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

Rate cuts were unnecessary in a shutdown economy

Introduction

As a consequence of the Covid-19 pandemic and the potential catastrophic impact on the global economy, the Fed slashed interest rate to zero in March after four years of effort to increase its benchmark rate. In addition, it has also increased drastically the size of its balance in order to prevent the whole market from collapsing; the Fed’s balance sheet is now expecting to grow to USD 8/9 trillion by the end of the year, twice more than the high reached in October 2014. Even though there is no question that the whole economy was healthier this time than prior to the Great Financial Crisis and that the Fed’s interventions and liquidity injections were timely and mandatory to save the whole market, we believe that the rate cuts were unnecessary.

A slowing economy pre-virus

As we know, the US economy peaked in the last quarter of 2018 and was already considerably slowing down in 2019 due to the high uncertainty in the market (Brexit, followed by the China-US trade war). Figure 1 (left frame) shows the global and US manufacturing PMI overlaid with the US 10Y yield. After the global economy peaked in Q4 2017, the outperformance of the US relative to the rest of the World in 2018 led to a rising USD and a rising 10Y yield, but eventually the slowdown of the US economic growth brought the long-end of the Treasury curve to the downside.

In addition, the sharp sell-off in equities in Q4 2018 (nearly 20 percent from peak to trough) reversed the Fed’s policy guidance with the famous ‘Powell pivot’ from ‘a long way from neutral’ in October 2018 to ‘appropriate stance in January 2019. Policymakers even cut rate three times in the second half of 2019 in order to stimulate demand after the 2Y10Y yield curve inverted in August.

Figure 1

RR1Source: Eikon Reuters, Bloomberg

Hence, the reversal in global central banks’ policy (from global tightening to global easing) combined with the significant increase in global liquidity led to a sharp recovery in stocks, with the SP500 recording one of its best year in the past 30 years (figure 2, right frame). However, the 2020 events generated a global panic and equities sold off aggressively in February/ March amid concerns of the global supply shock will soon spill over demand. Did the Fed increase volatility at first by just cutting interest rates to zero? Even though we understand that policymakers globally wanted to quickly reassure markets by hinting participants that it will not let the whole market fail, there has been very few debates on whether rate cuts are useful in a shutdown economy. In theory, rate cuts should decrease the incentives to save and increase demand for credit and the incentives to consume. We think that the massive liquidity injections would have been enough this time to halt the global panic and that policymakers should have save the little room left in the benchmark rate for later (i.e. when the economy reopens). In addition, we believe that the aggressive rate cuts may have increased price volatility in March; figure 2 (right frame) shows that stocks tend to sell rapidly in when Fed cut rates aggressively.

Figure 2

RR2Source: Eikon Reuters

US shadow rate to hit -5 percent in 2020

Even though some economists have been speculating that the Fed will adopt a negative interest rate policy (NIRP) in the coming months as a response of the Covid-19 crisis, we are not convinced of that and we think that policymakers will first wait and see if the massive liquidity injections will be enough to stimulate the economy. Figure 3 shows the historical path of the Fed Funds rate since 1960, including the ‘shadow rate’ based on Wu-Xia calculations (2015),a tool that researchers have proposed in recent years to estimate how low would the benchmark rate be had the the Fed not used unconventional monetary policy.

This time, the shadow rate is expected to fall down to -5% by the end of the year, 2 percent lower than the -3 percent low reached in the third quarter of 2014 (due to QE3), which should in theory represents a massive stimulus for the economy.

Figure 3

Source: Eikon Reuters, Wu-Xia (2015)

Key economic measures such as r-star have become less relevant in the past cycle

Unlike most of the central banks, the Fed follows a triple mandate when conducting its monetary policy, which is to achieve the following goals: maximum employment, stable prices and moderate long-term interest rates. In addition, policymakers have tried to estimate the dynamics of the (unobservable) neutral rate of interest, r-star, which can be defined as the interest rate that supports the economy at maximum employment while keeping stable prices. Figure 4 (left frame) shows the relationship between r* (estimated by Holston et al. (2017)) and the implied Fed Funds rate (including the shadow rate). Policymakers’ have usually immediately been reacting by lowering the FFR when the r-star was starting to decrease due to an economic shock / recession.

We do not have the recent Q1 updates for r-star, but it is fair to say that it will decrease drastically, which would support the argument of a lower FFR. However, the Fed should just have increased the size of its balance sheet this time (which would have lowered the shadow rate) while keeping extra room for FFR intervention in the coming months when economies reopen.

In addition, we can also see that the relationship between the implied FFR and the US saving rate has broken down in the past cycle (figure 4, right frame). Before 2008, lower FFR was usually leading to a lower saving rate in the following 2 to 3 years (lower rates decrease the incentive to save and should increase the incentive to consume). However, since 2009, while interest rates reached the lower bound and even decreased if we look at the shadow rate, the saving rate has increased. The saving rate could actually go even higher given the uncertainty that households will face post lockdown.

Figure 4

RR4

Source : EIkon Reuters, Holston et al. (2017), Wu-Xia (2015)

In short, more rates cuts are useless in a shutdown economy; policymakers should leave some room for later in case of a ‘Wsss – shape’ recovery.

