing managers' index this week.

The London Metal Exchange index, representing a basket of six primary metals, fell by 2.2 per cent on the first day of trading this year, while iron ore prices were marked down by 2.8 per cent at Tuesday's fix.

Importantly for New Zealand, the first dairy auction of the year also proved disappointing, with prices down for the first time in three sales.

Few investors relaxed

The commodity weakness followed Monday's turmoil on Chinese stock exchanges, where trade was suspended after a 7 per cent fall on the main indices. The plunge provoked a widespread equity sell-off amid renewed jitters about global growth and market stability this year.

Calm was restored with a reported series of monetary and regulatory measures by Chinese authorities on Tuesday, but few investors are relaxed on the outlook, according to BK Asset Management's managing director of foreign exchange strategy, Kathy Lien.

"Although Chinese stocks stabilised overnight and the Dow Jones Industrial Average ended the day unchanged after falling over 100 points, foreign exchange traders are worried that the losses at the start of the year foreshadow a deeper correction in the days, weeks and maybe even months to come," Ms Lien wrote on Wednesday.

The yen, by contrast, continues to firm as investors seek out safe-haven assets amid general market unease. It gained 0.4 per cent overnight to be valued at 119 to the US dollar.

"The yen remained well-supported in the more volatile and uncertain market environment and was the best-performing of the majors," said Bank of New Zealand currency strategist Jason Wong.

Ms Lien also pointed to investor buying to cut losses on short yen bets as a driver.

Pressure set to continue

Although still holding easily above its 2015 low of US68.98¢, the Australian currency is likely to remain under pressure as long as the country's terms of trade – the ratio of export to import prices – continue to ease, according to most analysts.

Some see it again slipping below US70¢.

However, many see it stuck around current levels as foreign interest in Australian assets such as companies and bonds offsets the effect of softening commodity prices.

Further monetary tightening by the US Federal Reserve will also continue to support the greenback against most currencies.

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