(Bloomberg) -- The yuan carry trade is back.
The appeal of owning the Chinese currency is growing, after two years of depreciation wagers. Selling the greenback and using the proceeds to buy yuan has delivered Asia's highest Sharpe ratio -- a measure of returns adjusted for price swings -- over the past three months.
The turnaround has much to do with the People's Bank of China, which has -- with a combination of policy changes, higher interest rates and a decline in the dollar -- managed to engineer the drastic reversal. The yuan's increasing draw signals prospects of further appreciation and quicker inflows, leading forecasters including Bank of America Merrill Lynch and Barclays Plc to strengthen their end-2017 predictions for the currency.
“We're more upbeat about the renminbi,” said Ken Hu, chief investment officer for Asia-Pacific fixed income at Invesco Hong Kong Ltd., referring to the currency by its official name. “We see value in yuan bonds because the yields are high relative to consumer inflation.”
The stars have aligned in favor of the yuan trade: the exchange rate is near the strongest level since October, expected volatility is close to the lowest in almost two years and interest rates are relatively high after a government campaign to spur deleveraging. The gap between the one-year sovereign bond yield and the inflation rate jumped to the highest since February 2015 in May, and has fallen only slightly since.
Betting the yuan will rise against the dollar isn't the only potentially profitable trade: Gao Qi, a strategist at Scotiabank in Singapore, recommends buying the Chinese currency against South Korea's won, which he said may lose ground amid rising tensions over North Korea's missile tests.
While the dollar looks oversold, the implied yields in offshore yuan forwards still offer a buffer against declines, said Dennis Tan, a strategist at Barclays Plc in Singapore. The Bloomberg Dollar Spot Index fell 2.6 percent in July in its fifth monthly decline in a row, spurring speculation the greenback may be due for a rebound. The onshore yuan was trading at 6.7219 per dollar late Tuesday.
Still, Chinese authorities have gone to great lengths to push back against depreciation pressures, with several officials and state-run media coming out to say that the exchange rate will be stable. While the Politburo -- the Communist Party's highest decision-making body -- on July 24 called for policy consistency to create a “favorable environment" for the 19th Party Congress later this year, PBOC Assistant Governor Zhang Xiaohui wrote in the China Finance magazine that the nation will balance yuan flexibility with stability.
“Before the Congress, the yuan will remain steady, but there might not be a lot of room to appreciate against the dollar,” said Invesco's Hu.
To contact the reporter on this story: Justina Lee in Hong Kong at jlee1489@bloomberg.net.
To contact the editors responsible for this story: Robin Ganguly at rganguly1@bloomberg.net, Sarah McDonald
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