EURCHF is the FX ‘value’ trade according to PPP

Unlike bonds or equities, currencies do not carry any fundamental value and have historically been known as the most difficult market to predict. In our FX fair value model page, we look at different ways of estimating a ‘fair’ value for a bilateral exchange rate. One of the simplest models is based on the Purchasing Power Parity theory, which stipulates that in the long run, two currencies are in equilibrium when a basket of goods is priced the same in both countries, taking the account the exchange rates. We know that the OECD publishes the yearly ‘fair’ exchange rate based on the PPP theory or each economy.

Based on the OECD calculations, it appears that the Euro is the most undervalued currency among the G10 world relative to the US Dollar, as PPP prices in a fair rate of 1.42 (implying that EURUSD is 18% undervalued). On the other hand, the Swiss Franc is the most undervalued currency (+26%). Therefore, if we were to believe that exchange rates converge back to their ‘fundamental’ value in the long run, being long EURCHF is the position with the most interesting risk premia among the DM FX world.

Source: Eikon Reuters, OECD

Steeper yield curve or stronger US Dollar?

In the past few months, we argued that the rise in uncertainty over inflation expectations and economic output will certainly levitate the term premium and therefore steepen the 2Y10Y yield curve. For instance, figure 1 (left frame) shows that the US 10Y term premium has historically strongly co-moved with the unemployment rate and that the deterioration in the job market amid strict lockdown measures could lead to higher long term yields. Figure 1 (right frame) shows that the sharp yield curve ‘steepener’ that occurs prior or during economic recessions is mainly coming from the dramatic rise in the term premium.

Even though we do not expect the 2Y10 yield curve to dramatically steepen as during the Great Financial Crisis (by 3 percent), we still see a higher retracement on the 2Y10Y towards 1% (currently trading slightly below 70bps).

Figure 1

Source: NY Fed, Eikon Reuters

At the same time, we are also bullish on the US Dollar as a hedge against rising uncertainty over a range of macro events (US elections, Brexit, new lockdowns imposed by governments…). In the past 18 months, it is interesting to see that a cheaper US Dollar has usually coincided with higher equities (SP500) and vice versa (figure 2); therefore, we think that being long the US Dollar at current levels offer investors a good hedge against a sudden reversal in equities.

Figure 2

Source: Eikon Reuters

However, the question now is: can the US Dollar appreciate as the yield curve continues to steepen? Figure 3 shows an interesting relationship between the greenback and the 2Y10Y in the past 15 years; a steeper yield curve has generally been associated with a cheaper US Dollar and not a stronger USD.

Figure 3

Source: Eikon Reuters

Go long the US Dollar as a hedge against rising uncertainty

In the past few weeks, US equities have shown some signs of ‘fatigue’ amid rising uncertainty over US elections and the lack of stimulus from both the Fed and the government. Most of the rise in risky assets such as equities in the past few months has been mainly attributed to the massive liquidity injections from major institutions to avoid economies from falling into a deflationary depression.

It is interesting to see that in the past year, a cheaper US Dollar has been mainly associated with stronger US equities, especially since the pandemic (figure 1). Hence, the ‘close elections’ may certainly lead to a choppy equity market in the last quarter of 2020 and therefore should result in a strong demand for safe assets such as the USD. We think that going long the Dollar could offer a good hedge against a new round of equity selloff in the coming weeks.

Figure 1

Source: Eikon Reuters

In addition, long the USD remains a contrarian trade as the ‘short Dollar trade’ is still very crowded (figure 1). We are confident that the US Dollar will remain strong if price volatility rises in the near term, especially against risk-on currencies such as the British pound or the Australian Dollar.

Figure 2

Source: CFTC

Great Chart: US Dollar – DXY vs. broader index (NEER)

The past few months have been marked by a significant depreciation of the US Dollar relative to major currencies. The massive liquidity injections from the Fed to desperately avoid the country from falling into a deflationary depression combined with the risk of a second ‘strict’ lockdown in some southern states (Sun Belt) have left the greenback vulnerable, with some investors speculating that the ‘Bear Market of the USD’ has eventually begun. The USD index is now down 1.7% year-to-date, following two years of positive momentum, and currently trades at its lowest level since September 2018. The US Dollar has significantly weaken against the major currencies and particularly the Euro as EU leaders have recently shown improving signs of coordination and the ‘better management’ in the Covid19 crisis will surely be reflected in the real growth differential between the two economies, which is one of the key drivers of currencies over the long run.

