Best Currency Positions For October 2017

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Includes: BTC-USD, COIN, CROC, DBV, DRR, ERO, EUFX, EUO, FXA, FXB, FXC, FXE, FXF, FXS, FXSG, FXY, GBB, ICI, JYN, RSX, UDN, ULE, URR, USDU, UUP, YCL, YCS
by: Ruerd Heeg

Summary

This month the European currencies saw great momentum.

I took profits and sold out my long position in the Canadian dollar.

The euro and the Israeli shekel are good shorts. Australian dollar is a good long.

This is an update of my article from last month. See also the first article in this sequence.

4 currency trading strategies

Like last month I value currencies based on 4 statistical currency strategies:

  1. Changes in purchasing power relative to changes in purchasing power of other currencies. In other words: suppose the 5-year difference in inflation between 2 currencies is not compensated by a 5-year decrease in the value of the currency with the most inflation. Then a long position in that inflationary currency and a short position in the other currency is a statistically favorable bet.

  2. The term spread. This is the difference between long term interest rates and short term interest rates. Currencies with inverted or flat yield curves have better returns, at least on average. I use the difference between the 10-year yield and the overnight interest rate.

  3. The 1-month change in the 10-year yield. The larger this change the better the statistical return of that currency.

  4. Momentum: I use 6-month raw price momentum.

For each of these 4 basic strategies I compute for each currency a rank number. Low rank numbers predict low, or negative, returns and high rank numbers predict high (positive) returns, at least on a statistical basis. Average rank numbers are computed for 4 combinations of currency strategies. I combine the following strategies:

1. Changes in purchasing power with the term spread strategy

2. Changes in purchasing power with 1-month changes in the 10-year yield

3. Momentum with the term spread strategy

4. Momentum with 1-month changes in the 10-year yield.

From the paper Value and Momentum Everywhere we know the correlation between changes in purchasing power and momentum is low. From this yield-curve paper we know the correlation between the term spread strategy and 1-month changes in the 10-year yield is also low. Therefore it does not make sense to consider other combinations apart from these 4.

Basic currency data

First I will present basic data I have used to make the rankings. In the table below data is presented for each currency from September 22, 2017. The arrow behind the currency symbols shows whether it went up or down compared to last month. The column price is the exchange rate relative to the USD with the USD being the base currency in the currency pair. Currencies are sorted using the term spread, which is the currency strategy with the highest Sharpe ratio. The higher the term spread the lower the statistical return. The column “Changes in purchasing power” is the difference between the left hand side and the right hand side in the second formula of this wiki-article. I compute this difference using 5-year inflation data and the 5-year change in the exchange rate. Positive differences indicate undervaluation relative to the USD while negative differences signal overvaluation.

Ranking

&

Symbol

Price

(USD.XXX)

Term
spread
(%)

Changes in

purchasing

power

1-month

Δ 10Y yield

(%)

6-month

momentum
(%)

1. CZK

22.75↓

2.77

0.17

0.27

-9.05

2. HUF

258.88↓

2.64

0.18

-0.52

-9.52

3. EUR

0.84↑

2.02

0.10

0.07

-9.76

4. SEK

7.95↑

1.84

0.22

0.25

-9.59

5. PLN

3.56↑

1.80

0.15

0.00

-10.02

6. ILS

3.49↑

1.67

-0.03

0.03

-4.38

7. SGD

1.34↑

1.56

0.12

-0.07

-3.91

8. DKK

6.22↑

1.51

0.10

0.04

-9.73

9. HKD

7.81↑

1.48

-0.11

0.04

0.54

10. ZAR

13.19↑

1.40

0.32

-0.10

5.04

11. NOK

7.79↑

1.40

0.28

0.02

-8.04

12. CAD

1.22↑

1.34

0.21

0.20

-8.54

13. CHF

0.97=

1.19

0.10

0.10

-2.05

14. AUD

1.25↑

1.18

0.26

0.12

-3.78

15. GBP

0.74↑

1.10

0.15

0.06

-7.79

16. USD

1.00

1.09

0.00

0.00

0.00

17. KRW

1131.20↓

1.01

0.01

-0.04

1.14

18. NZD

1.36↑

0.85

0.12

0.09

-3.93

19. JPY

112.00↓

0.61

0.37

-0.01

0.82

20. RUB

57.55↑

0.57

0.47

-0.20

-0.57

21. MXN

17.74↑

-2.10

0.22

-0.06

-6.98

Ranks of 4 basic currency strategies

The data from the table above results in the following rankings of the 4 currency strategies. See the table below. The lower the rank number the lower the statistical return. For example, based on changes in purchasing power, the expected return of the Hong Kong dollar is lower than that of the Russian ruble.

