Forex Traders Should Be Cautious Buying Chinese Yuan - ProShares Ultrashort FTSE China 50 (ARCA:FXP)

In China, for the month of May, money growth reached a 30-month low. Loan creation slowed, and the M2 money supply expanded at its slowest rate, according to Reuters. The People's Bank of China has been actively working to slow the expansion in the money supply. Quantifying the total amount of "money" in an economy can be a tricky objective. For example, while cash in hand is considered money by all, what other forms of money count? M2 defines the total supply of money in an economy as currency, bank reserves, and close substitutes for money such as traveler's checks and savings deposits. There are other measures of money such as M0 and M3, but central banks generally use the M2 measure to make policy decisions. While a moderating pace of monetary growth may be indicative of a moderating pace of economic growth, and therefore potentially dangerous to traders, in the long-term this sluggishness may be a net positive. The Chinese economy has been under stress recently due to

inflationary pressures

, particularly in the cost of food, which has been rising in price at annual rate of nearly 12%. Some economic commentators, such as

The Wall Street Journal's

Ronald McKinnon, have alleged that the Federal Reserve's quantitative easing policies have been to blame for inflation in the developing world. The central banks of many developing countries (such as China) peg their currency to the U.S. dollar. This decision to peg helps to stabilize their currencies and boosts exports. As the U.S. dollar has been depreciating, the central banks with dollar pegs must print more of their own currency to maintain the peg. This may contribute to inflation in the developing economies. Of course, developing countries peg their currencies to the dollar voluntarily. Thus, they have the option of removing their peg.

Evidence is growing

that the Chinese

may do just that

. The Chinese must fight food inflation, no doubt. Yet, will they go too far and effectively stifle Chinese economic growth? While many are bullish on the yuan, it could prove to be a bad buy if the Chinese economy tanks.

Action ItemsBullish:

Traders who believe that the Chinese will be able to guide their economy to a pleasant landing might want to consider the following trades:

Buy WisdomTree Dreyfus Chinese Yuan Fund CYB as a long play on the Chinese currency. Particularly if the Chinese have to de-peg, the yuan may do extremely well.
Go short ProShares UltraShort FTSE China 25 FXP in a play against the China-bears. FXP is a short Chinese ETF, and that trade may be becoming overcrowded as negative news about the Chinese economy may have created false confidence. FXP rallied sharply on Friday, and though it has come off its highs, it may be do for a larger pullback.

Bearish:

Traders who believe that the People's Bank will manage the slowdown improperly may consider taking positions in the following:

CurrencyShares Japanese Yen Trust FXY is a long play on the yen. If the Chinese economy takes a turn for the worst, Asian-centric investors may shift their assets to the safer yen.
PowerShares DB US Dollar Bearish Index UUP is a play in a similar vien to FXY. The yen brings its own set of problems with supply disruptions persisting. Investors may wish to seek a different haven in the U.S. dollar.

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