FxWirePro: ZAR carries highest beta ahead of political and fiscal headwinds – Strangle shorting to finance USD/ZAR ATM call

The major downtrend of USDZAR that took place since January 2016 has now turning out to be in the consolidation phase. We continue to foresee the same range bounded trend but with slight upside biased (refer monthly chart).

We are underweight on ZAR, with insufficient carry compensation for high idiosyncratic risks. We find ZAR’s yield too low to compensate for political uncertainty, fiscal/rating risks, and structural growth challenges. The yield is also too low to provide the currency with protection against the reversal in global risk sentiment and EM FX corrections.

Currently, USDZAR exhibits the highest beta to US rates in EM FX. Rand is, therefore, our preferred portfolio hedge.

Political risks and fiscal headwinds increase the risk of ratings downgrades. We expect the news flow to remain noisy in 2H’17 on both the fiscal and political front. The likelihood of a compromise candidate for the December ANC conference has increased, decreasing hopes of any reformist agenda. Fiscal risks hinge on the upcoming medium-term budget policy statement and the policy response to support SOEs.

Many economists expect fiscal authorities to acknowledge revenue slippage of 1-1.1% of GDP for FY2017/18. Local ratings downgrades remain a medium-term risk. As per the JPM, they could trigger $6bn-8bn forced selling.

As a result, we recommend below option strategies using right options, thereby, one can benefit from certain returns.

The execution: Buy 2m ATM call + 1m short OTM call + 1m short put

Strangle Shorting is advocated as you could make out from the above technical chart, the major trend of this underlying spot has lasted longer more than 21-months. Hence, shorting 1m USDZAR OTM put (1.5% strike difference referring lower cap) and shorting OTM call simultaneously of the same expiry (1% strike referring upper cap) (we reiterate, preferably short-term for maturity is desired).

These premiums can finance to reduce the cost of hedging to buy 2m ATM +0.51 delta calls.