Wandering Balloon Deflates the Rise of Chinese Yuan
CME: USD/RMB Futures (
CNH1!)
US-China relations are arguably the most challenging bilateral relations in the 21st century. It has been in a free fall since the 2018 trade conflict. The competition has intensified and spread to investment, technology, among other arenas since then.
On November 14th, 2022, President Biden met with President Xi during the G-20 summit in Bali, Indonesia. This was expected to be a turning point to stabilize the relations.
Secretary of State Antony Blinken planned a follow-up trip to China, scheduled to depart on February 3rd. However, a massive balloon floating in the skies of Montana causes a diplomatic panic. The US alleges that it is a high-altitude military surveillance balloon from China, while China claims that it is a civilian airship derailed by wind, a force majeure accident.
Last Friday, Secretary Blinken announces the postponement of his China trip. The next day, U.S. military shoots down the balloon over the Atlantic Ocean off South Carolina.
The drama between Washington and Beijing has significant impacts over the annual $700 billion bilateral trade. Tensions could be a nightmare for tens of thousands of US companies operating in China. Today, we focus on the most prominent market risk of all, USD/CNH, the US dollar – Chinese Yuan exchange rate.
The Rise and Fall of USD/CNH
In FX spot and futures markets, USD/CNH is quoted as Yuan per Dollar. When the quote of USD/CNH rises, CNH depreciates because each dollar can be exchanged for more yuan. Similarly, a falling quote represents dollar depreciation which in turn is yuan appreciation.
How is the USD/CNH exchange rate determined? Interest rate parity (IRP) states that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. The formula for IRP is:
F0=S0×((1+ ic)/(1+ib)), where:
Forward Rate=Spot Rate × ((1+ Country C’s Interest Rate)/(1+ Country B’s Interest Rate) )
The 10-Year US Treasury Yield is currently quoted at 3.623%, higher than the 10-Year Chinese Government Bond Yield of 2.934%. Plug these into the IRP formula with a spot rate of 6.792, we will arrive at a forward rate of 6.837.
Examining the 1-year price chart of CME CNH futures, we find that Yuan lost 10,000 points between March and October last year, from 6.3 to 7.3. The trend closely correlates with the Fed rate hikes. This is a vindication of sound economic theory. While China’s central bank exercises control over its currency, in recent years it adopted open market operations and phased out strong-armed government directives.
The parallel trends diverged in November, as China ended its 3-year-long Zero-Covid policy. China’s reopening becomes the main driver of USD/CNH, which receded 6,000 points from 7.3 to 6.7 in three months.
Yuan’s strengthening has been interrupted last week as the Balloon incident hits the newswire. USD/CNH lost 900 points in two days, currently quoting at 6.792.
In my opinion, as the Fed tightening cycle enters the last inning, it no longer has an overarching impact over USD/CNH. Going forward, US-China bilateral relations take over.
Bilateral relationship between the countries will remain unpredictable. This is a developing story. Will there be a strong retaliation, or a mulled response? Different actions could swing the Yuan exchange rate from one extreme to the other.
Hedging for Currency Exposure Amid Unstable Relations
US importers, exporters, and US companies operating in China all face significant risks when the exchange rate is so volatile. Some of the cost may be in one currency, while the revenue is in another. Hedging net currency exposure is key to lock in the profit.
US-China trade has been very unstable in the past few years. But overall, a “decoupling” trend has already been under way. In 2017, China was the largest US trading partner. Bilateral trade accounted for 16.9% of all US foreign trade.
The most recent data for the first 11 months of 2022 shows a different story now:
• Canada is the No. 1 US trading partner with $733.1 billion and a 14.9% share
• Mexico is the 2nd largest, with $718.3 billion (14.6%)
• China is now only the 3rd largest with $639.5 billion and a 13.0% share
The US has become less dependent on China in its global supply chain. This is evident by the huge growth in bilateral trades with Vietnam (+122%), Taiwan (+102%) and India (+89%) in the last five years, while China trade only managed to grow 2%.
Short-term Trades May Prevail
In “Year of the Rabbit: Short-tailed Trading”, I discussed my preference for short-range trading this year over longer-term holding done in the past year. Market uncertainties pose more challenges in analyzing multiple moving targets with uncharted trajectories.
The Chinese currency is exactly what I am talking about. Just when you think China’s reopening would induce a secular bull run, a wandering balloon out of the blue sky deflates that hope. I would not be surprised if we have a repeat of the 2018 Trade Conflict. When the tension between the two superpowers intensifies, it could swing the market wildly.
For readers who have followed my stories, once again, we could leverage the game theory and event-driven strategy in response to this unexpected market event. In the past few years, I have deployed game theory and strangle options across a number of highly volatile and uncertain market scenarios, upon US-China Trade Conflict, the Russia-Ukraine Conflict, the Fed Rate Hikes, the US Midterm elections, and the US Debt Ceiling Showdown. Most of these ideas have been published on TradingView. You will find links to these stories at the end of this report.
While there isn’t an option contract available on the CNH, short-term trade on the currency futures contract may be considered.
Take the balloon incident as an example: Do you think Beijing will retaliate or merely protest in words? The former could worsen the US-China relations, and in my view, push the value of the Yuan down. The latter indicates the conflict can be managed without getting out of control, which is good news for the Yuan.
In summary:
• Hawkish response – Yuan value Down and CNH futures price Up;
• Dovish response – Yuan value Up and CNH quote Down
Once you form an educated opinion on which action is more likely, consider placing a long (hawkish) or short (dovish) futures position accordingly. Then hold on for the events to unravel. If history is any guide, the market often tends to over-shoot in response to overreaction.
