Global Economics & Markets Research Email: GlobalEcoMktResearch@uobgroup.com URL: www.uob.com.sg/research FX Strategy Is CNY Strength Over? Friday, 09 February 2018 Heng Koon How, CAIA Head of Markets Strategy Heng.KoonHow@uobgroup.com Peter Chia Senior FX Strategist Peter.ChiaCS@uobgroup.com Quek Ser Leang Markets Strategist Quek.SerLeang@uobgroup.com Over the past 48 hours, the CNY weakened dramatically against the USD from 6.25 to 6.32. A whole list of factors was responsible for this rebound. They ranged from tentative stabilization in US Treasuries yield curve, risk aversion triggering sell-off in CNY and Asian currencies and various news reports suggesting that Chinese authorities may have allowed the resumption of limited investor capital outflow. From a currency markets perspective, various signs like renewed widening of CNH vs CNY spread, return of risk reversal bias for USD calls (CNY puts) in the options market, renewed widening of USD/CNY forward premium all suggest that investors have started to hedge or position for renewed CNY weakness yet again. Overall, we deem it premature to extrapolate and conclude that CNY strength is over and that a new weakening trend has started. Rather, this may well be yet another attempt by CNY to consolidate. Similarly, our technical analysis of USD/CNH suggest that while there is ample room for the spot rally to extend to as high as the 6.40 handle, it is premature to expect a major bullish reversal. Over the past week, the equity rout persisted as 10 year US Treasuries yield stayed stubbornly high above the 2.8% handle. As a result, the equity de-risking has started to spread to other risky assets as well. In particular, various Emerging Market (EM) and Asian currencies have started to endure some renewed selling. To be fair, Asian currencies have rallied non-stop since Jan 2017 and are due for a correction. Our thesis for Asian currencies remains unchanged, i.e. 2018 will be a year of two halves. Specifically in the first half of 2018, Asian currencies are likely to remain biased on the stronger side. However, in the second half of 2018, Asian currencies may face renewed seasonal weakness and start to give up some gains. Events of the past week would suggest that this turning point in Asian currencies may have happened much earlier than we had anticipated. US Dollar Recovers As US Treasuries Yield Curve Shows Signs Of Stabilization With 10 year US Treasuries yield back above 2.8%, yield curve flattening trend in late 2017 has been partly reversed. The 10s2s US Treasuries yield spread has recovered from its low of just above 50 bps at the start of the year to about 72 bps now. Concurrently, the US Dollar Index (DXY) recovered from its low of 88.50 to current level of 90.20. Friday, 09 February 2018 1 Page
Chart 1: Tentative Signs Of Stabilization In US Treasuries Yield Curve 160 140 120 100 80 60 40 Jan 17 Mar 17 May 17 Jul 17 Sep 17 Nov 17 Jan 18 10Y vs 2Y US Treasuries yield spread US Dollar Index (DXY) - RHS 104 102 100 98 96 94 92 90 88 Throughout 2017, this flattening of the yield curve has been actively debated and was attributed as one of the key drivers of persistent USD weakness. As the 10s2s US Treasuries yield spread flattened from 130 bps at the start of 2017 to 50 bps at the start of 2018, the US Dollar Index (DXY) fell in tandem from 103 in Jan 2017 to 89 in Jan 2018. Now the USD appears to be drawing some strength from this tentative rebound in the yield spread. However, it may be increasingly difficult for the US Treasuries yield spread to recover further. The US Federal Reserve is widely expected to make a 25 bps hike at the upcoming 20/21 March FOMC, thereby lifting front end yield further and limiting further yield curve recovery. Just barely 48 hours ago, USD/CNY had dropped to an intra-day low of about 6.2530. Since then, the pair has rebounded smartly to current level of 6.32. More dramatic is the rebound in USD/ CNH from its intra-day low of 6.2560 on 7 February to current level of 6.35. The abovementioned broad rebound in the USD alongside US Treasuries yield curve stabilization, was one of the key drivers for this rebound in both USD/CNY and USD/CNH. Possible Renewal Of QDLP Program Also Triggers Renewed Weakness In CNY Concurrently, news reports yesterday suggested that Chinese authorities may have resumed the Qualified Domestic Limited Partnership (QDLP) program. The QDLP program allows foreign asset managers to raise funds onshore for offshore investment. The program was previously suspended in late 2015 