Best Currency Positions For April 2018

I invest based on statistics. For more on investing in statistically undervalued stocks see this freely accessible article. But you can also short overvalued currencies and use the proceeds to buy undervalued currencies. To keep track of currency valuations I publish articles like this one every month.

In my qualitative discussion of longs and shorts I will focus on currencies that can directly be traded with Interactive Brokers. Among the currencies in my quantitative analysis the Turkish lira, the Indian rupee, the Indonesian rupiah and the Brazilian real cannot be traded with Interactive Brokers.

Four currency trading strategies

Like last month I value currencies based on 4 statistical currency strategies:

  1. Changes in purchasing power relative to changes in purchasing power of other currencies. In other words: suppose the 5-year difference in inflation between 2 currencies is not compensated by a 5-year decrease in the value of the currency with the most inflation. Then a long position in that inflationary currency and a short position in the other currency is a statistically favorable bet.

  2. The term spread. This is the difference between long-term interest rates and short-term interest rates. Currencies with inverted or flat yield curves have better returns, at least on average. I use the difference between the 10-year yield and the 1-year yield.

  3. The 1-month change in the 10-year yield. The larger this change the better the statistical return of that currency.

  4. Momentum: I use 6-month raw price momentum.

For each of these 4 basic strategies I compute for each currency a rank number. Low rank numbers predict low, or negative, returns and high rank numbers predict high (positive) returns, at least on a statistical basis. Average rank numbers are computed for 4 combinations of currency strategies. I combine the following strategies:

1. Changes in purchasing power with the term spread strategy

2. Changes in purchasing power with 1-month changes in the 10-year yield

3. Momentum with the term spread strategy

4. Momentum with 1-month changes in the 10-year yield.

The strategies in these combinations have low correlations. For example, from the paper Value and Momentum Everywhere we know the correlation between changes in purchasing power and momentum is low. From this yield-curve paper we know the correlation between the term spread strategy and 1-month changes in the 10-year yield is also low. We should not combine correlated strategies. Therefore it does not make sense to consider other combinations apart from these 4.

Basic currency data

First I will present basic data I have used to make the rankings. In the table below data is presented for each currency from March 20, 2017. The column price is the exchange rate relative to the USD with the USD being the base currency in the currency pair. Currencies are sorted using the term spread, which is the currency strategy with the highest Sharpe ratio. The higher the term spread the lower the statistical return. The column “Changes in purchasing power” is the difference between the left hand side and the right hand side in the second formula of this wiki-article. I compute this difference using 5-year inflation data and the 5-year change in the exchange rate. Positive differences indicate undervaluation relative to the USD while negative differences signal overvaluation.

Ranking

&

Symbol

Price

((USD.XXX)

Term
spread
(%)

Changes in

purchasing

power

1-month

Δ 10Y yield

(%)

6-month

momentum
(%)

1. BRL

3.30

2.92

0.32

-0.36

-4.90

2. HUF

254.19

2.60

0.17

-0.03

2.13

3. PLN

3.45

2.04

0.14

-0.10

3.70

4. EUR

0.82

1.66

0.10

-0.15

2.85

5. ILS

3.48

1.60

-0.00

-0.14

0.85

6. SEK

8.20

1.50

0.28

-0.11

-2.71

7. ZAR

11.96

1.44

0.09

-0.03

11.12

8. CZK

20.74

1.42

0.08

0.14

5.26

9. NOK

7.73

1.27

0.29

-0.01

1.05

10. IDR

13765

1.25

0.21

0.28

-3.61

11. DKK

6.08

1.22

0.11

-0.14

2.53

12. NZD

1.39

1.09

0.15

-0.14

-1.59

13. RUB

57.63

1.02

0.50

-0.06

0.56

14. INR

65.19

0.98

-0.05

-0.00

-0.59

15. HKD

7.84

0.88

-0.06

-0.03

-0.49

16. SGD

1.32

0.85

0.12

0.05

2.49

17. AUD

1.30

0.82

0.28

-0.17

-3.01

18. USD

1.00

0.82

0.00

-0.00

0.00

19. CHF

0.95

0.78

0.09

-0.08

1.75

20. GBP

0.71

0.72

0.12

-0.06

3.37

21. KRW

1071.90

0.72

-0.02

-0.08

5.71

22. CAD

1.31

0.63

0.28

-0.10

-5.64

23. CNY

6.33

0.49

-0.00

-0.10

4.08

24. JPY

106.40

0.19

0.18

-0.03

5.62

25. MXN

18.77

-0.19

0.34

-0.11

-4.81

26. TRY

3.93

-1.09

0.72

0.60

-10.79

Ranks of 4 basic currency strategies

The data from the table above results in the following rankings of the 4 currency strategies. See the table below. The lower the rank number the lower the statistical return. For example, based on changes in purchasing power, the expected return of the Hong Kong dollar is lower than that of the Turkish lira.

