October 28, 2018: Forex Weekly - Relative Valuation And Trading Opportunities

|
Includes: CROC, DAUD, DCHF, DGBP, DJPY, FXA, FXB, FXC, FXF, FXY, GBB, JYN, UAUD, UCHF, UDN, UGBP, UJPY, USDU, UUP, YCL, YCS
by: Splendid Exchange

Summary

The most important themes impacting global foreign exchange market right now are: U.S. earnings season and the prospect of a major trade war between Washington and Beijing.

Canadian dollar appears to be the most overrated currency both among 25 global currencies and among the "seven majors".

Australian dollar and New Zealand dollar look "undervalued".

I see at least five trading opportunities based on the latest relative valuation analysis.

Broadly speaking, I am bullish on AUD and NZD and bearish on CAD and JPY.

As you know, once in a while, 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.

Macro Forces

Before revealing the results, let me first say a few words about the current global market environment. This is important, because global macro conditions cannot be numerically measured and cannot be directly factored into econometrical models. They must be studied in qualitative terms. In my opinion, the most important themes impacting global foreign exchange market right now are: U.S. earnings season and the prospect of a major trade war between Washington and Beijing.

We saw how the U.S. dollar followed Wall Street lower on Friday, falling from the two-month high hit earlier in the day after news of stronger-than-expected third-quarter gross domestic product. Safe-haven currencies moved in lock-step with U.S. stocks. In the afternoon trade, the Japanese yen was up for the day, but as stocks recovered, the yen had retraced almost all the gains it had made on the initial dollar drop. The move in the Swiss franc was similar, weakening in the afternoon after having risen to its highest since Aug. 20. Clearly, traders are still worried about the U.S. earnings season and their worries are being reflected in the foreign exchange market as well.

The prospect of a possible trade war between the U.S. and China is another worry. Central banks' attempts to normalize monetary policy are now endangered by possible currency wars, which is just a logical fallout of any trade war. Forex traders should therefore be on high alert for competitive devaluations, as countries across the globe take steps (either implicitly or explicitly) to depreciate the value of their currency to boost their economy.

In this regard, it becomes particularly important to monitor currencies' relative value. This is exactly what my econometric studies attempt to achieve. Below are the latest results.

Latest Results

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 October 28, 2018

On balance, Canadian dollar appears to be the most overrated currency with the total net score of +37 (see the chart above). However, Japanese yen, Mexican peso and Turkish lira are not far behind, with +34, +27 and +25 points, respectively. The most "underrated" or undervalued currencies are the Indian rupee (-41 points), Chinese yuan (-36 points) and the New Zealand dollar (-32 points).

When looking solely at the major currencies, we get very similar results. The Canadian dollar stands out among the rest as the most overvalued currency on the basis of all four studies. By turn, the New Zealand dollar appears to be the most undervalued currency among the majors (see the chart below).

Source: Personal calculations; ranking as of June 22, 2018

What is important is that the relative overvaluation of the Canadian dollar and the relative undervaluation of the New Zealand dollar is broad-based in both cases. In other words, the results are above zero for all four econometric studies + positioning analysis in case of Canadian dollar. At the same time, the results are below zero for all four econometric studies + positioning analysis in case of New Zealand dollar.

If you are a contrarian investor, you will want to short the most overvalued currency against the most undervalued currency. At this point in time, the most contrarian trade among the major currencies is to buy the New Zealand dollar against the Canadian dollar (or go long NZD/CAD).

Now let's have a look at the effective exchange rate.

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, the U.S. dollar has appreciated the most among its peers, followed by Swiss franc, while the Canadian dollar, the Japanese yen and Australian dollar are clearly lagging behind. Overall, the EER analysis does not confirm the relative overvaluation of the Canadian dollar, but it does support the notion of New Zealand dollar being at least "fairly valued".

Source: Central bank official statistics

Econometric Studies

Over-Extension Analysis

Over-extension analysis ranks the exchange rates in percentages of their respective trading ranges over the past years and allows us to see how far each currency has deviated from its historical (three-year) trading range. I choose to look at the three-year period for several reasons. First of all, it is long enough to capture more than half of a standard business cycle of most economies (according to the National Bureau of Economic Research, the average length of a business cycle is about 69 months, or a little less than six years). At the same time, 3-year range is short enough to be relevant and not to produce too smoothed out results. In other words, analytical curves maintain some healthy volatility and tend to generate actionable trading signals.

The most overextended currency is the Canadian dollar. As of last Friday, it was trading at 60% of its 3-year range. The most lagging currency is the New Zealand dollar, trading at only 9% of its 3-year range.

