April 9 Forex Weekly: Ranking Major Currency Pairs - A Contrarian Overview

Summary

• Answering two simple questions - which currency is the most overvalued and which one is the most undervalued?
• Turkish Lira and Brazilian real are two most undervalued currencies among the emerging economies, while Czech koruna and South African rand are the most overvalued ones;
• Among the majors, British pounds is now the most overvalued currency, followed by the Japanese yen and the euro;
• I haveclosed my EUR/CAD short (390 pips of profit) and will now consider shorting GBP.

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.

Relevant ETFs (most popular): CROC, ERO, EUFX, FXA, FXB, FXC, FXE, FXF, FXY and GBB.

Click here for studies' description.

Latest Results

Recently, I decided to expand the coverage of currencies. The main focus is still on the majors, but I will also briefly look at 18 other currencies.

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 -11.5 to +12.5 for each of the studies, where -11.5 indicates oversold conditions and +12.5 indicates overbought conditions. Therefore, the overall minimum score that any currency can have is -46.0, while the maximum is +50.0.

Source: Personal calculations; ranking as of March 23, 2018

On balance, Czech koruna appears to be the most overrated currency with the total net score of 34 (see the chart above). However, South African rand and the Japanese yen are not far behind, with 26 points each, followed by Chinese renminbi and Norwegian krone with 23 and 22 net points, respectively. British pound also stands out among overvalued currencies with 21 net points.

The most "underrated" or undervalued currencies are the Turkish lira and the Brazilian real with a total net score of -40 each. These two currencies are far behind their counterparts. The next closest currency in terms of undervaluation is Israeli new shekel with only -22 net point.

Judging by the results of four econometric studies, the most contrarian trade is to buy Turkish lira or Brazilian real against Czech koruna or the British pound. Indeed, over the last two years, the lira has already lost 28% of its values against GBP and has depreciated by almost 40% against CZK (see the charts below). Concurrently, the decline in Brazilian real has been less severe.

Source: investing (website)

Source: investing (website)

Is it risky to go long TRY and BRL against GBP and CZK? Absolutely, and not only because it is a contrarian trade, but also because these currencies are exotic. I am not recommending these trades and I am not going to comment on their fundamentals. I am just saying that statistically, these are two most contrarian trades among 25 currencies that I analyze.

When looking at the major currencies, we see that the picture has not changed quite noticeably since the previous update. British pound is now the most overrated currency among the majors, followed by Japanese yen and the euro. However, just as previously, all three currencies are relatively "expensive" for different reasons.

Source: Personal calculations; ranking as of April 6, 2018

Japanese yen overvaluation is broad-based (the results are above zero for all four econometric studies + positioning analysis – see the chart above), but relatively weak. By contrast, the British pound scores highest marks, but not in all studies – specifically, GBP appears relatively undervalued in the over-extension study. Similarly, the euro is relatively undervalued in the economic divergence study, as its exchange rate has departed from the traditional correlation with the short-term bond yields. In absolute terms, however, the British pound is currently the most “expensive” currency based on:

• secular performance study (which compares a currency's performance against the price of gold);
• oil correlation study (which examines the link between a country’s exchange rate and the price of oil);
• economic divergence study (which looks at the relationship between a country’s exchange rate and its short-term bond yields);
• positioning analysis (which explores sentiment extremes based on CFTC COT reports).

The overall ranking picture is still 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

Monetary Sentiment

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, the United Kingdom and Canada are the only two countries (among the developed nations), where inflation target has been breached. Unsurprisingly, the Bank of England (BoE) is on the hawkish course, while the bank of Canada (BoC) may turn more hawkish in the months ahead. 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)

Over-extension Analysis

The most overextended currency is the euro. As of last Friday, it was trading at 89% of its 3-year range. The most lagging currency is the British pound, trading at only 53% of its 3-year range.

Sources: FXCM, forexlive (website), personal calculations

Secular Performance

Based on the 12-month running secular performance observations, I have calculated that US dollar is currently undervalued by an average of 2.50% against seven majors. However, as of last Friday, it was most undervalued against the British pound (4.00%) and the Japanese yen (3.70%). In other words, GBP/USD is the most undervalued currency pair based on secular performance analysis.

Sources: FXCM, forexlive (website), personal calculations

Oil Correlation

Based on the 12-month running oil price standard correlations, I have calculated that the British pound is overvalued by almost 3.00%, while the Japanese is overvalued by around 2.90%. Australian dollar is undervalued by 1.10%.

Sources: FXCM, forexlive (website), personal calculations

Economic Divergence

Based on the 12-month running 2-year bond spreads correlations, I have calculated that the British pound is the most overvalued currency among the majors (3.20%), followed by Canadian dollar (3.20%) and Japanese yen (1.70%). The euro is actually undervalued, but only by 1.20%.

Sources: FXCM, forexlive (website), personal calculations

Positioning

On a 3-year percentile basis, the most overbought currency is the British pound (commercial and non-commercial players have accumulated 94.8K of net-long contracts in GBP futures, which is 6.0% above a three-year maximum). By the same measure, the euro is currently the 2nd most overbought currency among the majors. Conversely, the Canadian dollar is the most oversold currency in terms of traders' positioning as there are 65.0K of net-short contracts outstanding in CAD futures (74% below a three-year maximum).

Sources: CFTC, personal calculations.

Conclusion

The most "contrarian trade" based on the recent studies among the majors would be to short the British pound against the Australian dollar (i.e., go long AUD/GBP). In one of my previous articles, I said that I am not a big fan of the Australian dollar, but the currency has already retreated from previously overbought levels and has NOW stabilized. So, I am not excluding the AUD/GBP long from the list of potential trades. However, I would also advise to consider going long AUD/JPY base on the result from econometric studies.

As for the euro, I have now closed my EUR/CAD short at 1.5640, as planned (see this article), for the profit of 390 pips (2.43%).

Still, I continue to believe that Canadian dollar is a buy and will elaborate on it in my future articles.

Analyst’s 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.