How China's liquidity may suffer from QE tapering

And here's how it can fight back.

According to Bank of America Merrill Lynch, the QE tapering makes it tough for China on liquidity side.

Here's more from BofAML:

This should lead rates higher, so we do marginally favor paying at the moment. But the PBoC has weapons to fight back by cutting RRR. We do not think the PBoC will cut RRR fast enough to offset the capital outflow as to be able to net-inject liquidity.

The market will nevertheless interpret such action as a strong easing signal to bid the bond or receive rates. Thus, we prefer to express our China view through receiving AUD 2y fwd 2y.

On the continued weakness of Australia fundamental and China’s gradual slowdown, we have been recommending receiving AUD 2y fwd 2y swaps as our core position.

The QE led lower liquidity puts even more hardship on China, further limits China’s hand in terms of rolling out large scale stimulus. It eliminates a large risk from receiving AUD 2y fwd 2y.

The most direct Fed tapering trade is to position for higher AUD back end rates given that part of the curve is most sensitive to US rates and the spread with US rates is on the narrow side of recent range.

However, there is a significant amount of uncertainty around Fed tapering, the timing and the pace. The negative carry makes the outright short or paying rates position hard to hold onto unless one has a near 20/20 vision in terms of timing.