China’s yuan breached 6.83 to the US dollar this week for the first time since May 2019 and will continue to appreciate as China maintains a neutral monetary policy while other major economies loosen aggressively.
China’s shift to expanding domestic demand, promoted by President Xi Jinping under the rubric of “dual circulation,” favors a strong currency.
A bearish flattening of China’s yield curve between 3-year and 10-year maturities shows that the market expects the People’s Bank of China (PBC) to keep short-term rates high for some time.
China is now the only big fixed-income market in the world that offers positive real interest rates; it is the only major economy that will grow during 2020, and; it is the only one to recover without drastic monetary easing.
All these factors point to a rising yuan with a goal of 6 to the greenback. The State Council’s plan to shift industrial demand more to the domestic market benefits from a stronger currency.
The rate differential attracts foreign “carry trade” capital, while the neutral-to-stringent stance of the central bank signals China’s comfort with yuan appreciation.
The chart below shows year-on-year growth in broadly-defined money supply (cash plus checking and savings deposits at banks) in the US and China, respectively.
China’s money supply growth barely accelerated during the Covid-19 crisis, while US M2 growth reached an unprecedented 23%.
A key shift in market expectations occurred in early August when the off-shore yuan (CNH) broke below a two-year trend line. After breaching that technical barrier, the yuan has appreciated nearly nonstop.
Let’s examine the yuan’s sources of strength in more detail. For starters, the interest differential between Chinese and US short-term government bonds is the highest since 2015.
There’s a world of difference between 2015 and today, however. Five years ago, China suffered from producer price deflation, and the strong yuan was a drag on China’s economy. The PBC had no choice but to ease monetary policy and allow the currency to depreciate.
China has no such problem today. After a few months of price declines due to Covid-19 lockdowns, Chinese producer prices rebounded in June and July, after second-quarter gross domestic product (GDP) growth rebounded to 3.2% following a 6.8% decline in the first-quarter.
Overall, China will grow by nearly 3% in 2020, while all Western countries and Japan shrink.
Remarkably, China returned to growth without monetary stimulus. On the contrary, short-term rates rebounded sharply during the second-quarter in line with the real economy.
The 3-year government bond has risen back to its pre-Covid level as the central bank abstained from short-term interest rate cuts.
The bearish flattening of the yield curve is reflected in the underperformance of intermediate maturities relative to longer ones. This is gauged by the price of a so-called bond butterfly – the sum of the 2-year and 10-year Chinese government bond yields minus twice the 5-year bond yield.
As the chart below makes clear, the price of the butterfly, measured in basis points of bond yield, tracks the yuan exchange rate fairly closely.
China is attracting substantial inflows from hedge funds and other financial institutions seeking higher interest rates. That is the so-called “carry trade”, where “carry” simply means “interest.”
The interest rates of popular “carry trade” currencies such as the Brazilian real, the Indonesian rupiah and the Philippines peso fell sharply during 2020 as central banks tried to stimulate their economies through monetary easing.
As a result, China’s stable interest rates are now higher than those of the former high-yielders.
To determine the relative attractiveness of carry currencies, Global Value Strategist created a portfolio of one-year deposits in emerging market currencies and calculated the portfolio that offered the least volatility against the US dollar.
The results are instructive. Nearly 60% of the total portfolio would be invested in just one currency, China’s yuan.
Results of Mean-Variance Optimization Test:
I don’t recommend investing on the basis of any sole model, but the calculation highlights the relative attractiveness of RMB against emerging market currencies as well as developed market ones.