Emerging Market FX: China FX Volatility To Return In The New Year

Emerging Market FX: China FX Volatility To Return In The New Year

China FX volatility appears set to return when the domestic markets reengage after the Chinese New Year holidays. The CEFTS released a statement about the CNY basket overnight. Which could represent an important signal about how the government hopes to manage the CNY when markets return from vacation next week. The risk it introduces is of a return to USDCNY volatility after the holiday period and possibly a bias to rise to at least 6.59, if not above 6.60 en route to the 6.70 level.

Risk is skewed to the topside.Markets are reading the statement as making the following key points:

  • 100 on the CEFTS basket seems to be the neutral/midpoint of the basket from a policy perspective.
  • The CEFTS wants to “enhance” flexibility of CNY versus the basket soon and probably beginning after Chinese New Year.
  • The conclusion of the statement reasserts that the government will keep the basket roughly stable. Putting this into the context of Singapore’s familiar SGD basket management regime, the Chinese government seems to be saying it wants to manage the CNY basket with 100 as the mid-point of a flat slope for the basket trend, but with volatility bands around 100.

The first key risk for markets is potential confusion over 100 as the middle of the bands. The basket fixed today at 100.5. Markets seem to view 100 as a lower threshold for the basket, below which would signal an attempt at trend depreciation or devaluation. In contrast, if the government takes 100 as neutral it would imply that USDCNY spot could rise to 6.584 and still be at a neutral level assuming the current USD levels against other currencies remain constant.

Since the beginning of this year the CNY basket has not been sustained above 101. If this is the new top of the bands it would imply that the basket is only about 0.5% below the point at which the government would need to begin pushing USDCNY fixes higher. That seems implausibly tight. But if the mid-November basket levels are the top then the basket is still only about 1.5% away from the point at which the government would need to begin pushing USDCNY higher rather than keeping it stable as it has recently. For the current USDCNY level, that equates roughly to USD Index rallying back to its March 2015 level.

Although it’s possible that the government chooses to keep the CNY on the strong side of neutral, i.e. above 100, the larger risk for markets would be it tries to establish symmetry by allowing downside volatility below 100. Using a tight 1% band around mid, the government could allow the basket to break lower to 99 or 6.649 given current broad USD levels. A 2% band and so a basket level of 98 would imply 6.715 for USDCNY.

Of course, a problem with these estimates is that they assume the USD is steady vs. other currencies. However, increases in USDCNY of this magnitude would be likely to trigger a USD rally against most EM currencies and some DM such as AUD. This implies that for the CNY basket to fall to 99 or 98, USDCNY would have to rise much more significantly against the USD. Levels such as 7.0 and above become easy targets.

Technical & Trading Takeaway

2016-02-02 11_56_07-USDCNY_ 6.5793 ▲+0.02% - EU - TradingView

From a technical and trading perspective the USDCNY remains bullishly orientated and is currently threatening to break the topside of the daily bullish flag pattern that has been developing. The Upside break from this consolidation would target the topside of the projected channel towards 6.7050.

If price breaks lower i believe there will be an excellent risk reward with trend entry as price retests former spike highs and ascending channel support at the the 6.4900 level where I would be watching for intraday reversal patterns to venture long targeting the topside of the channel.

For updates on trade of the day set ups and the other trades I am currently monitoring be sure to follow me on Twitter @LFXPatrick

Posted in Emerging Market FX, Forex Analysis, tagged with on