Executive summary

In this issue, Rich analyzes China’s economic growth using indicators like China CPI, M2, and Total Social Financing, evaluating currency pairs and recommending a slightly bullish AUD/USD Strap strategy.

Image 1: China CPI, PPI, and M2 money supply growth

As a recent host of CFA Society Chicago Macro Matters podcast, I discussed the topic of Chinese growth. Market expectations were for China to experience a post-lockdown economic growth acceleration similar to the U.S. in late 2020 and 2021. The co-host, an expert on China, highlighted China’s objective to de-risk its economic growth by shifting away from reliance on exports and external growth, aiming for increased emphasis on domestic consumption. 

The reality is that Chinese growth has not met expectations this year. Again, that became clear last week when China PMI came in barely above the 50 expansion/contraction level. On July 10, the Chinese economy received even more unfavorable news when CPI came in at zero percent. What does that mean?  It means no inflation, which must be a good thing for consumption, right? Perhaps if it was thought to be temporary. However, if consumers believe deflation will take hold, they may defer consumption with the expectation that prices will still be lower in the future. Bernanke’s knowledge of the U.S. Great Depression led him to adopt an ultra-easy policy to combat deflation. Japan’s experience of struggling to get inflation above zero percent and usually below one percent for the past 30 years supports this, causing a growth slowdown. 

The chart above shows China CPI in white, PPI in blue, and M2 money growth in purple. I drew vertical lines when CPI went below zero percent. Both times PPI was also deep in the negatives, which is where we are today.  In 2009, this occurred with Chinese export partners struggling due to the Great Financial Crisis. It also happened in 2020 given the global Covid-19 lockdowns. The difference between these two situations was that in 2009 the government stimulated the economy and M2 money grew. It didn’t do that in 2020 so M2 growth actually shrank. 

With a desire to drive domestic consumption, what will the Chinese government do now that CPI appears to be on the brink of deflation? 

Image 2: China CPI, China M2, and Chinese Total Social Financing

The chart above is similar to the chart showing CPI and M2 growth, but with Chinese Total Social Financing growth included. This is often the preferred form of Chinese stimulus, but I can see that over the last year the growth of it has collapsed. Does this mean there is more capacity for the government to stimulate the economy? There are well known China strategists that suggest that Chinese stimulus may be the critical story for the market in the second half.

Image 3: China CPI, China M2, Chinese Total Social Financing, and AUD/USD

I have included the AUD/USD cross on the chart above. I can see that in the past, when there were moves higher in Chinese money growth and social financing, there was a move higher in AUD/USD. When these numbers decrease, it typically results in a sideways to lower trend for AUD/USD. If we see Chinese stimulus in the second half, does this set up for a bullish AUD/USD move?

Image 4: China CPI, China M2 growth, Chinese Total Social Financing, and USD/CNH

Here is the same chart as before but USD/CNH is included. The pattern is not as clear here, as USD/CNH moved in tandem with CPI in 2019-2022 but this year it has moved higher even though CPI has moved lower. The currency pair has become disconnected. In order to reconnect, one might expect USD/CNH to move lower. However, we can see that in some ways, CNH may be anticipating and leading the changes we see in M2 and TSF back in 2019, followed by a call in 2021 and a move higher in 2022. Does this mean that CNH might be signaling more stimulus to come?

Image 5: AUD/USD Currency pair and Li Keqiang Index

Former Premier of China Li Keqiang once said that measures such as GDP were man-made. In order to assess the economy, he preferred to look at railway cargo volume, electricity consumption, and loans disbursed by banks. The Economist created this index, which we can track it on Bloomberg. You can see that when this index of economic growth moves higher, the AUD/USD does too, then when it moves lower, the AUD/USD also tends to follow. This may feel intuitive to most traders, but I like to see this intuition corroborated in the data.

Image 6: AUD/USD Currency Pair and RBA cash target rate less FOMC target rate

China is not the only driver of AUD/USD though. The RBA policy rate also seems to be a key driver of the pair particularly relative to the U.S. FOMC target rate. In white, I have created an index, which is simply RBA rates less FOMC rates and have overlaid that versus AUD/USD. The market may be currently one more rate hike in the U.S., but then a pause with cuts possible in 2024. Conversely, the market is expecting the RBA to continue hiking rates throughout 2023. This suggests the white line will start marching higher. Is AUD/USD soon to follow?

Image 7: AUD/USD daily Ichimoku Kinko Hyo chart

The daily technical chart for AUD/USD is starting to look bullish to me. In the Ichimoku chart on top, I can see the Leading Spans starting to go higher. In addition, the Conversion line has moved above the cloud and prices are also breaking out above the cloud. In the middle, I can see this is corroborated by the MACD starting to cross and move higher. The RSI in the bottom panel is in neutral territory painting a picture that the AUD might be on the move to go higher soon.

Image 8: CNH daily Ichimoku chart

The opposite appears true for CNH. The trend is very strong and higher as I see the price, base line, conversion line, and the cloud all pointing higher. However, the MACD is turning lower in the middle panel and the RSI is overbought and rolling over. While the trend is strong, it might be time for a counter trend to move lower.

