China Reminds Hedge Funds That the Yuan Is a Dangerous Short

(Bloomberg) -- It’s exactly the kind of shock that many hedge fund managers feared as they mulled whether to bet big against China’s currency.

In a surprise statement on Friday night, the People’s Bank of China announced a rule tweak that will make bearish yuan trades much more expensive. The move, which sparked a sharp rally in the currency, echoed efforts to deter short sellers almost three years ago. It also underscored why hedge funds have largely avoided wagers against the yuan in recent months, missing out on one of the world’s most profitable currency trades.

While China’s slowing economy, rising debt risks and escalating trade war with Donald Trump are all pointing to a weaker exchange rate, memories of a dramatic government-engineered short squeeze in early 2016 are still too fresh for many managers to risk getting caught in a repeat. Even Crescat Capital’s Kevin Smith, a long-time China pessimist who predicts the yuan will sink by at least 50 percent over the next 18 months, trimmed his bearish positions in recent weeks to lock-in profits as the currency sank toward a 15-month low.

“Nobody dares to intensely build short trades,’’ said Tommy Ong, managing director for treasury and markets at DBS Hong Kong Ltd. “Traders were punished a few years ago, and they made very little money, if not losses.’’

Read more: Down $240 Million on Seven-Year Short, a China Bear Gives In

Only time will tell whether Friday marks the end of the yuan’s slide or just a pause. Bears like Smith say the most likely endgame is a major devaluation. But other investors are far more sanguine, citing China’s efforts to bolster economic growth, attract foreign investors and prevent capital outflows.

The onshore yuan gave up morning gains and declined 0.22 percent to 6.8436 per dollar as of 5:25 p.m. in Shanghai, while the currency weakened 0.19 percent in overseas trading. In an article Monday, the Economic Observer cited PBOC adviser Sheng Songcheng as saying the yuan won’t fall to 7, which he called a psychological barrier.

Below is a summary of views from several hedge fund managers and asset allocators, most of whom spoke to Bloomberg before the PBOC’s announcement on Friday.

Arvin Soh, New York-based portfolio manager at GAM Holding AG’s Alternative Investments Solutions team

• There aren’t many hedge funds with short-yuan trades despite a bearish consensus on China
• There could be some activity after the summer, when there’s more clarity on the trade war and better liquidity
• A lot of general macro funds are avoiding the trade

August Li, deputy fund manager at PruLev Global Macro Fund

• No plan to short yuan now and “probably never”
• Yuan will strengthen if authorities are comfortable allowing more foreign capital; U.S. fiscal deficit will weigh on the dollar
• If the U.S. economy enters a recession and China opens up, yuan will strengthen quickly
• In the near term, the yuan will gradually weaken as U.S. interest rates rise; depreciation will be controlled and limited so as not to inflame Trump

Ashvin Murthy, fund manager at AVM Global Opportunity Fund

• Has exited yuan shorts; trade lost momentum after the currency hit 6.8 per dollar
• Yuan will bounce back if there’s constructive developments on the trade front
• Not surprised to see the PBOC let the yuan fall after it appreciated quite a bit at the start of the year
• Sees good chance of a tactical pullback in the dollar unless Fed is really hawkish

Rob Christian, head of research at Franklin Templeton Investment’s K2 Advisors, which invests $11.6 billion in hedge funds

• Shorting the yuan isn’t a crowded trade
• Managers aren’t playing the China theme directly with the yuan, they’re trading stocks and other currencies in the region
• Hedge funds are betting on dollar strength across the board rather than a yuan specific trade
• The yuan has more noise, hard to predict
• “You can see a scenario, if things get really ugly, where China implements capital controls and hedge funds are cognizant of that as an outcome. They got burned last time around and that’s still in their memories”

Kevin Smith, founder and CEO of Denver, Colorado-based Crescat Capital, which oversees $56 million

• China is in the early innings of a large credit bust, and the non-performing loans problem is becoming too big to ignore
• Government will print money to bail out banks and the economy; massive monetary easing will cause “an outright collapse” in the currency
• Yuan will weaken 50 to 70 percent in the coming 18 months
• Measures such as verbal support, direct intervention and capital curbs are “finger in the dike,” and “temporary band-aids”
• Fund recently trimmed 25 percent of its profitable short position in yuan options

Brett Gillespie, head of global macro at Ellerston Capital Ltd.

• Still shorting yuan; PBOC has made a strategic decision to weaken yuan against CFETS basket
• Sees no reason for a firming CFETS RMB Index given the slowing economy and benign inflation, while PBOC is also cutting reserve requirements; yuan weakness is justified on economic grounds
• Authorities will intervene to smooth the move, rather than reverse it

Anna Titarchuk, director of research at Marto Capital, a hedge fund in New York that manages about $200 million

• Using forwards and options to short the yuan
• The trade isn’t crowded like it was in 2015 and 2016; back then, hedge funds had a “China blow up” view on and expressed it by shorting the currency; they got burned
• Now, China is going through an engineered deleveraging, not a hard landing, so the short-yuan trade is not that popular
• “The yuan isn’t out of the woods yet, but the majority of the decline has been done”

--With assistance from Suzy Waite.

To contact the reporters on this story: Tian Chen in Hong Kong at tchen259@bloomberg.net;Emma Dai in Hong Kong at edai8@bloomberg.net;Saijel Kishan in New York at skishan@bloomberg.net;Klaus Wille in Singapore at kwille@bloomberg.net

To contact the editors responsible for this story: Richard Frost at rfrost4@bloomberg.net, Michael Patterson

©2018 Bloomberg L.P.