China’s stealthy yuan support ebbs, denting hot hedge fund trade

A lucrative trade that offered hedge funds a way to ratchet up profits on Chinese debt instruments is starting to lose its charm.

Data due this week may show a popular strategy – which had resulted in a fourfold increase in foreigners’ holdings of Chinese bank notes over the past year – has lost momentum in August, analysts said.

The trade involves overseas investors lending out their dollars in return for the yuan and using the proceeds to buy short-term bonds. Returns on the strategy have dwindled due to a lower demand for foreign-exchange in the swaps market.

The development is significant because it is partly due to easing dollar borrowing by Chinese state banks, which had been using foreign-exchange obtained in the swaps market to support the yuan in spot trading. Now with the Chinese currency stabilising, the need for such a tacit way of intervention has moderated.

But that is bad news for hedge funds. China’s short-term bank debt had been a favourite for them – the securities attracted inflows for a record-smashing 11 straight months – even when government and quasi-sovereign notes were losing buyers. It is likely to narrow investment options for global investors in China as a sluggish economy and geopolitical tensions hurt sentiment in yuan assets.