Traders Eye Yuan Proxies as China Intervention Risks Linger

(Bloomberg) -- China bears are shorting yuan proxies, as risks of central bank intervention loom large with the currency edging closer to its decade-low again.

Yuan proxies -- such as the Australian and New Zealand dollars -- are appealing, as they are more flexible, liquid and less affected if the Chinese central bank intervenes, according to Sean Callow, senior currency strategist at Westpac Banking Corp. Other popular proxies include the Korean won, and the Taiwanese, Singaporean and Hong Kong dollars, analysts say. Such exchange rates tend to decline on negative sentiment toward China because the nation is their major export market.

The yuan posted the worst weekly loss since July in the five days through Nov. 9, after a short-lived rebound built on bets the world’s two largest economies may reach a deal on trade. The slide in the currency, also fueled by looser monetary policy and slower growth, stoked concerns that the People’s Bank of China may punish bears by removing liquidity or selling the dollar aggressively -- tactics it used repeatedly in 2016-17.

"I can’t help but be bearish on the Aussie, which is the most liquid proxy to express China risks," said Stephen Innes, head of trading for Asia Pacific at Oanda Corp. in Singapore. If needed, "the PBOC can be merciless and jack up interest rates to outrageous levels. While the proxies will follow the yuan stronger in that case, they will not do so with the same vigor and allow a more comfortable exit if you decide to cut and run."

The yuan has tumbled 6.6 percent this year, prompting investment banks from Goldman Sachs Group Inc. to JPMorgan Chase & Co. to predict a breach of 7 per dollar for the first time since the global financial crisis. The Aussie has plunged nearly 8 percent, while the won has slid 5.6 percent during the same period.

There are signs that policy makers are growing less comfortable with the depreciation. The PBOC sold bills in Hong Kong for the first time on Nov. 7, a move that Standard Chartered Plc said may signal tougher currency management ahead. Late last week, the officials signaled tougher management of the yuan by dropping a phrase underlining the importance of market forces from a key policy report for the first time in five years.

While heavy, direct intervention hasn’t been seen of late, it can happen anytime at the whim of the PBOC. In January 2017, when officials grew upset about the yuan’s weakness, they choked cash supply in Hong Kong and sent the currency’s deposit rates to record highs. A stampede of bears followed suit, fueling a 2.4 percent spike in the offshore yuan within two days. But during the same period, the Aussie and kiwi both strengthened about 1.6 percent.

Proxies are "a lot more logical vehicle for China bears because of limited flexibility of the yuan," said Callow, who sees a strong chance of intervention before the Chinese currency hits 7 per dollar. "Plus, they are tradeable 24 hours a day and five days a week, liquid and do not have a central bank threatening to step in."

Also, interest rates on proxies are usually cheaper than those on the yuan, making it less expensive for bears to place short bets. While the offshore yuan’s one-month forward implied yield -- a gauge of traders’ expectations on the currency’s funding costs -- stood at 5.3 percent on Monday, the equivalent for the won was around 1.9 percent and 2.3 percent for the Aussie.

Crowded Trade

However, some traders -- especially those who are foreseeing a major devaluation in the yuan -- may prefer to short the currency directly. That’s because the proxies aren’t as overvalued and have become a crowded trade, said Kevin Smith, founder and CEO of Denver, Colorado-based Crescat Capital. The company, whose global macro fund returned 17.5 percent in October, has been adding wagers against the yuan with put options.

Also, the proxies may not follow the yuan perfectly all the time as they are also affected by domestic conditions. The Aussie, for example, gained 0.5 percent last week, while the Chinese currency weakened.

Looking ahead, the proxies will likely weaken as the yuan may depreciate further amid risks that the trade war may escalate again, according to Mingze Wu, a Singapore-based foreign-exchange trader with Intl FCStone Global Payments. The yuan will slide to 7.5 per dollar by the end of next year, dragged down by slower growth in China, trade tensions and higher interest rates in developed nations, said Sue Trinh, head of Asia FX strategy at Royal Bank of Canada.

The onshore yuan fell 0.15 to 6.9663 per dollar as of 4:45 p.m. in Shanghai on Monday. It slid to as low as 6.9780 in late October, its weakest level since May 2008.

To contact the reporter on this story: Tian Chen in Hong Kong at tchen259@bloomberg.net

To contact the editors responsible for this story: Richard Frost at rfrost4@bloomberg.net, David Watkins, Ron Harui

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