SHANGHAI, July 30 (Reuters) - The U.S. dollar's

narrowing premium over the yuan in the forwards market has

dampened foreign interest in Chinese bonds, despite recent gains

in the Chinese currency.

WHY IT'S IMPORTANT

Foreign investors had steadily accumulated yuan bonds since

late 2023. A popular trading strategy involved purchasing

short-term yuan-denominated bank debt through currency-hedged

swaps, which offered higher yields exceeding those of U.S.

Treasuries.

However, rising implied yuan rates, reflected in the

forwards market, eroded those gains and made such yuan debt less

appealing. One-year swaps hovered near the highest

level since October.

BY THE NUMBERS

Foreign investors sold China's onshore yuan bonds for the

second consecutive month in June. Notably, they offloaded a net

73 billion yuan ($10.18 billion) worth of negotiable

certificates of deposits (NCDs), a short-term debt instrument in

the interbank market, accounting for over 60% of total outflows

last month.

One-year yuan forwards were quoted at 6.9982 per dollar

versus a spot rate of 7.1767 on Wednesday, allowing investors to

swap dollars for yuan at an implied yield of about 2.48%. The

currency swap mechanism shields investors from yuan fluctuations

.

Using the yuan acquired from the swap market to invest in a

one-year NCD will fetch a combined return of

about 4.1%, roughly the same as yields from Treasuries

. Previously, the strategy could book an extra yield

of about 90 basis points versus the Treasuries.

CONTEXT

Rising implied yuan rates come amid easing yuan depreciation

pressure. As a result, major state-owned banks are feeling less

urgency to acquire dollars via swaps to defend the yuan in the

spot market.

Previously, state banks were seen swapping yuan for dollars in

the forwards market and selling those dollars in the spot market

to prop up a weakening yuan, sources told Reuters.

KEY QUOTES

** Goldman Sachs

"The rise in back-end USD/CNY forward points hints at a

potential unwind of banks' dollar short positions accumulated

over the past year, which should help buffer appreciation

pressures."

** OCBC

"The NCD outflows had been expected as asset swap pick-up

narrowed further during the month and NCD maturity was heavy ...

But for a quick and strong comeback of inflows, U.S.-China yield

differentials probably need to narrow from here."

($1 = 7.1744 Chinese yuan)