Sharpe Ratio Flags Yuan as Best BRIC Carry TradeLilian Karunungan
A measure of the yuan’s risks and rewards signals it is the most attractive carry trade among the largest emerging markets, as the yield advantage of China’s bonds over U.S. Treasuries has widened to a 22-month high.
The currency’s Sharpe ratio, which measures investor returns adjusted for price swings, has increased to 9.78 percent since the end of June, while the indicator was 0.55 percent for Russia, minus 1.81 percent for Brazil and minus 1.58 percent for India. China’s ratio is second only to Argentina’s 14.74 percent among developing nations. The rate premium for the nation’s two-year notes over Treasuries rose to 343 basis points on Aug. 14, the highest since October 2011.
“The Chinese currency has remained extremely strong and I think the big reason is the interest-rate differential,” Rajeev De Mello, who manages $10 billion as head of Asian fixed-income assets at Schroder Investment Management Ltd. in Singapore, said in an Aug. 14 interview. “It will keep the yuan supported. The rates are already quite high when one takes into account the economy is slowing and inflation is low.”
The yuan has delivered the best performance among 24 emerging-market currencies this year, rising 1.96 percent, as the central bank seeks a stable currency while tackling economic growth forecast to be the slowest in 23 years. The nation’s two-year yields rose because of a cash crunch engineered by authorities in June to curb excessive lending, while the Federal Reserve has pledged to keep monetary stimulus in place until the U.S. economy improves.
The Sharpe ratio, named after Nobel laureate and Stanford University professor William Sharpe, is a measure of the excess return per unit of risk in holding a currency position. This is used to determine how well an investor is compensated, with a higher ratio translating to more of a reward.
China’s three-month central bank bill rate climbed 93 basis points this quarter to 3.5 percent, while the 10-year yield rose 45 basis points to 3.96 percent. The two-month gauge of expected fluctuations in the yuan fell to 1.2 percent on Aug. 14, the lowest level since January 2010, according to data compiled by Bloomberg. That compares with 13.4 percent for the Brazilian real, 12.6 percent for the Indian rupee and 8.2 percent for the Russian ruble.
China’s slowing economy may limit returns on its assets. Gross domestic product growth will ease to 7.5 percent this year, the worst since 1990 and matching the government’s target, according to the median estimate of analysts surveyed by Bloomberg. Inflation was 2.7 percent in July and June, compared with an average 3.5 percent in the past six years, official data show.
While government data released this month showed rebounding exports and manufacturing, smaller borrowers are reluctant to add to their debt after the cash crunch. Credit downgrades surged to a record 46 companies last month, according to an estimate by Guotai Junan Securities Co., which began compiling the data in 2005.
Credit-default swaps insuring China’s debt against non-payment have fallen 16 basis points this month to 106 on Aug. 15 in New York, after reaching a 17-month high of 147 on June 24, according to CMA prices. Aggregate financing, the broadest measure of new credit, fell to a 21-month low in July at 809 billion yuan ($132 billion), data showed Aug. 9.
“Growth is still quite low,” said Rees Kam, a strategist at SJS Markets Ltd., a Hong Kong-based financial services company that expects the yuan to drop to 6.13 per dollar by the end of September. “Further room for yuan appreciation will be quite limited.”
The yuan, which touched a 19-year high of 6.1090 today, will remain stable at an equilibrium level and the exchange rate’s two-way flexibility will be increased, the People’s Bank of China said in a May 9 report. The currency’s moves are limited to 1 percent on either side of a band set daily by the People’s Bank of China.
The authorities probably won’t let the currency weaken as they open the onshore market to more international investors, Frances Cheung, a senior strategist in Hong Kong at Credit Agricole CIB, said yesterday. “Inflows into China will likely go into short bonds, like the two-year, and stocks,” she added.
Regulators expanded a program in March allowing institutions to raise yuan offshore for investment in the mainland, a step that moves the nation closer to a freely traded currency. Six institutions won Renminbi Qualified Foreign Institutional Investor licenses in July, up from three in June.
The yield on two-year government bonds has risen 54 basis points since the end of the second quarter to 3.76 percent on Aug. 14, the highest level since September 2011. In contrast, the two-year note yield in the U.S. declined three basis points to 0.33 percent.
Front-end interest rates in China will probably move higher as policy makers rein in credit while the improvement in July data lessens the risk of easier monetary policy, Kumar Rachapudi, a senior rates strategist in Singapore at Australia & New Zealand Banking Group Ltd.
“The market will be reluctant to price much lower yields because the data is positive enough for the market near term to worry less about growth,” Rachapudi said.