Emerging Market FX: USDCNY Buy The Dips?
Emerging Market FX: The Chinese Yuan’s decline looks like it has room to run as we open the books on 2016, there appears to be decent fundamental support for the current depreciation to develop further. I see three core drivers supporting this trade
- Hedging of FX liabilities as the domestic economic backdrop continues to deteriorate and the underlying credit risk rises
- An increase in the Chinese Authorities capacity for currency appreciation, which ultimately drives the Yuan higher increasing volatility
- Unwinding of carry trades interest rate differentials
The most recent round of regulatory reforms by the PBOC is driven by two main ideas. Primarily there has been a change in the approach to in the USDCNY fixing strategy first witnessed in August 2015 and most latterly overnight with the PBOC demonstrating an intent to defend the Yuan from speculative driven trade and a clear desire to align the spot and fix rates. Secondly there has been the implementation of a CNY effective exchange basket initiated in December to refocus market perception from a bilateral USDCNY to a trade weighted view.
While these moves are broadly consider constructive in the development of the CNY has freely traded currency, they are the the foundations required to achieve longer term objectives which have the inevitable impact of near term market disruption and volatility. The shift towards a trade weighted approach to the the CNY has a derivative consideration, the Chinese authorities are signalling that USD strength against the CNY will be accommodated on the premise that the USD is also strengthening against its trade partner domestic currencies. So essentially CNY deprecation against the USD will be permitted as long as the basket remains stable.
Recent price action supports this thesis. From a technical perspective USDCNY has potential to reach 7.0 this year without the authorities getting overly concerned. The crucial constituent to this move will be basket stability if USDCNY reached 7 by the end of the year, as China’s trade partner currencies are likely to weaken even more. Given the various challenges of re-balancing the economy, the Chinese policymakers seem to be shifting priority to growth as against currency stability. In 2015, the authorities undertook monetary and fiscal easing, while attempting simultaneously to keep USDCNY stable through intervention and various macro-prudential measures. It’s a tenuous strategy, as China came face-to-face with an impossible trinity – monetary easing and a gradual opening of the capital account were in direct conflict with its desire to keep USDCNY stable. As the focus shifts to stabilizing growth, the authorities are likely to ease monetary policy more actively, even at the expense of a weaker currency. Markets expect the Fed to hike rates by at least 50bp this year, versus 50bp of cuts by the PBoC.
This large policy divergence will put further upward pressure on USDCNY, as narrowing rate differentials encourage carry-seeking trades to unwind and support onshore repayment and refinancing of USD liabilities. A simple historical relationship would suggest that for every 100bp of narrowing in rate differentials, USDCNY tends to move higher by 30 big figures.
FFX outflows will likely persist and remain an important driver of Yuan weakness this year. In 2015, China recorded about $700bn of FX outflows despite having a sizeable current account surplus. In 2016, at a minimum this will be repeated, considering: 1) growth headwinds are unlikely to dissipate; and 2) corporate are likely to continue to unwind FX liabilities. There are other possible outflows to consider, like: 1) increased desire for domestic investors to buy more offshore assets, evident in an increase in services deficits; and 2) further unwind of carry trades, evident in China’s widened errors and omissions deficit over the past two years. Put together, it is reasonable to expect outflows to continue to overwhelm inflows, putting upside pressure on USDCNY.
Risk of further Yuan weakness is likely front-loaded in first half of the year, because 1) current account surpluses tend to be smaller in the first vs. 2H; 2) seasonal economic data tends to be weaker in the first half; 3) expectations that the Fed will hike more actively in the first half of 2016 (a potential two 25-bp hikes) while the PBoC could cut more actively; and 4) ahead of CNY’s official entry into the IMF’s SDR basket on 1 October.
Now we have a pulse check on the fundamental flows lets take a look at the technical set up that is developing in the USDCNY and where the premium trading opportunists may be developing.
Technical & Trade Takeaways
‘I will be looking or an equidistant pullback which will retest prior highs at 6.36 where I will be looking to get long targeting the topside of the projected channel at 6.49.’
Price action has developed with the bullish impetus that I envisaged. The weekly chart has a bullish structure, since breaking through the topside of the projected ascending channel, I have overlaid a further bullish channel as highlighted in the chart above. This suggests scope for a pullback to test the spike highs printed in August 2015 .6.4486which coincides with the projects ascending trend line support of the new bullish channel and also a retest of the prior trend line resistance to now act as potential support. It is from a successful retest of this level that I would venture long for the next leg higher which initially targets a test of 6.700
Open Emerging Market FX Trades
Long USDINR 65.25. First Target Achieved at 66.85, stay long to target a retest and break of 2015 highs next. Moving trialing stops up to recent weekly swing lows to lock in gains while allowing the trade sufficient room to extend to next target as per chart below.
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