The offshore renminbi (CNH) cross-currency swap (CCS) curve has steepened to its highest level in 12 months and is likely to consolidate at the current level, with the three year carrying a moderately bearish bias, according to Linan Liu, strategist at Deutsche Bank.
The CCS market has become much more active since the start of this year than it has been in the past. The average daily trading volume has more than doubled from US$1.5 to US$2 billion in January to US$3.5 to US$5 billion currently, according to Liu’s estimates.
The CNH CCS curve also rallied strongly in the first four months of the year, with three-year rates strengthening from 2.2% to 1.3% early in May, due to strong corporate liability hedging flows. However, since May three-year rates have risen to 2.4% for five reasons, she said.
“Investors turned to the CCS market for hedges of their CNH cash bond exposure amid the sell-off in the global credit market and CNH bond market in June. Secondly, there was a lack of CNH liability hedging flows to balance on the other side due to low volumes of CNH bond issuance,” she said.
Thirdly there was a spillover from the sharply rising onshore interbank interest rates in June, which primarily impacted the front end of the curve. Fourthly, US dollar issuers such as commercial banks have been swapping into CNH in order to make CNH corporate loans – which are usually remitted onshore.
Finally, higher US dollar core rates pushed up the CNH CCS rates. For these reasons, the curve is now at the steepest it has been for a year and Liu argues that the current balance of risks does not suggest that it will steepen further.
“Core rates have fully priced in the impact of [US Federal Reserve] tapering, onshore liquidity conditions have normalised and are likely to remain stable with the central bank’s liquidity accommodation, [and] CNH bond issuance is likely to gather momentum after August, which means there will be higher CNH liability hedging demand,” she said.
In addition, the implied CNH lending rates by US dollar issuers, throughout which commercial banks borrow US dollars to make CNH loans, are no longer attractive for tenors longer than three-years, she said.
For example, for a large commercial bank with a USD funding cost at USD Libor + 128 basis points (bp) in the five year, swapping into CNH, and lending its out with a margin of 120bp would imply a corporate offshore CNH loan rate of 5.14%.
This is a very similar level to the onshore borrowing cost for a high grade corporate, on a five-year loan at a 20% discount from the policy lending rate at 5.12%.
“In other words, at the current CCS rates in five-year and longer tenors, for high grade corporations, borrowing offshore does not offer any cost savings relative to onshore corporate funding. However, for corporations looking for shorter loans, we believe three-year CCS still offers 80bp to 100bp in cost savings relative to onshore loans,” she said.
“Hence in the near-term, we see little room for further bear steepening in the five-year and longer tenors of the CCS curve and expect it to consolidate at the current level.”