China's epic short squeeze is back as yuan rally crushes bears

[BEIJING] For yuan bears, it's the worst kind of deja vu.

As China's currency posts a record two-day rally offshore and skyrocketing interbank rates make short positions prohibitively expensive, memories of an epic squeeze last January are rushing back to bearish traders. The abrupt market reversal almost exactly a year ago marked the beginning of a nearly 5 per cent rally that lasted two months.

"Another extraordinary day in China," said Gareth Berry, a foreign-exchange and rates strategist at Macquarie Bank Ltd. in Singapore.

"It looks like a classic case of a consensus trade blowing up at the start of a new year."

The turbulence represents the latest twist in a battle between China bears - who say slowing economic growth makes a devaluation inevitable - and policy makers fearing a sudden drop will destabilize the financial system.

Pessimists have mostly been on the right side of the trade since a one-time exchange rate adjustment in Aug 2015, but sudden bouts of strength have proven painful for short sellers who need to periodically roll over their bets.

Derivatives markets show the extent to which some speculators were caught off guard. The extra cost of bearish options over bullish contracts posted its biggest three-day drop since May 2014, according to three-month risk reversal prices compiled by Bloomberg. Option-implied odds of the onshore rate hitting 7 per US dollar in the first quarter tumbled to 36 per cent, from 65 per cent just two days ago.

The onshore yuan gained 0.7 per cent to 6.8830 per US dollar in Shanghai, while the rate in Hong Kong extended its two-day advance to 2.5 per cent. The city's overnight deposit rate touched a record 100 per cent, while the spread between the offshore and onshore exchange rates reached the widest since 2010.

"It's painful to sit on short yuan positions now, given the soaring funding costs," said Sim Moh Siong, a currency strategist at Bank of Singapore Ltd.

While the role of government intervention in the latest squeeze is unclear, Bloomberg News reported this week that policy makers were encouraging state-owned enterprises to sell foreign currency.

National Australia Bank Ltd says bears are unlikely to see a major reprieve any time soon as authorities keep tight control of the yuan before this month's inauguration of US President-elect Donald Trump.

"There are no signs of the market loosening," said Ngan Kim Man, deputy head of treasury at China Everbright Bank Co's Hong Kong branch.

The People's Bank of China has plenty of reasons to give the yuan some short-term support. Mr Trump has pledged to label the country a currency manipulator on his first day in office, while the exchange rate came close to breaking through the psychologically-important level of 7 per US dollar earlier this week. Policy makers also want to avoid a flood of capital outflows as citizens' annual foreign-exchange quotas reset for the new year.

Reserve Currency?

"Judging from the speed of the yuan's appreciation, the PBOC may have intervened to prop up the exchange rate," said Kenix Lai, a Hong Kong-based foreign-exchange analyst at Bank of East Asia Ltd.

"The PBOC is expressing its strong determination to keep the currency stable and is seeking to restore confidence."

The central bank didn't immediately respond to a faxed request for comment sent outside regular business hours.

Short squeezes like the one in Hong Kong's offshore market this week come at a cost. While surging interbank rates help deter bearish speculators, they also undermine China's push to make the yuan an international reserve currency, said Michael Every, head of financial markets research at Rabobank Group in Hong Kong.

"What's the point of being a reserve currency and having fought so hard to become a reserve currency, and then not letting anybody get hold of that currency," he said.

"China basically wants to have its cake and eat it on all fronts."

Analyst estimates compiled by Bloomberg suggest China will eventually let the yuan continue its descent. The exchange rate will fall to 7.15 per US dollar by year-end before sliding to 7.3 the following year, according to the median projections.

In the short term, though, the currency is unlikely to be a one-way wager, said Angus To, deputy head of research at ICBC International Research Ltd in Hong Kong.

"After this round of liquidity squeeze, speculators will at least scale down short yuan bets for the next two months," Mr To said.

"We expect the offshore yuan to stabilise at around 6.8 yuan per dollar after the market run."

BLOOMBERG