Trade idea - Short USD/CNH FX

I went short USD/CNH at 6.9850 today with a stop at 7.05 and a target of 6.65. If you’ve been subscribing for a while, you have already heard my view that the US is heading into recession and the Fed will have to hike less than expected and cut faster than expected.

China, on the other hand, has decided to rapidly exit its zero-covid strategy. Everyone outside of China has been through this and knows that the only way to completely reopen the economy and borders is to let covid rip through your population and for the country to gain herd immunity. Any attempt to lock down the population only delays the inevitable. Sure, there will be some hospitalizations and deaths along the way, but the omicron strain is much milder than the original strain that originated in Wuhan and the delta strain in 2021. I’ve heard estimates of 2 million deaths if covid runs rampant, but my guess is that the number of actual deaths will come in well below that. Anecdotally, what I’m hearing about this current wave of Omicron is that it is nothing compared to the dire circumstances seen in New York, Italy, and India during the worst waves of covid.

There are a lot of differing opinions on how this sudden relaxation of covid rules will play out for the Chinese economy. Some believe it will depress growth and inflation, others think the opposite. At the moment China is in the fear phase, where most people have either caught covid or are hiding from it by staying at home. In a few weeks we will enter the acceptance phase, where those who have caught it and recovered will start going about their regular life, while those who haven’t caught it will realize that it’s mostly harmless and accept that they will catch covid eventually. I don’t see how it will play out any differently from what we have experienced in the rest of the world, whether we are in the US, Singapore, or elsewhere - a surge in demand coupled with supply chain and labor shortages.

Consumers will likely have built up a large cushion of savings during the past several years of lockdowns, and will start spending on goods and services. Rolling waves of covid will result in rolling waves of absent workers, resulting in supply chain disruptions and a labor shortage. The combination of revenge spending, supply chain disruptions, and a labor shortage should result in a pickup in growth and inflation by H2 2023. Sound familiar?

The dramatic uptrend in USD/CNH this year was driven not only by the Fed’s hiking cycle, but also the deflating of China’s real estate bubble and its strict zero-covid lockdowns. To combat the recession, China stimulated and pumped liquidity into the economy while the Fed was tightening. Next year will be the reverse of 2022 - The Fed will be loosening policy while China will have to tighten.

Not only do the macro fundamentals point to USD/CNH lower, but the chart is also a picture of beauty. We broke the neckline of a picture perfect head and shoulders pattern at 7.02, and are now consolidating right below it.

When you zoom out on this decade-long chart of USD/CNH, you can see how its long, smooth trends make it a global macro trader’s speculative vehicle of choice:

These nice trends happen for two reasons - 1) the economic cycles of China and the US often run opposite to each other, where China is easing while the US is tightening, and vice versa. This policy divergence results in very strong trends. 2) China is a managed economy and USD/CNH is a managed currency. Economic policies often run in one direction for a long time (for example, the stimulative policies that led to the real estate bubble), imbalances build up, and then have to correct. The currency itself spends a lot of time not reflecting economic fundamentals (such as Q1 2022), and once those imbalances get released, USD/CNH tends to embark on an explosive trend.

What could go wrong with this trade? For one thing, a stop at 7.05 is pretty tight. CNH is a risk-on currency, so a risk-off move like what we are seeing today could send USD/CNH through my stop level. This is also a negative carry trade, due to the interest rate differential. China could also decide that this current wave of covid is too intense and make a policy U-turn by locking down again. We could get some hot US economic data that sends USD higher across the board. Anything could happen - I could get stopped out tomorrow! My long-term win rate is only 45%. This is not financial advice and do your own homework.