Rank

Changes in

purchasing

power

Term
spread

1-month

Δ 10Y yield

6-month

momentum

1

HKD

CZK

HUF

ZAR

2

ILS

HUF

RUB

KRW

3

USD

EUR

ZAR

JPY

4

KRW

SEK

SGD

HKD

5

CHF

PLN

MXN

USD

6

EUR

ILS

KRW

RUB

7

DKK

SGD

JPY

CHF

8

SGD

DKK

USD

AUD

9

NZD

HKD

PLN

SGD

10

PLN

ZAR

NOK

NZD

11

GBP

NOK

ILS

ILS

12

CZK

CAD

DKK

MXN

13

HUF

CHF

HKD

GBP

14

CAD

AUD

GBP

NOK

15

MXN

GBP

EUR

CAD

16

SEK

USD

NZD

CZK

17

AUD

KRW

CHF

HUF

18

NOK

NZD

AUD

SEK

19

ZAR

JPY

CAD

DKK

20

JPY

RUB

SEK

EUR

21

RUB

MXN

CZK

PLN

Ranks of the 4 combined currency strategies

Below are the ranks of each currency in the 4 combination strategies. Behind each currency you will find the average rank of the 2 basic currency strategies. Again the lower the rank number the lower the expected return of a long position. A change I made is the ordering when 2 or more currencies have the same average rank. Then I am looking for a third, mostly uncorrelated signal: either the momentum ranking or the ranking based on changes in purchasing power decides the order of the currencies.

Rank

Changes in

purchasing

power +

Term spread

Changes in

purchasing

power +

1-month

Δ 10Y yield
spread

Momentum

+

Term spread

6-month

momentum

+ 1-month

Δ 10Y yield

1

ILS 4.0

KRW 5.0

ZAR 5.5

ZAR 2.0

2

EUR 4.5

USD 5.5

HKD 6.5

KRW 4.0

3

HKD 5.0

SGD 6.0

SGD 8.0

RUB 4.0

4

CZK 6.5

ILS 6.5

ILS 8.5

JPY 5.0

5

SGD 7.5

HKD 7.0

CZK 8.5

USD 6.5

6

HUF 7.5

HUF 7.0

KRW 9.5

SGD 6.5

7

DKK 7.5

DKK 9.5

HUF 9.5

HKD 8.5

8

PLN 7.5

PLN 9.5

CHF 10.0

MXN 8.5

9

CHF 9.0

MXN 10.0

USD 10.5

HUF 9.0

10

USD 9.5

EUR 10.5

SEK 11.0

ILS 11.0

11

SEK 10.0

ZAR 11.0

AUD 11.0

CHF 12.0

12

KRW 10.5

CHF 11.0

JPY 11.0

NOK 12.0

13

GBP 13.0

RUB 11.5

EUR 11.5

NZD 13.0

14

CAD 13.0

NZD 12.5

NOK 12.5

AUD 13.0

15

NZD 13.5

GBP 12.5

PLN 13.0

GBP 13.5

16

ZAR 14.5

JPY 13.5

RUB 13.0

PLN 15.0

17

NOK 14.5

NOK 14.0

DKK 13.5

DKK 15.5

18

AUD 15.5

CAD 16.5

CAD 13.5

CAD 17.0

19

MXN 18.0

CZK 16.5

NZD 14.0

EUR 17.5

20

JPY 19.5

AUD 17.5

GBP 14.0

CZK 18.5

21

RUB 20.5

SEK 18.0

MXN 16.5

SEK 19.0

As you can see most currencies score bad on at least one of the 4 basic strategies. In other words: in efficient markets there is no such thing as a free lunch.

Statistical shorts

I find the combination of a favorable term spread and undervalued based on 5-year changes in purchasing power the most attractive forex strategy. This is the first column in the table above. It might not be the best strategy but I still prefer it because I think it involves the least trading. Based on this strategy good shorts are the Israeli shekel, the euro and the Hong Kong dollar.

Previous comments from the European central bank about tapering asset purchases might have made markets too optimistic. However we may not be at the point of maximum optimism yet. In the mean time the German election result with more seats for anti-European forces has started to weigh on the euro. Also the US might increase interest rates more and faster than expected.

The Hong Kong dollar is also a good short based on momentum. Many traders are still betting on de-pegging from the USD. As long as the HKD is not at the end of its trading band the Hong Kong Monetary Authority will not intervene.

The Israeli shekel is also a good short based on the 1-month change in the 10-year yield. Last month I made the same observations for the ILS and the HKD but this month the signals are weaker than last month. Both the Hong Kong dollar and the Israeli shekel seem to be less good shorts as last month.

