Best Currency Positions For November 2017

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Includes: AYT, BZF, CEW, CNY, CROC, CYB, DBV, DRR, ERO, EUFX, EUO, FXA, FXB, FXC, FXCH, FXE, FXF, FXS, FXSG, FXY, GBB, ICI, INR, JEM, JYN, PGD, UDN, ULE, URR, USDU, UUP, YCL, YCS
by: Ruerd Heeg
Summary

Most currencies declined versus the USD.

Overvalued currencies are the ILS, HKD, PLN CZK and EUR.

Undervalued currencies are the CAD, MXN, JPY and RUB.

I invest based on statistics. For more on investing in statistically undervalued stocks see here. But you can also short overvalued currencies and use the proceeds to buy undervalued currencies. To keep track of currency valuations I publish articles like this one every month. See for example my article from last month and 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 1-year yield. Until last month I used overnight interbank interest rates instead of a 1-year yield but this data is not available anymore.

  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. I have added data for the Brazilian real. In the table below data is presented for each currency from October 24, 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. BRL

3.25↓

2.65

0.31

-0.07

3.77

2. HUF

263.01↓

2.53

0.20

-0.03

-8.34

3. PLN

3.61↓

2.01

0.16

0.05

-7.71

4. ZAR

13.74↓

1.80

0.37

0.39

5.68

5. ILS

3.50↓

1.68

-0.03

0.08

-4.16

6. EUR

0.85↓

1.63

0.12

-0.08

-7.69

7. SEK

8.21↓

1.58

0.26

0.01

-7.49

8. CZK

21.75=

1.26

0.12

0.46

-11.99

9. NOK

7.99↓

1.22

0.32

0.04

-6.74

10. DKK

6.33↓

1.12

0.12

0.02

-7.64

11. NZD

1.45↓

1.12

0.19

-0.01

1.61

12. HKD

7.80↑

0.98

-0.11

0.19

0.32

13. AUD

1.29↓

0.98

0.29

0.00

-2.81

14. GBP

0.76↑

0.89

0.18

0.20

-2.77

15. SGD

1.36↓

0.87

0.14

0.14

-2.20

16. USD

1.00

0.83

0.00

-0.15

0.00

17. CHF

0.99↓

0.73

0.12

0.03

-0.75

18. CAD

1.26↓

0.67

0.26

-0.06

-6.39

19. KRW

1128.2↑

0.65

0.01

0.19

-0.51

20. JPY

113.94↓

0.21

0.38

0.05

3.85

21. MXN

19.16↓

-0.06

0.33

0.46

2.50

22. RUB

57.50↑

-0.16

0.47

-0.01

-0.65

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

BRL

USD

ZAR

2

ILS

HUF

EUR

JPY

3

USD

PLN

BRL

BRL

4

KRW

ZAR

CAD

MXN

5

CZK

ILS

HUF

NZD

6

CHF

EUR

RUB

HKD

7

DKK

SEK

NZD

USD

8

EUR

CZK

AUD

KRW

9

SGD

NOK

SEK

RUB

10

PLN

DKK

DKK

CHF

11

GBP

NZD

CHF

SGD

12

NZD

HKD

NOK

GBP

13

HUF

AUD

JPY

AUD

14

CAD

GBP

PLN

ILS

15

SEK

SGD

ILS

CAD

16

AUD

USD

SGD

NOK

17

BRL

CHF

HKD

SEK

18

NOK

CAD

KRW

DKK

19

MXN

KRW

GBP

EUR

20

ZAR

JPY

ZAR

PLN

21

JPY

MXN

MXN

HUF

22

RUB

RUB

CZK

CZK

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. When 2 or more currencies have the same average rank 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 3.5