Image 9: CVOL tool for FX products

The next stop for me is to look at the level of volatility in the market. As I bring up the CME CVOL tool, I can see that across the board, FX vols are lower than they were a year ago and are at the low end of the range. This is also true for AUD where the CVOL is around a 10 vol, at the low end of its one-year range.

Image 10: AUD/USD CVOL history: index and skew

Looking at the CVOL history for both the headline index but also skew for AUD/USD, I see that the volatility has moved lower this year with the move lower in the future. The skew in purple is at the high end of the range. By high end here, I mean it is favoring puts much less than it has over the past year.

Image 11: AUD/USD skew, UpVar, and DownVar

Digging into this further, I see that this move in skew is a function of the relative pricing of puts vs. calls collapsing as overall volatility has moved lower. With volatility low, traders seem to be taking premium out of the options wherever they can find it.

Image 12: AUD/USD implied volatility by delta

The collapse in any option premium is shown more clearly in this chart above where I can see from the 25 delta puts through every call strike, there is no premium to options at all. Not only is skew collapsing but so is kurtosis, except for the extreme downside options. To me, that speaks of a market that does not want to own any optionality.

Image 13: AUD/USD delta vol surface

The table above shows that same chart as before but for every expiration. You can see how flat skew and kurtosis is across every delta and every expiration. It seems like a market that is long volatility already, and thus is keen to take out any premium it can. However, catalysts can change that tone in a short time. We saw above that AUD/USD technically may be poised for a breakout. What could drive that? Potential catalysts over the next few weeks include China PMI, U.S. FOMC, and Australia RBA meetings all in the last week of July. At that time, we will have a better picture of how imminently China may need to stimulate as well as what the relative difference is U.S. and Australian policy rates may be. If things play out as I laid out above, this last week of July may be a catalyst for a breakout (or breakdown) in AUD that will get some volatility back into the market.

Image 14: AUD/USD open interest

The interest in the options market has primarily been on the put side of the ledger. I can see that as the relative open interest in puts (orange) vs. calls (blue) has grown and is now well above two times whereas the opposite was true a year ago. There has not been much interest on the call side for AUD/USD.

Image 15: Expected return and Greeks for an AUD/USD August STRAP strategy, long one 0.6750 put, and two 0.6750 calls

As I put this information together, I am inclined to get long optionality. There are possible catalysts coming up that may be critical drivers of FX. I have looked at AUD/USD options here because I can easily build it out in SpreadBuilder creating an AUD/USD Strap strategy. One could also consider CNH options that are now listed by CME Group. This strategy is one that positions for a big move in either direction, with a lean toward and preference for a bullish outcome. It is long gamma and some vega (though it is front dated). As with a long straddle or strangle, on an immediate or rapid move in either direction, the strategy benefits. However, tt goes up and twice the rate on a move goes higher. The breakevens for this are 0.6850 and 0.6550 relative to a futures price of 0.6700. I have chosen to do a Strap instead of a Straddle to show my slightly bullish bias toward the outcome of these catalysts, given the bullish technical set up, and given the lack of interest in calls by the market. Though, I acknowledge that these catalysts may not play out the way I expect and that is why I want to do a Strap instead of simply using a bull spread or outright calls. A Strap allows me to lean bullish but to still be able to profit if overall volatility increases on a move in either direction.

Image 16: Payout simulations for an August 0.6750 Strap strategy

As I mentioned, traders know a long options idea like this is fully convex and can benefit on instant gratification, quick moves, and rapid moves in either direction. Yet, how would the strategy perform if AUD/USD moves in either direction but does so at a much slower pace? QuikStrike’s SpreadBuilder allows a trader to simulate just that. In the top chart, I show the payout to the strategy if AUD/USD moves up slowly. I can see that it takes a little time (about 10 days) to kick in, but then the long delta from the structure takes over and as AUD still moves higher, even at a slow pace, the strategy can show strong profits. Is the same true on a move lower? Not quite. It can take longer for the strategy to show gains, over 15 days, but even on a move down slowly, eventually the strategy can show gains.  What if nothing happens? Being long options and having nothing happen can be a fear. That is the bottom panel where the strategy only shows small losses in the first 10 days before having P&L collapse in the end. This means if I am acting quickly, I have time to potentially limit losses in the first two weeks after the catalysts play out by trading out of the structure to limit downside. 

Long option structures look appealing to me because big moves in either direction can show gains. However, long option ideas also require constant monitoring and are often rebalancing. I could look to trade the gamma of this structure in the days before the catalysts to possibly make back the nightly theta, then leave on the directional trade for the catalysts. I could also use the options structure as a base upon which to press directional ideas when the news comes out either from catalysts or other government headlines. Staying on top of the Greeks and the P&L is critical, but using a Strap strategy can also allow me to set up a view on both volatility as well as direction. 

Good luck trading. 

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