- In the note below, we analyze a series of quantitative RISK MANAGEMENT and fundamental RESEARCH factors to rate each of the G3 currencies with an eye for expected performance over the intermediate-term TREND. Those factors include:
- The market setup relative to our proprietary quantitative RISK MANAGEMENT levels;
- Our propriety GROWTH/INFLATION/POLICY outlook for each country/region;
- Sentiment via Bloomberg CFTC net length data;
- Expectations for monetary POLICY via 2YR OIS spreads;
- Sell-side expectations via 2013 Bloomberg consensus forecasts for each currency; and
- The outlook for fiscal POLICY across each geography.
- All told, our comprehensive analysis of G3 currency fundamentals and market indicators suggests the USD (via the DXY) is poised to trade marginally higher vs. the EUR throughout 2013 and demonstrably higher vs. the JPY over that same duration.
- Importantly, broad USD strength vs. these two peer currencies should continue to auger negatively for global inflation expectations and market prices for inflation hedge assets, such as gold and TIPS.
We assign 1pt if a particular factor screens bullish, (1pt) if the factor screens bearish and 0pts if the factor is inconclusive for each of the aforementioned factors across each currency – with the exception of our quantitative overlay. For the latter, the magnitude of scoring is both amplified and unique:
- 1pt for bullish TRADE/(1pt) for bearish TRADE;
- 2pts for bullish TREND/(2pts) for bearish TREND; and
- 3pts for bullish TAIL/(3pts) for bearish TAIL.
As a point of process, PRICE, VOLUME and VOLATILITY signals tend to dominate our interpretation of fundamentals for a particular security or asset class, as well as our expectations for future PRICES; for this reason, we assign a greater weight to our quantitative overlay relative to the other factors.
Lastly, it should be duly noted that while we analyze each factor on an absolute basis by the signal(s) it is currently projecting, the overall analysis is one that is relative in nature – just like the currency crosses themselves. As such, investors should not interpret the final scores of this exercise as anything other than how each currency currently stacks up against the other two with respect to this comprehensive analysis.
On our quantitative factoring, the USD (via the DXY) is trading right at our immediate-term TRADE line of 80.24 and is bullish TREND and TAIL for a total of +5pts:
On our quantitative factoring, the EUR is trading right at our immediate-term TRADE line of $1.31 vs. the USD and bullish TREND and TAIL for a total of +5pts:
On our quantitative factoring, the JPY is bearish TRADE, TREND, and TAIL vs. the USD for a total of -6pts:
Those familiar with our fundamental RESEARCH process are likely aware of our G/I/P analysis. While this process is used primarily to front-run short-cycle deltas in a particular country and/or region’s economic fundamentals, we have added a new overlay that allows us to view those deltas on a full-year basis as well. For more details on the associated methodology, please refer to our 1/3 note titled: “SIZING UP ASIA & LATIN AMERICA FOR 2013”.
From a full-year 2013 perspective, the US economy appears poised to register a trip to Quad #1 on our G/I/P screen – specifically, GROWTH is likely to accelerate YoY, while INFLATION is likely to decelerate (+1pt):
From a full-year 2013 perspective, the Eurozone economy appears poised to register a trip to Quad #1 on our G/I/P screen – specifically, GROWTH is likely to accelerate YoY, while INFLATION is likely to decelerate (+1pt):
From a full-year 2013 perspective, the Japanese economy appears poised to register a trip to Quad #3 on our G/I/P screen – specifically, GROWTH is likely to decelerate YoY, while INFLATION is likely to accelerate (-1pt):
We use CFTC reporting of net futures and options contracts to gauge market sentiment and positioning for particular currencies or asset classes. Additionally, while it is common for market participants to focus on the non-commercial (i.e. speculators) data in lieu of the commercial (i.e. hedgers) data, we prefer to combine the two data sets to form a more holistic view of the market.
On our amalgamated look, the market is positioned net long of the US Dollar Index to the tune of 786 combined contracts for a z-score of 1.72. As it relates to market prices, this data series has a lagging relationship to the DXY, forming cycle peaks as the z-score breaks through 0 to the upside and forming cycle bottoms as the z-score breaks through 0 on the downside.
The current reading of 1.72 suggests we’ve either recently begun a phase change with regards to the market’s position (which was net short for much of the past three years) or there is further weakness to come. While we are inclined to believe the former view, historic data supports the latter conclusion, for now, for a score of -1pt:
On our amalgamated look, the market is positioned net short of the EUR to the tune of -2,346 combined contracts for a z-score of -2.44. As it relates to market prices, this data series has held a contrarian relationship with the EUR/USD cross since MAR ’09, after having held a coincident relationship for much of the 5-7 years prior to then.
As such, the current reading of -2.44 suggests the EUR is poised for further upside vs. the USD with respect to the intermediate term for a score of +1pt:
On our amalgamated look, the market is positioned net long of the JPY to the tune of 44,732 combined contracts for a z-score of 1.33. As it relates to market prices, this data series has held a contrarian relationship with the JPY/USD cross since mid-2007, after having held a coincident relationship for much of the two years prior to then.
As such, the current reading of 1.33 suggests the JPY is poised to give back some of its recent correction vs. the USD with respect to the intermediate term for a score of +1pt:
We find that fluctuations in the spread of two countries and/or regions’ interest rates can often be a powerful driver of currency crosses. Moreover, we use 2YR overnight index swaps (OIS) to gauge where market expectations for said rates are.
