When others are fearful …
Written on 2023-12-02, first published on 2023-12-05
Markets in focus
The Shanghai Composite Index has fallen to a two-decade trend support amid a slew of negative news on the economic challenges. The downward momentum is slowing, suggesting the potential to reverse at this most significant support line.
USD/CNH has been moving in a multi-year rising channel and just turned back from the channel’s upper resistance. In the previous two cycles, when the up trendline was broken, USD/CNH sharply reversed the rally and fell back to the channel’s lower support.
On the daily timeframe, USD/CNH has arguably formed a rounding top pattern, and the neckline is in danger of being breached.
Since 2022, the Japanese yen has been moving in tandem with the Chinese yuan. Yen is also at the cusp of breaking its year-long rising channel, confirming the strengthening of these two currencies against the US dollar.
Other major currencies against the Japanese yen are also at their respective multi-decade resistance. A broad Yen strengthening would lead to sharp reversals from here.
Our market views
“Be fearful when others are greedy, and greedy when others are fearful,” Warran Buffett wisely counsels. John Templeton echoes this sentiment, noting, “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.” These investment titans, among others, have underscored a timeless truth in finance.
In this reflection, our gaze turns to China. The fleeting optimism for China’s re-opening earlier this year swiftly dissipated, replaced by a steady stream of disheartening news. The narrative now fixates on foreign investors retreating, a climbing unemployment rate, and a stressed real estate market. We acknowledge China’s formidable domestic and international challenges, yet as rational investors committed to judicious decisions and calculated risks, we ponder: Have these woes been overly priced in?
In these moments, we recall the legends’ wisdom, striving to be less swayed by emotion or narrative. Instead, we turn to the charts, letting them whisper the likely path ahead.
Firstly, the Chinese equity market has been, at best, unremarkable. It has stagnated for nearly two decades, apart from two dramatic boom-and-bust cycles in 2008 and 2015. It’s no surprise that capital has flowed elsewhere, with many investors favoring emerging markets like India. Numerous Chinese indices linger at decade-long supports, with downward momentum waning. The once abundant bulls are scarce – a clear sign of deep-rooted pessimism as many have thrown the towel.
Next, we turn our lens to the Chinese currency. Forex is always a relative game; therefore, beyond China’s economic state, we must consider the global macro canvas. Examining the yuan’s trajectory, we’ve witnessed three pivotal USD/CNH cycles in the last decade. The 2015 cycle began with the yuan’s devaluation, sparking market unrest and leading to a weaker yuan amidst China’s economic reforms and capital outflows. In 2017, the tide turned: China’s stabilizing economy and a global recovery fostered yuan appreciation, reversing earlier trends.
The second cycle, which started in 2018 with U.S.-China trade tensions and divergent monetary policies, saw the yuan’s depreciation again. This phase culminated with the pandemic’s onset, where a rush to the USD as a safe haven ensued. However, post-pandemic, as central banks, including the Fed, responded with massive easing and economies began recovering, the yuan strengthened notably.
Now, with the Fed’s aggressive tightening cycle possibly ending amid signs of a cooling US economy, we anticipate a potential shift, possibly heralding a strengthening yuan in the current cycle.
Finally, we must not overlook Japan, a recurring theme in our past analyses (18th Jan, 2nd Aug, and 10th Oct). We posit that Japan is on the cusp of monumental monetary policy shifts, still unnoticed by many. The yen, moving in tandem with the yuan for various reasons – including their roles as export rivals and significant US treasury holders – may soon strengthen significantly, especially if the Bank of Japan continues normalizing its policies. The dynamics of a broader weakening of the US dollar and a meaningful strengthening of the yen would pave the way for China to embrace a stronger yuan, balancing its currency’s fortitude without compromising its edge in export competitiveness.
Rarely do investment opportunities align so well across positioning, sentiment, and technicals. We have now become very excited about China again.
How do we express our views?
We consider expressing our views via the following hypothetical trades1:
Case study 1: Short USD/CNH future
We would consider taking a short position on the USD/CNH future (CNHZ3) at the current level of 7.12, with a stop-loss above 7.30, which could bring us a hypothetical maximum loss of 7.30 – 7.12 = 0.18 points. Looking at Figure 3, once the support is broken, USD/CNH has the potential to fall back to 6.70, a hypothetical gain of 7.12 – 6.70 = 0.42 points. Each USD/CNH futures contract represents 100,000 USD; therefore, each point move is 100,000 USD.
Case study 2: Short EUR/JPY future
We would consider taking a short position on the EUR/JPY future (RYZ3) at the current level of 159.5, with a stop-loss above 170, which could bring us a hypothetical maximum loss of 170 – 159.5 = 10.5 points. Looking at Figure 5, if the upper resistance holds, EUR/JPY has the potential to fall back to 120, a hypothetical gain of 159.5 – 120 = 39.5 points. Each EUR/JPY futures contract represents 125,000 EUR, and each point move is 125,000 EUR.
EXAMPLES CITED ABOVE ARE FOR ILLUSTRATION ONLY AND SHALL NOT BE CONSTRUED AS INVESTMENT RECOMMENDATIONS OR ADVICE. THEY SERVE AS AN INTEGRAL PART OF A CASE STUDY TO DEMONSTRATE FUNDAMENTAL CONCEPTS IN RISK MANAGEMENT UNDER GIVEN MARKET SCENARIOS. PLEASE REFER TO FULL DISCLAIMERS AT THE END OF THE COMMENTARY.
 | A guest post by
|