Head of FX Strategy
Summary: As the US and China face off over trade policy issues, China may at some point choose to walk away from its commitment to maintain a floor under the renminbi versus the US dollar. Here we take a look at how to position for a larger USDCNY move, now that the exchange rate has pushed back close to what many perceive as the critical level of 7.00.
Near record low volatility has plagued trading conditions for currency traders in recent months, both in terms of the actual daily trading ranges and the general lack of sustained trending moves. One of the chief drivers of low volatility has been China’s policy of anchoring the CNY to a narrow trading range versus the US dollar and maintaining an assumed cap on USDCNY ahead of 7.00, all while US-China trade talks are ongoing. Given the recent escalation in the tone and conduct of the two sides, the question is more pressing than ever as the exchange rate has rapidly approached that 7.00 level again for only the third time since late 2016.
Here we aren’t going to argue about the probability or timing of an eventual move by China on its currency policy. We’re simply going to make the case that it is a possibility at any time and offer a bit of perspective on how the options market is priced for this eventuality in case traders would like to hedge or otherwise position for an outcome in which the CNY (and for our purposes, the offshore version of the CNY, the CNH) moves slightly or more significantly lower.
First, let’s have a look at why China might want to allow the CNY to weaken, followed by reasons China might be expected to maintain its current policy on the CNY
Reasons for China to allow CNY to fall:
• A weaker CNY would offset some of the sting of US tariffs as exports could be priced lower in USD terms to offset the tariffs.
• The currency is “fundamentally” overvalued in inflation-adjusted terms if measured in a longer-term perspective and lower is the path of least resistance.
• Allowing the currency to float more freely (to the downside) would give more leeway to provide more accommodative monetary policy if more stimulus is needed to offset growth risks from any trade policy showdown and to help deleverage the very leveraged corporate sector.
• A more floating and market set currency after some initial volatility is a necessary step if China would like to deepen its capital markets and attract foreign capital as it transforms its economy to a more balanced approach.
• The USD is strong and the history of the US dollar since the global financial crisis shows the dysfunctions that arise due to the USD being used as the world’s global reserve currency: liquidity traps develop for offshore countries whenever the US Fed is tightening policy and the US fiscal issuance rises. Allowing the USD to move higher might help usher a new mini-crisis that forces the US and the rest of the world to consider how to create an later (this is a very thorny, long-term subject, but one that will return again and again until some other asset is found to being replacing the US dollar, or at least reducing its use by China).
Reasons for China to maintain the floor under the CNY:
• Concern that a fall suggests a show of weakness and risks capital flight and financial and socioeconomic instability domestically that impacts the government’s mandate to deliver ever upwards growth and prosperity.
• The loss of purchasing power means that the price of the commodities in China’s enormous import bill will rise. (Although one might argue that as China is such a large buyer of some commodities like iron ore, that those prices might adjust to reflect the weaker currency.)
• This could be seen from the US side – fair or not – as a dramatic escalation in the ongoing showdown over trade, making coming to terms potentially that much more difficult to achieve.
So there are compelling reasons for both maintaining the status quo – especially as long as an eventual salvaging of the US-China trade talks is a priority – as well as compelling reasons for China to take the plunge and allow market forces to set the price for the renminbi. Then how to trade the weaker CNH outcome? Here are some ways traders can approach this:
Long USDCNH spot or forward: the most straightforward way to trade for a weaker CNY (or CNH in our case) is via a USDCNH spot or forward trade. The difficulty there is that China has at times in the past mobilised punitive swap rates to make holding such positions very expensive, as high swap rates can mean expensive rolling costs. That being said, the current swap rates as of this writing are negligible, even as USDCNH has risen above 6.90.
USDCNH call options: A long USDCNH call option is likely the “safest” way to trade for a weaker CNH, if only in terms of knowing the maximum downside risk on a straight, plain vanilla call option: the risk that an option expires worthless and all of the premium paid is lost. Some perspective on how USDCNH volatility is prices is shown in the chart below. Keep in mind that 3-month implied volatility, although it has risen considerably from recent lows
Below are a couple of ways to trade for a USDCNH move using 3-month options, which of course assume that something will unfold within a three-month time frame – longer dated options of six months or more are of course more expensive but offer more time for a situation to develop:
Trading for a more modest move:
The idea here is that USDCNH might move, but not necessarily by a significant amount – a few percent at most. A call spread is an approach that allows a lower breakeven on the option structure, though it can be more challenging to hedge, while a plain vanilla approach offers a more straightforward outcome and hedging can enhance the overall profitability of the option
Long USDCNH call spread:
The trade: Long 3-month (expiry Aug 21) USDCNH 7.05 call and short USDCNH 7.25 call
Net cost: 0.0345 (spot ref 6.93 on May 21)
Breakeven price: 7.0845 (spot moves about 2.2% higher from current 6.93 area)
Maximum gain: 0.1655 at 7.25 (spot moves a bit over 4.5% from 6.93 area), or about 4.8x the amount of premium risked
Long USDCNH vanilla call option
The trade: Long 3-month (expiry Aug 21) USDCNH 7.10 call
Net cost: 0.0418 (spot ref 6.93 on May 21)
Breakeven price: 7.1418 (spot moves about 3% higher from current 6.93 area)
Maximum gain: no theoretical maximum. But example at 7.50 on expiry, profit is over 8.5x amount risked.
Looking for a larger USDCNH move higher:
Here the idea is to achieve significant leverage relative to the amount risk on upfront premium in the event a very large USDCNH move unfolds.
The trade: Long 3-month (expiry Aug. 21) USDCNH 7.25 call
Net cost: 0.0240 (spot ref 6.93 on May 21)
Breakeven price: 7.274 (spot USDCNH moves about 5% higher from current 6.93)
Maximum gain: no theoretical maximum. But example at 7.50 on expiry, profit is 9.4x the amount risked, and at 7.6 is over 13.5x amount of premium risked.
The unconventional trade: long USDHKD – this is a somewhat unconventional way to trade for a weaker CNH indirectly, as a loosening of the commitment to the CNY floor could also see a weakening of regional Asian currencies, and in that regard one of the most interesting exchange rates is US dollar versus the Hong Kong dollar, an exchange rate managed with a currency board arrangement by the Hong Kong Monetary Authority with the mandate to keep the exchange rate in a narrow 7.75-7.85 corridor that has been in operation since 1983. The idea here isn’t whether the HKMA is able to maintain the corridor, but whether it makes any sense longer to do so if the CNY moves significantly lower and takes much of the rest of Asia with it. Already, the 7.85 level has been tried multiple times late last year and this year – requiring significant intervention efforts to maintain.
The Trade: Long USDHKD at 7.85, stop below 7.80. This position pays modest carry to the trade as the USD short interest rate is higher than the HK rate. So if nothing happens and the spot stays near the current price, the trader walks away with a small profit. Of course, if the HKMA abandons the corridor and allows HKD to weaken, the position moves into more notable profit.
Chart: USDCNH versus 3-month implied volatility and the 25-delta and 10-delta options skew, which shows that traders looking for a large move have to pay significantly more in implied volatility terms, relative to the cost of puts – as the market assumes that if USDCNH is going to move a lot, it will be to the upside.