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From a mark-to-market perspective, the risk to the trade is a further rise in 3m30y US
rates vol, coming this time with a depreciation in the USD (risk-off event in the US).
Potential US-China trade barriers: bullish CNH vol
The Republican clean sweep has already sparked a strong USD rally and US rates selloff,
but could put further pressure on the USDCNY exchange rate. A stronger USD by itself
adds pressure to depreciate as China still needs looser financial conditions to maintain
stability in the debt market, a relationship confirmed by the USDCNY rally following the
2015 Fed hike. With Trump’s victory, we see increased risk of a larger depreciation.
Trump publicly labeled China as a currency manipulator on multiple occasions during the
campaign, so any speculation of anti-trade policies could put significant depreciation
pressure on the Renminbi. Potential trade tariffs on Chinese exports to the US could
raise the probability of a trade war. Furthermore, Trump could encourage the Treasury
to alter its criteria for labelling currency manipulators, which could also hurt trade
relationships. Either scenario would lead to a sharp re-pricing of risk premia higher.
The Trade: Buy USDCNH 6m 7.60 call
We recommend buying a 6m USDCNH 7.60 call for 0.37% USD (off 6.9700
forward), with a target of 1% USD. USDCNH topside is now at the cheapest levels
since the August 2015 depreciation (Chart 56). The trade could benefit from either a
rally in spot as well as any increase in the risk premium between now and inauguration
on speculation of anti-trade policies. The structure appreciates significantly from
increases in volatility, which is plausible given the 300% increase in volatility in August
2015 and the 100% increase from October 2015 to February 2016. The risk to the trade
is that China increases capital controls and dampens USDCNH appreciation, which could
cause the options to expire worthless.
Chart 56: USDCNH topside the cheapest since pre-depreciation
Table 4: Hypothetical trade performance on Inauguration Day (Jan 20th)
20 + Spot Vols Vols 20% Vols 50% Vols 100%
46 unchanged | __ higher higher higher
+3 % 6.8 24% 197%
12 69 41% 235%
8 7 %. 100% 278%
4 iA 49% 132% 305%
0 72 0% 103% 170% 378%
13 49% 122% 232% 441%
s RS sy & eS RS ys yf 7A 124% 200% 305% 522%
5 224% 319% 441%
——USDCNH 6m 104 call vol 78 386% 410% 565%
Source: BofA Merrill Lynch Global Research
Source: BofA Merrill Lynch Global Research
Bankof America
Merrill Lynch
Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 31
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