Currency Positions For August 2018

by: Ruerd Heeg
Summary

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

Relative valuations in terms of a combination of changes in purchasing power and term spread have not changed much for the best shorts and longs.

According to statistics good shorts are the Israeli shekel and the Czech koruna. Good longs are the Mexican peso and the Canadian dollar.

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 July 21, 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]

Termspread(%)

Changes in

purchasing

power

1-month

Δ 10Y yield

(%)

6-month

momentum(%)

1. BRL

3.779

3.50

0.49

-1.16

-15.24

2. HUF

286.630

2.87

0.31

-0.18

-11.93

3. ZAR

13.431

2.69

0.18

-0.18

-9.98

4. PLN

3.687

1.76

0.22

0.00

-7.82

5. ILS

3.605

1.74

0.07

-0.02

-5.26

6. CZK

22.045

1.38

0.15

-0.13

-6.05

7. EUR

0.854

1.31

0.17

-0.04

-4.37

8. SEK

8.868

1.15

0.39

-0.03

-9.42

9. NZD

1.470

1.02

0.23

-0.15

-6.99

10. IDR

14442.000

0.99

0.20

0.38

-7.24

11. NOK

8.188

0.97

0.34

-0.09

-3.95

12. RUB

63.457

0.87

0.67

0.05

-10.80

13. DKK

6.336

0.84

0.17

-0.04

-4.21

14. KRW

1129.000

0.73

0.04

-0.09

-5.20

15. CHF

0.994

0.70

0.15

-0.02

-3.21

16. AUD

1.349

0.67

0.28

0.00

-7.46

17. SGD

1.364

0.64

0.14

-0.15

-3.25

18. INR

68.770

0.57

0.00

-0.01

-7.10

19. HKD

7.851

0.50

-0.04

-0.15

-0.41

20. USD

1.000

0.50

0.00

-0.03

0.00

21. GBP

0.763

0.50

0.19

-0.07

-6.01

22. CNY

6.774

0.43

0.09

-0.10

-5.45

23. CAD

1.314

0.38

0.27

0.03

-5.20

24. JPY

111.750

0.16

0.17

0.00

-0.72

25. MXN

19.038

-0.45

0.36

-0.11

-1.82

26. TRY

4.789

-2.68

1.02

0.51

-20.99

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

Termspread

1-month

Δ 10Y yield

6-month

momentum

1

HKD

BRL

BRL

TRY

2

USD

HUF

HUF

BRL

3

INR

ZAR

ZAR

HUF

4

KRW

PLN

NZD

RUB

5

ILS

ILS

HKD

ZAR

6

CNY

CZK

SGD

SEK

7

SGD

EUR

CZK

PLN

8

CZK

SEK

MXN

AUD

9

CHF

NZD

CNY

IDR

10

EUR

IDR

NOK

INR

11

DKK

NOK

KRW

NZD

12

JPY

RUB

GBP

CZK

13

ZAR

DKK

DKK

GBP

14

GBP

KRW

EUR

CNY

15

IDR

CHF

USD

ILS

16

PLN

AUD

SEK

CAD

17

NZD

SGD

CHF

KRW

18

CAD

INR

ILS

EUR

19

AUD

HKD

INR

DKK

20

HUF

USD

PLN

NOK

21

NOK

GBP

AUD

SGD

22

MXN

CNY

JPY

CHF

23

SEK

CAD

CAD

MXN

24

BRL

JPY

RUB

JPY

25

RUB

MXN

IDR

HKD

26

TRY

TRY

TRY

USD

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 yieldspread

Momentum

+

Term spread

6-month

momentum

+ 1-month

Δ 10Y yield

1

ILS

0.16

HKD

0.08

BRL

0.02

BRL

0.02

2

CZK

0.24

SGD

0.22

HUF

0.06

HUF

0.06

3

ZAR

0.28

CZK

0.26

ZAR

0.12

ZAR

0.12

4

EUR

0.30

KRW

0.26

PLN

0.18

NZD

0.26

5

KRW

0.32

CNY

0.26

SEK

0.24

CZK

0.34

6

PLN

0.36

ZAR

0.28

RUB

0.28

SEK

0.40

7

HKD

0.36

USD

0.30

CZK

0.32

CNY

0.42

8

INR

0.38

NZD

0.38

IDR

0.34

GBP

0.46

9

HUF

0.40

INR

0.40

NZD

0.36

PLN

0.50

10

USD

0.40

HUF

0.40

ILS

0.36

SGD

0.50

11

DKK

0.44

ILS

0.42

AUD

0.44

TRY

0.50

12

SGD

0.44

EUR

0.44

EUR

0.46

RUB

0.52

13

CHF

0.44

DKK

0.44

TRY

0.50

KRW

0.52

14

BRL

0.46

BRL

0.46

INR

0.52

AUD

0.54

15

IDR

0.46

CHF

0.48

NOK

0.58

INR

0.54

16

NZD

0.48

GBP

0.48

KRW

0.58

HKD

0.56

17

CNY

0.52

MXN

0.56

DKK

0.60

NOK

0.56

18

SEK

0.58

NOK

0.58

GBP

0.64

MXN

0.58

19

NOK

0.60

JPY

0.64

CNY

0.68

DKK

0.60

20

AUD

0.66

PLN

0.68

CHF

0.70

EUR

0.60

21

GBP

0.66

SEK

0.74

SGD

0.72

ILS

0.62

22

JPY

0.68

IDR

0.76

CAD

0.74

IDR

0.64

23

RUB

0.70

AUD

0.76

HKD

0.84

CHF

0.74

24

CAD

0.78

CAD

0.78

USD

0.88

CAD

0.74

25

MXN

0.90

RUB

0.94

MXN

0.92

USD

0.78

26

TRY

1.00

TRY

1.00

JPY

0.92

JPY

0.88

How to use the 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 can be profitable opportunities. Especially so in combination with already heavy under- and overvaluations according to the second and the third table. See this article for examples and more explanation.

Important currency news

The valuation of most currencies is tied to news and developments for the most important currencies: the euro and the USD. Therefore I will discuss the most important news for these currencies before going into the details of the 2 longs and shorts of the month.

