Best Currency Positions For May 2018

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Includes: FXE, JEW-USD, PSB-USD, RUBIT-USD, UDN, UUP
by: Ruerd Heeg

Summary

I have ranked 26 currencies according to four measures and I combined these rankings into four combined measures.

Good shorts are the Israeli shekel and the euro. Good longs are the Mexican peso, the Russian ruble and the Japanese yen.

Combine tables with news and momentum to determine maximum pessimism for long positions and maximum optimism for short positions.

I invest based on statistics. For more on investing in statistically undervalued stocks, see this freely accessible article. 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.

In my qualitative discussion of longs and shorts, I will focus on currencies that can directly be traded with Interactive Brokers. Among the currencies in my quantitative analysis the Turkish lira, the Indian rupee, the Indonesian rupiah and the Brazilian real cannot be traded with Interactive Brokers.

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.

  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.

The strategies in these combinations have low correlations. For example, 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. We should not combine correlated strategies. 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 April 19, 2018. 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

3.397

3.29

0.36

0.05

-6.18

2. HUF

251.24

2.44

0.15

-0.12

3.98

3. PLN

3.374

1.74

0.11

-0.33

6.51

4. ILS

3.522

1.60

0.02

0.01

-0.86

5. EUR

0.809

1.54

0.10

-0.10

4.84

6. ZAR

11.957

1.44

0.07

-0.05

14.44

7. SEK

8.400

1.42

0.32

-0.05

-2.77

8. IDR

13732

1.19

0.19

0.01

-1.33

9. NOK

7.774

1.17

0.30

-0.04

2.72

10. DKK

6.031

1.16

0.11

-0.06

4.72

11. CZK

20.515

1.10

0.07

-0.23

6.51

12. NZD

1.373

1.05

0.14

0.01

4.49

13. SGD

1.310

0.92

0.12

0.05

3.85

14. AUD

1.290

0.81

0.26

0.08

-0.89

15. CHF

0.970

0.80

0.11

0.02

1.41

16. KRW

1065.2

0.77

-0.02

-0.05

6.29

17. GBP

0.705

0.73

0.10

-0.06

7.51

18. USD

1.000

0.71

0.00

0.02

0.00

19. INR

65.831

0.69

-0.04

0.03

-1.23

20. HKD

7.848

0.69

-0.06

0.14

-0.57

21. CAD

1.263

0.66

0.24

0.09

-0.25

22. CNY

6.279

0.54

-0.00

-0.26

5.46

23. RUB

60.97

0.33

0.60

0.28

-5.63

24. JPY

107.33

0.19

0.17

0.02

5.67

25. MXN

18.309

-0.13

0.30

-0.12

3.73

26. TRY

4.036

-1.25

0.75

0.09

-9.00

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 Turkish lira.

Rank

Changes in

purchasing

power

Term
spread

1-month

Δ 10Y yield

6-month

momentum

1

HKD

BRL

PLN

TRY

2

INR

HUF

CNY

BRL

3

KRW

PLN

CZK

RUB

4

CNY

ILS

HUF

SEK

5

USD

EUR

MXN

IDR

6

ILS

ZAR

EUR

INR

7

ZAR

SEK

DKK

AUD

8

CZK

IDR

GBP

ILS

9

EUR

NOK

ZAR

HKD

10

GBP

DKK

KRW

CAD

11

DKK

CZK

SEK

USD

12

PLN

NZD

NOK

CHF

13

CHF

SGD

IDR

NOK

14

SGD

AUD

ILS

MXN

15

NZD

CHF

NZD

SGD

16

HUF

KRW

USD

HUF

17

JPY

GBP

CHF

NZD

18

IDR

USD

JPY

DKK

19

CAD

INR

INR

EUR

20

AUD

HKD

BRL

CNY

21

NOK

CAD

SGD

JPY

22

MXN

CNY

AUD

KRW

23

SEK

RUB

CAD

CZK

24

BRL

JPY

TRY

PLN

25

RUB

MXN

HKD

GBP

26

TRY

TRY

RUB

ZAR

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.

Also be aware that these are very simple models. Other, more sophisticated, models can result in totally different predictions.

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. Before computing the average, I have normalized the 4 individual ranks to numbers between 0 and 1. Hence the averages are also between 0 and 1. Again the lower the rank number, the lower the expected return of a long position.

