FX: DEER recommendations (August 2023)
- The DEER Strategy recommends long in JPY, GBP, and CAD, and shorts in USD, CHF, and EUR.
- The strategy posted a net loss of 2.1% over the last 3 months due to sharp JPY depreciation.
- The JPY could turn with Fed-BOJ policy divergence at a peak, and if JGB yield volatility rises.
- CHF’s over-valuation could also narrow, with the Swiss manufacturing sector entering a recession.
- In Asia ex-Japan, MYR and CNY are most under-valued, while PHP and THB are most over-valued.
Latest G10 DEER valuations
For major G10 currencies, the JPY and CAD are the two most undervalued, and GBP the least overvalued. JPY’s undervaluation has widened back to extremes seen in Nov after the BOJ increased flexibility of YCC slightly in July, with a reference range that is +/-0.5% around the 0% target. The CAD undervaluation has widened marginally, given a stronger USD. GBP has reversed its undervaluation and is now slightly above fair value, as BOE shifts to a 50bps rate hike in June to tackle persistent inflation.
USD, CHF, and NZD remain the three most over-valued, based on our DEER valuations. The USD’s over-valuation has expanded slightly, with growth remaining strong in Q2. CHF’s valuation has risen along with continued SNB FX intervention to dampen price pressures. SNB’s FX reserves have now fallen to its lowest since Q3 2017. NZD’s over-valuation has narrowed after RBNZ left rates unchanged in July.
DEER Strategy Recommendations
Given no change in the ranking of DEER valuations, our DEER strategy maintains longs in JPY, GBP, and CAD. The JPY’s valuation is back to extreme lows, as markets expect the BOJ to be patient in maintaining easing. Still, there has been a meaningful shift after the BOJ changed its YCC target range to an elastic reference range instead, with a new hard cap of 1%. Given increased uncertainty over inflation, the BOJ may be prepared to allow more market determination of yields going forward. If so, the corresponding rise in yield volatility should support the JPY (see here). Furthermore, large domestic bond outflows could reverse if yields are allowed to rise by a larger extent. Downside risks for the JPY should also be limited after the Japanese government repeatedly warned of excessive FX volatility, raising risks of MOF intervention in FX markets to support the JPY.
GBP could benefit from further BOE policy tightening, with markets expecting at least a 25bps hike for Aug. BOE might also accelerate QT by increasing government bond sales. Though the impact on gilts is estimated to be small, the move could reinforce BOE’s inflation credibility, alongside the appointment of ex-Fed Chair Bernanke to review its inflation forecasting record. On the trade front, the UK is expected to lodge its accession into CPTPP within the next 12 months, facilitating its cross-border provision of services. While growth is not particularly strong, the UK still seems to have done better than other major European economies in Q2.
CAD is mostly stable against the USD, helped by the BOC restarting rate hikes in June after being on pause since January. Canada’s economy remains strong, and the BoC is now worried that disinflation towards its 2% target could stall amid excess demand and persistent underlying inflation. While BOC seeks a balance between risks of under- and over-tightening, stronger than expected growth momentum could perhaps necessitate further tightening.
Our strategy maintains shorts against USD, CHF, and the EUR. The US economy is admittedly stronger than expected given the policy tightening delivered, and so the USD has proven resilient despite its high valuation. But with the Fed likely done with rate hikes by now given slowing inflation, USD strength is likely to abate.
The ECB has shifted to a more data-dependent stance, after a series of consecutive rate hikes this year. Guidance for further rate hikes has thus changed to consideration on a meeting-by-meeting basis. While Eurozone’s Q2 growth of 0.3% q/q is reasonable, German growth is flat for two quarters already and the Italian economy had contracted in Q2. Space for further ECB rate hikes look limited amid uneven growth and could thus curb EUR gains.