Happy trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trade set-ups and express my market views. If you have futures in your trading portfolio, check out on CME Group data plans in TradingView that suit your trading needs tradingview.com/gopro/
CNH1!)US-China relations are arguably the most challenging bilateral relations in the 21st century. It has been in a free fall since the 2018 trade conflict. The competition has intensified and spread to investment, technology, among other arenas since then.
On November 14th, 2022, President Biden met with President Xi during the G-20 summit in Bali, Indonesia. This was expected to be a turning point to stabilize the relations.
Secretary of State Antony Blinken planned a follow-up trip to China, scheduled to depart on February 3rd. However, a massive balloon floating in the skies of Montana causes a diplomatic panic. The US alleges that it is a high-altitude military surveillance balloon from China, while China claims that it is a civilian airship derailed by wind, a force majeure accident.
Last Friday, Secretary Blinken announces the postponement of his China trip. The next day, U.S. military shoots down the balloon over the Atlantic Ocean off South Carolina.
The drama between Washington and Beijing has significant impacts over the annual $700 billion bilateral trade. Tensions could be a nightmare for tens of thousands of US companies operating in China. Today, we focus on the most prominent market risk of all, USD/CNH, the US dollar – Chinese Yuan exchange rate.
The Rise and Fall of USD/CNH
In FX spot and futures markets, USD/CNH is quoted as Yuan per Dollar. When the quote of USD/CNH rises, CNH depreciates because each dollar can be exchanged for more yuan. Similarly, a falling quote represents dollar depreciation which in turn is yuan appreciation.
How is the USD/CNH exchange rate determined? Interest rate parity (IRP) states that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. The formula for IRP is:
F0=S0×((1+ ic)/(1+ib)), where:
Forward Rate=Spot Rate × ((1+ Country C’s Interest Rate)/(1+ Country B’s Interest Rate) )
The 10-Year US Treasury Yield is currently quoted at 3.623%, higher than the 10-Year Chinese Government Bond Yield of 2.934%. Plug these into the IRP formula with a spot rate of 6.792, we will arrive at a forward rate of 6.837.
Examining the 1-year price chart of CME CNH futures, we find that Yuan lost 10,000 points between March and October last year, from 6.3 to 7.3. The trend closely correlates with the Fed rate hikes. This is a vindication of sound economic theory. While China’s central bank exercises control over its currency, in recent years it adopted open market operations and phased out strong-armed government directives.
The parallel trends diverged in November, as China ended its 3-year-long Zero-Covid policy. China’s reopening becomes the main driver of USD/CNH, which receded 6,000 points from 7.3 to 6.7 in three months.
Yuan’s strengthening has been interrupted last week as the Balloon incident hits the newswire. USD/CNH lost 900 points in two days, currently quoting at 6.792.
In my opinion, as the Fed tightening cycle enters the last inning, it no longer has an overarching impact over USD/CNH. Going forward, US-China bilateral relations take over.
Bilateral relationship between the countries will remain unpredictable. This is a developing story. Will there be a strong retaliation, or a mulled response? Different actions could swing the Yuan exchange rate from one extreme to the other.
Hedging for Currency Exposure Amid Unstable Relations
US importers, exporters, and US companies operating in China all face significant risks when the exchange rate is so volatile. Some of the cost may be in one currency, while the revenue is in another. Hedging net currency exposure is key to lock in the profit.
US-China trade has been very unstable in the past few years. But overall, a “decoupling” trend has already been under way. In 2017, China was the largest US trading partner. Bilateral trade accounted for 16.9% of all US foreign trade.
The most recent data for the first 11 months of 2022 shows a different story now:
• Canada is the No. 1 US trading partner with $733.1 billion and a 14.9% share
• Mexico is the 2nd largest, with $718.3 billion (14.6%)
• China is now only the 3rd largest with $639.5 billion and a 13.0% share
The US has become less dependent on China in its global supply chain. This is evident by the huge growth in bilateral trades with Vietnam (+122%), Taiwan (+102%) and India (+89%) in the last five years, while China trade only managed to grow 2%.
Short-term Trades May Prevail
In “Year of the Rabbit: Short-tailed Trading”, I discussed my preference for short-range trading this year over longer-term holding done in the past year. Market uncertainties pose more challenges in analyzing multiple moving targets with uncharted trajectories.
The Chinese currency is exactly what I am talking about. Just when you think China’s reopening would induce a secular bull run, a wandering balloon out of the blue sky deflates that hope. I would not be surprised if we have a repeat of the 2018 Trade Conflict. When the tension between the two superpowers intensifies, it could swing the market wildly.
For readers who have followed my stories, once again, we could leverage the game theory and event-driven strategy in response to this unexpected market event. In the past few years, I have deployed game theory and strangle options across a number of highly volatile and uncertain market scenarios, upon US-China Trade Conflict, the Russia-Ukraine Conflict, the Fed Rate Hikes, the US Midterm elections, and the US Debt Ceiling Showdown. Most of these ideas have been published on TradingView. You will find links to these stories at the end of this report.
While there isn’t an option contract available on the CNH, short-term trade on the currency futures contract may be considered.
Take the balloon incident as an example: Do you think Beijing will retaliate or merely protest in words? The former could worsen the US-China relations, and in my view, push the value of the Yuan down. The latter indicates the conflict can be managed without getting out of control, which is good news for the Yuan.
In summary:
• Hawkish response – Yuan value Down and CNH futures price Up;
• Dovish response – Yuan value Up and CNH quote Down
Once you form an educated opinion on which action is more likely, consider placing a long (hawkish) or short (dovish) futures position accordingly. Then hold on for the events to unravel. If history is any guide, the market often tends to over-shoot in response to overreaction.
Happy trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trade set-ups and express my market views. If you have futures in your trading portfolio, check out on CME Group data plans in TradingView that suit your trading needs tradingview.com/gopro/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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