First a reduction in political uncertainty in Germany strengthened the euro. Then the euro appreciated because of a rumor that the European Central Bank might increase interest rates already in July 2019 instead of a couple of months later. Also the euro and other currencies like the Japanese yen went up because Trump said a lower USD would be better for the US economy. See also here. Before these remarks the USD was up because of remarks of the Fed chairman about the strength of the US economy. He also downplayed fears of a serious trade war. BTW, I agree with many traders that a policy change from the Bank of Japan will be necessary to more permanently lift the yen.

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 Czech koruna.

The Israeli shekel appreciated a bit compared to last month. New reports confirm inflation is increasing in Israel. It is possible though the Bank of Israel also increases the interest rate. See here. Otherwise there is not much news. With this new alleged racist “nation state law” also changing the status of Jeruzalem I think the country is further isolating itself. For a small country with a relatively open economy that cannot be good, at least not on the long term. See also here.

After my previous article the Czech National Bank indeed followed the interest rate hike in the US, as expected. ING Bank expects at least one more interest rate hike before the end of the year. I agree that would be necessary to maintain the Czech koruna at its current level. But especially with its overvaluation there may be circumstances that Czech policy makers prefer a lower currency instead. The Czech National Bank wants to normalize interest rates but says further steps are highly dependent on new fundamental data.

Statistical longs

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

The Turkish lira is also a good long but this article focuses on currencies that can be traded via Interactive Brokers. Though I do not follow the lira closely I have still some remarks. It seems the Turkish president is now focusing on the economy again. Before he played games with other countries like The Netherlands as part of his strategy to get certain proposals approved in Turkey. As a consequence of these approvals he got much more powerful and can afford focusing on the economy again. One of the first steps in that direction has already been taken: normalizing the relations between Turkey and The Netherlands. They agree to disagree.

The Canadian dollar appreciated since my previous article. Still it is one of the cheapest currencies. One of the reasons for it is a better than expected economy. Inflation in Canada is increasing making an extra interest rate more likely. In the mean time other headwinds such as US trade risks may fade, see here.

When would Trump close a new Nafta deal? We don’t know. But at a certain point I suppose this self created uncertainty will start to work against him. That could be after mid-term elections. After all China and the EU seem to respond using the tit-for-tat principle. This will costs American jobs, especially short term and among his voters, while results from better trade deals are uncertain and only play out in the long run. BTW, Canada also seems to have plans for a tit-for-tat response. It is even planning to build a pipeline to deliver its oil easier to China instead of the US.

For the Mexican peso the situation is similar compared to the Canadian dollar. The lack of a new trade agreement puts pressure on the peso. But also leftish AMLO was elected. I read he was only elected because he has moved much to the center. He voted the majority. After his election traders might have realized this and the peso rose much. The analyst who predicted this post-election rally sees more gains.

The Trump administration is thinking about separate trade agreements with Canada and Mexico. It may close such a deal first with Mexico and then with Canada.

Since last month the oil price did not change much. Still I expect the oil price to increase again, which will be good for the Canadian dollar, the Mexican peso but also for the Russian ruble.

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.