FxWirePro: Glance through ZAR ahead of SARB rate cut hopes –USD/ZAR option trade via strangle writing on shrinking vols

SARB meets today to make a monetary policy decision: the majority of analysts expect a 25bps cut to the benchmark rate today. The South African Reserve Bank lowered its benchmark repo rate by 25bps to 6.75 percent on July 20th, saying the inflation outlook has improved while domestic growth prospects have deteriorated further following the surprise GDP contraction in the first quarter of the year.

We forecast one more rate cut this year, which would bring the policy rate to 6.5%. Therefore, a cut today would be wholly consistent with our view. CPI data showed yesterday that inflation moderation continues on the back of a relatively stable exchange rate and well-behaved commodity prices. SARB's core inflation measure softened to 4.6% YoY in August. Since the MPC voted for a cut last time and there have been no major hawkish development since, it makes sense to assume that policymakers may want to get their easing done sooner in the year rather than later when the impact of Fed rate hikes and tapering announcement by the ECB could end the EM-supportive risk environment.

We currently do not see political risk premium priced in. For instance, 1y FX implied volatility has now fallen substantially to sub 14%. We can hardly notice a difference between USDZAR and USDBRL exchange rates (refer above figure), also suggesting there is no obvious medium-term “bullish political developments” trade. CDS spreads are also at compressed levels.

Additionally, as China growth momentum slows, metal prices could be vulnerable to a correction (also as positioning in some metals appears very stretched –for instance, in gold). These factors are more significant for ZAR than TRY, given its exposure to commodity prices and low yield protection.

USDZAR has been drifting between upper side at 13.5311 and lower side at 12.3126 levels from last 8 months. Well, as the IVs of USDZAR are shrinking away, and as we could still foresee range bounded trend to persist for USDZAR in near future (refer monthly charts), and is puzzling this pair to drag slightly upward but very well within above stated range.

As a result, we recommend below option strategies using right options, thereby, one can benefit from certain returns.

Naked Strangle Shorting: Short 2W USDZAR OTM put (1.5% strike difference referring lower cap) and short OTM call simultaneously of the same expiry (1% strike referring upper cap) (we reiterate, preferably short term for maturity is desired).