As China's currency hits nearly 16-year lows, investors bet on more declines

China's tightly managed currency fell to the lowest level against the greenback in almost 16 years on Thursday.

Why it matters: The weakness of the currency (officially known as the renminbi, but often referred to as the yuan) reflects the growing consensus that the world's second-largest economy and biggest single driver of global economic growth for decades is in deep trouble.

• And with the economy looking weak, speculators appear to be betting against the yuan.

How it works: Besides trade and economic conditions, currency values are heavily influenced by "interest rate differentials," or big gaps between where central banks in different countries set the short-term rates they use to control monetary policy.

• When a country sets low-interest rates — usually when it is sputtering economically — its currency tends to weaken.
• When a country's interest rates are high — often when growth is strong, like in the U.S. — its currency tends to appreciate, as investors flock to the higher yields.

Zoom in: One of the most popular kinds of currency trades employs both types of currencies.

• In what's known as a "carry trade," speculators borrow money in the low-rate — or "funding currency."
• Then they convert that money to the currency of a country where interest rates are higher and use it to invest in something with a higher yield.
• The difference between the two sets of interest rates — also known as the "carry" — is the profit on the trade. (Thus, "the carry trade.")

Flashback: In the years before the financial crisis in 2008, it was incredibly popular to use the Japanese yen as the "funding currency," i.e. the one that's cheap to borrow — and likely falling in value, making it cheaper to pay back — for this kind of trade.

• That started in the mid-1990s, as the Bank of Japan pioneered ultra-low interest rates in an effort to revive the nation's troubled economy.
• Now currency analysts are saying that China's yuan, or CNY as it's known in markets, would make a fine funding currency for carry trades.

What they're saying: "With expectations of more monetary policy easing, CNY is likely to remain an attractive funding currency for carry trades," wrote Goldman Sachs analysts in a note published Thursday morning. "In our client conversations, hedge fund investors have shown rising interest in riding the waves."

• "With China employing monetary stimulus, expect the renminbi to stay soft and remain a popular funding currency," ING analysts wrote late last month.

Threat level: Carry trades like these are risky, and they work best with currencies that aren't that volatile — since big swings in currency value can wipe out the profit of the trade.

• Officially, China has a massive war chest of roughly $3 trillion in foreign currency reserves like dollars that it could flood the market with, driving down the value of those currencies against the yuan — and crushing carry traders.
• Case in point: Back in 2015, when a slide in the yuan started to snowball out of control, Chinese officials plowed roughly $1 trillion of that stockpile into markets, a costly — but ultimately effective — effort to stamp out what became an embarrassingly sharp sell-off.

The bottom line: Those attempting to profit off of China's weak currency should tread lightly, as they could find themselves up against a very big opponent, with a lot of ammo at its disposal.

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