to reduce the risk of capital outflow from China and limit further CNY depreciation. The exact quota is unclear and so far, there were no official announcements from Chinese authorities. But if indeed the QDLP program has resumed and new investment quotas were given, then this may suggest that Chinese authorities are now comfortable with the current level of the CNY to allow measured investor capital outflows. This is also consistent with on-going commitment from Chinese authorities to further liberalize and open up China s capital account. It is worth noting that as CNY strength persisted over the past few months, Chinese authorities have made various strategically timed policy changes to slow down the pace of CNY appreciation. Back in last September, when USD/CNY first fell below the 6.50 level, the People s Bank of China (PBoC) announced that it has removed the 20% reserve requirement rule for the purchase of foreign exchange forward positions. That measure was previously implemented in 2015 to limit the pace of CNY depreciation. Thereafter, in mid-january this year, when USD/CNY retested the 6.50 floor again, the PBoC subsequently announced that it has reduced the Counter Cyclical Factor (CCF) component in the central parity fixing rate for USD/CNY. The PBOC had added that the CCF was previously implemented to reduce herd mentality and that its use is now reduced as the exchange rate has stabilized for some time. For more details, kindly refer to FX Strategy note: Is 6.50 the line in the sand for USD/CNY, dated 10 Jan 2018. Friday, 09 February 2018 2 Page
In the greater scheme of things, the PBoC has reiterated on a regular basis its efforts to internationalize the CNY and allow greater two way flexibility. Hence, this one way appreciation in the CNY over the past year may be deemed excessive and some correction to CNY strength may well be on the cards. Specific to currency markets, here are some key observations: CNY And CNH Have Started To Diverge Again Over the past few months, both CNY and CNH have rallied in tandem against the USD and the spread between both onshore CNY and offshore CNH has narrowed down to a bare minimum. In this week s sell-off, this onshore CNY vs offshore CNH spread has started to tear again. Specifically, CNH has started to weaken at a faster pace than CNY, i.e. USD/CNH has rebounded to a larger magnitude above 6.30 to 6.35, while USD/CNY traded up to a more restrained 6.32 level. Typically, this spread widening is associated with expectations of further weakening of the currency. Chart 2: Spread Between CNH And CNY Has Started To Widen 6.70 6.60 6.50 6.40 6.30 6.20 6.10 0.05 0.04 0.03 0.02 0.01 0-0.01-0.02 Nov 17 Nov 17 Dec 17 Dec 17 Dec 17 Jan 18 Jan 18 Feb 18 Spread Between USD/CNH and USD/CNY (RHS) USD/CNH USD/CNY Bias For USD Calls Has Returned To Front End USD/CNY Options In the currency options market, the bias for USD calls (i.e. CNY puts) has returned in front month options. Last week, the risk reversal bias for USD/CNY in the 1 month was relatively flat and this has now increased to about 1.0% for USD calls (i.e. CNY puts). Nonetheless, it is worth noting that this bias for USD calls is relatively low compared to the peak of about 5% for USD calls back during the intense days of CNY devaluation in late 2015. Chart 3: Bias For USD Calls Has Returned To Front End USD/CNY Options 5.00 4.00 3.00 2.00 1.00 0.00-1.00 Feb 13 Sep 13 Apr 14 Nov 14 Jun 15 Jan 16 Aug 16 Mar 17 Oct 17 USD/CNY 1Y Risk Reversal USD/CNY 1M Risk Reversal Friday, 09 February 2018 3 Page
Has The USD/CNY Forward Curve Narrowed Too Much? When the PBoC previously triggered the devaluation of the CNY back in Aug 2015, the 1Y USD/ CNY forward premium jumped to as high as 4,000 pips in late 2015. Over the past year, the CNY has strengthened and taken back nearly all of its losses since Aug 2015. Concurrently, the 1Y USD/CNY forward premium has narrowed to about +1,100 pips last week. Over the past week, this 1Y USD/CNY forward premium has retraced back to +1,500 pips. Has the USD/CNY forward curve bottomed? Chart 4: 1Y USD/CNY Forward Premium Rebounded From The Low 7.40 7.20 7.00 6.80 6.60 6.40 6.20 Feb 15 Jul 15 Dec 15 May 16 Oct 16 Mar 17 Aug 17 Jan 18 USD/CNY 12M Outright USD/CNY Spot 4,000 3,500 3,000 2,500 2,000 1,500 1,000 Feb 15 Jul 15 Dec 15 May 16 Oct 16 Mar 17 Aug 17 Jan 18 USD/CNY 12M Points USD/CNY May Be In The Early Stages Of Bottoming; But Renewed CNY Depreciation Is Not Yet On The Cards We stick to our view of two halves for this year for USD/Asia. In the