A major and frequent fundamental theme in currency markets is the role of China. With the global economy in a fragile state, all eyes are on what happens to Chinese growth and to the Chinese yuan, also known as the renminbi.
There is great controversy regarding Chinese economic projections. Continuous Chinese growth is not inevitable, and inflation pressure on its economy is causing currency sentiment to sway between fear and hope. The fear of a property market bubble bursting or of unrest in labor markets is real. On the other hand, the ability of China to provide macro control is a countervailing bullish sentiment. Current projections reported by the Chinese State Information Center envision a slowdown to an 8.2% annual GDP growth rate compared to an 11.9% rate of growth in the beginning of 2010. Even at 8.2%, the slowdown still keeps China in a very strong growth mode. Premier Wen Jiabao said in a recent speech reported by Reuters that the Chinese economy was “heading in the expected direction of macro control.” On June 19, China announced a major change in its currency regime and offered prospects of greater flexibility in the way the yuan is valued. This has been a long-term promise since before China adjusted its currency peg to the U.S. dollar two years ago. Now, however, if the dollar peg is gone, there will be a basket of currencies instead. As a result, strengthening of the Chinese currency is now part of global expectations. The questions are who benefits and who gets hurt by the new Chinese currency policy and when will it actually happen?
A stronger Chinese currency is hoped for by other countries because it makes their goods more competitive. Too strong a rate of appreciation could, however, become a drag on the export sector of the Chinese economy. Until China develops consumption-driven growth, the currency valuation becomes a key pivot point in the clash of expectations about China.
A direct approach is to trade the yuan. Institutions are doing so by trading in non-deliverable forwards (NDFs), but participating in these instruments requires millions of dollars. This may change as interest in the yuan increases. In fact, the Nanyang Commercial Bank is offering Renminbi NDFs with minimum contract sizes of 10,000. But these instruments are illiquid and not for the average forex trader. Since there is no spot market for the yuan, the best way for the average trader to trade it is to own a Chinese currency ETF (The Wisdom Tree Dreyfus Chinese Yuan Fund (CYB)). The price movement of CYB, however, is flat and the prospect of significant returns is small.
Another approach is to trade the expectation of Chinese appreciation through other currencies. This leads us to the Mexican peso. Mexico and China are fighting for market share in numerous sectors, particularly auto parts and electronics. A stronger yuan means Mexican exports become cheaper as a source of manufacturing. Also, while Mexico is a competitor on exporting, it also has a major interest in a stronger Chinese economy. As China grows, it stimulates global recovery, which increases capital flow to Mexico as risk aversion to emerging markets declines. A stronger China translates to a stronger Mexico and a close observer will notice the peso reacting to Chinese events.
Forex traders can play that connection by building a position in the Rydex Currency Shares Mexican Peso Trust ETF (FXM). This ETF provides an opportunity for both long-term growth as well as short- term tactical trading and moves nearly in tandem with the Chinese ETF FXI (see “Strange bedfellows”).
FXM also has options. A safe play would be trading covered calls. In this strategy, a trader would purchase the underlying shares of the ETF and write (sell) a call at a higher strike price against those shares. For example, a trader owning 100 shares of FXM could sell a December 2010, 81 call at $1.05. If FXM goes above 81, the shares are called away and you receive the difference in the principle from 763 to 810, or 6.1%. If the option remains out-of-the-money, you collect the premium, $105 as of July 2, nearly 14% of the $763 value, protecting you against a decline. The maximum return on this trade is 20% if the ETF rallies but remains out of the money. Using a covered call strategy on the Mexican ETF not only provides a play on China continuing to grow, but also generates growth plus income. In today’s low interest environment, that combination is attractive.
Abe Cofnas is the author of “Sentiment Indicators” (Bloomberg Press). He can be reached at email@example.com.