The yuan hit an 11-and-a-half year low against the US dollar on Tuesday, rising above 7.16 amid a worsening US-China trade backdrop. The depreciation follows the US announcement that it would increase existing tariffs on USD 250bn of Chinese exports to 30% (from 25%) on 1 October, and would ratchet up planned tariffs on USD 300bn of Chinese exports to 15% (from 10%) in two steps over September and December. More positive rhetoric from President Donald Trump on Monday failed to stem the decline.

But while further yuan weakness is likely in the face of domestic and external pressures, we expect the currency's fall to be both controlled and limited:

* Rapid yuan depreciation would likely further provoke the White House. When USDCNY climbed past the 7.0 mark in early August the US Treasury in turn labeled China a “currency manipulator”. China this week called for "calm negotiations" in the wake of the latest trade escalation, and is unlikely to pursue a currency policy that would fuel US claims of yuan weaponization.

* Beijing is well aware of the potential negative consequences of currency depreciation. It needs to adopt a balancing act that weakens the yuan quietly without creating expectations for a sharp fall that could spur a repeat of the capital outflows of 2015-16. Tuesday's yuan move by the People's Bank of China, which outdid market expectations, looks like an attempt to slow the pace of depreciation.

* USDCNY trade is a two-sided affair. A stronger easing bias from the Federal Reserve amid heightened trade tensions could potentially limit USDCNY upside. At the same time, if the US continues to raise tariffs, we think China might find holding a specific line on the yuan against depreciation pressure to be counterproductive and unfeasible.

So, barring a significant improvement in US-China trade relations, on balance we believe further depreciation could be ahead for the yuan. We have shifted our USDCNY forecasts higher to 7.4 over the next three and six months, and 7.3 over the next 12 months. With heightened trade tensions and a slowing Chinese economy, we continue to advise investors to hedge CNY long exposure versus the US dollar.