April 10, 2019: Forex Weekly - Relative Valuation And Trading Opportunities

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Includes: CROC, DAUD, DCHF, DGBP, DJPY, ERO, EUFX, FXA, FXB, FXC, FXE, 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 are no longer limited to just Brexit and U.S.-China trade negotiations.

Recession risks are stemming from the eurozone.

The British pound and New Zealand dollar look "overvalued".

I see three trading opportunities based on the latest relative valuation analysis.

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, OTC:ERO, EUFX, FXA, FXB, FXC, FXE, FXF, FXY and OTC: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 no longer limited to just Brexit and US-China trade negotiations. New fears have emerged - most notably, recession fears in the eurozone.

Indeed, the German economy has slowed sharply and looks to be in recession. German industrial orders fell by 4.2% mom in February following a 2.1% decline in January. Even taking into account that this is a volatile series, the weakness is astonishing. In fact, industrial orders are down by 8.4% over the last year, the weakest since the Global Financial Crisis. Historically, declines of industrial orders of this magnitude have been consistent with periods of recession in the overall economy. Germany has not recorded a technical recession yet (defined as two successive quarters of contraction). However, for all intents and purposes, it is experiencing a modest recession. The economy contracted in Q3, was flat in Q4, and looks set to be contracting in the first few months of this year.

To make matters worse, President Trump has hinted that he is considering imposing tariffs on imports of cars and vehicle parts from Europe. If imposed, European car production and exports would drop, with a knock-on effect on other sectors that rely on the car industry. So, while the Brexit and the negotiations between the US and China have stolen the headlines when it comes to global economy, the macroeconomic picture in the eurozone has been quietly getting bleaker.

The prospect of a possible trade war between the U.S. and China and also between the U.S. and the EU is still a real 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, will 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 April 10, 2019

On balance, the Mexican peso and Israeli new shekel appear to be the most overrated currencies, with a net score of +44 and +37, respectively (see the chart above). The Russian ruble and Indian rupee are not far behind, at +35, +33, respectively. The most "underrated" or undervalued currencies are the Swedish krona (-41), Danish krone (-25) and euro (-24).

When looking solely at the major currencies, we see that the British pound and New Zealand dollar stand out among the rest as the most overvalued currencies on the basis of all four studies. By turn, the euro and Australian dollar appear to be the most undervalued currencies among the majors (see the chart below).

Source: Personal calculations; ranking as of April 10, 2019

What is important is that the relative overvaluation of the British pound and that of the New Zealand dollar is rather broad-based. In other words, the results are above zero for most econometric studies + positioning analysis. Conversely, the relative undervaluation of the euro and that of the Australian dollar is less extensive. For instance, in case of the euro, the over-extension study indicates that the currency is still somewhat pricey. Likewise, in case of the Australian dollar, economic divergence analysis contradicts the general results, indicating that the Aussie could still be slightly overvalued.

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 sell British pound against the euro (buy EUR/GBP).

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 the Swiss franc, while the Canadian dollar, the Australian dollar and the Japanese yen are clearly lagging behind. Overall, the EER analysis does confirm the relative overvaluation of the New Zealand dollar (107.00) but does not confirm the relative overvaluation of the British pound and shows that sterling is "fairly valued" (100.02) - see the charts below.

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, a three-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 euro. As of Wednesday, it was trading at 42% of its three-year range. The most lagging currency is the Australian dollar, trading at only 17% of its three-year range.

Sources: FXCM, Forex Databank (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 any 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 that of 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 0.8% against seven majors. However, as of last Friday, it was most overvalued against the euro (1.50%) and the Japanese yen (1.2%). In other words, EUR/USD is the most undervalued currency pair based on secular performance analysis.

Sources: FXCM, Forex Databank (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 the 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 euro is undervalued by 3.20%, while the British pound is undervalued only by around 0.80%. No major currency is overvalued based on oil correlation.

Sources: FXCM, Forex Databank (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 a 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 global "safe haven" (at least for now). In theory, GDP growth should act as an ultimate barometer of economic health, but GDP 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.

Two-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' two-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 in 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 two-year bond spreads correlations, I have calculated that the Australian dollar is the most overvalued currency among the majors (+1.30%), while euro is the most undervalued one (-4.6%).

Sources: FXCM, Forex Databank (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 the 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 the British pound, while the most oversold currency is the Australian dollar.

Sources: CFTC, personal calculations

Trading Opportunities

I see several trading opportunities based on the above results:

  1. Short NZD/AUD. Targets: 93.60, 93.25, 92.50, 92.00. Stop loss: 95.30.
  2. Long AUD/USD. Targets: 0.7200, 0.7230, 0.7290, 0.7340. Stop loss: 0.7050.
  3. Long EUR/JPY. Targets: 126.0, 126.7, 127.0, 127.40. Stop loss: 123.60.

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.