For a few months in early 2016 it was cool to make fun of Kyle Bass’ career bet on Yuan devaluation; now that the Yuan is back to 6 year lows and sliding as China once again quietly loses control of its capital outflows, it is not so cool any more.
And with every passing day, it is only going to get worse because despite all the rhetoric, China’s economy is getting worse by the day. As SocGen puts it, “there have been signs of reviving capital outflow pressure since early 2Q. If the deprecation continues apace, capital outflow pressure will build up further and potentially quite quickly. The fact that the PBoC keeps stepping up capital controls despite the innocuous official flow data seems to suggest that it is also expecting an uphill battle.“
And speaking of SocGen’s outlook for China’s currency , this is what the French bank – which just cut its Yuan forecast from 6.80 to 7.10 – thinks will happen next.
A New Normal for the RMB
We revise our peak forecast for USD-CNY to 7.10 from 6.80. Similar to immediately following the August devaluation, consensus is too complacent on the ability and willingness of policymakers to arrest the nearly three-year-old depreciation trend.
The new normal in recent months is gradual RMB depreciation that doesn’t create a negative feedback loop to other currencies or broader market sentiment. This could embolden policymakers to keep pushing the limits of depreciation, especially if speculative positioning stays subdued. Implied volatility, risk reversal, forward points, and the forward curve have all been unresponsive to the recent RMB weakness. This is partly due to the reluctance of speculative investors to add exposure after being burned by the RMB depreciation trade in January, but also because intervention remains ongoing despite not showing up in headline reserves or the forward book.
The best solution remains for policymakers to let the RMB find its market clearing price. This is not an exact science and we can only guesstimate what the level would be – 6.80 was our previous assumption but 7.10 now seems more realistic. The recent depreciation at a time when the dollar has not been strengthening suggests policymakers are increasingly giving in to capital flow pressures and are willing to the test the limits of depreciation. Further depreciation could reinforce capital outflows in the short term but should eventually help capital flows reach equilibrium.
7.10 peak – our base case, 80% probability
The next wave of RMB depreciation will see USD-CNY trade up to 7.10 by mid-2017. Since USD-CNY bottomed in early 2014, there have been five waves of depreciation and each has followed a predictable pattern: three to five months of USD-CNY increasing (+3.5% on average), followed by modest gains (+1%) spanning an equivalent time span, before another round of depreciation ensues. The predictability is suboptimal from a policy perspective, but it appears to be the PBoC’s standard playbook. While there could be some consolidation or modest strength after the current depreciation phase ends (3.6% since April), the ensuing wave and medium-term path should see USD-CNY reach 7.10 over the next year.
Cumulative depreciation of 6% over the next year would be similar to what has been experienced since October. This would not be an atypical base case for a country in a structural slowdown, with perceptible credit and banking sector risks, an imbalance in the supply-demand of capital, a tenuous reserve adequacy position, and local residents harbouring a strong desire for FX diversification.
We continue to believe that consensus is underestimating the chances of CNY depreciation, both from the ability and willingness of policymakers to prevent further depreciation. Consensus is at 6.80 in one year, which was our prior out-of-consensus call immediately following the August devaluation (back in late August consensus was at 6.50).
A gradual and controlled depreciation with periods of stability and bouts of accelerated weakness is still the most likely scenario (80% probability). A move to 7.10 may continue to be absorbed by investors without disturbances to broader market sentiment occurring, and as such we see no need to revise our EM forecasts, which currently entail modest spot depreciation that broadly matches the forwards.
Importantly, the USD-CNH trading pattern since 2014, of only retracing a portion of its gains and never revisiting the lows after an up move, should remain in place. Coupled with little fundamental justification for a stronger CNH over a 12-month horizon and fairly neutral speculative positioning, it is unlikely that USD-CNH will trade below the 6.50-6.55 area.
8.0 – the new risk scenario, 20% probability
Back in January (CNY7.50 World) we identified USD-CNY trading up to 7.50 as the risk scenario for the currency. Given ongoing capital outflows, the ability of the market to absorb recent depreciation without negative consequences, the policy decision to weaken the renminbi when the USD has been stable, and our new forecast of 7.10, the risk scenario for CNY is now much higher.