In Switzerland, the manufacturing sector, which contributes 18% of GDP, has entered a deep recession. Swiss manufacturing PMI tanked to 38.5 in July, well below its 1H average of 46.4 and marks its lowest read since April 2009. Inflation has also been decisively tackled, having fallen below 2% in June. The SNB should be more concerned about growth than inflation at this juncture and should cease its efforts to strengthen the franc.
Comparison with individual FX forecasts
The DEER model valuations are entirely based on data, and there can be differences with our FX forecasts, which are based on analyst judgement. Analysis is based not just on the DEER factors, but numerous other factors that include monetary policy shifts, broader market developments, and even soft data such as sentiment. Still, our readers could benefit from a comparison of our DEER model recommendations with our published FX forecasts for EUR, JPY, and GBP.
Based on current market prices, our DEER recommendations for EUR and JPY should deliver a positive return if our forecasts for 3Q 2024 are realized. But it is not a perfect association, with the DEER recommendation for GBP expected to underperform based on our forecast. Nevertheless, the addition of GBP offers a valuable diversification benefit, by negating excessive European concentration in shorts. The return of the DEER strategy portfolio should be viewed in totality on a risk-adjusted basis, and not singularly focussed on individual currencies.
Recent DEER return breakdown and analysis
We review the returns of our previous DEER recommendations made on 9 May 2023 (see here). The returns are calculated based on closing prices on 2 Aug 2023 vs forward prices on 8 May 2023.
The USD had a mixed return this quarter, as support from previous Fed rate hikes is diminishing, but the US economy is still showing resilience. Both our short EUR and long GBP positions delivered a positive return of 1.1% and 0.6% respectively, with the BOE’s larger rate hikes helping GBP become the best performing G10 currency year-to-date. The EUR is now lagging, as growth concerns are starting to restrain ECB hawkishness. Our CAD long is flat, with the BOC balanced between under- and over-tightening. Our CHF short show a marginal loss of 0.3%, given persistent CHF strength.
Finally, our JPY long posted a large 7.6% loss and continues to be an outsized drag on the DEER Strategy return, even with diversification. USD/JPY volatility has grown extreme, with JPY weakness driven by large domestic bond outflows this year. Given low JPY valuations and heavy short positioning in the JPY for carry, we see risks of a snapback in the JPY if market volatility jumps, or if the BOJ allows a more significant rise in JGB yields.
On an aggregated basis, our DEER strategy posted a 2.1% loss from 8 May 2022 to 2 Aug 2023. JPY underperformance due to monetary policy divergence has been a setback for our strategy, but the negative impact from short-term rate differentials and US rates volatility could be over if the Fed halts further rate hikes.
Since inception, our DEER Strategy has underperformed the S&P500 Index and the global HY index, as risky assets outperformed on a better US outlook. It still outperforms the DM short-term bond index, US 10y Treasury, as well as the global IG credit index.
In our correlation analysis based on weekly returns, the DEER strategy continues to display small correlations (between 0.20 to 0.32) with equity and bond assets, proxied by the S&P 500 and the Bloomberg Global Aggregate Bond Index. Low correlations against traditional assets implies that the DEER Strategy can offer a valuable diversification benefit for most portfolios. Currency strategies still provide good diversification, even as bonds and equities are now showing greater correlations in returns (between 0.48 to 0.74).
Latest Asian ex-Japan DEER valuations
For Asian ex-Japan currencies, both PHP and THB remain the two most over-valued. However, the THB’s over-valuation has narrowed substantially, given protracted political uncertainty post elections. The PM is still not appointed, with the Move Forward party failing to get enough support for its leader.
MYR and RMB remain the two most under-valued Asian currencies. The MYR had strengthened noticeably in July though, as the Malaysian government announced some success in courting FDI investment, particularly from China. The RMB is also stabilizing despite a growth slowdown. Chinese authorities had made clear their preference for a stronger RMB via daily CNY fixings, relaxing regulatory parameters to allow more foreign borrowings by Chinese companies, and providing guidance to banks to delay their USD purchases. An already undervalued RMB means that the authorities are not likely to consider RMB depreciation as a policy option to support growth.
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