FxWirePro: Short risk premium and calendar spreads as front-end vol spikes, nosedive in risk reversals overdone after CNH fireworks

The sharp appreciation of CNH was a major development in FX markets this week. Coming on the heels of a change in the PBoC's daily USDCNY fix mechanism the previous Friday, markets seem to have interpreted these moves as signaling a regime shift in FX policy in favor of RMB appreciation, or at the very least, an end to the controlled depreciation strategy of the past two years.

The reaction in options markets was swift and severe, with 1M ATMs spiking more than 2 vols at one stage, and 1M risk-reversals flipping to negative (bid for USD puts over USD calls) for the first time since 2011. A semblance of calm returned to CNH markets towards the end of the week, as the move in the spot below 6.74 closed a yawning catch-up gap vis-à-vis the rest of USD/Asia and prompted a wave of profit-taking on long CNH positions.

The market’s long-standing experience with Chinese gradualism – the memory of the 2015 devaluation episode is still fresh, when widespread expectations of follow-on RMB weakness after an initial one-day 2% shock were thoroughly disappointed – and unease at the disconnect between the pressures of financial deleveraging and the seeming policy desire for currency strength also perhaps played a part in the relatively quick late-week unwind of CNH longs and cooling off in spot momentum.

One place where there is scope to deviate from this script is CNH. Markets’ sights were trained firmly on China this week given the multi-sigma collapse in USDCNH. The spike in front-end vols and the nosedive in risk-reversals are overdone in our view as the bulk of the CNH’s catch-up room vis-a-vis the rest of the region is now exhausted, and we recommend selling that risk premium via -6w/+3M calendar spreads and AUD-CNH 2M vol spreads.