China's tightly managed currency fell to the lowest level against the greenback in almost 16 years yesterday, Matt writes.

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 is in deep trouble.

Driving the news: Another disappointing economic report, this time on trade data, came out yesterday showing imports and exports falling yet again (more on that below).

The big question: Why is China tolerating the sell-off?

• After all, China's government manages the yuan carefully, setting a "central" price for it every day, around which a certain amount of trading is tolerated.
• If they wanted to, China's authorities have the means to put a stop to the slide — their "big bazooka" is a pile of foreign exchange reserves that they can deploy (see item 4).

The bottom line: China seems OK with a weaker currency, which will aid its export economy by making its products cheaper to foreign buyers.

The world's largest trading nation is facing a large slump in trade.

The latest: New numbers out yesterday showed imports were down year over year for the sixth straight month, a sign of the weak domestic economy.

• Exports fell for the fourth consecutive month.

Why it matters: Trade is by definition a two-way street. With over $7 trillion of imports and exports in 2022, China's problems translate into issues for the roughly 120 nations where China is the top trading partner.

Between the lines: The trade slump is also a driver of the current slide in China's currency.

• Since foreign buyers pay for Chinese goods in yuan, the falloff in trade translates into a lower demand for the currency and a weaker exchange rate.

Context: The dour trade data was just the latest in a series of disappointing economic updates, signs of financial stress, and signals from the government suggesting growth in the People's Republic won't improve much any time soon.

With the economy and trade looking weak, speculators appear to be betting against the yuan.

The big picture: 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, typically in government bonds.
• 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.

Yes, but: There's a bit of a sticking point. Unlike the yen, the Chinese currency, as we mentioned earlier, is managed by the government and isn't freely convertible.

• So, most traders outside China speculate on the Chinese currency by using the offshore market for the yuan in Hong Kong.
• In the weeds: You can also do the trade synthetically, by calling up a top-shelf investment bank and asking it to tailor the exact exposure you're looking for via a product known as a "total return swap."

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 yesterday 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.

The bottom line: It seems like a pretty popular trade at the moment.

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.

Threat level: Officially, China has a huge war chest of roughly $3 trillion in foreign currency reserves like dollars (charted above) 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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