Comprehensive First Quarter FX Outlook From GTAA
Following the relase of its general equity market overview, GTAA has followed up by releasing the quarterly FX market analysis. In a nutshell, Cleusix sees the USD as the fulcrum security with substantial upside (we would agree...if Bernanke were to not pursue further debt monetization). "The USD is becoming increasingly undervalued against most currencies. It is at a 40 years low on a real broad trade-weighted basis. Sentiment is increasingly supportive for the USD. Speculators had their biggest USD net short position ever a week ago and have covered a third despite continued USD weakness (a positive divergence. Assets in the the Rydex Weakening Dollar have surpassed assets in the Rydex Strengthening Dollar fund but have yet to spike briefly higher as they usually do when the USD decline exhausts itself. There is a big global short USD position which is growing by the day as the increase in foreign central bank reserves can not be completely explained by their current account balance and the net foreign direct investments. Hot money is flowing to emerging markets and we are on the look out for canaries…" All this and much more in the full 56-page report enclosed.
The USD is becoming increasingly undervalued against most currencies. It is at a 40 years low on a real broad trade-weighted basis. Its economy is much more dynamic and has started to rebalance earlier than other developed economies. Companies have been cutting costs aggressively and are much more competitive in the international markets.
The big problem remains that the Fed is suppressing real government bond yields through quantitative easing. Ceteris paribus, the USD will have to be more undervalued on a PPP basis to be in equilibrium. Indeed, the deficit of interests payment foreigners are receiving has to be compensated by a lower price I.e. lower USD (this is another reason why emerging markets with negative real yields have very undervalued currencies on a PPP basis). At current levels we think the compensation is large enough.
The declining USD is pushing other Central Banks/Treasuries to become increasingly aggressive buyer of USD to weaken their own currencies. They then have to recycle their newly acquired USD and in so doing are exerting a downward pressure on real rates in the US and thus weakening the USD. This can not last forever. This will end by a radical redesign of our current monetary system and the sooner the better. The winner… Gold.
Sentiment is increasingly supportive for the USD. Speculators had their biggest USD net short position ever a week ago and have covered a third despite continued USD weakness (a positive divergence. Assets in the the Rydex Weakening Dollar have surpassed assets in the Rydex Strengthening Dollar fund but have yet to spike briefly higher as they usually do when the USD decline exhausts itself.
There is a big global short USD position which is growing by the day as the increase in foreign central bank reserves can not be completely explained by their current account balance and the net foreign direct investments. Hot money is flowing to emerging markets and we are on the look out for canaries…
A new “Homeland Investment Act” could be voted in the month to come which could offer some support for the USD as it did at the end of 2004, while oil price rising further might reach a level where its historical highly negative correlation with the USD turns positive as it does when oil price rise enough to break the back of the macro up cycle.
The Euro is 7-10% overvalued, after its recent rebound (more like 20-25% overvalued if you are leaving in Spain and much more if you are Greek). Yields spreads remain favorable and in synch (which is even more important) but the spread momentum has been faltering in the past 2 weeks despite M. Trichet "strong vigilance".
Sentiment is not supportive with Speculators having accumulated a large net long position and a short-term positive risk reversal divergence.
The Euro has been supported by the strong growth in emerging markets and the rapid inflows of hot money. Indeed exports to emerging markets are contributing strongly to the recent performance of the European core area and Emerging Central banks are busy rebalancing their currency holding toward greater diversification (even if they did not they would have to sell some USD to keep the mix stable). We should also remember that a big chunk of emerging markets credit expansion is and has been financed by European banks. So if emerging markets slow down is larger than most expect (our scenario) Europe and the Euro are likely to suffer much more than the US and its currency.
The trend is up but extended. We would exit long positions at least until we get an upside break. We would sell 1.5-3% OTM calls with 1-3 months maturity and would start to build an outright short position on a move below 1.39 and increase it if it moves below 1.375. We would use an initial stop at the high the Euro will make before it move below our trigger zone (so not 1.4248 but higher or lower depending where the current intraday rebounds stop).
Longer-term we maintain that the Euro could fall below 1. We think that it will bottom near 0.7 if it survives. Crazy? We met the same skepticism when we forecasted a rise above 1.5 when the ECB started to intervene when it was hovering near 0.85 almost 10 years ago. While supportive political decisions might be taken in the near future (but it seems they won't as is usual) , the problems won't disappear and will come back later to hunt them. The system, both political and financial has to be reformed but we will probably need a new crisis.
