Yuan rally may not last much longer

Don’t cheer too early for the yuan’s renewed strength. It’s largely a reflection of a weakening dollar, and that trend may not persist. The outlook for China’s currency has turned around, helped by progress in trade talks with the US and, particularly, the US Federal Reserve’s shift to a more cautious policy stance. Having flirted with 7 per dollar last year, the yuan is at its strongest since July and completed its best week since 2005. Predicting currencies is a fool’s errand, though. Rather than trying to forecast the direction of future exchange rates, dollarbased investors in yuan assets should take advantage of the US currency’s weakness and hedge now. The costs of protection have become far cheaper: hedging the yuan with offshore one-year forwards will set you back only 0.2%, compared with 5.6% at the beginning of 2017 and 2.2% at the start of 2018. The yuan’s rally is part of a broad comeback for emergingmarket currencies this year. The Brazilian real leads the Fragile Five club (which also includes India, Indonesia, Turkey and South Africa) with a 4.4% gain. The Chinese currency is up 1.7%. The Fed’s dovish turn has widened the expected differential between US and emerging-market interest rates, making currencies of the latter more attractive. Futures traders see no further tightening this year. Traders are again paying attention to interest-rate parity. Where emerging-market currencies are concerned, fiscal and current-account deficits may be more important to watch than interest-rate differentials. A new bombshell may drop from China in 2019: its first current-account deficit in two decades. Slower export growth will put a dent in the country’s external accounts. But the picture is more nuanced than that. China is no longer a frugal nation, selling a lot abroad and buying little back. In the third quarter, China’s middle class spent about $63 billion on overseas travel. This is eating away at the hard-won surplus earned by exporters. This brings us back to interest-rate parity. Thanks to the theorem’s renewed primacy in foreign-exchange markets, it’s becoming cheaper to take risk off the table in such an uncertain environment. Investors should take advantage.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets.