FxWirePro: TWD under-performance links with China - Hedging carry trade risks

The TWD has had a good run so far this year, and with the largest current account surplus in emerging markets, it will require a negative exogenous event – China growth or a wobble in global sentiment that drags down equities – for it to weaken meaningfully.

With Chinese growth concerns to surface around year end, and coupled with negative carry and strong performance so far this year, risk-reward favours long dollar exposure or using TWD as a funding currency against regional peers. The CBC is likely to tolerate only so much currency strength, especially when growth dynamics start to worsen. 

Key drivers: Performance of domestic equities (and associated flows) has taken over from interest rate differentials as the main factor impacting the TWD. 

Risks: A longer period of stability in Chinese growth will keep the TWD stronger than we expect. A contused upward march in global and domestic equities would also be positive. A weaker TWD would result from CNH depreciation or a very intense Chinese growth slowdown

Hedge against carry trades and a EUR reversal: We remain constructive on EM high yield currencies but prefer to short low yielders, such as the TWD when entry levels are attractive (currently near the bottom of the cyclical range).

A near term catalyst for a wobble in EM currencies could come from a short-term retracement in EUR, which is expensive compared to real rate differentials and where spec positioning is at seven year highs.

North Asia most susceptible to earlier re-rating of growth expectations: In the event Chinese growth - or even US growth - slows earlier than we expect, the growth-sensitive North Asian currencies should be hit the hardest.

Spot and vol parameters line up: USDTWD has failed to close below 30 (intra-day low of 30.12) and CBC intervention should limit the downside, while volatility and skew are low. We find having a downside knock-out to cheapen a USDTWD call is attractive.