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In what can only be called a dramatic change of direction, the upward move of the Chinese yuan has caught a lot of investors off guard, as their attention, in the currency market has mostly been on the Japanese yen, once it implemented a policy to drive down its value.

Meanwhile, the yuan has moved strongly in the opposite direction, strengthening against the U.S. dollar in a meaningful way since the beginning of 2013.

As of this writing (May 9, 2013) the exchange rate between the RMB yuan (CNY) and the U.S. dollar is 100 619.25. Since the middle of February, the yuan has climbed about 1.5 percent against the U.S. dollar. From the beginning of the year it has jumped close to 1 percent against the U.S. dollar.

Impetus Behind the Move

When one analyzes China, it must be taken into account the view the culture and country have of time, as they have a much longer view of things, along with a tendency to move incrementally rather than in big steps.

So by the standards of China, it appears it is now taking steps to free up its currency in preparation to allow it to be moved by market forces, or at least to allow the market to have a bigger role in the value of the currency.

A parity rate is set each day for the yuan against the U.S. dollar before the opening of each day of trading. China has been allowing the rate to rise, resulting in the currency jumping over the last three months. For those watching closely, it really began in July 2012, although it flattened from November to mid-February before resuming its upward move against the dollar.

While the Chinese are battling shorting the currency and money inflows, it is interesting that they aren't taking steps to manage the exchange rate at this time.

Is There Room for the Yuan to Rise?

Stuart Oakley, managing director of Asian currency trading at Nomura, sees a lot of upside remaining in the trade. He says this:

There is still a lot of juice in this trade. To be short dollars and long yuan is the real trade and it seems to have by-passed the market completely.

I think he's right in his assessment. China, by western standards, is notoriously slow to respond to events, but over time the country can be understood as to its intentions.

It appears at this time China has definitely adjusted its currency policy to be more market oriented. Management of the currency will continue in the short term, but over time it looks like China is slowly moving towards a market currency.

Consequently, over time, the strength of the yuan should continue to rise against the U.S. dollar, even in the short term.

The bullish long-term view comes from the current giant trade surplus of the Middle Kingdom, as well as the healthy economic fundamentals of the country. Those and the apparent move towards internationalizing the renminbi are the catalysts driving the yuan higher.

Risks to the Trade

The major risks to the trade, as I see it now, isn't in the long term but in the short term.

On Monday the yuan fell against the U.S. dollar for the first time since April 22. That was based on the introduction of new regulations to stem the inflow of foreign currencies into the country.

China's concern is the economy would start to grow too fast while possibly inflating asset prices. All the stimulus money from the U.S., Europe and Japan is looking for attractive places to park. China is a leading candidate for that capital. The outcome is banks located in China now have more foreign-currency loans than deposits. At the end of the first quarter deposits were at $441.6 billion, while foreign-currency loans were a robust $754.3 billion, according to the central bank.

In response, China now requires banks in the country with foreign-currency loans above 75 percent of their foreign-currency deposits to adjust their holdings in order to meet new thresholds being put in place.

While that could slow the appreciation of the yuan, it shouldn't stop the ongoing trend it is in. That's why I mentioned it should continue to rise even in the short term, albeit at a probable slower pace.

Unless some unknown drastic step is taken by China, this shouldn't change the upward trend of the yuan. The risk at this time is slowing the appreciation of the currency, not stopping it.

For the U.S. dollar the opposite is true in the trade, as in the short term it could strengthen against the yuan in response to these measures, which are scheduled to be implemented in July.

Another new regulation, which will have some effect concerns the shorting of the U.S. dollar by banks located in mainland China. That will make it harder to continue to hold the short positions by the banks.

U.S. Monetary Policy

To understand the U.S. dollar/China yuan trade, as well as all other currency trades, U.S. monetary policy must be understood.

The Federal Reserve has been creating money at an unprecedented rate. The U.S. dollar being the world's reserve currency means when it continues to print or digitize money, it causes the value of the dollar to decline.

If countries want to compete with exports, they must respond by creating more of their own money to lower the value of their respective currencies. That's what the Japanese yen story is all about.

So when the U.S. accuses China of manipulating its currency, it's better understood why it is pegged within a certain range. When you come right down to it, the Federal Reserve is the biggest currency manipulator in the world, it just does it under the guise of attempting to stimulate the economy. Since the creation of the Fed 100 years ago, the U.S. dollar has lost over 95 percent of its value. If countries didn't respond, only America would have an export industry.

Why does the U.S. dollar appear to be so strong then? The majority of currencies it's trading against are even weaker. The weakness of those currencies gives the impression of dollar strength. It also depends on what you're measuring the dollar against.

That's the world we live and invest in though in regard to currencies, and for now the dollar will continue to be strong as measured against competing currencies. Nonetheless, the U.S. wants a stronger yuan so it can compete better against it in exports.

Implications

While there are a variety of implications with a stronger yuan, one that immediately stands out is retailers with a large exposure to Chinese products. Others would be manufacturers importing parts and other products from Chinese suppliers.

The most obvious companies in the retail sector are Wal-Mart (WMT), Amazon.com (AMZN) and Target (TGT), with smaller retailers like Kohl's (KSS), Dollar General (DG) and Family Dollar (FDO) being exposed to the price move as well.

The question wouldn't be so much domestic competitive pressures, because if import prices rise in general, all the retailers and manufacturers will experience that at some level, basically leaving margins at similar levels across the various firms.

Where it could make a difference is in consumers cutting back on spending in response to higher prices, which could pull the overall industry down. Like everything else associated with this trade, this shouldn't have any further implications in the short term than it already has. Over the long term though, the implications could be staggering if the yuan really takes off against the dollar.

The three-month charts below show the strength in some of the retailers over the last several months. Comparing that with the chart showing the appreciation of the yuan above implies, as least for now, it isn't having a significant effect on the share price and performance of the companies.

Wal-Mart

(click to enlarge)

Target

(click to enlarge)

Family Dollar

(click to enlarge)

Dollar General

(click to enlarge)

Exasperating this would be a slowdown in economic growth.

On the positive side, a stronger yuan would benefit U.S. exports.

For the yuan/U.S. dollar trade itself, over time betting on an appreciating Chinese currency looks very solid.

Conclusion

The moves by the Chinese government in response to the soaring yuan is good to remind us that it is still a managed currency, although the focus of that management strategy may be changing.

If the exchange rates are loosened up even more by China, which it has been hinting it's going to do, the yuan will be a strong currency for several years. It's the pace of the boost in value that is at question, not whether or not it's going to continue appreciating in value.

Any company significantly exposed to the Chinese currency rates will be effected by these changing conditions. Be sure to take that into account in your overall investment strategy over the long term.

Source: Forget Yen, Yuan Making Big Move