first half of the year, Asian currencies will be biased on the stronger side, supported by on-going strong momentum in regional export and activity growth as well as strong reserve accumulation. Thereafter, Asian currencies may face renewed weakening and give up some of their gains in the second half. By then the USD may exhibit more signs of stability as the FED continues its normalization process. The above mentioned events of the past week would suggest that this anticipated turning point may be nearer than we anticipated. While it is premature to extrapolate that we have seen the end of this round of CNY strength, it is possible that USD/CNY may be in the process of establishing a bottom around the 6.30 level. The 6.30 level may well be the near term floor in USD/CNY as we head into the extended Lunar New Year holiday in China. Going forward it is worth noting that this does not yet signal renewed depreciation in the CNY. The 3M implied volatility of USD/CNY has risen from 4% to 7%, the highest in over a year. Previously back in late 2015, when CNY was facing intense depreciation pressure, 3M implied volatility for USD/CNY spiked to as high as 9%. PBOC currently maintains a prudent and neutral monetary policy. China s growth outlook has stabilized and FX reserves have returned to moderate growth. Friday, 09 February 2018 4 Page
The recent steep drop in China s trade surplus from USD 55 bn in Dec to USD 20.3 bn in Jan would suggest on the surface that CNY has appreciated too much. However, such a conclusion is premature as the sharp contraction in monthly trade surplus for China may be due to seasonal noise in Chinese trade ahead of the Lunar New Year holiday. Indeed, Chinese imports had surged by a much larger than expected 37% YoY in Jan, compared to the more modest gain of +11% YoY in Jan for Chinese exports, contributing to the trade surplus contraction. Hence, while USD/CNY may be in the early stages of bottoming, this does not yet suggest renewed depreciation. Overall, We Maintain Our Existing Forecast For USD/CNY At 6.50 By End 2018 What s happening to USD/CNY bears closer scrutiny as it will affect the rest of USD/Asia and USD/SGD as well. Over the past week, various USD/Asia pairs, including USD/SGD also recovered some lost ground. In line with the rebound in USD/CNY back above 6.30, USD/SGD has also rebounded from 1.30 to 1.33. Overall, we stick to our existing forecast for USD/CNY, i.e. 6.30 for end 1Q, followed by 6.35 for end 2Q, 6.40 by end 3Q and 6.50 by end 4Q. USD/CNH: 6.3500 Rally has ample room to extend higher but premature to expect a major bullish reversal Source: Reuters, UOB Global Economics & Markets Research USD hit a multi-year low of 6.2563 on Wednesday (07 Jan) before rocketing higher to close at 6.3197 and in the process, registered a bullish outside day. USD continues to surge yesterday and over the two days, it gained a whopping 1.35%, the largest 2-day gain since the devaluation of yuan back in 2015. The 6.2563 low is clearly an important low but at this stage, it is premature to expect a major bullish reversal. Note that USD staged a similar 2 consecutive days of strong gains in January (albeit of lesser magnitude) but the rally was short-lived (see box in chart above). All that said, the strong rally has ample room to extend higher but strong resistance can be expected at 6.4000 followed by the 2-month declining trend-line at 6.4390. At this stage, the prospect for a clear break above the trend-line is not that high. Overall, USD is expected to stay underpinned as long as it can stay above 6.2960 in the next several days. Disclaimer: This analysis is based on information available to the public. Although the information contained herein is believed to be reliable, UOB Group makes no representation as to the accuracy or completeness. Also, opinions and predictions contained herein reflect our opinion as of date of the analysis and are subject to change without notice. UOB Group may have positions in, and may effect transactions in, currencies and financial products mentioned herein. Prior to entering into any proposed transaction, without reliance upon UOB Group or its affiliates, the reader should determine, the economic risks and merits, as well as the legal, tax and accounting characterizations and consequences, of the transaction and that the reader is able to assume these risks. This document and its contents are proprietary information and products of UOB Group and may not be reproduced or otherwise. Singapore Company Reg No. 193500026Z