Table 2: rankings

Rank

Changes in

purchasing

power

Term
spread

1-month

Δ 10Y yield

6-month

momentum

1

HKD

BRL

BRL

TRY

2

INR

HUF

AUD

CAD

3

KRW

PLN

EUR

BRL

4

ILS

EUR

NZD

MXN

5

CNY

ILS

ILS

IDR

6

USD

SEK

DKK

AUD

7

CZK

ZAR

SEK

SEK

8

ZAR

CZK

MXN

NZD

9

CHF

NOK

CAD

INR

10

EUR

IDR

PLN

HKD

11

DKK

DKK

CNY

USD

12

GBP

NZD

KRW

RUB

13

SGD

RUB

CHF

ILS

14

PLN

INR

RUB

NOK

15

NZD

HKD

GBP

CHF

16

HUF

SGD

HUF

HUF

17

JPY

AUD

HKD

SGD

18

IDR

USD

JPY

DKK

19

AUD

CHF

ZAR

EUR

20

CAD

GBP

NOK

GBP

21

SEK

KRW

USD

PLN

22

NOK

CAD

INR

CNY

23

BRL

CNY

SGD

CZK

24

MXN

JPY

CZK

JPY

25

RUB

MXN

IDR

KRW

As you can see most currencies score bad on at least one of the 4 basic strategies. In other words: in efficient markets there is no such thing as a free lunch.

Also be aware that these are very simple models. Other, more sophisticated, models can result in totally different predictions.

Ranks of the 4 combined currency strategies

Below are the ranks of each currency in the 4 combination strategies. Behind each currency you will find the average rank of the 2 basic currency strategies. Before computing the average I have normalized the 4 individual ranks to numbers between 0 and 1. Hence the averages are also between 0 and 1. Again the lower the rank number the lower the expected return of a long position.

