Yuan hits 2022 high against weaker dollar, but upside seen limited

China's yuan strengthened on Wednesday to its highest level so far this year against the dollar, but gains were capped as softer inflation left the door open for more monetary easing in the world's second-largest economy.

The rise came as the dollar fell to its weakest level since November against major peers after Federal Reserve Chair Jerome Powell said it may take several months to make a decision on running down the central bank's $9 trillion balance sheet.

China's factory-gate inflation rose more slowly than expected in December after the government took steps to contain lofty raw material prices. Softer inflation leaves room for more monetary easing, which could weigh on the yuan.

"Lower inflation opens room for the government to loosen monetary policies further. The probability of interest rate cut is rising, in our view," Zhiwei Zhang, chief economist at Pinpoint Asset Management, said in a note.

Prior to market opening, the People's Bank of China (PBOC) set the midpoint rate at 6.3658 per dollar, 26 pips firmer than the previous fix 6.3684.

In the spot market, the onshore yuan market opened at 6.3690 per dollar and rose to a high of 6.3633 per dollar, the strongest level since Dec. 31, 2021. The spot rate was changing hands at 6.3653 around midday, 80 pips firmer than the previous late session close.

But analysts said the upside for the yuan was also limited by the fact that major central banks elsewhere were starting or preparing to tighten monetary policies, buoying their currencies.

Xing Zhaopeng, senior China strategist at ANZ, said this week that he expects the PBOC may cut the rate on its medium-term facility (MLF) loan by 10 basis points in the first quarter of this year.

"The window to monetary easing is only in the first quarter, after that (the policy stance) will be affected by the Federal Reserve and shift to neutral," Xing said.

In December, China cut its lending benchmark loan prime rate (LPR) and the amount of cash banks must hold in reserve, but markets are widely expecting authorities to do more to support the economy.

By 0322 GMT, the global dollar index had fallen to 95.561 from the previous close of 95.624, while the offshore yuan was trading at 6.3708 per dollar.