Yuan Turns Worst Emerging Carry Trade on PBOC’s Actions

The yuan has gone from being the most attractive carry trade bet in emerging markets to the worst in the space of two months as central bank efforts to weaken the currency cause volatility to surge.

The yuan’s Sharpe ratio, which measures returns adjusted for price swings, turned negative this year as three-month implied volatility in the currency rose in February by the most since September 2011. The exchange rate tumbled the most since 2010 on Feb. 25, losing money for investors who borrowed dollars to buy yuan, amid speculation the People’s Bank of China was intervening to deter one-way bets on currency gains.

“A lot of investors globally were invested in the yuan because of the interest-rate differential and the low volatility,” Rajeev De Mello, who manages $10 billion as Singapore-based head of Asian fixed income at Schroder Investment Management Ltd., said in a Feb. 25 phone interview. “All of a sudden, the low volatility part of the argument is no longer there.”

An unwinding of the carry trade may spur a slide in the yuan, which is set for the biggest monthly decline since the government unified official and market exchange rates at the end of 1993. Deutsche Bank AG, the world’s largest foreign-exchange trader, estimated this week that bullish bets on China’s currency amount to about $500 billion.

Dollar-funded carry trades in the yuan lost 1.1 percent this year, compared with a gain of 5.6 percent in the Indonesian rupiah and a return of 2.1 percent in the Brazilian real, according to data compiled by Bloomberg. The trades involve borrowing funds in a nation with low interest rates to purchase higher-yielding assets elsewhere.

Fixing Guidance

The Sharpe ratio dropped to minus 8.7 this month from a fourth-quarter positive reading of 8.4 that was the highest in 23 emerging markets tracked by Bloomberg. Three-month implied volatility, a measure of expected moves in the exchange rate used to price options, climbed 78 basis points in February to 2.1 percent, compared with a 45 basis point drop in January, data compiled by Bloomberg show.

Policy makers lowered the currency’s daily reference rate for five straight days through Feb. 24, the longest period of cuts since November. It was set at 6.1224 per dollar today. The spot rate converged with the fixing on Feb. 25 for the first time since September 2012, leading to speculation the central bank is moving closer to widening the 1 percent trading band.

Yields Fall

The currency weakened 1.1 percent this month to 6.1284 per dollar in Shanghai, China Foreign Exchange Trade System prices show. It touched a seven-month low of 6.1351 yesterday, and has dropped 1.4 percent since reaching 6.0406 on Jan. 14, the strongest since the exchange rates were unified.

The Shanghai Composite Index of shares has dropped 6 percent to 2,047.35 since reaching a two-month high on Feb. 20. It climbed 0.3 percent today.

The cost for Chinese banks to borrow from one another for seven days sank as low as 3 percent yesterday, the least since July, according to a weighted average compiled by the National Interbank Funding Center. The repurchase rate climbed to 3.44 percent today.

A drop in yields on Chinese bonds may also reduce the attraction of carry trades, Schroder’s De Mello said, adding that the company had cut its position.

The yield on two-year government debt fell 28 basis points this month, narrowing the differential over similar-maturity U.S. Treasuries to a six-month low of 321 basis points, data compiled by Bloomberg show.

Chinese policy makers are moving to drive away speculators as President Xi Jinping seeks to liberalize interest rates, allow more room for the exchange rate to fluctuate and set up yuan-trading hubs around the world.

Volume in over-the-counter options on the dollar-yuan reached $26 billion yesterday, representing the largest share of trades at 33 percent, according to data reported by U.S. banks to the Depository Trust Clearing Corp. and tracked by Bloomberg.

‘Speculative Positioning’

“There’s definitely going to be a lot more two-way volatility,” Christian Wildmann, a fixed-income fund manager at Union Investment Privatfonds in Frankfurt, part of Germany’s Union Investment Group overseeing about 206 billion euros ($281 billion), said in a Feb. 25 e-mail interview. “Speaking for the next couple of weeks, I remain cautious due to the still-heavy one-way speculative positioning in the market.”

China’s currency has strengthened 35 percent against the dollar in Shanghai since a dollar peg was scrapped in July 2005, the best performance among 24 emerging-market currencies. Bloomberg strategist surveys indicate it will lead Asian gains for the rest of this year with a 2.7 percent advance.

The yuan’s appreciation has led to inflows of speculative capital and inflated China’s foreign-exchange reserves to a record $3.8 trillion, the world’s largest, making them a “liability,” said Stephen Jen, a partner at London-based hedge fund SLJ Macro Partners LLP. That’s resulted in money creation and excessive credit extension, he said.

‘Surprise Element’

Aggregate financing, China’s broadest measure of credit, climbed to an unprecedented 2.58 trillion yuan ($421 billion) in January, the central bank reported on Feb. 15.

“The yuan is no longer obviously undervalued,” Jen said in a Feb. 25 e-mail interview. “Beyond a certain point, foreign reserves become a liability rather than an asset.”

Flushing out hot money inflows in yuan carry trades would help attain longer-term stability, said Aaron Low, principal of San Francisco-based emerging-market hedge fund Lumen Advisors LLC in Singapore.

“If that was an explicit policy to alleviate excessive carry trades and leverage, then the policy needs to maintain the surprise element to have any impact,” Low said in a Feb. 25 e-mail interview. “This would certainly reduce the appeal of the carry trade going forward, but it would not remove it as long as the carry is significant.”

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