Lower Asian FX volatility seen; CGBs not a good hedge

Relative monetary policy set to stay stable, lowering Asian currency volatility. CGBs not a good hedge for Dec 15 scheduled tariffs.
Chang Weiliang, Duncan Tan10 Dec 2019
    Photo credit: AFP Photo

    FX: Monetary policy stability could see lower Asian volatility

    With markets now expecting the Fed to be on hold into mid-2020, Emerging Asian central banks may also follow suit in keeping policy unchanged in the interim, barring any unexpected changes in the macroeconomic environment. After all, the global economy is showing some signs of a bottoming, while regional central banks have already delivered a series of rate cuts earlier. BI Senior Deputy Governor Damayanti has flagged that rates may remain on hold while BI assesses the impact of 100bps of rate cuts since July. Our economist also sees BSP as likely to remain on hold this week, with inflation picking up again. With renewed stability in Asian monetary policy going forward, alongside progress on US-China trade negotiations, there could be reduced volatility in Asian currencies going forward, absent a complete breakdown of trade negotiations. In such circumstances, carry trades could regain popularity, and the IDR looks the best placed to benefit given its attractive yields of over 5%.

    Rates: CGBs not a good hedge for Dec 15 tariffs

    With the December 15 round of scheduled tariffs approaching, we highlight that China Government Bonds (CGB) are not a good hedge for the risk event. One interesting characteristic of CGB has been the bifurcation of fx and interest rate drivers. The FX component is very reactive to the trajectory of US-China negotiations. We have seen CNY weaken 2.6% and 4.0% respectively in the escalation months of May and August, and seen CNY strengthen as much as 2.2% since news of phase 1 deal talks surfaced. On the other hand, CGB yields are more insulated from the negotiations and are chiefly driven by domestic monetary policy and onshore factors such as inflation and bank funding conditions (ownership dominated by commercial banks). Thus far, PBOC has been restrained in its easing, cutting the 7D Reverse Repo and 1Y Medium-term Lending Facilities rates by a mere 5bps. Consequently, 10Y CGBs yields are largely unchanged year-to-date and bond price has fluctuated in a tight +/- 2.0% range. In short, for China, the potential for a large move in currency is much greater than that for interest rates.

    Earlier in the year, we liked 10Y CGBs because they have a A+ rating and offered high yields (100-160bps spread over US Treasury (UST)) and high carry (65-85bps spread over onshore repo rates). Today, the high yield/high carry argument doesn't hold up as well. FX-hedging costs have risen persistently, from 0-10bps in 1H to 110bps today. Ie Current FX-hedging costs would wipe out most of the yield advantage over UST. Carry via repo funding have also compressed 10-30bps in recent months. Alternatively, one could hold CGBs on an unhedged basis to keep the yield advantage over UST, 136bps as of last week. However, that would come with the risks of significant FX losses (from any fallout in negotiations) that would likely overwhelm the yield buffer.

    Chang Wei Liang

    Credit & FX Strategist

    Duncan Tan

    FX and Rates Strategist - Asean

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