Putting the euro under the microscope
7 minute read
Italy’s budget headlines, softening in eurozone data and the Fed’s monetary policy path are all currently under the currency market’s microscope for attractive currency opportunities.
We currently see a couple of potentially interesting developments in EUR/USD and EUR/CHF, using a framework that captures some of the most important and persistent drivers for G10 currencies.
This article looks at the three key elements of our framework and our subsequent view on the euro.
The first driver captures a behavioural element such as investor sentiment is derived from high frequency pricing data, which adds value as a shorter term contrarian indicator.
We’ve found that a contrarian strategy of buying currencies that have excessively underperformed, while selling outperforming currencies outperformed, tends to add value over time.
Evidence of herding among market participants within the FX markets can be seen in our results, implying that excessive sentiment can be taken advantage of.
An investor’s ‘carry’
The second driver we monitor is the ‘carry’ investors receive by holding currency exposure.
According to the theory of uncovered interest rate parity, returns from holding a higher yielding currency should be fully offset by the currency’s subsequent depreciation in order to neutralise this interest rate differential.
However, it has been observed that exchange rate movements tend not to fully offset these interest rate differentials - a phenomenon referred to as the ‘forward rate bias’.
We also find that, on average, a currency that has appreciated/depreciated for a prolonged period of time tends to exhibit a subsequent price reversal over the following years.
By following a strategy that incorporates both the forward rate bias and price reversal effect, we observe that such a strategy also tends to provide a positive return stream over time.
Purchasing power parity
Finally, we look at purchasing power parity (PPP) estimated exchange rates as a long-run equilibrium in which a currency should converge towards over time.
The intuition is that currencies can deviate from an equilibrium value over the short to medium term, but over time these deviations should be eventually corrected by fundamental economic forces.
A high PPP value is ‘expensive’ and therefore lowers expected returns, while a low PPP value implies the opposite.
Admittedly, PPP theory isn’t without its challenges.
Frictions like regulatory barriers, differing tax rates, tariffs and transport costs may prevent PPP-deviations from ever being corrected. Meanwhile, non-tradeable services or the differing composition of country-level CPI baskets may lead to measurement error for estimated PPP values.
Nonetheless, we find that a value-based strategy of shorting and buying currencies that deviate excessively from their PPP values, has tended to yield positive returns over time.
Europe’s value hunt
With regards to developments for EUR/USD and EUR/CHF, both currency pairs screen positively on our carry and PPP-valuation screens. For EUR/CHF, we have seen a safe-haven driven pull-back based on Italian budget headlines (figure 1).
Here, we see potential upside for EUR/CHF.
The Swiss National Bank (SNB) has a reputation of foreign exchange intervention, and with Switzerland finally emerging from deflation, the SNB has no incentive to tighten monetary policy anytime soon.
On the other hand, the European Central Bank (ECB) intends to halt its asset purchase programme by the end of this year, and will likely focus more on guiding policy rate expectations upwards in 2019.
For EUR/USD, we feel a lot potential downside for the currency pair has already been priced-in (figure 2).
Among others, there has been softening in eurozone data relative to the US, a re-appraisal of the Fed’s monetary policy path, as well as headline news regarding Italy.
Here, we shall be monitoring ongoing developments closely for any attractive tactical opportunities.