Yen trade crashed, now get ready to trade yuan

Transactions involving borrowing yuan to buy higher-yielding assets will be more resilient as China’s central bank maintains its accommodative monetary policy, the Royal Bank of Canada says. Trading in the yuan differs from that in the yen because it mainly involves exporters and multinationals rather than speculators, Macquarie Group Ltd data shows.

Carry trades, which involve seeking to capitalize on differences in global interest rates, became the focus of financial markets in early August as the relaunch of the yen version fueled a sell-off in risk assets. Investors cashed in after an interest rate hike by the Bank of Japan supported the local currency, which in turn hurt the value of higher-yielding targets such as the Mexican peso and Brazilian real.

“It still makes sense to short the yuan against a basket of emerging market currencies, as it would be counterintuitive to allow the currency to strengthen when the central bank is trying to ease policy,” said Alvin T. Tan, head of currency strategy at Asia. at the Royal Bank of Canada in Singapore.

“China’s economy is struggling and the PBOC is widely expected and indeed has signaled that it will ease policy further in the coming months,” he said.

A carry trade that involves borrowing the yuan and investing in a basket of eight emerging market currencies returned 0.5 percent this quarter, even as the yen-backed alternative fell about 7 percent, data compiled by Bloomberg showed.

The yen trade collapse following the July 31 BOJ decision spilled over to the yuan, at least initially. The yen rose 6.8 percent in the week to Aug. 5, while the yuan rose 1.7 percent. Gains in the funding currency for a carry trade can wipe out potential returns.

The key differences

There are a number of substantial underlying differences between yuan and yen transactions. The yuan is not fully convertible as the authorities limit the inflow and outflow of foreign currency to aid their control over the economy. This automatically shrinks the size of yuan trades compared to yen trades.

Second, while yen-financed transactions are invested in a wide range of overseas targets, the large proportion of those using yuan borrowings are held in dollars by Chinese exporters and multinational corporations. They only became profitable in 2022, after Federal Reserve interest rate hikes pushed US borrowing costs above those in China.

Chinese exporters and multinationals have raised more than $500 billion by 2022, according to Macquarie.

There are a number of reasons why investors are attracted to the yuan exchange, said Wee Khoon Chong, a senior Asia Pacific markets strategist at BNY in Hong Kong.

“Ongoing offshore yuan liquidity conditions could make it difficult for market participants to resist re-engaging in carry trades as market volatility eases,” he said.

However, the overall size of yuan-funded carry trades may be limited as the People’s Bank of China has sufficient tools to prevent what it may see as an excessive build-up of speculative positions, Wee wrote in a client note in this month.

“Will offshore yuan shorts be rebuilt? Sure, why not?” he said. “There will always be some opportunistic entrants into the market, but we don’t see it as a significant size.”

Commercial recommendations

A number of financial firms are telling clients that borrowing yuan will continue to be a profitable method of financing carry positions.

Citigroup Inc. recently advised investors to bet on the Mexican peso and Brazilian real against the yuan and yen in the options market, according to a research report by strategists including Dirk Willer of New York.

Goldman Sachs Group Inc. and Nomura Holdings Inc. are also among those recommending investors short the yuan against a trade-weighted basket of other currencies due to challenging macro headwinds from China and a softer US dollar context.

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