This is an update of my article from last month. See also the first article in this sequence. In that article, I value currencies based on changes in purchasing power relative to changes in purchasing power of other currencies. I also explain this concept further. In short, suppose the 5-year difference in inflation between 2 currencies is not compensated by a 5-year decrease in the value of the currency with the most inflation. Then a long position in that inflationary currency and a short position in the other currency is a statistically favorable bet.

Changes in 5-year inflation and currency exchange rates result in a new ranking of the currencies discussed in my previous article. See the table below.

Rank (change)

Currency

Price

(per USD)

Mar 22, 2017

Last month’s

result

Price

(per USD)

Apr 26, 2017

Current

Result

1

HKD ↓

7.766

-0.089

7.781

-0.091

2

KRW ↑

1121

0.000

1134

0.009

3

SGD =

1.398

0.127

1.398

0.129

4

CHF ↓

0.9927

0.143

0.9959

0.137

5

NZD ↓

1.420

0.152

1.454

0.172

6

EUR ↑

0.9256

0.228

0.9201

0.213

7 (-2)

GBP ↑

0.8015

0.264

0.7791

0.219

8 (+1)

DKK ↑

6.883

0.236

6.845

0.220

9 (+1)

PLN ↑

3.965

0.249

3.891

0.227

10

HUF ↓

285.7

0.278

287.6

0.279

11 (-1)

MXN ↑

19.15

0.314

19.14

0.306

12 (-3)

SEK ↑

8.811

0.343

8.790

0.338

13 (+2)

AUD ↓

1.303

0.308

1.340

0.344

14 (+1)

CAD ↓

1.337

0.322

1.359

0.348

15 (+1)

ZAR ↓

12.66

0.337

13.29

0.396

16 (-1)

JPY =

111.5

0.444

111.5

0.442

17 (+1)

NOK ↓

8.481

0.414

8.594

0.452

The higher the rank number, the more undervalued a currency is against the USD, at least on a statistical basis. For example, the Korean won with ticker KRW at place 2 is almost fairly valued compared to the USD. The Norwegian krone with ticker NOK at place 17 is the most undervalued currency on a statistical basis. A negative value (e.g. the Hong Kong dollar or HKD at 1) in the column “Result” means the currency is overvalued compared to the USD.

Another statistical favorable trade is being long in the currencies with high interest rates and short in currencies with low interest rates. This is also called the carry trade. Investors with a carry trade position make money from the extra interest they get. Their risk is in the exchange rates. In practice, however, such a position is profitable on a statistical basis based on the exchange rates alone. So, it is more likely the currency with the low interest rate goes down instead of going up against the currency with the high interest rates.

I have also made a list ranking currencies on interest rate difference with the USD. Again, the higher the rank number, the more undervalued (or less overvalued) a currency is, based on the difference in interest rate with the USD. A negative difference means the currency is more likely to be overvalued and a positive difference means a currency is more likely to be undervalued against the greenback. I took the interest rates from a different source than last month. This month, I use the interbank rates from Interactive Brokers (25 April 2017):

Rank (change)

Currency

Δ %

1

CHF

-2.289

2

SEK

-1.939

3 (-1)

EUR

-1.803

4 (+1)

DKK

-1.780

5

JPY

-1.138

6 (-2)

GBP

-1.043

7 (+1)

HUF

-0.951

8 (+1)

HKD

-0.799

9

NOK

-0.441

10 (-1)

SGD

-0.370

11 (+1)

CAD

-0.368

12

KRW

0.340

13 (-1)

PLN

0.730

14 (+1)

AUD

0.743

15

NZD

0.910

16

MXN

6.353

17

ZAR

6.634

If we combine these strategies by adding the ranks of each strategy, then we get the following list:

Rank (change)

Currency

Price

(per USD)

Apr 26, 2017

Rank RPPP

+

Rank Δ %

1

CHF

0.9959

6

2

HKD

7.781

9

3

EUR

0.9201

10

4

DKK

6.845

13

5

USD

1

14

6

SGD

1.398

14

7 (-2)

GBP

0.7791

14

8 (-2)

SEK

8.790

15

9 (+2)

KRW

1134

16

10 (+2)

HUF

287.6

18

11 (-1)

JPY

111.5

22

12 (+1)

NZD

1.454

22

13

PLN

3.891

24

14

CAD

1.359

26

15 (-1)

NOK

8.594

27

16 (-1)

MXN

19.14

30

17 (+2)

AUD

1.340

29

18

ZAR

12.29

34

Carry trades that are also good based on relative purchasing power parity

The carry trades I suggested last month are still good trades. A good carry trade would be to short the CHF and go long the ZAR. Another possibility is shorting the CHF against the AUD or the MXN as discussed in last month’s article. In terms of relative purchasing power parity, the first 2 carry trades are also good. Good carry trades not involving currencies of less developed countries are shorting the CHF against the AUD or the NOK.

As I suggested in last month’s article, of course, the HKD could be shorted as well instead of the CHF. Then the bet is on a fall in the USD or on de-pegging from the USD followed by depreciation of the HKD.

Discussion

The dollar has weakened against most European currencies. I think the reason is there are now less fears for the euro falling apart. In France, a non-populist candidate, Macron, seems to have a good chance of winning the presidential election. He won the first round of the election. The final second round is on May 6 and goes between him and the populist Marine Le Pen.