For shorters of the Israeli shekel it is still a waiting game. The currency has not experienced any inflation during the last 5 years. But when oil goes up inflation comes back. Furthermore politicians always overspend during good times.

Last month it looked as if the Danish krone could become a good statistical short. However this situation has reversed and the Danish krone continued to move up with the euro. Both the euro and the Danish krone have shown great momentum. Last month I also wrote the Hungarian forint might be overvalued. This month this became clearer in the rankings, although we are not at maximum optimism yet. Here the rankings do not tell the whole story. Last month the changes in the 10-year interest rates were much smaller than this month. And guess which currency saw the biggest change? The Hungarian forint, predicting lower returns. But traders think the forint will strengthen more. While writing this article the Hungarian central bank adds liquidity to money markets.

Someone who does not follow the news might think the Korean won is a good statistical short. It looks bad based on changes in purchasing power and based on momentum. These signals are largely uncorrelated. And indeed I think the bad momentum in the Korean won has nothing to do with fundamentals reflected in interest rates and changes in purchasing power. I do not think South Korea is going to be bombed by their North Korean brothers. Therefore the momentum will probably reverse, see also here. The weakening of the Japanese yen might also be related to the troubles with North Korea.

How about the North Koreans themselves? How will they cope with the sanctions? What their leaders have in common with certain criminals and investors on Seeking Alpha is they are said to be interested in bitcoins (COIN).

Statistical longs

Based on the combination of changes in purchasing power the most undervalued currencies are the Russian ruble, the Japanese yen, the Mexican peso, and the Australian dollar.

Last month I mentioned the Canadian dollar as a good long. Then the currency had a good run. I took profits and closed my position. For the moment long positions in the loonie are not optimal any more.

A rate cut by the Russian central bank resulted in lower long term interest rates compared to last month. This is a negative for the ruble. The forecast is still a “moderately tight monetary policy.” Despite the rate cut the ruble is still the second best based on term spread.

The Bank of Japan remains committed to achieve its inflation target. A new development is Prime Minister Shinzo Abe calling a snap election. He gave multiple reasons for the snap election. Often this means the real reason is yet another reason. According to the Japan Times Abe sees an opportunity to maximize votes. To get even more votes he will increase spending, delaying fiscal balance. I don’t see how these opportunistic policies are good for the yen.

Scotiabank predicts an upward trend for the Mexican peso, among others based on NAFTA-discussions. After their report was released the peso suffered from an earth quake in southern Mexico. I see this as a temporary setback.

The Australian dollar is attractive based on changes in purchasing power, term spread, and also based on 1-month changes in the 10-year yield. What might hold the currency back is the expectation the Reserve Bank of Australia will not increase rates until 2020. Australian lender Westpac thinks wage increases will be limited and therefore inflation modest. Strategists at Numora and ANZ Bank think however the Reserve Bank will increase interest rates already in 2018. In my previous article the discussion was about the possibility of rate cuts, now about the timing of the first rate increases. I just follow statistics and therefore my bet is bullish.

Relevant ETFs and ETNs:

  • PowerShares DB US Dollar Index Bullish Fund (UUP),

  • UltraShort Euro ETF (EUO),

  • Guggenheim CurrencyShares British Pound Sterling Trust ETF (FXB),

  • UltraShort Yen ETF (YCS),

  • Guggenheim CurrencyShares Euro Trust ETF (FXE),

  • WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU),

  • Guggenheim CurrencyShares Canadian Dollar Trust ETF (FXC),

  • Guggenheim CurrencyShares Australian Dollar Trust ETF (FXA),

  • Guggenheim CurrencyShares Swiss Franc Trust ETF (FXF),

  • PowerShares DB G10 Currency Harvest Fund (DBV),

  • Guggenheim CurrencyShares Japanese Yen Trust ETF (FXY),

  • Double Short Euro Index ETF (DRR),

  • PowerShares DB US Dollar Index Bearish Fund (UDN),

  • Guggenheim CurrencyShares Swedish Krona Trust ETF (FXS),

  • UltraShort Australian Dollar ETF (CROC),

  • Short Euro ETF (EUFX),

  • Ultra Euro ETF (ULE),

  • Ultra Yen ETF (YCL),

  • iPath GBP/USD Exchange Rate ETN (GBB),

  • Guggenheim CurrencyShares Singapore Dollar Trust ETF (FXSG),

  • iPath EUR/USD Exchange Rate ETN (ERO),

  • iPath Optimized Currency Carry ETN (ICI),

  • Double Long Euro ETN (URR),

  • iPath JPY/USD Exchange Rate ETN (JYN),

  • Market Vector’s Russia ETF (RSX).

I do not recommend these products. I only include them such that this article can be syndicated along their ticker symbols.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.