As you know, every week, Splendid Exchange looks at seven major currency pairs in search of the evidence of popular delusions and the madness of crowds. The idea is to find anomalies and bullish or bearish divergences that will break the trend, not prolong it. It is a painful exercise, but also highly rewarding.
In order to find the most overbought and oversold currency, I conduct four econometric studies: over-extension analysis, secular performance analysis, oil correlation and economic divergence. Additionally, I look at traders' positioning to understand the psychological state of the market.
Analyzed currency pairs: AUD/USD, EUR/USD, GPB/USD, NZD/USD, USD/CAD, USD/CHF and USD/JPY
Click here for studies' description.
In this week's report, I decided to supplement my standard analysis with two additional indicators: effective exchange rate and monetary sentiment.
I will not go through the results of each of the studies, but instead illustrate the final ranking. If you want to see the individual results of each of the studies, scroll down to the charts section below.
I have ranked the currencies on the scale of -2.5 to +3.5 for each of the studies, where -2.5 indicates oversold conditions and +3.5 indicates overbought conditions. Therefore, the overall minimum score that any currency can have is -12.5, while the maximum is +17.5.
Source: Personal calculations; ranking as of March 11, 2018
On balance, Japanese yen appears to be the most overrated currency among the majors with a total net result of 8.5 (see the chart above). However, the euro is not far behind, with 7.5 points, followed by British pound with 5.5 points. However, all three currencies are relatively "expensive" for different reasons.
Japanese yen overvaluation is primary driven by the results of two econometric studies: secular performance study, which compares currency's performance against the price of gold and economic divergence study, which examines the link between a country's bond yields and the exchange rate of its currency. Conversely, the euro appears "overvalued" because its exchange rate has departed from the traditional correlation with oil prices (oil correlation study) and also for purely technical reasons (over-extension study), which can easily moderate with time. In terms of positioning, however, both currencies are on the opposite sides: Japanese yen is the most oversold currency with 163K net-short contracts outstanding in the futures market, while the euro is the most overbought currency with 306K net-long contracts outstanding in the futures market.
Overall, the ranking picture is quite mixed. If you are a contrarian investor, you will want to short the most overvalued currency against the most undervalued currency. However, at this point in time, there are no clear leaders and no obvious laggards.
That is why I decided to refine the results by applying two additional indicators: effective exchange rate and monetary sentiment.
Effective Exchange Rate
Effective exchange rate (EER) equals nominal exchange rate (calculated as geometric weighted averages of bilateral exchange rates) adjusted for relative consumer prices. The most recent weights are based on trade in the 2011-13 period, with 2010 as the indices' base year. As you can see from the chart below, Swiss franc has appreciated the most among its peers, while Canadian dollar is lagging behind. The Japanese yen's EER is actually still below its 2010 level. Conversely, the euro's EER is already at 4-year high, very close to a previous peak level set in 2014.
Source: Central banks official websites
The majority of central banks around the world pursue an inflation targeting approach to monetary policy. As a rule, an inflation-targeting central bank will raise or lower interest rates based on above-target or below-target inflation, respectively. Therefore, it is important to understand where a country's inflation rate stands in relation to that country's inflation target. By subtracting the inflation target from the latest inflation rate, we can get a rough idea on central banks' "monetary sentiment". The chart below illustrates the latest results.
Source: Official statistics (publicly-available reports, government websites, central banks, statistical bureaus), personal calculations
As you can see, United Kingdom is the only country (among the developed nations), where inflation target has been breached. Unsurprisingly, the Bank of England ((BoE)) is on the hawkish course. Conversely, both the euro and the Japanese yen still have some margin of safety when it comes to maintaining price stability and therefore, they can afford to remain dovish for now.
Econometric Studies (Charts Section)
The most overextended currency is the euro. As of this Monday, it was trading at almost 91% of its 3-year range. The most lagging currency is the British pound, trading at only 47% of its 3-year range.
Sources: personal calculations
Based on the 12-month running secular performance observations, I have calculated that US dollar is currently undervalued by an average of 3.0% against seven majors. However, as of this Monday, it was most undervalued against the Japanese yen (4.40%) and British pound (3.80%). In other words, USD/JPY is the most undervalued currency pair based on secular performance analysis.
Sources: FXCM, forexlive (website), personal calculations
Based on the 12-month running oil price standard correlations, I have calculated that the euro is overvalued by 6.0%, while Japanese yen is overvalued by 4.20%. Canadian dollar is undervalued by 0.05%.
Sources: FXCM, forexlive (website), personal calculations
Based on the 12-month running 2-year bond spreads correlations, I have calculated that Japanese yen is the most overvalued currency among the majors (3.05%), followed by Canadian dollar (2.95%) and British pound (1.97%). The euro is actually undervalued, but only by 0.70%.
Sources: FXCM, forexlive (website), investing (website), personal calculations
On a 3-year percentile basis, the most overbought currency is the Euro (commercial and non-commercial players have accumulated 306K net-long contracts in EUR futures, which is just 2% below a three-year maximum). By the same measure, British pound is currently the 2nd most overbought currency among the majors. Japanese yen is the least overbought currency in terms of traders' positioning as there are just 163K net-short contracts outstanding in JPY futures.
Sources: CFTC, personal calculations.
The most "contrarian trade" based on the recent studies would be to short the Euro against Australian dollar (EUR/AUD). However, as I said in one of my recent articles, I am not a big fan of Australian dollar. Still, as I explained in this article, I do like the idea of shorting the euro. So if I were to pick the most "contrarian trade", I would go for EUR/CAD short. Canadian dollar is just slightly less undervalued than the Australian dollar. Furthermore, EUR/CAD is approaching strong resistance levels near 1.6100 and is about to set a double-top on the daily chart and a triple-top on a monthly chart.
So, if you are a contrarian, I would advise to start looking for opportunities to short EUR/CAD. But, of course, this trade requires a separate analysis, which I hope to cover in my next article. Stay tuned.
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.