 

Mind The Rise In The Term Premium!

Introducing the Term Premium

Through the use of economic models, academic research has decomposed the observable long-term bond yields (i.e. US 10Y Treasury bond yield) into the expected path of the real interest rate (r*) and the additional term premium, which is thought as the extra return that investors demand to compensate them for the risk associated with a long-term bond. Using the dominant measure developed by the NY Fed (Adrian et al., 2013), we overlay it with a set of macro and financial variables and look at the pros and cons of a rise in the term premium in the coming months.

Figure 1 shows that the evolution of the US 10Y yield along with the expected r* and the term premium. While we can notice that part of the fall on the 10Y was driven by the decrease in the expected r* from 3.15% to 1.80%, the elevated volatility in the short run was mainly coming from the moves on the Term Premium (TP). The TP hit a historical low of -1.47% on March 9th and is still standing at extreme low level of -1.1%. Many investors had expected the term premium to start rising the US in 2018 and in the first half of 2019, but it surprised most of them by constantly reaching new lows.

Figure 1

fig1Source: NY Fed

Term Premium: a counter-cyclical variable

One important characteristic of the term premium is that it is a counter cyclical variable that tends to rise when the uncertainty around unemployment (or the business cycle) and inflation expectations starts to increase.

Figure 2 (left frame) shows the striking relationship between the unemployment rate and the term premium since 1961. Periods of rising unemployment have been generally associated with a sharp increase in the term premium. Now that we expect the jobless rate to skyrocket following the dismal prints of NFPs and initial claims in recent weeks, could we see a response in the term premium as well?

Figure 2 (right frame) shows another interesting relationship between the US 2Y10Y yield curve and the term premium. We know that the inversion of the yield curve is usually marked by a sharp steepening effect within the next 12 to 24 months as the economy enters a recession. This is referred as a ‘bear steepener’ as the long end of the curve starts rising due to a surge in the term premium. Will the Fed’s emergency measures and QE purchases be enough to deprive the yield curve and term premium from rising significantly in the coming months?

Figure 2

fig2Source: Eikon Reuters

Term Premium vs. inflation expectations

The 2-trillion USD increase in the Fed’s balance sheet as a response of Covid-19 has brought its holding of securities to a new all-time high of $5.85tr. The Fed has recently been buying $625bn of securities each week, which corresponds to an annual pace of $32.5tr and is $25bn more than the entire QE2 run between November 2010 and June 2011. The balance sheet of the Fed is now expected to hit 8 to 9 trillion USD by the end of the year in hopes that it will bring back confidence in the market. Hence, it is fair to raise the following question: will we experience rising inflation in the medium term?

As the term premium is very sensitive to the uncertainty around inflation expectations, it shows an interesting co-movement with the 12-month volatility of the Fed’s balance sheet assets. When interest rates reach the zero bound, central banks run aggressive asset-purchase programs in order to decrease the shadow rate below the neutral rate of interest rate (r*) and stimulate demand and inflation. Figure 3 (left frame) shows that previous periods of rising 12M vol in Fed assets were associated with a short-term increase in the term premium.

Investors could argue that inflation expectations have been falling if we look at the market-based measures – the USD 5Y5Y inflation swap. Figure 3 (right frame) shows that the 5Y5Y inflation swap is currently trading at a historical low of 1.75%, down from nearly 3% in January 2014. However, we previously saw that inflation swaps have been very sensitive to equity and oil prices in the past cycle; in theory, an oil shock should not impact inflation expectations as better monetary policy readjustments from central banks will offset that shock. Hence, these products represent more the demand for inflation hedges (which decreases when energy prices fall), but do not tell us anything about long-term inflation expectations.

Figure 3

fig3Source: Eikon Reuters

Term premium and free-floating bonds

Certainly, moves on the term premium also depends strongly on the amount of free-floating securities in the market. As central banks keep increasing their balance sheet through the purchase of securities such as government bonds, the amount of free-floating bonds have dramatically been reduced in the past cycle. For instance, it was estimated that large asset-purchase programs in the Euro area have decreased the free float of German government bonds from approximately 40% in 2015 to 3% in early 2020 (figure 4, left frame). Figure 4 (right frame) shows how the relationship between the 10Y Bund term premium and the free float flattened in the past few years; low free float is associated with a flat term premium.

In the US, the amount of free float is much higher due to the large quantity of marketable debt securities (USD 16tr) held by the non residents; non-resident holders (NHR) hold nearly 40% of the US debt. Hence, even though the Fed’s aggressive purchases will reduce the free float in the medium term, there is still the risk of a sudden rise in the term premium in the short run as the economy enters a recession.

Figure 4

fig4

Source: Danske, ECB

To conclude, the risk of higher long-term interest rates in the US is still there in the coming months; even though we do expect long-term rates to eventually go to zero, there is still a high probability to see a little short-term surge in the 10Y -plunge in US Treasury prices (TLT), which would significantly steepen the yield curve coinciding with the drastic rise in unemployment.