With the euro, the big question is when will the ECB end its bond purchases? I guess this will be when the South European countries show solid economic growth. This is probably far away. First, because of insufficient structural reforms in South Europe. Second, because the current up going economic cycle probably will not last much longer. With about 7 years, it has already lasted much longer than usual.

Trump decided to renegotiate NAFTA instead of terminating it which was good for the CAD and the MXN. Speculators are also bullish on the Mexican peso.

Trump’s tax reform plans were received less enthusiastically. Tax decreases for companies could make them repatriate foreign cash adding strength to the USD. It seems, however, these measures are further away than the markets initially thought. Trump does not give a timeline in his pdf. Reducing corporate tax will increase the budget deficit too much. Passing a tax bill might be also difficult because there is a conflict of interest.

Going forward, I think rate hikes will continue to push the USD higher. I think monetary policy in the EU will continue to lag monetary policy in the US. But sudden political events such as a new war in Asia or in the Middle East can have a much bigger impact.

Renegotiation of NAFTA instead of terminating it was good for the CAD but increased import tariffs on lumber imports were not. See also here. Oil prices stayed more or less flat at low levels. If oil rebounds, that would be very good for the CAD. I think it will.

The markets also reacted on the news of the earlier elections in the UK with a surge of the GBP against the USD. The market expects the election to increase political stability in the UK. I think this surge was an emotional trade and will be reverted.

The Bank of Japan will continue its asset purchases. It sees 2% inflation only after 2018 and only then it will taper its asset purchases. I wonder how the Japanese government will then pay the interest on its debt. See also this detailed discussion in the Japan Times. I still think these asset purchases could easily lead to runaway inflation. In many complex systems, there are tipping points. Up to a certain extent, the system can absorb inputs, but then suddenly the system reacts on the last input (asset purchase) with all previous similar inputs still in “memory”. This is a common phenomenon in ecosystems and epidemiology, but it can occur in economies as well.

One of the strongest currencies based on changes in purchasing power is now the Australian dollar. In the first quarter of 2017, inflation went sharply up. Unfortunately, the official CPI number is only expected in May, so I still use the CPI number from December 31, 2016 in my calculations. But if we add 1.5% to the inflation over last 5 years, the AUD goes up only one place in the purchasing power list, from 14 to 13 in the first table. In the combined list (3rd table), the AUD goes up from 17 to 16. Conclusion: The recent increase in inflation is already priced into the AUD. It is hard to tell, however, whether this higher inflation will continue down under.

Another interesting currency is the South African rand. Last month, the rand lost value because South Africa’s president Zuma sacked many ministers in his attempts to escape corruption investigations. It reminds me of the troubles with the Brazilian real some time ago. The difference is institutions in South Africa are not as strong as in Brazil. On the other hand, the South African economy is now in better shape than the Brazilian economy at the time. I continue to be long in the South African rand.

Last month, a Swiss government official said the Swiss franc is “grossly overvalued”. Compared to the USD, this is a bold statement, but compared to the NOK or the ZAR, it is much more likely. Bank of America also predicts a stronger euro against the Swiss franc because it thinks the Eurozone will start tightening before the Swiss do.

Finally, highly undervalued based on relative purchasing power is also the Norwegian krone. It is not so undervalued based on the interest rate. Lloyds Bank agrees with me and sees a 6-7% higher krone by the end of 2017. The price increase will be fueled by a “recovery in investment” which will lead to more GDP growth. Of course, higher oil prices help too. Also, Danske Bank says the Norwegian krone is undervalued based on stabilizing inflation.

Relevant ETFs and ETNs:

  • PowerShares DB US Dollar Index Bullish Fund (UUP)
  • ProShares UltraShort Euro ETF (EUO)
  • CurrencyShares British Pound Sterling Trust ETF (FXB)
  • ProShares UltraShort Yen ETF (YCS)
  • CurrencyShares Euro Trust ETF (FXE)
  • WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU)
  • CurrencyShares Canadian Dollar Trust ETF (FXC)
  • CurrencyShares Australian Dollar Trust ETF (FXA)
  • CurrencyShares Swiss Franc Trust ETF (FXF)
  • PowerShares DB G10 Currency Harvest Fund (DBV)
  • CurrencyShares Japanese Yen Trust ETF (FXY)
  • Market Vectors Double Short Euro ETN (DRR)
  • PowerShares DB US Dollar Index Bearish Fund (UDN)
  • CurrencyShares Swedish Krona Trust ETF (FXS)
  • ProShares UltraShort Australian Dollar ETF (CROC)
  • ProShares Short Euro ETF (EUFX)
  • ProShares Ultra Euro ETF (ULE)
  • ProShares Ultra Yen ETF (YCL)
  • iPath GBP/USD Exchange Rate ETN (GBB)
  • CurrencyShares Singapore Dollar Trust ETF (FXSG)
  • iPath EUR/USD Exchange Rate ETN (ERO)
  • iPath Optimized Currency Carry ETN (ICI)
  • Market Vectors Double Long Euro ETN (URR)
  • iPath JPY/USD Exchange Rate ETN (JYN)

I do not recommend these products. I only include them such that this article can be syndicated along their ticker symbols.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



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