Rank

Changes in

purchasing

power +

Term spread

Changes in

purchasing

power +

1-month

Δ 10Y yield
spread

Momentum

+

Term spread

6-month

momentum

+ 1-month

Δ 10Y yield

1

ILS

0.14

ILS

0.14

BRL

0.04

BRL

0.04

2

EUR

0.24

EUR

0.22

SEK

0.22

AUD

0.12

3

ZAR

0.26

KRW

0.26

IDR

0.26

CAD

0.18

4

CZK

0.26

CNY

0.28

HUF

0.32

NZD

0.20

5

INR

0.28

DKK

0.30

ILS

0.32

MXN

0.20

6

HKD

0.28

HKD

0.32

NZD

0.36

SEK

0.24

7

PLN

0.30

NZD

0.34

EUR

0.42

ILS

0.32

8

HUF

0.32

AUD

0.38

NOK

0.42

EUR

0.40

9

DKK

0.40

CHF

0.40

INR

0.42

DKK

0.44

10

BRL

0.44

BRL

0.44

AUD

0.42

RUB

0.48

11

KRW

0.44

PLN

0.44

PLN

0.44

HKD

0.50

12

USD

0.44

INR

0.44

CAD

0.44

TRY

0.50

13

SEK

0.50

ZAR

0.50

RUB

0.46

CHF

0.52

14

NZD

0.50

USD

0.50

HKD

0.46

IDR

0.56

15

IDR

0.52

GBP

0.50

TRY

0.50

INR

0.58

16

CHF

0.52

SEK

0.52

DKK

0.54

PLN

0.58

17

CNY

0.52

CAD

0.54

USD

0.54

HUF

0.60

18

SGD

0.54

CZK

0.58

MXN

0.54

USD

0.60

19

NOK

0.58

HUF

0.60

CZK

0.58

CNY

0.62

20

GBP

0.60

MXN

0.60

ZAR

0.62

NOK

0.64

21

AUD

0.68

JPY

0.66

SGD

0.62

GBP

0.66

22

RUB

0.72

SGD

0.68

CHF

0.64

KRW

0.70

23

JPY

0.78

RUB

0.74

GBP

0.76

SGD

0.76

24

CAD

0.80

NOK

0.80

CNY

0.86

JPY

0.80

25

MXN

0.94

IDR

0.82

KRW

0.88

ZAR

0.86

26

TRY

1.00

TRY

1.00

JPY

0.92

CZK

0.90

Statistical shorts

I find the combination of a favorable term spread and undervaluation based on 5-year changes in purchasing power the most attractive forex strategy. This is the second column in the table above. I think this strategy generates the highest returns, in the long run. I also prefer it because I think it involves the least trading. As with any other investment strategy it does not always work though. Based on this strategy good shorts could be the Israeli shekel, and the euro.

The Bank of Israel decided to keep the interest rate unchanged. Over the past month the Israeli shekel has strengthened again. Israeli policy makers expect inflation over 2018 to be between 0.3 and 0.6%. The IMF says higher inflation would be better but otherwise confirms the Israeli economy is in good shape. Despite the shekel being such a bad statistical long position, big US banks recommend buying the shekel. In the meantime the Bank of Israel continues to intervene. See here. It is easy to make money if others place statistically unfavorable bets against an asset you are controlling the market for.

Long positions in the shekel are not looking good according to 2 other measures either: 6-month momentum and the one-month change in the 10-year interest rate, see the last 2 columns in the second table.

Discussing the euro means also discussing the US dollar. Yesterday the Fed raised the interest rate with a quarter of a percent. Most likely 2 more rate hikes will follow this year. If inflation rises it could cause the Fed to increase interest rates more aggressively. See here. So it seems likely the difference in short-term interest rate between the euro and the dollar is going to widen. That should be bullish for the USD, but yet the dollar dropped yesterday. Apparently the market had expected a more hawkish statement from the Fed.

A closer look at what Jerome Powell said reveals the Fed also decided to increase tightening by $10 billion a month. That will also cause upward pressure on the 10-year yield. See here. That article suggests the Fed might increase the short-term interest rate too fast causing the yield curve to invert or at least to flatten much. That will make lenders act less prudent and bring the next crisis closer. As I mentioned above it would also increase attractiveness of long positions in the USD.

At the beginning of March the European central bank removed a sentence about more easing, if necessary for financial conditions or inflation. That caused the euro to move up but then Draghi downplayed the significance of this omission. See here and here. Another negative for the euro was the support for populist parties in the Italian elections.

Other concerns for the dollar are the US budget deficit and the current account deficit and the upcoming trade war. Yet another concern is the flow of speculative capital into European stocks. Analysts are mixed. Some remain optimistic about economic growth in Europe, despite many problems have not been solved, especially in Southern Europe. Others think budget deficits can lead to “a stronger dollar in the medium-term, and a protectionist trading policy would generally support the dollar.”

Statistical longs

Based on the combination of changes in purchasing power and the term spread the most undervalued currencies are the Mexican peso, the Canadian dollar, and the Japanese yen. The Turkish lira is also a good long but this article focuses on currencies that can be traded via Interactive Brokers.

The Mexican peso went slightly down compared to my previous currency article. The exchange rate of the Canadian dollar decreased much more since then. The decision of the Canadian central bank not to raise interest rates might be the reason for the plunge. Though the Canadian dollar appears to be a great long right now, there are those who think it can go much lower.

The peso and the Canadian dollar also keep fluctuating on new NAFTA developments. See also here and here. A good thing was the US exemption from import percent tariffs on steel and aluminum for Mexico and Canada. I think both currencies are still pressured by uncertainty about the outcome of the NAFTA discussions. I still expect oil prices to increase further, which will be good for the peso and the Canadian dollar. BTW, higher oil prices also put more pressure on the euro than on the USD.

The Japanese yen appreciated since my last currency report. The main news was the trade deficit, also higher than expected. The Bank of Japan confirmed again it will continue its massive quantitative easing program. Together with the new trade policies in the US and the interest rate increase by the Fed this is all bearish for the yen. Moreover inflation will be lower on yen strength: another reason for monetary stimulus to continue. See here.

With so many economies prospering I must say, again, it will be only a matter of time before oil prices and prices of other commodities increase, by much. That will be put more pressure on the yen than on the USD.

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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