The Yen overvalued by at least 25%. And the authorities have now started to intervene again (this time jointly) putting an implicit floor below 80. The potential sterilization of the BOJ Yen selling and increase in the size of its balance sheet relative to other countries should push the Yen lower. With regard to repatriation, it is a myth. There are no data confirming it after the Kobe earthquake. Yields spreads are diverging negatively with price. This should ultimately leads to a lower Yen.
There is a big non-commercial net long position which is diverging with price (net long position not increasing on Yen strength). “Housewives” have a huge net short position against the USD, the AUD and most other currencies. Position that large have historically led to Yen weakness in the short-term.
There are/have been continued big inflows of hot money in the past 8 of months with the Yen rising despite the broad balance of payment registering a deficit of more than 5% of GDP.
We would need a break above 84.5 for a clear change in the cyclical trend. Until then, our strategy is to sell downside volatility (USD/JPY puts with strike from 80.5 and below and 1 to 3 months to expiry). We would get outright long (the USD/JPY) on a move above 84.5 with a stop at the rising 65 days exponential moving average or on a new move below 80.5. Our first target would be a move to 93.5-94 and then 100. We would totally hedge the Japanese equity holding of “gaijin” investors.
The British Pound is now slightly overvalued and deserve to trade at a bigger discount with lower real short-term yields than in the US. Many accidents are just waiting to happen with notably the residential real estate market. Authorities will use, among others, a depreciation of the Pound to support the British economy. Yields spreads are not confirming the recent Pound appreciation.
Speculators are net long but they have sold some on strength which is a bearish divergence. The risk reversal is still in synch with the cross.
The British Pound is in the middle of its up channel entering an important resistance zone. We might contemplate taking a short position on a move below 1.60. We are seller of upside volatility on a move above 1.65. We would sell 1.675-1.69 1-3 months to expiry calls.
The CHF is more than 50% overvalued. The SNB has its hands partly tied having been to early to the party. It has already intervened massively and is running out of options (we would not be surprised to see capital controls be introduced on further strength. They could take the form of a tax on foreign money entering the country or negative yields on CHF denominated deposit owned by foreign entity). Walls of money are still heading to Switzerland from European banks while many holders CHF-denominated mortgage in Eastern Europe are slowly but surely getting squeezed. As for the JPY the yields spreads have not confirmed the recent CHF strength.
Speculators have a huge net CHF long position.
The pair is very extended below its 200 and 50 days exponential moving average. This configuration has historically led to a “return to the mean”. The technical structure remains favorable to the CHF with no identifiable trend change. While we do not usually fight trends, we would take a short position at the current 0.8980-0.9015 level. If we can move above 0.935 and then 0.975, the move could extend to last years high.
Commodities currencies are overvalued… The AUD is probably more than 35% above fair value while the NZD is 15-20% overvalued. The CAD is more than 10% overvalued. They have profited from the "Chinese inventory build-up“, Emerging Markets boom, institutional love affair and more recently QE2 related commodity rally. We think that the latter rally is very long on its tooth so…
Speculators have a large AUD long position while there is a negative divergence building in the risk reversal.
The AUD might be in the process of forming a complex top. It looks distributive to us. Remember that when the AUD corrects, it tends to do have a waterfall shape. We can not recommend a long position at this juncture anymore. The level of overvaluation and the fragility of the foundation of its strength makes it to risky. We are seller of upside volatility on a move above 1.02 and would even take a tiny outright short position to profit from the probable RBA selling. We would have to wait for some technical deterioration before we are willing to fight against the carry with more commitment but a close below the recent 0.985 lows would be a move in the right direction.
On emerging currencies, we prefer to stay on the sidelines for now as valuation are not attractive and authorities seems to have decided, especially in Latin America, that their currency will not be allowed to strengthen. If we had to we would maintain a long position on the Taiwan Dollar and the Singapore Dollar. The more then Yen decline the less attractive the Won proposition will become so we are no longer recommending the South Korean currency for those who have to be long…We would not short, however, as the carry is too high for most of them. There will come a time were we will short emerging market currencies opportunistically, as we last did in 2008 but not yet.
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