The first quarter of the year ended with palpable anxiety. The second quarter produced a spectacular reversal in both sentiment and prices. It appears that investors have placed their faith in an amicable relationship between a mercurial US president and in an oppressive regime waging an existential fight against its adversaries. Simply put, confidence is so strong that tensions between Iran and the US and Israel will be kept under the cosh, and that the Strait of Hormuz, the Alpha and Omega of all that went wrong in the first quarter, will gradually reopen, that stock markets staged a magnificent rally during the second quarter, reaching all-time highs several times in the process, greatly aided by the US technology sector.

Oil, especially after April, and crude in particular, was abandoned. There is no doubt that part of the downturn was driven by investors seeking cash to deploy into soaring equities, but the sell-off was also the result of the on-and-off negotiations over the resumption of trade flows through the Strait. Physical markets gradually became better supplied, as reflected in the contango at the front end of the Brent curve and in the CFD market. The M1/M7 Brent spread collapsed from a backwardation of more than $37/bbl at the end of March (equivalent to more than $6/bbl per month) to almost parity. Meanwhile, refined products, supported by soaring temperatures in the northern hemisphere and the effective Ukrainian obliteration of Russia's oil infrastructure, fared significantly better than crude oil. The continued drawdowns in global and regional oil inventories went largely unnoticed, however. Betting on a market bottom could prove risky, though we are brazen enough to believe it cannot be far off. Significant factors that could shape and alter this sanguine sentiment going forward include the expiry of the extended ceasefire in mid-August, followed by the Israeli and US midterm elections at the end of October and early November.

Lest We Forget China

Oil markets are dancing to the tune of the US-Iranian peace talks and views on whether oil flows through the Strait of Hormuz will remain stable and uninterrupted. Stocks are also being influenced by events in the Middle East, combined with the seemingly unbroken optimism that artificial intelligence will boost productivity beyond imagination, setting equities on an almost unprecedented upward trajectory. Bond markets are doing their best to price in the inflationary impact of the Persian Gulf hostilities, while central banks face the unenviable task of deciding whether to raise interest rates or hold them steady. The proverbial road, which once led to Rome, now ends in Washington, D.C.—1600 Pennsylvania Avenue, to be more precise. Yet, there is life beyond the realms of the United States, although the incumbent Administration has successfully made a habit of making its presence felt in major events and developments around the globe. While it is currently preoccupied with geopolitical skirmishes, one wonders when it will shift its focus back to China and, more specifically, to the strength of its currency.

As with every autocracy, the Chinese political leadership controls most aspects of social and economic life. This is true of its capital flows and currency. The yuan is not free-floating. Prior to 2005, it was pegged to the dollar, but more than 20 years ago, China shifted to a basket of currencies in an effort to achieve greater flexibility. The approach is known as a 'managed floating exchange rate system', which is based on an unpublished trade-weighted basket of currencies. While the term peg implies some form of automatic mechanism, this is not the case. The People's Bank of China (PBOC) sets a daily reference rate, and the yuan is allowed to fluctuate within a predetermined band around it. If the exchange rate moves beyond either the upper or lower limit, the PBOC intervenes, making it occasionally susceptible to accusations of currency manipulation from its international trading partners, including the United States.

Against this backdrop, it is intriguing that the Chinese currency rose to its strongest level against the dollar in more than three years two weeks ago. This rambunctious strength has eased somewhat of late, but the current exchange rate of ¥6.7847 remains significantly stronger than the April 2025 ('Liberation Day') low of ¥7.3509. There is no denying that one of the main reasons behind this appreciation has been the weakness of the dollar itself; however, other factors have also been at work. These include the country's trade surplus, which generates strong demand for the yuan; exporters converting their dollar and other foreign currency holdings into the domestic currency; the increasing use of the yuan in cross-border payments, as the dollar's status as the world's reserve currency, while still unquestioned, gradually weakens; and, to some extent, central bank intervention.

The potential impact of a strong yuan, while currently being dwarfed by the ongoing Middle East crisis, should not be ignored. It undeniably encourages domestic importers to become more active while also easing inflationary pressures in China by making raw materials cheaper. Consequently, Chinese consumers gain purchasing power. The downside is weaker export competitiveness and the resulting pressure on the manufacturing sector, although this has not been evident this month, as Chinese factory activity expanded. The official manufacturing PMI rose from 50.0 in May to 50.3 in June, with the private survey also confirming healthy expansion.

Globally, a strong yuan should support demand for commodities in general, including oil. On the other hand, it could add to inflationary pressures, particularly in countries that are major importers of Chinese consumer goods and industrial products.

The US Administration has been uncharacteristically quiet about its trade relationship with China of late. The reasons are twofold. First, as noted above, its immediate priority is the Middle East. Second, a stronger yuan runs counter to President Trump's, and, indeed, the interests of other importers of Chinese goods, long-standing criticism of China's trade practices, particularly its persistent trade surplus. However, it is probably only a matter of time before tensions between the world's two largest economies flare up again. The yuan's current strength is partly the result of recent dollar weakness. If the greenback continues to strengthen, as it has since January, Chinese export competitiveness will receive a timely boost. Furthermore, while a stronger yuan benefits US manufacturers, excessive appreciation would undermine China's economic stability, reducing the country's appetite for US goods and simultaneously threatening global economic growth prospects. A perpetually boisterous yuan is therefore likely to provoke a US response, especially once the Middle East crisis is resolved.

Overnight Pricing