The US-China trade dispute has abruptly taken centre stage again, and analysts believe the revived threat is acting as an electroshock on multi-year low FX volatility.
The epicentre of the revival in currency turbulence is the Chinese yuan, wrote Société Générale, analyst Olivier Korber wrote in a client note.
“The vol market implies a 52% probability that USD/CNH will touch 7.0 in the next quarter. Moreover, the CNH risk reversal curve is now flat, a rare event, and when it inverted for the last time in February 2018, it preceded the biggest ever yuan fall. The next developments will be highly dependent on the trade talks in Washington, D.C., over the next few days.”
As China is not a local but a global actor, contagion risks generated by fast yuan depreciation won't be limited to Asia, especially in a context of a sharper S&P correction.
(Source: SocGen)
Canadian dollar probably the most at risk
The Canadian dollar is now probably the most at risk, Korber opined, since it has the highest yuan correlation within G10 but has recorded the smallest G10 volatility increase since mid-April, when the yuan started to fall.
“Bank of Canada Governor Stephen Poloz made it clear to the Senate that accommodative rates are needed, with any rate hikes conditional on the dissipation of headwinds, including trade tensions. Policy is unlikely to cushion a weaker currency.”
USD/CAD and its volatility may head north
Korber said a fast move to 1.40 is possibly in the cards if trade-war fears escalate again. The 3m implied volatility is still trading below realised volatility, making it priced on the cheap side, with a negative vol risk premium.
(Source: SocGen)
Mechanics: Hedging trade wars risks via CAD volatility
Korber suggests going long USD/CAD 3m volatility swap (Indicative offer: 6.0), and buying USD/CAD 3m call strike 1.36, Sell call strike 1.37 with a knock-in at 1.42.
Indicative offer: 0.32% (spot ref: 1.3480)
(Source: SocGen)
Risks: Still low CAD vol
Korber also wrote that investors face unlimited downside if USD/CAD realised volatility is below 6.0 in the next three months. “If the 1.42 knock-in barrier is not hit, the pay-off is that of a long single vanilla call strike 1.36. If this barrier is hit, the structure becomes a tight call spread strikes 1.37/1.38, providing a small positive pay-off above 1.38.”
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