FxWirePro: Early hedging bets on CNY’s further weakness as commodity prices and capital market jitters spread across China

Q2 was marked by a continued depreciation of the yuan, both against the USD and in trade-weighted terms.

But markets have remained calm on the back of lower volatility in the Chinese currency, steady growth (+6.7% GDP in Q2) and stabilisation in FX reserves. Sovereign CDS spreads also tightened in Q2.

However, it is too early to write off the risk of capital outflows. Indeed, if the depreciation continues apace, capital outflow pressure could build rapidly.

Commodity prices affix extra pressure on CNY:

Commodity prices have become less correlated recently, with base metals rebounding strongly, while oil prices have edged down (WTI at $45/bbl).

Industrial metals have benefitted from the post-Brexit relief rally, as dovish central banks provided reassurance and global rates collapsed. But prices may have rebounded beyond fundamentals, especially for metals such as copper and aluminium, which remain oversupplied and where demand remains challenged by China’s rebalancing.

A more balanced market in 2H, but remains cautious in the near term, as stocks are still high and crude supply continues to return gradually from disruptions.

Base metals rally on short covering and buying from the speculative/investment community amid lacklustre physical markets.

All eyes on the Philippines as nickel prices record sharp gains on supply disruptions caused by an environmental crackdown on nickel mining.

Only a number of small mines are likely to be affected and shipments of ore are unlikely to be significantly disrupted.

Philippine nickel ore exports to China this year were already falling even before the mines crackdown in response to low prices and mine depletion. Copper prices to remain weak on China slowdown and a lack of production cuts.

Thus, we have revised their peak forecast for USDCNY over 2017 to 7.10.

In the meantime, following USD softness, CNY has weakened somewhat against the basket of currencies. Hence, it is recommended to buy either 3M USDCNY forwards of march expiries or deploy debit call spreads eyeing on above mentioned forecasts of USDCNY.

We understand that there is lower implied volatility in the OTM strikes which is why it is advisable to choose longs in ITM strikes in this call spreads.