Malaysia: Cash continues to push higher

Risk metrics in Malaysia have trended higher as the currency weakness has deepened. Concerns about Ringgit have increased further due to Yuan devaluation, capital outflows, lower oil as well as increased political uncertainty. It is believed that BNM would become more concerned if Ringgit weakens beyond 4.50. To stem currency weakness, BNM still has few policy options  Previous intervention has resulted in some tightening of the onshore liquidity, which has not been completely offset by maturing BNM bills. The market has started to price in a hike and/or tighter liquidity conditions.

Looking at 3x6 and 6x9 FRAs, the market is pricing in hikes of 42bp and 45bp, respectively. If BNM were to use the IMF-prescribed policy option of hikes to defend the currency, the hikes would have to be in multiples of 50bp, if not 100bp. So in that sense, there is still some room for front-end rates to go higher. 

However, it is believed that concerns about a downgrade are over-extended. CDS has crept up in conjunction with rates and weaker Ringgit. Malaysia 5y CDS is now trading close to BBB category. However, more recently, both Fitch and Moody's came out reassuring their current credit ratings on Malaysia - assuming that the government continues on its path of reforms and fiscal consolidation. 

"We believe upside risks to rates still exist despite the market pricing in a 45bp hike. However, there is limited scope for CDS to go higher from current levels. We recently initiated a new recommendation to pay 1y1y MYR NDIRS (current 4.23%) and sell 5y CDS (current 183bp)", says BofA Merrill Lynch.

Risks to the trade are both external and domestic in nature. On the external side, inability of Fed to hike rates this year and China sentiment stabilizing are the main risks. Domestically, BNM's resolve to not use interest rates as a policy to defend FX and positioning are the biggest risks. Offshore/onshore spread in IRS has widened close to all-time highs (2y 9bp; 5y 25bp). The other risk is that the government abandons its path of fiscal consolidation due to the deterioration of energy revenues - this could result in actual downgrades.