The new risk scenario for CNY is 8.0 (20% increase in USD-CNY). We assign 20% probability to this scenario. The caveat is that the pain threshold for the market appears to be much higher than before and the implications for the global financial markets will primarily depend on the speed of depreciation. We believe that it would take significantly more pressure on capital flows than what we have seen over the past few years, or an economic hard landing, for our risk scenario to unfold. Note that we have a 30% probability of a hard landing of the Chinese economy. We think that an economic hard landing might not necessarily trigger a sharp devaluation, as the authorities would most likely respond with strict capital controls amid concerns over capital flight.
Within the risk scenario, the path to 8.0 could be abrupt (not likely), slow (more likely), or fast (most likely).
- Scenario 1: one-off devaluation (<10% probability): A one-off move (i.e. step devaluation) where the PBoC then chooses to defend the new level. There would be enormous political backlash with the appearance of any active pursuit of devaluation. This would also be too risky for Beijing’s taste given that no one can say for sure how much depreciation is enough to equilibrate supply and demand. However, we assign it a nonzero probability because the authorities might ultimately decide it is the best way to realign expectations and halt domestic capital outflows.
- Scenario 2 (free float over the next year – >70% probability): The PBoC fast-tracks currency reforms through a big-bang approach to currency flexibility because either: a) capital outflows remain large and the depletion of FX reserves too great; or b) it deems the domestic and global financial markets able to absorb the shock.
- Scenario 3 (slow and steady move – 20% probability): The current strategy of steady depreciation picks up pace and intervention is used to limit overly destabilising volatility. The risk to a steady creep higher in USD-CNY is a build-up in speculative pressures and resident outflows that creates a vicious cycle of depreciation.
Finally, here is SocGen with its best ways to trade the coming Yuan devaluation:
Long USD-CNH: In our view, over a one-year horizon, being long USD-CNH has attractive risk-return characteristics on a 6% spot move, 2.5% negative carry, and limited potential for CNH to strengthen on a sustained basis. However, the entry point is critical to achieving a favourable PnL outcome and it might be prudent to wait until CNH consolidates or strengthens modestly to enter long USD-CNH positions.
Vanilla calls or call spreads are too expensive: Both these structures are too expensive when considering the probability-weighted terminal value of CNH a year from now. For example, a one-year 25d USD-CNH call has a breakeven at 7.37 while a 25d/10d call spread needs to see a move to the 7.50 area for risk-return to be attractive.
Buy 1-year call spread (6.85/7.20 strikes) and sell 1y-year 6.55 put: Under the premise that USD-CNH only retraces a modest portion of the recent gains (similar to past experience) coupled with no strong arguments for sustained appreciation on fundamental grounds, selling downside optionality can cheapen the cost of the call spread quite significantly. For example, the indicative cost of a 6.85/7.20 call spread is 1.43%, compared with a cost of 0.42% in a structure that buys the same call spread and also sells a 6.55 put. The 70% cost reduction entails unlimited losses below 6.55 but the position can be delta-hedged.
But 1-year 6.85 USD-CNH call with a knock-out at 8.0: Owning a 1-year 6.85 call option is quite expensive (indicative cost of 3% of notional) and has a poor breakeven (7.05). Whereas owning a 1-year 6.85 call with a knock out at 8.0 (our risk scenario) entails a 60% cost reduction over the vanilla call. The risk is limited to the premium paid. Positive PnL at expiry accrues above 6.90, but if the barrier level (8.0) is hit at any point over the life of the trade the structure is knocked out and the premium is lost. The structure has risk-reward of 10-1.
Short RMB against an abridged CFETS basket: Whether the CNY stabilises against the USD, depreciates modestly in an orderly and controlled manner (our base case), or experiences stronger depreciation (our risk scenario), the trade-weighted basket will be at best stable and could continue to fall. To mitigate fluctuations in the USD-CNY exchange rate, investors can short the trade-weighted exchange rate. An abridged CFETS index that includes the USD (36% weight), EUR (325), JPY (13%) and AUD (19%) is able to track the larger thirteen currency CFETS index very closely (link). The abridged basket is highly liquid and has similar negative carry as being long USD-CNH (22bp/month).
And with that, good luck in catching up to Kyle Bass.
via http://ift.tt/29tIHl3 Tyler Durden