May 2022: Forex Relative Valuation And Trading Opportunities –…
Every week, we look at 29 currencies in search of evidence of popular delusions and the madness of crowds. The idea is to find anomalies and bullish or bearish divergences that will either break the trend or prolong it. It’s a painful exercise, but also highly rewarding.
In order to find the most overbought and oversold currencies, we conduct five econometric studies: technical over-extension analysis, secular performance analysis, oil correlation review, economic divergence analysis, and effective exchange rate study. Additionally, we look at traders’ positioning to understand the psychological state of the market.
We hope that the information provided below will help you trade the following instruments:
- Major currency pairs: AUD/USD, EUR/USD, GPB/USD, NZD/USD, USD/CAD, USD/CHF, and USD/JPY.
- Relevant ETFs (single-currency): (FXA), (BTF), (FXF), (FXB), (FXC), (CYB), (FXE), (FXY).
- Leveraged ETFs: (ULE), (EUO), (YCL), (YCS).
- Strategy ETFs: (DBV), (UUP), (UDN), (CEW), (USDU).
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.
The war in Ukraine is having a significant impact on trade flows – particularly in agricultural commodities. Alongside China lockdowns, bottlenecks look set to worsen in the near term. However, a general cooling in consumption will help to ease pressure on the supply side. Risks to inflation continue to be to the upside.
Key Economics Forecasts
At its May meeting, the FOMC raised the target range of the Fed funds rate by 50bp, to 0.75-1.00%, in line with the consensus expectations. In addition, at the press conference, Chair Powell strongly signaled further such super-sized rate moves, saying that the Committee expected 50bp rises to be considered at the “next couple of meetings.”
US GDP contracted in Q1, by -1.4% q/q annualized, against expectations for a continued expansion in the economy (consensus: +1.0%). The contraction reflects continued supply bottlenecks in Q1, with demand remaining strong.
German factory orders dropped by 4.7% MoM in March, and production fell by 3.9% MoM that month. Both outcomes were well below consensus expectations. The slowdown in Germany’s industrial sector was pre-signaled by falls in Germany’s manufacturing PMI and Ifo business climate in the industry in March-April. Still, there seems to be room for a temporary acceleration in production in the course of this year as large backlogs have built up in recent quarters on the back of supply chain bottlenecks and shortages of labor.
Last week, the official PMIs and Caixin’s manufacturing PMI for April were published. The PMIs dropped further below the neutral 50 mark, to the lowest levels since the initial covid-19 shock in Q1-2020. The official manufacturing PMI fell to 47.4 (March: 49.5, consensus: 47.3) and the non-manufacturing PMI to 41.9 (March: 48.4, consensus: 46.0). This brought the official composite PMI to 42.7 (March: 48.8). Caixin’s manufacturing PMI fell to 46.0 (March: 48.1, consensus 47.0). All this clearly reflects the impact of the broadening of lockdowns seen since the second half of March, on the back of the spread of Omicron. This has created heavy headwinds to China’s economic growth and added to domestic supply bottlenecks spilling over to global supply chains.
Forex Valuation – Latest Results
Below is the complete Forex Market Summary (as of May 9, 2022) – filtered from the most “overvalued” to the most “undervalued” currencies (see “Dev.” column).
- KPR – key policy rate.
- INF – inflation.
- UNEM – unemployment.
- 2-Y Y – 2-year yield. The rate of return or interest paid to the bondholder (investor) of a 2-year government bond (yield to maturity, latest close).
- 10-Y Y – 10-year yield. The rate of return or interest paid to the bondholder (investor) of a 10-year government bond (yield to maturity, latest close).
- 10-2 SPR – 2-10 yields spread. The yield spread between the 10-year government bond and the 2-year government bond.
- FV – “FAIR VALUE” – Hypothetical estimation of a fair value based on four econometric studies.
- DEV – DEVIATION – Currency’s exchange rate deviation from the “fair value”.
- EER – effective exchange rate
- GOLDEN CROSS – The golden cross is a candlestick pattern that is a bullish signal in which a relatively short-term moving average crosses above a long-term moving average.
- DEATH CROSS – The death cross is a technical chart pattern indicating the potential for a major selloff. The death cross appears on a chart when a short-term moving average crosses below a long-term moving average.
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 a 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.
On balance, the Russian Ruble, Mexican Peso, and Singapore dollar appear to be the most “overrated” (or overvalued currencies), with a net score of +44 +34.2, and +29.4, respectively (see the chart above). The Canadian dollar, Brazilian real, and Hong Kong dollar are not far behind, at +29.2, +27.4, and +24.6, respectively. The most “underrated” (or undervalued currencies) are the Hungarian forint (-31.2), Japanese Yen (-27.8), and Swedish krona (-24.4).
When looking solely at the major currencies, we see that the Canadian dollar and Australian dollar stand out among the rest as the most “overvalued” currencies on the basis of all six studies. Conversely, the Japanese yen and the British pound appear to be the most “undervalued” currencies among the majors (see the chart below).
What’s important is that the relative overvaluation of the Canadian dollar is rather broad-based. In other words, the results are above zero for almost all econometric studies. However, the relative undervaluation of the British pound is less extensive.
Now let’s look at econometric studies.
Technical 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’s 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 Canadian dollar. As of last Monday, it was trading at 60.65% of its three-year range. The most lagging currency is the Japanese yen, trading at just 2.1% of its three-year range.
The 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 24-month running oil price standard correlations, I have calculated that all major currencies are “cheap” vs oil but the Canadian dollar is the least undervalued of all (-6.46%). Conversely, the New Zealand dollar is undervalued by 11.07%.
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 GBP/USD 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 assets, such as gold. Analysts call it a secular performance analysis.
Secular performance is a useful, but underused, a concept in forex trading. It’s an important measure because gold (it’s 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 24-month running secular performance observations, I have calculated that all major currencies are undervalued vs gold but the Canadian dollar is the least undervalued of all (-0.17%). Conversely, the Swiss franc is undervalued by 6.75%.
As a general rule, economic data should always justify the moves in currencies’ exchange rates. However, it’s 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’s 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 the 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.
Additionally, I look at the yield spread between the 10-year government bond and the two-year government bond (10-2 yield spread). The yield spread is often included among the leading forex indicators because interest-rate differentials determine the shape of the yield curve and the shape of the yield curve embodies fixed-income traders’ expectations about the economy.
Based on the 24-month running bond spreads correlations, I have calculated that the Canadian dollar is undervalued by 3.15% while the British pound is undervalued by 7.69%.
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 franc has appreciated the most among its peers, followed by the U.S. dollar and New Zealand dollar, while the Japanese yen is clearly lagging behind. Overall, however, the EER analysis does not confirm the relative overvaluation of the Canadian dollar (87.47), and neither does it confirm the relative undervaluation of the British pound (102.12) – see the charts below.
Commitments of Traders reports issued by the U.S. Commodity Futures Trading Commission help me analyze traders’ sentiment. In all my studies, I’m 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 a 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 New Zealand dollar (60.03), while the most oversold currency is the Japanese yen (5.70).
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 trades among the major currencies are the following:
- Sell AUD/JPY
- Buy GBP/AUD
- Sell CAD/JPY
- Buy GBP/CAD
In other words, sell the Canadian dollar and the Australian dollar and buy the Japanese yen and the British pound. However, one needs to be careful here because technical analysis must also be taken into account (see the very first table above).