Sources: FXCM, forexdatabank (website), personal calculations

Secular Performance

Assessing the strength of any given currency is quite tricky. Because we usually measure the performance of one currency against the other, the result is always biased. For example, a rising GBPUSD may not necessarily reflect improved fundamentals in the United Kingdom, but rather point to deteriorating fundamentals in the United States. A less biased approach would be to compare a currency's performance against some kind of neutral asset, such as gold. Analysts call it a secular performance analysis.

Secular performance is a useful but underused concept in forex trading. It is important measure because gold (it is assumed) has some intrinsic value as opposed to fiat currency, which is just a "legal tender" not backed by physical commodity. In the end, the price of gold will be determined by supply and demand rather than by central banks' monetary policy and the printing press. Analyzing currency performance against the gold allows us to see the scale of "real" demand for this or that currency.

Based on the 12-month running secular performance observations, I have calculated that the US dollar is currently overvalued by an average of 3.8% against seven majors. However, as of last Friday, it was most overvalued against the Australian dollar (6.40%) and New Zealand dollar (6.1%). In other words, AUD/USD is the most undervalued currency pair based on secular performance analysis.

Sources: FXCM, forexdatabank (website), personal calculations

Oil Correlation

Oil correlation study simply examines the link between a country's exchange rate and the price of oil. This relationship is important because oil prices serve as an important proxy for future changes in consumer price index, which influences countries' macroeconomic policies, which, in turn, affect the exchange rate. Based on the 12-month running oil price standard correlations, I have calculated that the Canadian dollar is undervalued by only 1.30%, while New Zealand dollar is undervalued by around 4.20%.

Sources: FXCM, forexdatabank (website), personal calculations

Economic Divergence

As a general rule, economic data should always justify the moves in currencies' exchange rates. However, it is difficult (if not downright useless) to cherry pick a single economic indicator and compare it to currency's performance because the relative importance of any given economic indicator will vary depending on the economy in question. For example, trade balance data can influence the exchange rate of commodity exporters, such as Australia and New Zealand, but it is less relevant for the United States, whose dollar is a world's "safe-haven" (at least, for now). In theory, GDP growth should act as an ultimate barometer of economic health, but the data is released too infrequently (usually, on a quarterly basis) to be relevant in my analysis. Instead, I prefer to look at countries' bond yields.

2-year bond yields are considered to be an important measuring stick for market confidence and investor appetites. Most importantly, yields essentially reflect investors' and traders' expectations of central banks' monetary policy, which is a major driver for the exchange rates. Therefore, the difference between two countries' 2-year bond yields should indicate which country is running a more expansionary monetary policy (which should be bearish for that country's currency) and which country is at the contraction stage (which should be bullish for that country's currency). Usually, the currency of the country with the higher bond yield appreciates against the currency of the country with the lower bond yield.

Based on the 12-month running 2-year bond spreads correlations, I have calculated that New Zealand dollar is the most undervalued currency among the majors (-3.80%), while Canadian dollar is the least undervalued (-1.2%).

Sources: FXCM, forexdatabank (website), personal calculations

Positioning

Commitments of Traders reports issued by the U.S. Commodity Futures Trading Commission help me analyze traders' sentiment. In all my studies, I am on a lookout for potential extremes over a three-year period. Specifically, I monitor net positions by non-commercial traders (large speculators, such as hedge funds) and convert them to the scale from 0 to 100. A reading close to 0 suggests that commitments are close to the lower bound of a three-year range, while a reading close to 100 suggests that commitments are approaching the upper bound. For me, overbought conditions are present when non-commercial positions are at 90 and higher, while oversold conditions are present when non-commercial positions are at 10 and lower. On this measure, the most overbought currency is euro, while the most oversold currency is New Zealand dollar.

Sources: CFTC, personal calculations

Trading Opportunities

I see several trading opportunities based on the above results:

  1. Long AUD/CAD. Target 1: 0.9490; Target 2: 0.9700; Stop loss: 0.9210
  2. Long AUD/JPY. Target 1: 80.00; Target 2: 80.75; Stop Loss: 78.90
  3. Long NZD/CAD. Target 1: 86.50; Target 2: 87.50; Stop Loss: 84.60
  4. Long NZD/JPY. Target 1: 75.45; Target 2: 76.10; Stop loss: 72.15
  5. Long GBP/CAD. Target 1: 1.6960; Target 2: 1.7075; Stop loss: 1.6590

Broadly speaking, I am bullish on AUD and NZD and bearish on CAD and JPY.

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.