FX: DEER recommendations (May 2023)
- The DEER Strategy recommends longs in JPY, GBP, and CAD, and shorts in USD, CHF, and EUR.
- The strategy posted a net loss of 1.8% over the last 3 months, amid a sharp decline in the JPY.
- JPY under-valuation is increasingly stretched, while the GBP remains undervalued despite gains.
- CHF and EUR over-valuations could moderate amid slower inflation and weaker lending.
- In Asia ex-Japan, MYR, CNY, KRW are most under-valued, while PHP, THB and IDR are most over-valued.
Latest G10 DEER valuations
Within major G10 currencies, the JPY, CAD, and GBP are the three most undervalued based on our latest DEER valuations. JPY has depreciated with new BOJ Governor Ueda reiterating a dovish stance in his inaugural meeting, while retaining YCC. The CAD undervaluation has narrowed marginally, with a strong labour market putting into question the BOC’s policy pause since Jan. GBP’s valuation has improved as it rallied to be the best performing currency year-to-date, helped by a recovery in UK business confidence.
USD, CHF, and NZD are the three most over-valued, based on our DEER valuations. The USD’s over-valuation has narrowed slightly, as the Fed signals a possible policy pause. CHF’s valuation has risen sharply, with SNB claiming to be intervening in FX markets to dampen price pressures. NZD’s over-valuation is supported by a surprise 50bps rate hike from RBNZ in April.
DEER Strategy Recommendations
After consideration of the DEER valuations and interest rates, our DEER strategy maintains longs in JPY, GBP, and CAD. The JPY’s under-valuation has widened back to December 2022 lows, when the YCC tweak was announced by Kuroda. With markets reverting towards expecting YCC to continue, there is possible asymmetry to JPY returns going forward. Further easing may pose marginal losses for the JPY. But as inflation rises and the output gap turns positive later this year, it will become difficult for the BOJ to cling on to its crisis-era policy settings. A potential change in the policy outlook should support stronger JPY returns.
GBP is helped by the UK successfully averting a recession in Q4. Furthermore, business sentiment has improved, with the British Chambers of Commerce’s Q1 quarterly survey showing that over half of UK firms expect turnover to increase over the next 12 months. Chancellor Hunt’s spring budget also posed no obstacles to fiscal credibility. Finally, inflation has been sticky above 10% for 7 months in a row, which implies that BOE will have to go further in rate hikes, supporting GBP.
CAD has been lacklustre after the BOC kept policy rates unchanged since Jan, to assess the impact of previous rate hikes. But Governor Macklem recently pointed out that the bank now sees upside risks to inflation amid a still tight labour market. With average monthly job gains rising to 62k for Jan-April, and the unemployment rate easing to another record low of 5.0%, the BOC could lean towards another rate hike, supporting the CAD.
Our strategy maintains shorts against USD, CHF, and the EUR. With the Fed signalling a potential pause in rate hikes in the May FOMC meeting, the USD is starting to soften, even if Powell has not taken more rate hikes off the table.
The EUR had strengthened amid ECB rate hikes and a strong recovery in the services sector. However, the Euro Area’s manufacturing PMI has dropped to its lowest since May 2020, signalling a deep contraction in manufacturing. With the latest Bank Lending Survey showing loan demand dropping sharply across enterprises and households, the ECB has moderated its hawkishness and downshifted to a 25bps rate hike in May. A slower and more data-dependent policy hike path could curb EUR gains.
In Switzerland, the SNB has a dual-pronged approach to restrain inflation, raising rates by 50bps in Mar while also intervening to strengthen the CHF. That said, Switzerland’s inflation has unexpectedly fallen to 2.6% in April, with prices staying flat m/m. An even stronger CHF may be counterproductive given the sharp decline in inflation now, and CHF could soften again if the SNB reduces its FX intervention.
Recent DEER return breakdown and analysis
We review the returns of our previous DEER recommendations made on 3 Feb 2022 (see FX: DEER recommendations (February 2023). The returns are calculated based on closing prices on 8 May 2023 vs forward prices on 2 Feb 2023.
The USD’s overall return is mixed. It underperformed European currencies but outperformed both CAD and JPY. Sentiment towards Europe has improved as the region successfully skirted a recession, while natural gas prices have now fallen to their lowest since 2021, with disruptions from the outbreak of the Russia-Ukraine conflict largely addressed. Our GBP long returned 3.2%, while our EUR and CHF shorts registered a -0.5% and -1.5% return respectively.
Our CAD long gave a -0.5% return, with USD/CAD mostly stuck in range as the BOC maintains a policy pause for now.
Our JPY long registered a 6.1% loss, as USD/JPY saw another quarter of elevated volatility, after posting a sharp 12% gain previously. The appointment of Ueda as the new BOJ Governor has not produced a significant policy change, and market expectations have swung back towards continued easing and YCC.
On an aggregated basis, our DEER strategy posted a loss of 1.8% from 2 Feb 2022 to 8 May 2023. For some time, convergence back to PPP-derived fair values have been disrupted amid higher than usual inflation and policy uncertainty, and our DEER strategy has underperformed in this context.
To understand performance better, we compare currency rankings based on the DEER Strategy (and the REER) against their FX return rankings, from 2011 to 2023. This is done through rolling 3Y regressions, with 1Y return rankings mapped against the respective DEER and REER rankings on a quarterly basis.
Our regression analysis found a strong positive beta (or correlation) between returns and DEER rankings from 2011 to 2021. Since then, the beta has become less positive. Still, it is clear from this analysis that PPP-based strategies have a good long-term record, even if performance is quite volatile across certain time periods. In the past, we have seen underperformance of PPP strategies around 2013-2014, followed by a period of strong performance from 2015-2021. Our optimized DEER strategy has cushioned some downside due to the current poor patch of PPP performance, but not as much as we had hoped for. We shall examine the latest data to improve our strategy configuration going forward.
Since inception, our DEER Strategy has underperformed the S&P500 Index and the global HY index, with risky assets making a strong recovery in recent months. 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 the DEER Strategy’s weekly returns, we found that the DEER strategy shows small, positive correlations (0.2 to 0.3) with equity and bond assets, proxied by the S&P 500 and the Bloomberg Global Aggregate Bond Index. Low correlation against traditional assets implies that the DEER Strategy offers a valuable diversification benefit for most portfolios. Investors can look to currencies for additional diversification, particularly as bonds have become more correlated with equity in recent times, evident from high correlations of 0.5 and 0.7 in our study.
Latest Asian ex-Japan DEER valuations
For Asian ex-Japan currencies, there have been some shifts in our DEER rankings. Both THB and PHP remain over-valued, though, the THB is no longer the most over-valued in Asia given its recent softening. Interestingly, IDR has turned from being undervalued to being close to fair value. This could be due to Indonesia’s terms of trade softening noticeably on a year-to-date basis.
The KRW has flipped back to being under-valued, as slowing exports and a wider trade deficit weighed. The RMB has also seen its undervaluation widen somewhat, with growth momentum not being as strong as hoped despite China’s reopening. The MYR remains the most undervalued, though a surprise rate hike by BNM in May could trigger a narrowing of its undervaluation.
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