FX: DEER recommendations (February 2023)

Latest G10 DEER valuations

Within major G10 currencies, the JPY, GBP, and CAD remain the three most undervalued based on our latest DEER valuations. JPY has strengthened and its undervaluation has narrowed slightly following USD/JPY selling interventions by the Japanese authorities, and a surprise widening of the BOJ’s YCC target band in Dec. GBP remains under-valued on a trade-weighted basis, even with GBP/USD rebounding by over 14% from its low post the mini-budget. CAD is the third most under-valued, seeing only modest strength against the USD since Nov.

USD, NZD, and CHF are still the three most over-valued currencies. The USD’s sharp over-valuation is narrowing, due to the Fed’s downshift to 25bps rate hikes amid disinflation, on top of an improving global outlook. NZD’s over-valuation has expanded amid optimism from China’s reopening. CHF’s over-valuation has also risen marginally.

DEER Strategy Recommendations

Our DEER strategy maintains longs in JPY, GBP, and CAD. The JPY’s undervaluation remains near historic lows even after its recent recovery. Inflation is picking up on both a headline and core-core basis, while the BoJ’s credibility with regards to its YCC policy is coming under question, resulting in the Bank having to intervene heavily to cap yields. With Governor Kuroda stepping down in April and given an improving global outlook, BOJ under new leadership may take more steps towards policy normalization, prompting a further narrowing of the JPY’s under-valuation.

For GBP, the UK is set to avert a contraction in GDP for Q4 2022, helped by the Energy Price Guarantee that has shielded the impact on households from higher energy prices. Though growth is projected to stay weak, the BOE voted by 7-2 to raise its Bank Rate by 50bps to 4% in Feb, given firmer than expected inflation. While BOE could be nearing its terminal rate, tight labour markets may still lead to further hikes and support the GBP.

In Canada, the BOC raised rates by 25bps to 4.50% in March, but expect to hold rates going forward while assessing the impact of cumulative rate hikes thus far. BOC expects growth to slow to 1% in 2023 from about 3.5% in 2022. That said, the Canadian labour market is tight, with an average 55k monthly gain in jobs over Q4 2022 while the unemployment rate has eased to a record low of 5.1%.

Our strategy maintains shorts against USD, CHF, and the EUR. The Fed has downshifted to a 25bps rate hike in Feb, and markets now expect the Fed to hit once more, before pivoting to rate cuts by the end of 2023. Given a peak in US inflation and less hawkish hues from Powell, there is less anxiety over the Fed’s restrictive policy stance. Coupled with an improving global outlook, this could allow the USD’s over-valuation to narrow further.

The EUR had strengthened amid signs that the Euro Area could avert a recession, with Q4 GDP expanding marginally by 0.1% (q/q sa). ECB continues to focus on reining in inflation, hiking by 50bps in February, while Lagarde has also indicated that another 50bps hike is likely in March. The EUR NEER has strengthened to its highest since June 2021, and some caution could be priced in again if risks escalate amid the Russia-Ukraine war.

For CHF, the SNB had raised rates by 50bps in Dec to counter inflationary pressures. The Bank expects growth to ease to 0.5% in 2023, from around 2% in 2022. With Switzerland’s manufacturing PMI having fallen sharply to 49.3 in Jan and giving its worst read since June 2020, excessive CHF strength is now a concern.

Recent DEER return breakdown and analysis

We review the returns of our previous DEER recommendations made on 4 Nov 2022 (see FX: DEER recommendations (November 2022)). The 3M returns are calculated based on closing prices on 2 Feb 2023 vs 3M forward prices on 3 Nov 2022.

The USD is the primary driver of returns. All our shorts against the USD had recorded gains, while our longs against the USD had seen losses. The USD has reversed its appreciation trend amid the start of disinflation in the US, and the Fed downshifting to smaller rate hikes.

As for individual crosses, our JPY short posted a double-digit gain of 12.1%, reversing from last quarter’s 11.6% loss. A rise in JGB bond volatility amid a widening of the YCC’s target band in December has helped to spur JPY gains. Our GBP long also showed a strong 9.2% gain, compared to last quarter’s 8.3% loss. GBP was helped by the UK averting a recession, and a diminishing political risk premium as the Autumn Budget by Chancellor Hunt helped restore macro stability. Our CAD long gained 3.0%, helped by a strong jobs outturn.

Our CHF short and EUR short posted an 8.9% and 11.1% loss respectively. Both EUR and CHF are helped by the ECB’s hawkish stance, European sentiment indicators showing an improvement, as well as hopes of an export uplift from China’s reopening.

On an aggregated basis, our DEER strategy posted a gain of 1.5% from 3 Nov 2022 to 2 Feb 2023. Misalignments from fair values in major G10 currencies, while having narrowed somewhat, are still large by historical standards. Further reversion to historical norms could support returns going forward.

Since inception, our DEER Strategy has marginally underperformed the S&P500 Index. It has outperformed US 10y Treasuries, the short-term DM bond index, as well as global IG and HY credit indices.

In our correlation analysis based on the DEER Strategy’s weekly returns, we found that the DEER strategy shows small, positive correlations (0.24 to 0.36) to both the S&P 500 and the Bloomberg Global Aggregate Bond Index. Low correlation against traditional assets provides a valuable diversification benefit. This is all the more so with equities and bonds having become more correlated in recent times, with correlations of over 0.5 in our study.

Latest Asian ex-Japan DEER valuations

For Asian ex-Japan currencies, there have been notable shifts in our DEER rankings. The THB has become the most over-valued Asian currency, with the THB showing the largest year-to-date gain. There is anticipation of a sharp recovery in tourist arrivals given China’s reopening, which should support Thailand’s current account.

The KRW has flipped from being undervalued to slightly overvalued. Indeed, softer exports in January amid a semiconductor downturn have catapulted Korea’s monthly trade deficit to a record high of USD 12.7bn. This could put the brakes on further KRW appreciation, notwithstanding optimism over China’s reopening.

IDR’s undervaluation has deepened despite IDR gains. Indonesia’s terms of trade have improved and remain near record highs, helping to support its valuation. For other Asian currencies, their DEER valuations are little changed from before. Notably, the CNY remains undervalued despite its recent gains.

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