(Bloomberg) — For currency speculators around the world, trading has long been a breeze: Simply borrow yen, which costs nothing due to sub-zero interest rates in Japan, and then park money wherever the returns are highest, earning a tidy profit from the difference.
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But now, a surprising low-cost alternative to the Japanese currency has started to emerge, this time from China. Last month, Invesco, Goldman Sachs, Citigroup and TD Securities all recommended the yuan as an attractive option to finance so-called carry trades as it weakens towards record lows.
While the cost of borrowing Chinese currency in overseas markets has risen in recent days as Beijing policymakers work hard to defend the currency and fend off speculators, proponents of the yuan carry trade are undeterred. They say their position has as much to do with the divergent fortunes of Asia’s two largest economies as it does with cold, hard profits or risk diversification.
Moribund for decades, the resurgence of Japanese inflation – and tentative signs of a recovery in growth – have fueled rumors that the Bank of Japan will finally end its seven-year negative rate policy. For China, the trade underlines how far the once-mighty giant has fallen. The heavy debt load, the collapse of the real estate sector and fears of deflation have prompted the People’s Bank of China to cut its key rate twice since June to a record low of 1.8%. Many expect further cuts, which will make the yuan even weaker and cheaper to borrow.
“If you think the BOJ is in play, then you get yen strength and you have to be careful, while the PBOC is still easing policy,” said Dirk Willer, head of global macro strategy and emerging markets at Citigroup. A weak Chinese economy is “an important part of this trade.”
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This month, Willer’s team advised clients to sell yuan against a basket of currencies that includes the dollar and euro.
There are plenty of caveats, of course. No one is suggesting that the yen carry trade is dead or that speculators will abandon the yen for the yuan. So far this year, financing purchases with the yen in Latin America – where policy rates reach as high as 13.25% – has been particularly profitable. An equal-weight basket of reals, Colombian pesos and Mexican pesos gained 42%, easily outpacing the Nasdaq rally.
And the yuan is not a safe bet as a funding currency. China has intervened aggressively to support it in foreign markets. State banks have periodically dried up the supply of offshore yuan to raise financing costs and scare off speculators. On Wednesday, the cost of borrowing in yuan for three months briefly rose above 4%, the highest in five years.
Concern about growth
Friday’s data on industrial and retail production in China showed the economy may be stabilising. Economists polled by Bloomberg expect China to reach the government’s growth target of 5% this year, versus an expansion of 1.8% in Japan. The growth gap between the two countries, while still considerable, has narrowed significantly. In 2021 it was twice as large.
“The PBOC has stepped in and made it very clear that they are concerned,” said Jae Lee, strategist at TCW Group. This raises the possibility that yuan-based carry trades could go in the wrong direction in the near term.
The central banks of Brazil, Mexico and Chile have also started to lower rates, reducing the “carry” (which is financial jargon for the return on an investment) on some of the most profitable operations.
Despite the risks, a growing number of traders still see the value of the yuan as a means to spread the financing risk on their carry trades.
While yen carry trades have boomed over the past two years, as nearly all central banks outside Japan have raised rates aggressively, the concern now is that the BOJ will join them, especially as inflation has exceeded its 2% target for more than a year. Traders have recently priced in expectations that the bank will raise rates in January.
Yen Whipsaw
The yen’s fluctuations have also become more pronounced, and Japanese officials have tightened their jaw when they sense excessive weakness – exactly what carry traders try to avoid in a funding currency.
“The yen whipsaw is something that kind of stops people from engaging” in Japan-based carry trades, said Simon Harvey, head of FX analysis at Monex Europe.
Instead of using the yen, Goldman Sachs recommended financing purchases of Colombian reals and pesos with the yuan. TD strategists also told clients to borrow yuan to buy Indian rupees, Mexican pesos and reais.
The logic is simple. The PBOC will have to lower rates to the lowest levels to support the economy. This will reduce financing costs and weaken the currency, while increasing yuan-based carry trade profits. In the local market, the yuan, which is non-convertible and out of reach for most foreigners, recently fell to a 16-year low.
Ireland
Carry trades are usually executed using forwards: over-the-counter contracts between two parties to exchange one currency for another at a fixed rate and time in the future. In theory, carry trades shouldn’t really work. What you earn in interest should be offset by what you lose in currency depreciation. But in real life things are much more complicated, which means there is still money to be made.
Ricardo Seabra of Banco de Investimento Global SA is among those who have achieved excellent results. Its BiG Diversified Macro fund returned 12% this year through August, versus a loss of about 1% for its benchmark.
Seabra has rotated funding currencies throughout the year and added the yuan to the mix in the past two months as China deteriorated. It is now one of its two main funding currencies, along with the yen.
He is not too concerned about the PBOC’s recent actions because he expects the bank will slowly let the yuan depreciate over time. And ultimately, what is most important is to maintain long positions.
In recent times, those have been currencies like the Brazilian real. Currently, three-month forwards yield 10.8% for reals. For Mexican pesos it is 11.7%. Since borrowing offshore yuan to finance the transaction costs 4%, this implies an annualized return of around 7%, if exchange rates remain stable. (It may not seem like much, but since these trades are almost always highly leveraged, actual profits can be many times greater.)
Juicy yields
“We like these juicy real returns,” Seabra said.
Paradoxically, Beijing’s intervention in the offshore yuan, and the fact that it has managed to keep the price close to its onshore counterpart, may even represent an advantage, dampening volatility and making profits more predictable. The yuan’s three-month implied volatility is 5.6, the third lowest among major currencies, versus 9.3 for the yen.
“We still view the yuan as an attractive funding currency, given its low yields, low volatility and moderately expensive valuations,” said Alessio de Longis, chief investment officer at Invesco Solutions.
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