USD 2.0

BRL 2.0

BRL 3.0

2

HKD 6.5

EUR 5.0

ZAR 2.5

USD 4.0

3

PLN 6.5

CHF 8.5

NZD 8.0

NZD 6.0

4

CZK 6.5

ILS 8.5

HKD 9.0

JPY 7.5

5

EUR 7.0

DKK 8.5

ILS 9.5

RUB 7.5

6

HUF 7.5

HKD 9.0

JPY 11.0

CAD 9.5

7

DKK 8.5

CAD 9.0

USD 11.5

CHF 10.5

8

BRL 9.0

HUF 9.0

PLN 11.5

EUR 10.5

9

USD 9.5

NZD 9.5

HUF 11.5

AUD 10.5

10

SEK 11.0

BRL 10.0

SEK 12.0

ZAR 10.5

11

NZD 11.5

KRW 11.0

EUR 12.5

HKD 11.5

12

KRW 11.5

AUD 12.0

NOK 12.5

MXN 12.5

13

CHF 11.5

SEK 12.0

MXN 12.5

KRW 13.0

14

ZAR 12.0

PLN 12.0

SGD 13.0

HUF 13.0

15

SGD 12.0

SGD 12.5

GBP 13.0

SEK 13.0

16

GBP 12.5

CZK 13.5

AUD 13.0

SGD 13.5

17

NOK 13.5

RUB 14.0

KRW 13.5

DKK 14.0

18

AUD 14.5

GBP 15.0

CHF 13.5

NOK 14.0

19

CAD 16.0

NOK 15.0

DKK 14.0

ILS 14.5

20

MXN 20.0

JPY 17.0

CZK 15.0

GBP 15.5

21

JPY 20.5

ZAR 20.0

RUB 15.5

PLN 17.0

22

RUB 22.0

MXN 20.0

CAD 16.5

CZK 22.0

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. I think this strategy generates the highest returns, in the long run. I also prefer it because I think it involves the least trading. As with any other investment strategy it does not always work though. Based on this strategy good shorts could be the Israeli shekel, the euro and the Hong Kong dollar, and the 3 East European currencies PLN, CZK and HUF.

In previous articles I was pessimistic about the Hong Kong dollar, but this article describes the benefits of holding the HKD instead of the USD.

The Polish zloty is the second overvalued currency after the Israeli shekel. Unfortunately I could not find significant new developments since last month.

Poland and Hungary already have a populist government. The Czech Republic will have one once Babiš has formed a coalition. Though the Czech Republic is not in the euro his election is a drawback for the European Union and hence not good news for the euro. There is certainly much uncertainty about Czech politics which is not good for the Czech koruna. In the mean time the Czech economy is doing fine but that seems to be fully reflected in the Czech koruna. Because the Czech economy is doing so well an interest rate hike is not unlikely.

Another challenge for the euro is the upcoming decision on tapering and how to communicate it to the markets. The consensus seems asset purchases could be halved from January 2018 and a new and yet unknown policy will start from October 2018. Depending on the economy the European Central Bank will increase asset purchases again in October 2018 or end them. An announcement telling us asset purchases will end sooner than October 2018 will be a surprise and therefore strengthen the euro and probably also the 3 other currencies.

Also the Hungarian economy is doing fine, but inflation is not expected to go up much. Therefore, unlike for the Czech koruna, an interest rate cut seems to be more likely for the Hungarian forint than a hike.

The Israeli shekel has stayed at a high level. Still, this economy resembles economies in developing countries. About a third of Israel’s economy works without receipts. In the same article there is also a good example of the Israeli government spending without funding. During the last 5 years there was hardly any inflation in Israel. These are signs this is changing although it is still too early to tell. For the moment the inflation is still way too low to justify a rate hike.

Statistical longs

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

Last month I mentioned the Australian dollar as a good long. Due to a better term spread the Canadian dollar is now a slightly better statistical long bet. Lower than expected inflation should have strengthened the Australian dollar but instead the currency further dropped.

The Russian Finance Ministry published its long term exchange rate expectation for the Russian ruble. The ruble will gradually depreciate to 82.5 per USD in 2031-2035. The decay will be driven by the inflation difference between the US and Russia. In the mean time I expect holders of the ruble to be compensated via the interest rate difference. Short term I still expect higher oil prices to cause the ruble to go up. For example Saudi Arabia is working to get oil prices higher again. See also this overview of the importance of crude for the ruble, the Canadian dollar, the Norwegian krone and Latin America.

To increase trade and reduce settlement risks China has established a payment system between the yuan and the ruble. In another attempt to de-dollarize the Moscow Exchange plans to start trading the Turkish lira and the Japanese yen in 2018. At the same time Russia tries to reduce Bitcoin. It might become the third country banning Bitcoins, after Bolivia and Ecuador.

The Canadian dollar is at a 2-months low because traders expect interest rates will not continue to increase, as a result of worse than expected economic data. See here for more details. This pause could be interpreted as a policy change after 2 consecutive rate increases. Investors also expect John Taylor as the new head of the Fed and, if so, expect him to be more hawkish than the Bank of Canada.

The Mexican peso went down much since last month. Like the Canadian dollar the peso is sensitive to a more hawkish policy from a new head of the US Fed. Also the peso is under pressure due to increased uncertainty about a new NAFTA agreement. See here and here for details.

Japanese Prime Minister Shinzo Abe got a landslide victory from his snap election. He might even have secured a 2/3 “super-majority”. What does this mean for the Japanese yen? The government debt is a huge problem for Japan. As I wrote last month, I expect him to continue spending, for example on the military. So this is not good for the Japanese yen. When I had that perspective last month I should have acted on it. Now the negative consequences of the election have been fully priced into the yen.

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.