Peering Into The Currency Crystal Ball

Includes: CYB, FXA, FXE, MXNS, UUP
by: Mercurial Markets


What could the price action in the currency markets tell us about the upcoming year?

Currencies markets tend to ‘price in’ growth, inflation, short term interest rate (mostly driven by central banks) expectations, and differentials. So what opportunities are the FX markets showing us?

Historically, the USD strengthened prior to liftoff, before declining over following six months, indicating that foreign exchange markets price future rate differentials in advance.

What could the currency markets tell us about the upcoming year? The forex markets should experience more volatility in 2016 given the divergence in central banks and interest rate cycles across major economies. And with that volatility comes opportunity…Let's start with a look at the US dollar (the most important currency in the world), credit markets and treasuries historical performance after the initiation of a Fed tightening cycle:

The question here is: Did the cycle of 'easy' monetary conditions ended last week with the Fed's 1st rate hike in 9 years, or had conditions already been tightening for a while now? It's important to know where we are in the cycle because it greatly impacts the return distribution. The research team at Columbia Threadneedle explain more about this timing issue: "Interesting is the performance of the U.S. dollar. Historically, the USD strengthened prior to liftoff, before declining over following six months, indicating that foreign exchange markets price future rate differentials in advance. Additionally, contrary to conventional wisdom, even when the pace of U.S. rate hikes beat the forwards, the dollar failed to outperform. In all three of the past hiking cycles, the Fed raised rates at a faster pace than the market expected, and yet the dollar still lost ground, in some cases significantly. Note the parallels between the last six months and the returns we typically see beginning six months after initial rate hikes (below). The similarities in these return patterns would suggest that the U.S. dollar, credit and Treasury inflation-protected securities are ahead of the Fed, or priced as though the Fed is well under way with its tightening campaign and the economy is starting to overheat. In contrast, short-duration Treasuries have yet to fully re-price to rising short-term rate expectations. The similarity of these return series reinforces our view that the U.S. tightening cycle actually began with the taper tantrum in mid-2013, since which 10-year real yields have risen by 1.56% (from -0.917% to 0.641%). Significant dollar strength, a re-pricing of corporate credit markets, and declining inflation expectations are all consistent with this theme." The thesis above appear to tie in well with the weakness in the US dollar from mid March 2015 to mid October 2015. In that period it acted much like the 'first 6 months' of a tightening cycle. The rally in the US dollar since late October may coincide with the start of the '2nd 6 month period after initiating a tightening cycle. See chart for an illustration of the price action:

Furthermore, it also ties in well with this discussion on the credit and treasuries market performance ahead of the Fed's 1st rate hike. If the thesis above is correct, we may expect strong returns in Asia ex-Japan and the emerging markets. See here for a note on historical performance.

We may express some the views above via the currency markets. Currencies markets tend to 'price in' growth, inflation, short term interest rate (mostly driven by central banks) expectations, and differentials. Let's have a look at some data points that drive currency performance.

What we are interested here is 'real interest rate' (interest rate less inflation) differences between various economies/currencies. Right now the most relevant themes are: Chinese devaluation, continued commodity declines and continued monetary easing in Europe/Japan. The Chinese have become increasingly aggressive devaluing their currency since summer of 2015. See chart below:

Coupled with a relatively high interest rate differential, further expected rate cuts, and continued lower growth/inflation - it's reasonable to expect the yuan to depreciate further. See the spread in rates, China vs. US below:

Easing of monetary conditions and currency devaluation should fuel higher growth in China and many other EM economies. However, the depreciating yuan and falling commodity prices have caused declines across the 'commodity currencies'. Namely the Russian ruble, Australian dollar, Canadian dollar and Brazilian real. The charts below are indicative of the damage done to those currencies. Not all currencies are equally correlated to commodity prices or Chinese import growth or even the US interest rate cycle. Those divergences create opportunities.

For example, the Australian dollar vs. the Russian ruble. Basic idea: ruble has negative real rates, negative growth, highly dependent on natural gas/oil exports - AND has a great deal of geopolitical risk. On the other hand, Australia has moderate growth, positive real interest rates. Also, remember the historical cycle discussed above favors Asia ex-Japan markets. See the AUD chart below, look to buy the Aussie dollar so long as it stays under 1.42 and continues to grind down toward 1.36.

With the ruble, we need a break above 71.50 to be a seller of the currency. However, a rally in energy prices could push the ruble 66 area. In that case, shorting the ruble against a long AUD position would get painful. Daily chart of RUB below:Buying AUD and selling RUB is essentially betting on an improvement in Asian growth while remaining short energy.

Another idea: the Mexican peso (although the peso is linked somewhat to oil) vs. Brazilian real. Mexico has positive growth and a positive rate differential vs. its main trading partner, the US. Note that Mexico is also raising interest rates in line with the US Fed, so inflation should be contained. Brazil has significant inflation issues (killer for a currency) and negative growth rates. See the overview chart in the beginning of the article for relevant data points. Below are interest rate and inflation differentials. MXN appears more stable than BRL.

What to do? From the chart below Brazil looks ready for another push higher likely devaluing the Real to over 4.20. On the other hand the Mexican peso, seems to have found some resistance in the low 17's.

The idea here is to buy MXN and sell BRL. Right now the cross is about 4.29 (MXN per BRL). On a breakdown below 4.2, it's possible that this cross-currency pair could drop to 3.60. See chart below. This idea is expressing the following scenario: US growth will stay strong and support Mexican growth (and higher interest rates); And, a bounce in commodities and China/EM growth rates will not come quickly enough such that Brazil will be able to raise interest rates in the near term.

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