Some Yen Charts…

In the past few months, investors have been questioning the Yen’s status of safe haven as the currency has constantly been depreciating in the past year despite the elevated uncertainty. The first surprising chart is the divergence between USDJPY and Gold prices (in USD terms). Figure 1 (left frame) shows that after co-moving strongly for 7 years, the USDJPY exchange rate decoupled from Gold (in USD terms). While Gold prices have been constantly soaring in the past year, and especially in recent weeks over growing concerns around Covid-19, USDJPY has remained steady oscillating around 109. In addition, we also noticed a significant divergence between USDJPY and US 10Y Treasury yield. Even though currencies have a variety of short-term drivers, the 10Y US-Japan interest rate differential has been one of the popular ones in the past cycle. As long-term interest rates in Japan have been trading around 0 percent in the past few years after the BoJ decided to keep the yield on 10-year Japanese government debt around zero percent, we just look at the US 10Y yield. Interestingly, demand for US Treasuries has been very strong in the past few weeks, leading to a sharp fall in the US 10Y yield to below 1 percent, while the move on the Japanese yen was more moderate (figure 1, right frame). Has the Yen lost his popularity in periods of market stress?

Figure 1

fig1

Source: Eikon Reuters

First of all, even though the US Treasuries have been considered as the ultimate safe haven in the past 30 years, which explain the success of risk parity strategies during that period, the Japanese Yen remains the preferred currencies in the G10 space in periods of elevated price volatility. For instance, figure 2 shows that the Yen tends to appreciates strongly when VIX starts to surge; in the past 30 years, the JPY has averaged 44bps in monthly returns against the USD when the VIX was trading above 20, nearly four times more than the other traditional safe CHF (Swiss Franc).

Figure 2

fig2

Source: Eikon Reuters, RR Calculations

Secondly it is important to know that the Yen is usually sensitive to the dynamics of the stock market and tends to appreciate in periods of equity sell-offs. Figure 3 (left frame) illustrates perfectly this example and shows a great co-movement between our favourite cross AUDJPY (also known as the proxy for carry trade) and the SP500. We can also see the strong relationship between USDJPY and Japanese equities in figure 3 (right frame); a cheaper currency is usually associated with higher equities in Japan (‘Pavlovian’ response).

Figure 3

fig3Source: Eikon Reuters

Hence, we do not think that the Yen has lost its status of safe haven and we saw last week that it has responded pretty well to the global equity sell-off, appreciating by nearly 5 figures against the greenback. In addition, to the exception of the US Dollar, the Yen has been strengthening in the past two years against most of the popular crosses such as EUR, GBP, AUD and CAD. Figure 4 (left frame) shows that the EURJPY and GBPJPY exchange rates have depreciated by 12% and 10%, respectively, since the start of 2018. We can also notice that the AUDJPY exchange rate has been constantly weakening amid elevated uncertainty, pricing in further weakness in global (ex-US) equities (figure 4, right frame). Is the AUDJPY actually right about the ‘fair value’ of equities.

Figure 4

fig4

Source: Eikon Reuters

Figure 5 shows that the USDJPY exchange rate has been also nicely co-moving with the digital safe: Bitcoin. In the past 3 years, strength in the crypto market has been associated with JPY appreciation. Even though the relationship is pretty new, it will be interesting to see if both assets (JPY and Bitcoin) continue to receive support if price volatility remains high.

Don’t lose faith on the Yen, not now!

Figure 5

fig5

Source: Eikon Reuters

Great Chart: CEO confidence vs. consumer sentiment surveys

In the past two years, the elevated economic and political uncertainty in addition to the lagged effect of quantitative tightening have significantly weakened growth expectations and as a consequence increased demand for safe assets such as the US Dollar and US Treasuries. While the situation seems to have improved slightly in the past 6 months on the back of aggressive rate cuts from central banks globally, business surveys are still pricing in further deterioration in the US economy. For instance, the ISM manufacturing PMI hit a low of 47.2 in December 2019, diverging significantly from the 50-percent threshold that separates growth from contraction. CEO confidence also dropped to its lowest level in a decade and is currently pricing a much higher probability of recession than other popular indicators. On the other hand, consumer confidence indicators have remained strong in the US as consumption remains solid (real PCE expenditure has been averaging 2.5% in the past few quarters).

How long can that divergence persist until US consumer sentiment starts to fade away? This great chart shows that the CEO confidence survey has acted as a good 12-month leading indicator of consumer confidence (University of Michigan) since 1980. We can notice that top executives in the US are currently pricing a significant deterioration in consumer sentiment for the next 12 months to come. However, some divergences occurred in the past, particularly in the late 1990s when CEO confidence started to fall drastically in 1998 and 1999, but consumer confidence was constantly rising during that period mainly due to the tremendous rise in equities that was inflating household wealth. Even though we are concerned about the deterioration of those business surveys, we may continue to see a divergence within the next twelve months between business and consumer confidence surveys as equities keep reaching new all-time highs and interest rates remain ‘too low’ relative to the current pace of nominal GDP growth in the US.

Chart. US CEO Confidence (12M Lead) vs. Consumer Confidence (Source: Eikon Reuters)

CEOconf

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