However, as the USD index is heavily weighted on the Euro (57.6%), it may show a misleading picture of the current state of the US Dollar. If we look at a broader measure of the US Dollar – Nominal Effective Exchange Rate (NEER), which measures performance of the USD against a broader rage of currencies weighted according to the value of trade with the domestic country – we can notice that USD NEER is up 3.1% YtD and still trades higher than its early March level. The chart below shows the interesting ‘divergence’ we observe since the start of the crisis. At this stage, the USD NEER index has given up most of its March gains, but is clearly not showing any signs of massive weakness coming ahead. Hence, we will need to see more downside on the USD NEER to confirm that a LT bear market on the USD has eventually started.

US Dollar: DXY vs. NEER (Source: Eikon Reuters)

Great Chart: USD REER vs. VEU/SPY

An interesting observation arises when we plot the annual change in the US Dollar with the relative performance of US vs. World (ex-US) equities. As you can notice it in the chart, the World (ex-US) equity market tends to outperform the US market when the US Dollar is weakening. For instance, the US Dollar (USD REER) performance in 2018 led to  an outperformance of US equites (SPY) over World (VEU) up to 20% before the last quarter.

In addition, this chart shows that the annual change in the USD tends to mean revert over time, fluctuating between -10 and +10 percent. Hence, investors could not only benefit from playing the range on the greenback, but also speculate on equity relative performance between US and non-US stocks. As we expect the US Dollar to weaken through the course of the year, this could lead to a significant performance of the world (ex-US) equities. A weaker USD also eases the pressure in the EM corporate bond market, which is heavily USD-denominated, and therefore loosens financial conditions.

Chart. USD REER vs. US / World (ex-US) equities – YoY Change

 

Is it time to go long UK financial assets?

Last year, there were worries that the continued depreciation of the British pound was going to increase inflationary pressure in the UK economy and therefore force policymakers to start a hawkish tightening cycle. With uncertainty still significantly elevated, demand for Gilts would keep UK LT years at low levels and many analysts predicted a potential ‘yield curve inversion’ as one of the main outcomes for this year.

However, over the past few months, the fall in oil prices in addition to the 12M lagged currency ‘effect’ have been pressuring inflation expectations to the downside. Our model, which incorporates the annual change in currency and oil prices as two key inputs, has been predicting a correction in future inflation prints in the UK (figure 1, left frame). Therefore, with the short-term implied yield curves Dec19 Mar19 and Dec20 Dec19 trading at 19.5bps and 15bps, respectively, the market expects slightly less than two hikes by the end of 2020 (figure 1, right frame). This leaves policymakers more flexibility concerning their interest rate normalization policy after warning that Brexit uncertainty ‘intensified considerably’ in the end of last year.

Figure 1

Inflation model

Source: Eikon Reuters, RR

Mixed signs from leading indicators and surveys

As for many developed countries, industrial production has contracted significantly in the few couple of months of 2018, down 1.5% YoY in November. However, we can notice that our leading indicator recently ticked up and therefore is pricing a stabilization in the UK business activity (figure 2, left frame). It is still too early to switch our forecast to positive and therefore the next few data points will be important to watch in order to take a fundamental view on UK financial assets. On the other hand, the CFO survey from Deloitte is standing at 2016 critical levels, as CFOs expect uncertainty to impact business spending and lower hiring in the medium term.

Figure 2

Leading

Source: Eikon Reuters,

Uncertainty and firms’ investments

Empirical studies from the Bank of England found significant negative relationship between uncertainty and firm’s investments. For instance, Melolinna et al. (2018) found that the uncertainty, along with the cost of capital and macroeconomic fundamentals, has been an important driver of investment. The authors measure the uncertainty at a firm-specific level, which is the daily volatility in individual stock prices that cannot be explained by general market variation (CAPM model). Figure 3 (left frame) shows negative co-movement between uncertainty (HFM) and the UK business investment.

In another study, Smietanka et al. (2018) look at the macroeconomic uncertainty, which looks at the dispersion in surveys of professional forecasters. Figure 3 (right frame) also demonstrates a negative relationship between uncertainty (U) and the level of investment (dash line is a fitted line based on post-2008 sample).