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

0.16

CNY

0.08

BRL

0.02

SEK

0.26

2

ZAR

0.22

CZK

0.18

SEK

0.18

IDR

0.32

3

EUR

0.24

PLN

0.22

ILS

0.20

MXN

0.34

4

PLN

0.26

KRW

0.22

IDR

0.22

HUF

0.36

5

HUF

0.32

EUR

0.26

HUF

0.32

BRL

0.40

6

KRW

0.34

ZAR

0.28

AUD

0.38

ILS

0.40

7

CZK

0.34

DKK

0.32

NOK

0.40

CNY

0.40

8

DKK

0.38

GBP

0.32

EUR

0.44

EUR

0.46

9

INR

0.38

HUF

0.36

INR

0.46

NOK

0.46

10

HKD

0.38

ILS

0.36

RUB

0.48

INR

0.46

11

USD

0.42

USD

0.38

PLN

0.50

PLN

0.46

12

BRL

0.46

INR

0.38

CHF

0.50

DKK

0.46

13

CNY

0.48

HKD

0.48

TRY

0.50

TRY

0.46

14

IDR

0.48

MXN

0.50

DKK

0.52

CZK

0.48

15

NZD

0.50

NZD

0.56

SGD

0.52

USD

0.50

16

SGD

0.50

CHF

0.56

NZD

0.54

AUD

0.54

17

GBP

0.50

IDR

0.58

USD

0.54

CHF

0.54

18

CHF

0.52

NOK

0.62

HKD

0.54

RUB

0.54

19

SEK

0.56

SEK

0.64

CAD

0.58

KRW

0.60

20

NOK

0.56

SGD

0.66

ZAR

0.60

NZD

0.60

21

AUD

0.64

JPY

0.66

CZK

0.64

GBP

0.62

22

CAD

0.76

AUD

0.80

KRW

0.72

CAD

0.62

23

JPY

0.78

CAD

0.80

MXN

0.74

HKD

0.64

24

MXN

0.90

BRL

0.84

GBP

0.80

ZAR

0.66

25

RUB

0.92

TRY

0.96

CNY

0.80

SGD

0.68

26

TRY

1.00

RUB

0.98

JPY

0.86

JPY

0.74

How to use these tables

I think the best way to use the information in the tables is to combine them with the principles of maximum pessimism for the longs and maximum optimism for the shorts. By itself the returns from these strategies are low, as can be expected from just holding cash. However, sudden changes in currency prices, like we just saw with the Russian ruble, can be profitable opportunities. Especially so in combination with already heavy under- and overvaluations according to the second and the third table.

The Russian ruble was already one of the most undervalued currencies with positive fundamentals such as a rising oil price, and inflation well under control. If there is a sudden 5% slide because of a rather ineffective attack on Syria by the US what can be expected? I think a quick reversion is the most likely scenario. Not everyone agrees with me: see here. However, I get much comfort from a great article from Paulo Santos: one of the sharpest minds of Seeking Alpha. Also Credit Agricole expects the ruble to revert and says the recent fall of the ruble is not backed by fundamentals.

Other recent examples of maximum optimism and pessimism were (in hindsight): the rise of the USD after Trump got elected, the fall of the Mexican peso after Trump got elected, the fall of currencies of oil exporting countries with oil and the South African rand because of corruption scandals involving the former president.

Stock indices usually take much longer to go up than to come down. I think something similar is true for currencies. Therefore, to determine maximum optimism, I suggest watching momentum. Overvaluation based on 5-year changes in purchasing power combined with worsening momentum may suggest maximum optimism.

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 second 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, and the euro.

The South African rand could be a good short as well but with 1-year interest rate at about 8% shorting it is probably sub-optimal. The Commerzbank thinks we are at maximum optimism with the rand. New reforms could still increase optimism but are unlikely to happen soon. The new South African president has implemented some reforms already but more reforms will take time. In the mean time, I think the central bank of South Africa would like to decrease interest rates and the American Fed still intends to increase interest rates. That won’t be good for the strength of the rand.

The governor of the Israeli central bank thinks the strong Israeli shekel reflects the good state of the economy. She warns a trade war between the US and China would be bad for Israel. Indeed as a small open economy, Israel profits more from free trade than many other countries. Also since foreign relations with many countries are not so good dependency of the US economy is high. See here.

Inflation stays low in Israel and the bank of Israel won’t increase inflation any time soon. So the spread with US interest rates will widen. See here. That won't be good for the shekel either.

Momentum is also clearly worsening for the shekel and therefore I think we are already past the point of maximum optimism.

Like the South African rand and the Israeli shekel, the euro could be affected by raising interests rates in the US as well. At the moment, the European bank still issues billions of new euros by buying assets like bonds. The first step is that this quantitative easing ends. The question is only when. North European countries would like to see this happen as soon as possible. Unfortunately, ending quantitative easing would lead to higher interest rates in South Europe, making the debts of these countries unmanageable again. It is difficult to predict who will win this battle: North or South Europe.

Diverging economic growth between the US and Europe could also depress the euro. See the Danske Bank here. This bank also notes a move from US equities to European equities could be good for the euro.

With so many pros and cons and still quite good 6 months' momentum, I do not think we are at maximum optimism yet.

Statistical longs

Based on the combination of changes in purchasing power and the term spread the most undervalued currencies are the Mexican peso, the Russian ruble, and the Japanese yen. The Turkish lira is also a good long but this article focuses on currencies that can be traded via Interactive Brokers. For a discussion of the Russian ruble see above.

Traditionally the Japanese yen is a safe haven asset. Investors buy yens in times of political tensions such as the recent intervention in Syria. However, the yen did not appreciate this time. Just as for the shekel a trade war between the US and China would be bad for the yen. That suggests we are at maximum pessimism.

Last month I saw several messages calling for 100 yen for 1 USD: here and tweets from another sharp mind on Seeking Alpha: Keubiko. The idea is inflation will increase causing the Bank of Japan to end its massive monetary stimulus. Indeed latest data shows inflation is increasing.

The other side of the medal is comparable with the euro. Like South Europe, the Japanese government has massive debts. These debts are only manageable when interest rates are low. To keep interests rates low, the Bank of Japan buys government bonds and other assets. The problem is markets and the government get used to this practice. In particular most economies and governments adapt easier to higher interest rates than to lower interest rates. That makes the Bank of Japan and the European bank a hostage of spending by their governments. See also here.

The Mexican peso is still under pressure not only because of NAFTA (as in the previous months) but also because of the upcoming presidential elections. The leftish candidate will likely win. He wants to rollback foreign participation in oil production and he also wants to increase social security spending. The Mexican state has not been a very efficient oil producer. In an attempt to produce more oil, it has allowed more foreign investments in Mexican oil. Reversing this, curbing foreign investments in Mexican oil, will not be good for exports.

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.