(Bloomberg) — For currency speculators around the world, the business has long been a no-brainer: simply borrowing the yen, which costs nothing because of Japan’s sub-zero interest rates, and getting high yields wherever you park your money. Net profit from the difference.
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But now a surprisingly low-cost alternative to the Japanese currency is starting to emerge – this time from China. Last month, Invesco, Goldman Sachs, Citigroup and TD Securities all advised holding the yuan as an attractive alternative as trading weakened to historic lows.
Even as the cost of borrowing Chinese currency in overseas markets continues to rise as policymakers in Beijing work hard to protect the currency and curb speculation, proponents of the yuan’s trade are undeterred. They say their position has as much to do with the differences between Asia’s two largest economies as it does with the cold, hard profits or various risks.
Morbid for decades, Japan’s rising inflation — and signs of a recovery in growth — have fueled talk that the Bank of Japan will finally end its seven-year policy of negative interest rates. For China, the trade shows just how far a once-mighty juggernaut has fallen. Fears of heavy debt burdens, housing shortages and inflation prompted the People’s Bank of China to cut its benchmark interest rate twice to a record high of 1.8 percent since June. Many expect more cuts to come – making the yuan weaker and cheaper to borrow.
Dirk Wheeler, head of global macro and emerging market strategy at Citigroup, said: “If you think the BOJ is playing games, you’ll find yen strength in there and you have to be careful, the PBOC is still easing policy. China’s weak economy is “an important part of that trade.”
This month, the Wheeler Group advised clients to sell the yuan against currencies that include the dollar and euro.
Of course there are many caveats. No one is suggesting that the yen carry trade is dead or that speculation will leave the yen for the yuan. So far this year, in Latin America – where benchmark rates are as high as 13.25% – cash purchases have been particularly profitable. An equally weighted basket of reais and the Colombian and Mexican pesos gained 42%, easily outperforming the Nasdaq’s rally.
And the yuan is uncertain as a funding currency. China has intervened aggressively to expand into overseas markets. State-owned banks regularly deplete the supply of offshore yuan to raise funding costs and scare off speculation. On Wednesday, the yuan’s three-month lending rate briefly rose more than 4 percent, the highest in five years.
Friday’s retail and industrial production data in China showed the economy may be stabilizing. Economists polled by Bloomberg expect China to meet the government’s 5% growth target this year, compared to Japan’s 1.8% expansion. The growth gap between the two countries is still large but has narrowed significantly. In the year By 2021, it will double.
“The PBOC has come in and clearly shown that they are concerned,” said TCW Group strategist Jay Lee. That raises the possibility that yuan-based trades could go awry in the near term.
Central banks in Brazil, Mexico, and Chile have also begun to cut rates by reducing the “carrier” (that is, the financing for investment returns) on the most profitable trades.
Despite the risks, more and more traders still see the value in yuan as a way to spread the financial risk in their business.
With every central bank outside of Japan increasing at a faster rate, the concern now is whether the BOJ will join in, especially as inflation has pushed its 2 percent target for more than a year and the yen’s carry trade has grown over the past two years. The bank will raise prices in January, according to recent price traders.
The yen’s volatility has also become more pronounced, and Japanese officials have raised their jaws when they see excessive weakness — exactly what traders are trying to avoid in the hard currency.
Simon Harvey, head of FX analysis at Monex Europe, said: “The yen’s whipsaw is really something that’s deterring people from participating” in Japan-based trades.
Instead of using the yen, Goldman Sachs recommends buying reais and Colombian pesos in yuan. TD strategists told clients to borrow yuan to buy Indian rupees, Mexican pesos and reais.
The reason is straightforward. The PBOC should drop rates to rock-bottom levels to boost the economy. That would reduce funding costs and weaken the currency — boosting profits for yuan-based carry trades along the way. In the domestic market, the yuan, which is volatile and inaccessible to most foreigners, recently fell to a 16-year low.
Forward transactions are usually forward – no-payment contracts between two parties to exchange one currency for another for a specified amount and future. In theory, carry trades shouldn’t actually work. What you lose in interest should be offset by what you lose in currency depreciation. But in real life, things are much more chaotic, which means there’s still money to be made.
Banco de Investinto Global SA Ricardo Sibra is one of the big winners. His BG Diversified Macro Fund has returned 12% this year through August, compared to a roughly 1% loss for the benchmark.
Zebra has added the yuan to the mix in the last couple of months as it has been rotating currencies throughout the year and China has weakened. It is now one of the two main financial support currencies along with the yen.
He is not too worried about the PBOC’s recent actions because he expects the bank to gradually depreciate the yuan over time. And finally, the most important thing is to rush long stretches.
Of late, those are real currencies like Brazil. Currently, the three-month forward yields 10.8% for Rails. For the Mexican peso, it is 11.7 percent. Since it costs 4% to borrow offshore yuan to carry out the transaction, this means an annual return of about 7% if the exchange rate is stable. (That may not sound like a lot, but since these businesses are almost always highly leveraged, the actual profits can be many times higher.)
“We love these juicy real products,” Sibra said.
Ironically, Beijing’s intervention in the onshore yuan, keeping its value close to its onshore counterpart, may have added to it by reducing volatility and making profits more predictable. The yuan’s three-month volatility stands at 5.6, the third lowest among major currencies, against the yen at 9.3.
“We still see the yuan as an attractive funding currency, given its low yield, low volatility and relatively high prices,” said Alessio de Longos, head of investments at Invesco Solutions.
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