Saturday, December 11, 2010

EMEA Weekly: FX market , CIS and Strategy update

FX market update 
TRY, PLN and CZK continue to underperform 
Over the past week (and month), the three worst performing EMEA currencies have been
the Polish zloty, the Turkish lira and the Czech koruna. A look at our EMEA FX
Scorecard shows that these three currencies are in fact the lowest scoring currencies and
as such we believe the underperformance is justified.
Overall, it seems to be especially the negative technical score that is the main
explaination for the continued weakness in most of the EMEA currencies. Hence, the
trend no longer seems to be our friend, but it is also notable that that the sub scores for
macroeconomic conditions seem to have been worsening recently for a number of EMEA

Short-term outlook worsens for CZK 
For some time our EMEA FX Scorecard has been signaling CZK weakness and that
signal clearly has been correct. This week’s updated scorecard shows that the outlook for
CZK has now worsened even more. It is especially notable that there is really no shortterm factor pointing in a positive direction for the Czech koruna.

Specifically, it is the low carry reading, negative technical score and now also the
deterioration in macroeconomic conditions which are weighing on the overall score for
CZK. In addition, it is worth pointing out that it seems like the speed of the recovery in
the Czech economy is losing some momemtum. This is having a negative impact not only
on the sub score for macro, but also means that the Czech central bank should not be
expected to hike interest rates anytime soon. In fact, our Monetary Policy Tracker for the
Czech Republic is now indicating that the CNB should keep rates on hold all through
2011 and if one looks in isolation at the growth momentum (or rather lack of positive
momentum) then there might actually be an argument for the CNB to cut rates.

The low rate environment in the Czech Republic is increasingly making the Czech koruna
an attractive funding currency – at least in the short run. That said, we also would like to
stress that the longer-term outlook for CZK is much more promising so while we see
more CZK weakness on a three-six month horizon we would expect a rebound in CZK on
a 12-36 month horizon; we continue to believe that CZK is fundamentally undervalued.
But for now, we expect CZK to become even more undervalued.

CIS Update
Russia seems to be advancing again in its negotiations on joining the WTO and the
Russian economic ministry is already talking about the possibility of joining the
organisation even in H1 11. However, the negotiations have been ongoing since the early
1990s and Russia was close to membership in 2006, when it had agreed the terms with
both the US and EU. The Russians have had very mixed views on the benefits of the
WTO membership and so far the political will to join has not been sufficient.

We believe that WTO membership would be a necessary positive signal for foreign
investors, making the much-needed, investment-led growth boom a bit more likely.
Russian consumers would benefit as well due to increased competition. However, we are
not confident that Russia is ready to make the necessary compromises, but we would
definitely become more optimistic on Russian longer-term growth prospects due to an
improved investment environment.

Kazakhstan is planning to return to the managed float currency regime in early 2011.
Currently, the tenge is trading in a corridor, which was introduced after the global
financial crisis started and the tenge was devalued by 18%. With current oil prices, the
tenge is likely to appreciate about 5% during H1 11 supported by the current account
surplus. However, the Kazakhstan economy is particularly connected to Russia, which
means that the tenge is likely to follow rouble moves quite closely.

Strategy update
As risk appetite has to some extent returned to the markets during the last ten days, high
carry currencies such as the South African rand have benefitted from this. Furthermore, as
gold prices brought new record highs this week, the rand gained back following the recent
correction. With the move higher in both the risk appetite level as well gold, USD/ZAR
has visited our stop loss level at 6.8600 on the downside and our long strategy from
7.0855 has therefore been terminated. The trendline support in the pair, however,
continues to hold, and though we have narrowly been stopped out, technically the bullish
picture in USD/ZAR remains intact. Despite our stop out of our USD/ZAR, we continue
to favour our short position TRY/BRL and we have also opened a new strategy of buying
a one-year EUR put/HUF call option where we recommend being positioned for forint

Short TRY/BRL 
We continue to favour the short TRY/BRL position. The trade continues to perform well
and was further supported by weak Turkish Q3 GDP numbers, which showed a much
weaker-than-expected performance of the Turkish economy in Q3 (growth only 5.5% y/y
in Q3, down from the revised 10.2% y/y) with weak exports being the main culprit behind
the weak number. While Turkish economic activity disappointed, Brazilian Q3 GDP, also
published this week, recorded fairly solid GDP growth of 6.7% y/y. The structure of the
growth was also somewhat healthier with investments contributing strongly to growth in
Q3. Therefore, from a growth perspective, Brazilian economic activity outperforms
relative to Turkey at this moment in time, providing further support to our trade.  

Position for forint normalisation
This week we opened a new strategy in which we are positioned for forint normalisation
via EUR/HUF option strategy.
While for much of 2010, the Hungarian markets and the forint in particular have fallen
prey to frequent political event risks and investor confidence has been hurt by
uncertainties surrounding future policy actions, we view the Hungarian markets as being
overly stigmatised. Going into 2011, despite many continued uncertainties, we look for
the Hungarian markets to normalise, allowing stronger forint levels among other things.

We recommend capitalising upon the fact that out-of-the-money puts on EUR/HUF are
trading at a significant discount to similar call options and utilising a EUR put/HUF call
option contract to position for a Hungarian forint recovery in 2011.

Hungarian fundamentals better than general perception
While Hungarian growth has significantly lagged behind its peer countries in the CEE
region and our estimate for 2010 is a meagre 0.3%, we expect a gradual improvement in
activity levels with our 2011 estimates pointing to a much improved 2.1%. This should
give some support to the forint. Furthermore, the Hungarian central bank has recently
initiated a monetary tightening cycle and with the key policy rate at 5.5% the carry on the
forint is well above its regional peers. This is also likely to be supportive for the forint.
Although the high external debt level – currently running around 125% – and financing
difficulties compounded by a recent Moody’s downgrade of sovereign credit rating
continue to weigh heavily on Hungary, the budget situation is structurally not in as bad a
shape as the common perception seems to make out. In our estimation, the Hungarian
budget deficit is likely to be about 4% of GDP, which is well below that of Poland, an
important peer country. The fiscal reforms that were passed by the previous government
in 2006 have, in fact, allowed for an improved Hungarian budget deficit and for the
country to be included in a category that might be termed as the healthier group of EU
member states with regard to budget deficits.

While the recent sell-off in Hungarian equities and concurrent punishment of the forint
has swiftly followed the market’s nervousness over government plans to nationalise the
private pension industry and subsequent Moody’s downgrade, we view the general
market reaction to political factors as somewhat excessive. While we too observe the
situation with the pension privatisation and host of other temporary measures the
government has taken to covering the budget gap with grave concern, we feel there is still
sufficient room for recovery in the Hungarian economy and markets going into 2011.
Volatility skew provides opportunity for inexpensive positioning for a
Hungarian recovery
The volatility skew, as seen in the EUR/HUF one-year 25 delta risk reversal readings and
with current indicative level of 3.77, implies significantly more expensive out-of-money
calls in EUR/HUF in comparison with corresponding put options. Considering also the
fact that the long-end of the EUR/HUF option volatility curve has been relatively better
shielded from the frequent market spill-over of political risk factors, one is afforded a
relatively inexpensive way of buying into the Hungarian recovery and forint
normalisation scenario for a year’s duration.

Although our strike price is at a significant distance from our current one-year EUR/HUF
forecast, currently at 275.00, we would be looking to capitalise on the premium
appreciation of our option contract, which will follow a significant downward move in
spot rates over the course of the option life span.
Full report: EMEA Weekly: FX market and CIS update

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