FX market update and Strategy Update : Between momentum and valuation

The global environment has become increasingly supportive for risk taking recently with especially US macroeconomic data surprising on the upside and the Federal Reserve introducing QE2. QE2 has undoubtedly sparked some rather speculative buying of Emerging Markets currencies – and some of these inflows have also been flowing into the EMEA currencies – in particular into the Turkish lira and the South African rand and to a lesser extent also the CEE currencies. Even though European debt worries have clearly
had a negative impact on the CEE currencies this week the overall picture remains a “risk on” environment for the EMEA currencies overall.

A concrete result of the inflow into the EMEA currencies is that conventional momentum indicators have been turning increasingly positive. In terms of our EMEA FX Scorecard, this is visible in the “technical” score, which in recent weeks has become more positive for most of the EMEA currencies covered by the Scorecard.

Hence, judging from the positive global environment and the massively positive momentum in especially ZAR and TRY, it is difficult not to jump on the bandwagon and go long in all of the EMEA currencies. And this is exactly what seems to be happening in the EMEA FX markets at the moment.

However, all is not good and we are seeing some reasons to be careful with riding along with the bandwagon. The PIIGS worries are an obvious reminder of this, but maybe more important is the valuation of some EM currencies getting very stretched and market positioning becoming a one-way street. Both the South African rand and the Turkish lira are significantly overvalued from a fundamental perspective and it might therefore be
advisable to scale back potential long positions in the rand and the lira.

Concluding, we like the EMEA currencies for now and we believe there is a good chance that the rally will continue for some time, but we are getting a little concerned about the fact that the valuation of both TRY and ZAR is becoming too stretched.

And now momentum is turning against the forint
In terms of momentum it is notable that it is now beginning to turn against some of the central and eastern European currencies. Hence, this week the European debt concerns have triggered some spill-over to the CEE currencies and especially hard hit has been the Hungarian forint. This is not overly surprising given Hungary’s large external debt – and the country’s historical performance, or rather non-performance in terms of fiscal consolidation. Our EMEA FX Scorecard the “technical” score – which is mostly a momentum based indicator – has been positive for the forint in recent weeks. However, the momentum in the forint is now turning negative and EUR/HUF has moved back above the 200-day moving average this week. Hence, technically the picture is certainly turning more bearish for the forint and with European debt worries continuing a further upward move in EUR/HUF looks more likely. Even though a total score for HUF in our
EMEA FX Scorecard remains slightly positive we are certainly becoming more bearish on the near-term outlook for the forint.


EMEA FX Scorecard outline

• All scores are computed on a scale from +5 to -5. A score is then derived by combining the different sub-scores.
• Macro: calculates the growth momentum in different monthly macro indicators.
• Technical: calculates the momentum in different volatility measures, short and longer-term moving averages and the level of the relative strength index.
• Carry: calculates the momentum in local three-month rates, carryto-risk, spread vs. EUR or USD three-month rates, and spread vs. peers.
• Global: consists of a global growth score based on leading global indicators, a liquidity score based on G3 real rates and a sentiment score based on performance in global equity markets and traditional funding currencies.
• Valuation: calculates whether currencies are over/undervalued compared with the long-term trend in the real effective exchange rate (REER). The trend is adjusted for external imbalances, i.e. an imbalance-adjusted REER. The scores are calibrated to reflect the short-term impact of the valuation on FX.

Strategy update
Having discontinued our HUF/PLN positioning, we continue to maintain our short strategy on TRY/BRL, where, despite active Brazilian currency market interventions, we have not observed a decisive break on the upside.

Short TRY/BRL
The past week has seen Brazilian IPCA inflation figures catching the markets with a small upside surprise, coming out at 5.20% against the median surveyed expectations of 5.11%. The rise has been however primarily due to continued rise in food prices and the CPI continues to be with the Brazilian Central Bank’s target range.

At the same, the current account deficit in Turkey continued to widen with the September number published at a negative USD4.1bn and the prior deficit reading being revised from minus USD3bn to minus USD3.2bn. The continued deterioration in the current account balance, although currently fully covered by the capital account – now also coinciding with a proportionate drop of FDI portion of capital inflows – is what brings the
current Turkish lira value into a significantly overvalued territory from our long-term fair valuation perspective.

Daily advances in TRY/BRL continue to be capped by the resistance coming into play at the upper end of the channel formation and we continue looking for a longer term reversal in TRY while receiving a moderate carry profits in our present strategy.

The largest risk to our strategy continues to emanate from the Brazilian currency market interventions aimed at halting further major strengthening in Brazil, as the high Brazilian yields continue to attract international capital flows following US Federal Reserve new round of monetary easing. Although Turkish lira is similarly a beneficiary of these international portfolio flows, the action seems far more determined in Brazil in limiting
the local currency gains. On the other hand, the renewed European debt worries are likely to benefit the trade on the margin.
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Full report: FX market update and Strategy Update : Between momentum and valuation