Interestingly, it is another traditional safe haven – the Swiss franc – which we believe is 30% overvalued against the G10.
Shorting any safe-haven currency is a risky business, of course, and the franc in particular burned a lot of fingers when the Swiss National Bank abandoned its euro peg.
However, with a yield curve negative out to eight years, the cost of carry on a long Swiss franc position will be painful and, with inflation running three percentage points below target, it is difficult to see the SNB throwing in the towel completely in its fight against the strong franc.
The flight-to-quality risk of a short Swiss franc position can be offset somewhat by an overweight in yen.
When we build portfolios, we select overweights and underweights based on a variety of fundamental factors. However, when we look at our relative value positioning, we do see two interesting currency crosses emerge.
One is the yen/Swiss franc position implied above – a position that is neutral to risk aversion. Another example is the Norwegian krone and the Canadian dollar.
Both are commodity currencies and both economies are struggling with the recent collapse in the price of oil. If anything, the krone has come off the worse of the two – so why are we long?
Again, it is an anti-consensus call. We think depreciation is overdone, even given weak data from Norway. During the past year, it has fallen by almost 25% against the dollar and almost 10% against the Canadian dollar.
Unlike in Japan, that depreciation is feeding inflation – Norway’s June CPI came in well above expectations at 2.6%, and core inflation is running at 3.2% – which could force the Norges Bank into a less dovish stance.
By contrast, the Bank of Canada’s rate cut of 15 July showed it is still in easing mode. With the Norwegian krone/Canadian dollar, we express a view on the valuations of two commodity currencies while remaining neutral with respect to the oil price itself (just as the yen/Swiss franc is neutral on risk aversion).
Absolutely relative
What theme brings all of these positions together?
One could say they are all about a shift from momentum trades to valuation trades, both absolute and relative: with mixed messages coming from fundamental indicators and geopolitical events, valuations are now a stronger driver of exchange rates.
That does not make us irresponsibly contrarian but it does mean we no longer believe in big, crowded consensus trades.
We would remind investors that some of the big exposures they are carrying – long the dollar and Swiss franc, short the euro and yen – are not as obvious now as they were 12 months ago, when fundamental dislocations were so much more evident.
Should the US economy continue to outperform strongly and the other major economies fail to catch up, it is still possible for the dollar to move higher, but significant appreciation would tighten US financial conditions and subsequently influence the pace of the Fed’s tightening cycle.
In our view, following those trends will not be the winning strategy for 2015. Relative value positions and tactical trading are likely to be more successful.