Figure 3

Mel

Source: Melolinna et al. (2018), Smietanka et al. (2018)

Interesting risk premia for the long-run

Hence, the elevated uncertainty, combined with low consumption growth (consumption growth decreased from 0.9% annual prior the financial crisis to 0.3% post-Brexit) and a sluggish growth in the housing market are all going to weigh on the 3 to 6-month outlook, which may be reflected in asset prices. However, fundamentals in the UK have not deteriorated as in some of the European countries (i.e. France), and therefore we could expect an outperformance of UK assets relative to European ones. Figure 4 (left frame shows that the UK stock market appears cheap relative to the US and Europe.

Figure 4

Excess liquidity

Source: Bloomberg, Eikon Reuters, RR

What does it mean for the pound?

As we mentioned it in our latest FX Weekly, the British pound got strong support when it fell below the 1.25 level against the US dollar, therefore we think that buying Cable below that support could offer interesting returns for longer-term investors. As we expect the US dollar to weaken within the next 12 months (in our base scenario), currencies such as the euro and the pound could offset some of the USD weakness.

As we can see it in Figure 5, Cable is currently flirting with the 1.29 level, which corresponds to the 61.8% Fibo retracement of the 1.1975 – 1.4350 range and the 100-day SMA. A breakout of this area could lead us to the next retracement at 1.32. However, GBP may stabilize in the short term and therefore we think it could be interesting to play the crosses (long EURGBP and short GBPJPY). In addition, we can notice an interesting observation in figure 6, which shows the strong co-movement between GBPJPY and the world (ex-US) equities; we usually tend to look at AUDJPY as a proxy for risk-on / risk-off environment. Therefore, GBP could also be impacted by a small consolidation in the stock market.  

Figure 5

Cable

Source: Eikon Reuters

Figure 6

GBP and VEU

Source: Eikon Reuters

FX Cross-Currency Basis Swaps and Hedging Costs

One interesting topic in the FX market that has been closely studied by both academics and practitioners over the past decade is the violation of the covered interest parity (CIP). CIP is a textbook no-arbitrage condition that states that interest rate differential between two currencies should equal the differential between the forward and spot exchange rates. In other words, in discrete time, we have the following condition:

Where S is the spot exchange rate, F is the forward exchange rate, i is the domestic interest rate and i* is the foreign currency interest rate. The problem is that the above equation has held since the Great Financial Crisis; as it started to become more expensive to borrow US Dollars against most currencies during periods of stress, the cross-currency basis swap (CCBS) has been diverging from zero for the Euro, the British pound and the Japanese Yen. Figure 1 (left frame) shows the evolution of the 3-month CCBS for the three currencies (against the USD) since 2012.

Low interest rates combined with the significant divergence in unconventional monetary policies run by the BoJ and ECB over the years has put pressure on the exchange rates and the CCBS, and therefore has increased the hedging costs for Euro and Japanese investors. The current rate on the US 10Y Treasuries (3.15%) looks certainly very interesting for unhedged international investors (relative to domestic bonds such as in the Euro area or Japan), however changes drastically when we adjust for hedging costs. Figure 2 represents the cash-flows that occur at the start, during the term and at maturity when a Euro investor (A) enters a cross currency basis swap. As you can see, each quarter A pays the 3M USD Libor and receives the 3M Euribor and the basis. Hence, the more negative is the basis, the higher the hedging cost. With the 3M Euribor at -0.316%, the 3M CCBS at -44bps and the 3M Libor USD at 2.61%, the current return on a FX-hedged 10Y US Treasuries is negative (-20bps). Figure 1 (right frame) shows that despite the rise in US yields since the middle 2016, it has been falling for Euro and JPY investors after adjusting for FX hedging costs. A UK investor would get an annual return of 1.35%, which is 15bps below he can get in holding a 10Y Gilt.

Figure 1

Fig1.PNG

Source: Eikon Reuters

 

Figure 2

Fig2.png

Source: BIS

 

Great Chart: GBPUSD vs. FTSE 100

As we are closely approaching our 1.40 target for Cable (here), we chose an interesting chart this week that shows a scatter plot of the UK equity market (FTSE 100) with GBPUSD exchange rate, using a weekly frequency since January 2009.  Even though the relationship is not as clear as for Japan Equities and USDJPY (here), we can still observe a negative ‘Pavlovian‘ relationship where a cheaper currency usually implies higher equities. For instance, the British pound was massively sold post referendum (June 2016) on the back of an elevated political and economic uncertainty, high volatility and negative investors’ sentiment. Cable plunged from 1.44 a week before Brexit vote to reach a low of roughly 1.20 in October 2016 before starting its recovery in the first quarter of 2017.

