China's yuan edged lower against the dollar on Friday but is on track to post its biggest weekly gain in two years, buoyed by expectations of a slower pace in U.S. rate hikes and China's gradual exit from its zero-COVID-19 policy.

Traders expect the yuan's recovery to be slow next year, however, despite signs of the dollar peaking, as China will likely keep interest rates low, while some foreign investors may hesitate to return to China assets due to geopolitical tensions. The onshore yuan was changing hands around 7.0580 per dollar in late morning trade, a tad weaker than the previous late session close.

Prior to the market open, China's central bank set the midpoint rate at 7.0542 per U.S. dollar, a two-week high. For the week, the yuan has gained roughly 1.5%, while the dollar index fell to a 3-1/2 month low amid signs the U.S. Federal Reserve will pivot away from rapid rate hikes as inflation ebbs. The Chinese currency has been bolstered by Beijing's latest measures to stabilise the wobbly property market, and by signs the government is preparing for an exit from strict COVID-related curbs. China will allow some individuals who test positive for COVID to quarantine at home, among supplementary measures to be announced in coming days, two sources with knowledge of the matter told Reuters on Thursday. "CNY rates are firmly on an upward trajectory while USD rates appear to have peaked, suggesting that China-U.S. rate differentials have bottomed," DBS wrote in a note to clients.

That view was echoed by HBSC. "The broad USD trend could shift once the Fed ends its hiking cycle, mitigating volatility and improving the outlook for EM FX," HSBC wrote in an outlook report. "We also assume China will pull through its economic and COVID-19 challenges." However, HSBC expects the yuan's recovery to be slow, and bumpy. "Inflows from some foreign investors in the West may return only gradually given lingering concerns about COVID-19 policy, geopolitical tensions and ESG matters," the bank said.

"Mainland China's interest rates will likely stay low for some time to foster a sustainable recovery in the economy, and as such, interest rate arbitrage activities among locals may persist." The yuan market at 3:23AM GMT: ONSHORE SPOT: Item Current Previous Change PBOC midpoint 0.97% 7.0542 7.1225 Spot yuan 7.055 -0.06% 7.059 Divergence from midpoint* 0.07% Spot change YTD -9.97% Spot change since 2005 revaluation 17.25% *Divergence of the dollar/yuan exchange rate. Negative number indicates that spot yuan is trading stronger than the midpoint.

The People's Bank of China (PBOC) allows the exchange rate to rise or fall 2% from official midpoint rate it sets each morning. OFFSHORE CNH MARKET Instrument Current Difference from onshore Offshore spot yuan * 7.057 0.03% Offshore non-deliverable 6.888 2.41% forwards ** *Premium for offshore spot over onshore **Figure reflects difference from PBOC's official midpoint, since non-deliverable forwards are settled against the midpoint. . (Reporting by Shanghai newsroom; Editing by Edmund Klamann)