Me Still Love You Yuan Time

China recently raised the Reserve Requirement Ratio by 50 bps to 16.5% for its domestic banks.  This is the second hike in the past month and certainly not the last as China’s economy is still sprinting ahead.  While equity markets have begun to price in the risk of “global exit strategies,” currency markets have yet to consider the implications of continued strong underlying growth in China.  It is likely that additional Chinese monetary tightening will be accompanied by pressure to revalue the yuan.

We came across an interesting piece from Ned Davis Research recently that increases our conviction for a Chinese currency revaluation.  Recall we first discussed the prospects for a major revaluation of the renminbi here.  NDR compiled the table below to illustrate current economic indicators relative to levels seen in July 2005 and July 2008 – other instances when China changed their currency peg.

Source: Ned Davis Research, Inc.

For individual investors unable to trade currency forward contracts, the Wisdom Tree Dreyfus Chinese Yuan Fund (CYB) remains the best vehicle to position for this event.  CYB is comprised primarily of U.S. government, corporate and treasury bonds; repurchase agreements; and short-term currency forwards.  The fund seeks to achieve total returns reflective of both money market rates in China and changes in value of the Chinese yuan relative to the USD.  While CYB does make income distributions, investors should not expect large movements in value until an actual revaluation takes place, so patience is a virtue.  That being said, when viewed relative to earning approximately nothing in a US savings account – and the near certainty of decaying purchasing power due to reckless monetary and fiscal policy – we are happy to sit and wait.  As we stated in our initial post:

We don’t believe that today’s expectations accurately reflect the yuan’s true trajectory.  To effectively dampen China’s underlying inflationary pressures, exchange rates would have to rise substantially more than levels implied by the market today.  A 50-100% revaluation is even plausible if trends in commodity prices persist, and as history suggests, China overshoots in policy accommodations.

Disclosure:  At the time of publication, the author was long WisdomTree China Yuan Fund, although positions may change at any time.