2011 Non-Predictions 4: FX

by: Macro Man

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<< Return to 2011 Non-Predictions 3: Rates

Having tried valiantly to avoid doing their homework on their FX Non-Predictions, today Team Macro Man (TMM) are finally ready to hand in an offering. But before we do, we will drag up one last delaying excuse and quickly have a look at the news and leaks coming out of Europe...

Whilst the market was focused on the Portuguese auction, which the market has done its utmost to peddle as a negative outcome, we were more fascinated by this headline.


TMM think that this innocuous looking headline may actually precede a policy that finally draws a line under the current problems. Casting their minds back to the financial crisis, they remembered that the Fed set up an SPV called TALF, with the aim of providing leverage to private investors who wanted to buy distressed assets. In that case, the Fed would provide the leverage through expansion of its balance sheet (if TMM remember correctly). However, in this case, EFSF would be selling bonds to Voldemort & friends and be buying peripheral debt with the proceeds. Given TMM's view that the loss-adjusted yields (i.e. - yields adjusted for our own assumptions of recovery in restructuring) on peripheral debt are actually pretty juicy, this sounds like a pretty good business model to us. TMM wonder if Klaus Regling will be charging the EU 2 and 20 %. But it doesn't matter what we think, the market appears to be blinkered to any positives preferring to gorge on the woes, but we hope there is a "surprise" Euro-rally later today as this factor is finally digested.

OK, we can't make any more excuses here are a few FX Non-Predictions...

18) USDJPY will NOT be easy.

Coming into 2011, one of the punters' favourite trades is to buy USDJPY. And not without good reason: US growth has reaccelerated, pushing up UST yields and after the dramatic rally in the Yen over the past few years, surely it's time for something of a reversal? Many valuations models show that the pair in undervalued (see below chart of US/Japan REER ratio showing USDJPY as about 15% "cheap" to its long run average)...

(Click to enlarge)

...but that is only half of the story. TMM have often forgotten over the years just how important Real Rates are, particularly when attempting to trade USDJPY. As far as currencies go, real rates do a pretty good job of explaining over or undervaluation (the Brazilian Real springs to mind, especially), and for countries undergoing deflationary experiences, this is all the more important given the Zero Bound for rates. The below chart shows the US versus Japan REER ratio (blue) plotted against the relative 2yr real rate spread, moved two years forward (red, 2yr yields vs. 36month moving averaged CPI). Although the fit is certainly not anything like perfect, it gives something of a sense of what is required to reverse this undervaluation which, if anything, is less than might be expected given the real rate situation.

(Click to enlarge)

Given TMM's views on the US rates market, which are for it largely to be range-bound, with the Fed on hold all year, it seems unlikely to us that the real rates situation is likely to change appreciably for a rally in USDJPY. That's not to say there might not be the occasional sell-off on Treasuries which leads to some USDJPY strength, but TMM reckon that the combination of the above and punters' preference to buy the pair mean that USDJPY will NOT be easy. Probably something like "up a bit, down a bit, downside stops mean a break of 79, then up a bit again, then everyone loses interest again"...And that is basically the script from the "Golden Shot" show of the early 1970s. (6:30 mins in on this clip).

19) The Equity/DXY correlation will NOT break down, meaning that the DXY will NOT finish the year higher than it entered it.

This is somewhat related to number 18), within the context of TMM's views on the relative real rate situation and the outlook for the (lack of) rate hikes from the Fed this year. As global policy rates converged in the aftermath of the financial crisis, the negative correlation between the Dollar and Equities has gradually increased and that of relative rate spreads has decreased (mainly because relative short rates have not moved all that much). Of course, every now and again for a week or so, short-term correlations break down, leading punters to start discussing how we are at the cusp of a "new regime" for the Dollar, where both Equities and the Dollar can rally together because US is becoming the engine of growth. That's all very well, but without real rate support, it is very difficult for a currency of a country running large twin deficits to rally. Indeed, in the past 10years, the Dollar has only managed to rally during periods where its relative short rate was high (see chart below, green line - US vs. DXY 2yr rate basket; red line - DXY vs. 2yr spread correlation; blue line - DXY vs. SPX correlation) during 2004-5 or during periods of extreme financial stress. In both of the latter cases, equities were also under pressure.

(Click to enlarge)

Combine the above with our views on rates and TMM believe that the DXY versus SPX correlation will NOT breakdown just yet, and given that, it is also likely that the DXY will NOT finish the year higher than it entered it.

20) EURCHF will NOT close the year below 1.30.

Throughout the past year EURCHF has been a veritable bellwether of the flight-to-quality phenomenon, as investors somehow came to a conclusion that vaults full of chocolate and gold offer THE answer to the global sovereign wobbles. While this may very well be true and Switzerland might just be one of the few “good” sovereigns out there (along with the likes of Sweden and Norway), it’s important to keep an eye on the flip side of the coin. For one, the Europeans, in their suitably haphazard fashion, are stumbling towards some sort of a solution. This will not only improve the credit quality and liquidity of EUR-denominated assets, but is also likely to unleash the Bundeathstar on the unsuspecting denizens of the marketplace. Now TMM doesn’t know what level of rates Darth Weber deems appropriate for the Eurozone, but with the latest EU HICP print of 2.2%, one can only imagine them heading one way. Given that the Swiss may or may not follow suit, carry should definitely favor EURCHF longs. In general, the best argument for EURCHF may just be summarized by the following graph (white line - EMU/Swiss CPI differential; orange line - EURCHF lagged 12m):

(Click to enlarge)

Disclosure: None