January 2020: Forex Relative Valuation And Trading Opportunities

Jan. 20, 2020 6:53 AM ETCROC, DAUD, DCHF, DGBP, DJPY, ERO-OLD, EUFX, FXA, FXB, FXC, FXE, FXF, FXY, GBB-OLD, JYNFF, UAUD, UCHF, UDN, UGBP, UJPY, USDU, UUP, YCL, YCS3 Likes
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Splendid Exchange
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Summary

  • The most important themes impacting global foreign exchange market are no longer limited to just Brexit and the U.S.-China trade negotiations.
  • Swiss frank and the British pound look "overvalued."
  • Australian dollar is the most "undervalued" currency among the majors.

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 five econometric studies: over-extension analysis, secular performance analysis, oil correlation, economic divergence analysis, effective exchange rate study. 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 U.S.-Iran tensions, U.S.-China trade deal and growing fears of a global recession.

U.S.-Iran Tensions

Although investors are starting to price in some risk that U.S.-Iran tensions get much worse, the fall-out up until now has limited implications for the outlook for global growth and inflation. The changes in oil prices and financial conditions simply have not been significant enough to date. There might be an impact on business and/or consumer confidence over and above these effects, though that remains to be seen.

U.S.-China Trade Deal

"Phase One" deal has certainly reduced tail risks, but it won't supercharge global economic growth. Chinese officials cautioned that any increases in imports "should be based on market principles and WTO rules." This creates plenty of opportunities for eventual disappointment. Indeed, it would be at the U.S.'s discretion to decide whether China had done enough to fulfill its side of the bargain.

Overall, I sense that trade relations will remain fragile. The fear is that the deal could be torn up if President Trump finds himself dissatisfied with the progress made this year. As such, while the downside risks to growth are certainly lower than in a continued escalation environment, global business confidence will probably remain relatively subdued.

Global Recession in 2020?

The United Nations has recently warned that weaker growth in both advanced and developing countries means the possibility of a global recession in 2020 is a clear and present danger. In a flagship report, the UN's trade and development body, UNCTAD, said that 2019 probably endured the weakest expansion in a decade and there was a risk of the slowdown turning into outright contraction next year.

While there is no consensus among the economists about the impending recession, there is certainly an agreement that growth in 2020 would be sluggish, at best. In addition, central banks' attempts to normalize monetary policy are now endangered by persistently low inflation.

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 in order to spur exports and boost the 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.

Forex Valuation - 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 28 currencies on the scale of -13.0 to +14.0 for each of the studies, where -13.0 indicates "oversold conditions" and +14.0 indicates "overbought conditions." Therefore, the overall minimum score that any currency can have is -65.0, while the maximum is +70.0.

Source: Personal calculations; ranking as of January 17, 2020

On balance, Thai baht, New Taiwan dollar and Israeli New shekel appear to be the most overrated currencies, with a net score of +47, +33 and +33, respectively (see the chart above). Indian rupee and Mexican peso are not far behind, at +32, +30, respectively. The most "underrated" or undervalued currencies are Chilean peso (-49), Hungarian forint (-44), Australian dollar (-32) and Turkish lira (-28).

When looking solely at the major currencies, we see that Swiss frank and British pound stand out among the rest as the most "overvalued" currencies on the basis of all six studies. By turn, the Australian dollar appears to be the most "undervalued" currency 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 Swiss frank and that of the British pound is rather broad-based. In other words, the results are above zero for most econometric studies + traders' sentiment analysis. Conversely, the relative undervaluation of the Australian dollar is less extensive. For instance, secular performance analysis indicates that the currency is more or less fairly valued.

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 Swiss frank against the Australian dollar (buy AUD/CHF). Indeed, a monthly double-bottom seems to be forming on a monthly chart (see below).

Source: Trading View

Now let's look at the econometric studies.

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 Swiss frank. As of Friday, it was trading at 53.15% of its three-year range. The most lagging currency is the Australian dollar, trading at only 12.08% of its three-year range.

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 quite critical 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 Australian dollar is undervalued by 5.36%, while the Swiss frank is overvalued by around 1.72%.

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 an 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 undervalued by an average of 3.5% against seven majors. However, as of last Friday, it was most undervalued against the British pound (4.28%) and the New Zealand dollar (4.13%). In other words, GBP/USD is the most overvalued currency pair based on secular performance analysis. Japanse yen is undervalued by 3.06%.

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 undervalued currency among the majors (-8.82%), while euro is the most overvalued one (+4.54%).

Sources: FXCM, Forex Databank (website), personal calculations

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 2014-16 period, with 2010 as the indices' base year.

As you can see from the chart below, the Swiss frank has appreciated the most among its peers, followed by the U.S. dollar, while the Australian dollar, the Canadian dollar and the Japanese yen are clearly lagging behind. Overall, the EER analysis does confirm the relative overvaluation of the Swiss frank (127.00) and the relative undervaluation of the Australian dollar (83.48) - see the charts below.

Source: Central bank official statistics

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 euro.

Sources: CFTC, personal calculations

Trading Opportunities

I see several trading opportunities based on the above results:

  1. LONG AUD/CHF. Targets: 0.7180, 0.7590. Stop loss: 0.6500.
  2. SHORT EUR/AUD. Targets: 1.5920, 1.5520. Stop loss: 1.6450.
  3. SHORT GBP/AUD. Targets: 1.8270, 1.7580. Stop loss: 1.9520.

This article was written by

Splendid Exchange profile picture
288 Followers
I trade commodities and high-yielding currencies. Fundamental analysis - 95%. Technical analysis - 5%.
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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.

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