One interesting observation is in the equity market; even though the FTSE 100 sold from 7,000 in April 2015 to 5,700 in February 2016 prior the event (as Cable), the post-Brexit rounds of Sterling depreciation played in favor of UK equities. However, over the past few months, the situation recovered in the UK, both the uncertainty and the volatility eased. If we look at the Economic and Political Uncertainty index, a monthly series based on newspaper coverage developed by Baker, Bloom and Davis, it is down from almost 1,200 (summer 2016) to 200, its prior Brexit average, bringing Cable’s 1M ATM implied volatility from 19 to 7.85 (here). At the same time, the 3-month 25 Delta Risk Reversal is back into the positive territory (from -6 in June / July 2016), meaning that the implied volatility on calls is more expensive than puts (here).

With an equity market closing at 7,730 on Friday and Cable at 1.3850 (flirting with the 1.39), we are curious to see if the relationship will continue this year. Hence the question is: will the Footsie break its 8,000 psychological resistance while Cable continues its momentum?

Our view is that the Bank of England may surprise the market in 2018 concerning its interest rate path. With the December 2019 short-sterling futures contract trading at 98.88 (i.e. implied rate of 1.12 by the end of 2019), market participants are currently pricing in two hikes for the next couple of years. We think that three to four hikes is more appropriate to the current economic climate, and policymakers may send a signal in the February update of its inflation forecasts, triggering some moves in the short-term interest rate market. We think that a potential move in the forward IR curves will benefit to the Sterling pound, however equities may struggle to reach new highs and break above the 8,000 level.

Chart: Cable vs. FTSE 100 (Source: Reuters Eikon)

Great Chart: TOPIX vs. USDJPY

As we always like to look at the Japanese Yen charts (USDJPY, AUDJPY, MXNJPY) as a sort of alternative barometer of investors sentiment and overall financial conditions, we chose an interesting chart this week that shows a scatter plot of the Japanese equity market (TOPIX) with USDJPY. The two assets have shown a significant relationship over the years, especially since Abe took office in Q4 2012 and the BoJ introduced QQME (i.e. extremely accommodative monetary policy) on April 3rd 2013. Investor Kyle Bass was one of the first to introduce the term Pavlovian response to this ‘weaker yen, higher equities’ relationship in Japan, which brought a lot of ‘macro tourists’ instead of long-term investors.

However, we noticed that the relationship between the Yen and the TOPIX broke down in Q2 2017. While the Japanese equity market has continued to soar over the past few months, currently flirting with the 1,900 psychological level (its highest level since 1991), USDJPY has been less trendy and has been ranging between 107 and 114 (see divergence here). Hence, we decided to plot a scatter chart between the two assets using a weekly frequency since 2001.

As you can see, a strong Japanese Yen (i.e. USDJPY below 100) usually goes in pair with a weak equity market. For instance, we barely see the TOPIX index above 1,000 when the USDJPY trades below the psychological 100 level. However, as the exchange rate increases, we see more dispersion around the upward sloping linear trend; for a spot rate of 120, we had times when the TOPIX was trading at 800 and other times when it was trading at 1,800. We did a simple exercise and regress the exchange rate returns on the equity returns (both log terms) to see if we get some significant results, using the following equation:

As you can see, the coefficient Beta is economically and statistically significant at a 1-percent level. Using 16 years of data, we find that a 1-percent increase in USDJPY spot rate is associated with a 0.76% increase in the stock market.

We highlighted the point where we currently are in the chart (Today), which is a TOPIX at 1,889, its highest level in the sample, for a USDJPY spot rate of 112.80. We can notice that the point is located at an extreme level of dispersion, and the question we raised a few weeks ago was ‘Can the divergence between the equity index and the exchange rate continue for a while?’

We think that the stock market in Japan will struggle to reach new highs and generate some potential interesting returns in the months to come due to the poor performance of the banking system (strong weigh in the index) and the constant decrease in the effectiveness of the BoJ policy measures. We mentioned a month ago that the Japanese Yen was 26% ‘undervalued’ relative to its 23Y average value of 99.3 according to the Real Effective Exchange Rate (REER valuation) (see here), hence we find it difficult to imagine a super bear JPY / Bull TOPIX scenario. In addition, we also raised the fact that the current level of oil prices were going to deteriorate Japan Trade Balance in the future (see here), pushing back the current account in the negative territory and potentially impacting the stock market.

Chart: Scatter plot of TOPIX vs. USDJPY – weekly frequency (Source: Reuters Eikon)