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2016 FX and Rates Market Summary

Core Content

This document outlines the top 10 FX and rates trades for 2016, based on the analysis by BofA Merrill Lynch's FX and Rates team. It discusses macroeconomic trends, policy divergence, capital flows, and market risks, with a focus on the Chinese yuan (CNY) and US dollar (USD) relationship, as well as the impact of global events like the Fed's rate hike and Brexit on currency and bond markets.

Main Points and Key Information

1. Top 10 FX and Rates Trades

• Buy USD/CNH 6m forward outright – the favorite FX trade for 2016 due to expected RMB depreciation.
• Buy US 30y real yields – RMB depreciation could slow Chinese selling and lower the real terminal Fed Funds rate.
• Buy EUR/USD 3m 1.10 call with 16 Dec 1.1050 window KO – anticipating short-term profit-taking after the first Fed hike.
• Buy 1y EUR/USD<1.00, USD/JPY<120 dual digital – a cheap way to profit from EUR down and JPY up themes.
• Long EUR vs US rates in 5y5y – still the favorite monetary policy divergence trade.
• Long UK versus US rates straddles – to hedge Brexit and other macro risks.
• Buy AUD/KRW – an attractive relative value trade insulated from RMB risk.
• Sell TRY/JPY – a technical team favorite.
• Sell 3y Fannie Mae debt vs Treasuries – the favorite US election trade.
• Long 12m Treasury bills against OIS – as money market reform may outweigh Chinese FX interventions.

2. RMB Depreciation and Its Impact

• The RMB is expected to weaken by up to 10% against the USD in 2016 due to diverging monetary policies between the US and China.
• RMB depreciation could slow the Fed's hiking cycle and reduce the real terminal Fed Funds rate.
• This would likely be negative for emerging market and commodity currencies, with KRW, TWD, and MYR being the most vulnerable.
• The RMB's depreciation may also lead to a rise in US real yields, making TIPS more attractive compared to nominal bonds.

3. Policy Divergence and Market Risks

• The divergence between US and Chinese monetary policies is a central theme, with the US tightening and China easing.
• The RMB's semi-peg with the USD and China's open capital account may limit its ability to defend the currency while lowering rates.
• The document highlights the risks of the Fed hiking rates, including potential RMB weakness and the impact on global markets.

4. Leading Indicators and Asset Allocation

• A big-data leading indicator, constructed from 135 macro series, outperforms traditional indicators like PMI and CLI in forecasting GDP and asset allocation.
• The indicator suggests moderate economic growth with downside risks for the Eurozone and Japan, but not for the US.
• The US dollar is now counter-cyclical, while commodity currencies are pro-cyclical.
• In scenarios of moderate negative growth momentum, the 10y UST tends to rally, and commodity currencies like AUD and NZD tend to fall.

5. Relative Value and Volatility Trades

• Buy AUD/KRW is recommended as a relative value trade, with low cost and limited RMB exposure.
• Sell TRY/JPY is a technical favorite, likely due to the yen's strength against the Turkish lira.
• Long volatility in JGBs and sell EUR/USD-USD/JPY correlation via dual digitals are suggested for Japan.

Key Takeaways

• The RMB is expected to weaken in 2016 due to policy divergence, capital outflows, and economic pressures.
• US real yields are likely to benefit from RMB depreciation, making TIPS a strong investment.
• The big-data leading indicator provides better forecasts than traditional indicators and is used to guide asset allocation.
• The US dollar is counter-cyclical, while commodity currencies are pro-cyclical.
• Strategic positioning for Brexit, US election outcomes, and FX volatility is advised through specific trades like straddles and dual digitals.

Risks and Considerations

• FX and rates trades discussed involve significant risk and are not suitable for all investors.
• The document acknowledges potential conflicts of interest due to BofA Merrill Lynch's business relationships.
• Back-testing results are hypothetical and do not reflect actual or future performance.
• The effectiveness of leading indicators may be impacted by data revisions and structural changes in the economy.

Conclusion

The 2016 FX and rates market is shaped by the divergence between the US and China, with a focus on RMB depreciation and its broader implications. Strategic trades are suggested based on macroeconomic trends, policy shifts, and technical indicators, with a strong emphasis on relative value and volatility management. The document serves as a comprehensive guide for investors navigating the complex landscape of global currencies and interest rates.