For the USD (via DXY), we formed a weighted average of 2YR OIS for the six currencies that comprise the US Dollar Index by their respective weights in the index, then subtracting that figure from 2YR USD OIS rates to form a basis point spread. The current spread of -17bps suggests the DXY should be tracking roughly +3-4% higher in the ~83 range for a score of +1pt:
The +4bps spread between EUR and USD 2YR OIS rates is supportive of a much lower EUR/USD cross in the area code of ~$1.23. That’s roughly -6% lower than the current price of $1.31 per USD for a score of -1pt:
The +17bps spread between USD and JPY 2YR OIS rates is supportive of a much lower USD/JPY cross in the area code of ~¥82. That’s roughly +7% stronger than the current price of ¥87.69 per USD for a score of +1pt:
Anchoring our expectations in and around consensus forecasts is not something we are ever inclined to do at Hedgeye. That said, however, because global moneycenter banks tend to dominate transactions in the FX market globally through a variety of trade and investment finance, hedging strategies and/or general flows of capital (i.e. repatriation of corporate overseas income, etc.), we would be remiss to discount their influence on market exchange rates.
In a similar fashion to how we constructed the weighted average 2YR OIS rate for the US Dollar Index constituent currencies, we have also constructed a weighted average Bloomberg Consensus 2013 year-end forecast for the US Dollar Index by amalgamating the Bloomberg Consensus 2013 year-end forecasts for each of the six constituent currencies according to their respective weights in the index.
On the metric, the sell-side expects the US Dollar Index to end the year roughly +2% higher at 82.10 for a score of +1pt:
The sell-side expects the EUR to end the year roughly -3% lower at $1.27 per USD for a score of -1pt:
The sell-side expects the JPY to end the year roughly flat at ¥88 per USD for a score of 0pts:
FISCAL POLICY OUTLOOK
While typically slow-moving in nature, relative deltas in fiscal POLICY can have demonstrable effects on currency crosses when expectations for critical metrics (i.e. deficit/GDP, debt/GDP, sovereign debt issuance, etc.) are exceeded or unmet. As a result, we think currency investors should be very focused on what is likely to be an eventful 2013 with regards to G3 fiscal POLICY – particularly in both Japan and the US.
It would be an understatement to suggest that the domestic fiscal POLICY outlook is a bit unclear at the current juncture. While it is certainly fair to argue that hopes for any meaningful fiscal reform in the US were, at best, punted to ~MAR 1st via the introduction of the American Taxpayer Relief Act of 2012, it is not unreasonable to hold out hope for further progress.
The upcoming reform process is likely to be as messy as ever, but it does appear the GOP has enough political leverage (i.e. Debt Ceiling) to force Obama to play ball with regards to meaningful entitlement reform and/or tax code restructuring. Unfortunately for global investors, the world will once again be forced to watch the how proverbial “sausage” is made – if any is made at all. As an aside, any short-term bout of global risk aversion in the days and weeks leading up to and through any official breach of the Debt Ceiling would likely prove positive for the DXY via TIC inflows.
For a deeper discussion of the US’s fiscal POLICY outlook, please refer to our 1/7 note titled: “CLIFF JUMPING 101… TAKEAWAYS FROM PASSAGE OF THE AMERICAN TAXPAYER RELIEF ACT OF 2012”. All in, we assign the US a score of “TBD”/0pts in the fiscal POLICY department.
Flipping over to the Eurozone, after ~two years of European fiscal POLICY dominating global financial markets from a headline risk perspective, 2013 appears rather boring on a relative basis – both relative to what investors have likely become accustomed to receiving from Europe and relative to the US (above) and Japan (below).
From Matt Hedrick, our head of European fundamental research:
“Fiscally the Eurozone remains anchored, at least rhetorically, under Draghi’s accommodative ECB policy stance to keep rates low and use its bond purchasing program (OMT) if requested by a member nation. 2013 is setting up to look a lot like 2012 in which countries muddle through the impact of previously issued austerity packages.”
All in, we think a lack of fiscal deterioration in Europe is at least worth 0pts – and possibly 1pt if Draghi & Co. can help indebted sovereigns reduce their structural balances by via a lower cost of capital. For now, we think a score of 0pts is warranted for the Eurozone’s 2013 fiscal POLICY outlook.
Turning to Japan, Japan’s new Prime Minster Shinzo Abe and his Finance Minister Taro Aso appear poised to accelerate public expenditures and sovereign debt issuance beyond previous expectations set by the outgoing DPJ. The latest news on this front is the announcement of a ¥12 trillion supplementary stimulus budget and the accompanying debt issuance needed to finance these expenditures.
For a deeper discussion of Japan’s fiscal POLICY outlook, please refer to our 12/26 note titled: “JAPAN TO LOOSEN FISCAL POLICY AS WELL”. All in, we assign Japan a score of -1pt in the fiscal POLICY department.
FINAL TALLY AND KEY TAKEAWAYS
The cumulative score/rank for each currency is as follows:
- USD (via the DXY): 7
- EUR: 5
- JPY: -6
Our comprehensive analysis of G3 currency fundamentals suggests the USD (via the DXY) is poised to trade marginally higher vs. the EUR throughout 2013 and demonstrably higher vs. the JPY over that same duration. Importantly, broad USD strength vs. these two peer currencies should continue to auger negatively for global inflation expectations and market prices for inflation hedge assets, such as gold and TIPS.