China's yuan firmed to its strongest against the U.S. dollar in five months on Wednesday, as the dollar weakened after a previously hawkish Federal Reserve policymaker said U.S. interest rate cuts could begin in months if inflation came down.

The comments by Fed Governor Christopher Waller fueled expectations that U.S. rates have peaked, and the yield gap between U.S. 10-year Treasuries and China's benchmark bonds narrowed to 161 basis points, the tightest since mid-September. China's offshore yuan strengthened more than 300 pips in late session on Tuesday to 7.1244 as the dollar weakened. Prior to the market's opening, the People's Bank of China set the midpoint rate, around which the yuan is allowed to trade in a 2% band, at 7.1031 per U.S. dollar, 101 pips firmer than the previous fix 7.1132 and 309 pips firmer than Reuters' estimate.

The difference between the official midpoint rate and market's estimate was steady at around 300 pips, continuing to exert the policy warning against any yuan bears out there, Maybank analysts said. The spot yuan opened at 7.1165 per dollar and was changing hands at 7.1231 at midday, 138 pips firmer than the previous late session close.

China's offshore yuan strengthened more than 300 pips in late session on Tuesday to 7.1244 as the dollar weakened, and was trading 13 pips weaker than the onshore yuan. "We reckon more likely there is going to be two-way trades for the USD/CNY and USD/CNH, which would range around 7.12 – 7.20," Maybank analysts said in a note to clients. Meanwhile, investors are watching China's factory activities data due on Thursday.

The global dollar index fell to 102.604 from the previous close of 102.746. The yuan market at 0255 GMT: ONSHORE SPOT: Item Current Previous Change PBOC midpoint 7.1031 7.1132 0.14% Spot yuan 7.1231 7.1369 0.19% Divergence from 0.28% midpoint* Spot change YTD -3.13% Spot change since 2005 16.19% revaluation Key indexes: Item Current Previous Change Thomson 0.0 Reuters/HKEX CNH index Dollar index 102.604 102.746 -0.1 *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 7.1244 -0.02% * Offshore 6.9405 2.34% non-deliverable 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 Simon Cameron-Moore)