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From a mark-to-market perspective, the risk to the trade is a further rise in 3m30y US rates vol, coming this time with a depreciation in the USD (risk-off event in the US). Potential US-China trade barriers: bullish CNH vol The Republican clean sweep has already sparked a strong USD rally and US rates selloff, but could put further pressure on the USDCNY exchange rate. A stronger USD by itself adds pressure to depreciate as China still needs looser financial conditions to maintain stability in the debt market, a relationship confirmed by the USDCNY rally following the 2015 Fed hike. With Trump’s victory, we see increased risk of a larger depreciation. Trump publicly labeled China as a currency manipulator on multiple occasions during the campaign, so any speculation of anti-trade policies could put significant depreciation pressure on the Renminbi. Potential trade tariffs on Chinese exports to the US could raise the probability of a trade war. Furthermore, Trump could encourage the Treasury to alter its criteria for labelling currency manipulators, which could also hurt trade relationships. Either scenario would lead to a sharp re-pricing of risk premia higher. The Trade: Buy USDCNH 6m 7.60 call We recommend buying a 6m USDCNH 7.60 call for 0.37% USD (off 6.9700 forward), with a target of 1% USD. USDCNH topside is now at the cheapest levels since the August 2015 depreciation (Chart 56). The trade could benefit from either a rally in spot as well as any increase in the risk premium between now and inauguration on speculation of anti-trade policies. The structure appreciates significantly from increases in volatility, which is plausible given the 300% increase in volatility in August 2015 and the 100% increase from October 2015 to February 2016. The risk to the trade is that China increases capital controls and dampens USDCNH appreciation, which could cause the options to expire worthless. Chart 56: USDCNH topside the cheapest since pre-depreciation Table 4: Hypothetical trade performance on Inauguration Day (Jan 20th) 20 + Spot Vols Vols 20% Vols 50% Vols 100% 16 P unchanged higher higher higher +3 % 6.8 24% 197% 12 69 41% 235% 8 7 %. 100% 278% 4 7 49% 132% 305% 0 72 0% 103% 170% 378% 13 49% 122% 232% 441% & 2 »o& © © Ww Yo gs FF FF KEK SS 74 124% 200% 305% 522% 15 224% 319% 441% ——USDCNH 6m 104 call vol 78 386% 410% 565% Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Bankof America Merrill Lynch Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 31 HOUSE_OVERSIGHT_014761