#1: Sell EUR/SEK strangle
We recommend selling a six-month 35D EUR/SEK strangle. Sell an 8.95 EUR/SEK put option and a 9.40 EUR/SEK call option for a premium of 2,660 SEK pips upfront – equivalent to 2.92% EUR notional. Break-even levels are 8.68 and 9.67.
The upside
The growth outlook continues to deteriorate and we expect Sweden to join the euro area in a mild recession. We expect exports to be hit and commercial Swedish krona demand to decline. A flow factor that was clearly krona supportive in 2011 would thus be reduced. We expect slower global growth to weigh on the inherently pro-cyclical Swedish currency but considerably less than after Lehman Brothers. Swedish exporters are not over-hedged, which limits downside in the krona this time around. Also, we do not see a full collapse in GDP.
We project CPIF inflation below 1% for most of 2012, with risks being skewed on the downside. We expect falling resource utilisation and low inflation to force the Riksbank to cut 25 basis points in December, thereby initiating an easing cycle taking the repo rate to 0.50% in H2 12, i.e. more cuts than the market is currently pricing in. While relative yields might not be a very strong argument, it is still an argument for higher levels in EUR/SEK. Despite the ECB moving lower as well, the removal of a SEK-EUR positive rate gap could reverse previous carry-related krona demand.
The downside
However, the upside in EUR/SEK is capped by strong fundamentals, savings surplus, low public debt, low default risk (CDSs) and a stable AAA rating.
Foreign demand for Swedish high-quality assets remains intact – as illustrated by foreign holdings of Swedish government bonds being close to an all-time high, above 50%. Between March and September foreigners have net bought Swedish government bonds for close to SEK100bn. Given the very poor fundamental backdrop abroad, we do not expect significant unwinding of Swedish assets in coming months. The recent warning from Standard & Poor‟s to downgrade even core euroland economies leaves only nine stable AAA countries in the world, one of which is Sweden. Given the challenging outlook for the euro area, with (further) downgrades threatening the UK and the US, it is difficult to see why investors should flee Swedish assets unless we get a full-fledged riskoff environment. We believe investors should realise that the krona is still slightly undervalued.
Range bound
There are only two periods since the euro was launched some 10 years ago when EUR/SEK has traded persistently more than one standard deviation below or above the 9.15 mean exchange rate; the IT era in 2001 and the financial crisis post-Lehman Brothers in 2008-09.
The current market is no doubt turbulent and driven by risk-on/risk-off sentiment. In recent months, (1) the world economy has been repriced for global recession, (2) the eurozone has been considered close to breaking up, (3) stock markets have tumbled, (4) the Riksbank has been priced for significant rate cuts, (5) Sweden has been singled out as one of few countries with a stable AAA rating, (6) foreign holdings of Swedish government bonds have reached close to all-time highs of above 50% and (7) EU summits have failed to deliver, etc. Still, EUR/SEK has not moved outside 8.90-9.40. Our main scenario is that the 8.80-9.50 EUR/SEK trading range is maintained for most of
2012. Hence, the proposed strategy.
#2: The Swiss deflation trade
The European recession and strong Swiss franc have caused deflation risks to rise once again in Switzerland. This is likely to prompt the SNB to ease monetary policy further and is more likely to happen via a higher EUR/CHF floor than via administrative measures. Buy EUR/CHF spot at 1.2325 for a 1.30 target with a 1.2050 stop/loss.
Alternatively, buy a 6M 1.29 EUR/CHF call option financed fully by a sold 3M 1.1500-1.2300 EUR/CHF put spread (with 1.75 × notional on the bought 1.15 put). This zero-cost strategy leaves the potential to benefit from a hike or break of the 1.20 minimum target.
SNB to attempt weakening the franc further
The Swiss National Bank‟s 1.20 floor below EUR/CHF has so far proven a success. Not only has the central bank managed to stop the strong appreciation trend but it has done so with what is likely to be limited intervention. However, while the new currency regime may have gained a high level of market credibility, it has not removed deflationary risks.
Since the 1.20 floor was introduced in early-September, the Swiss economic outlook has deteriorated significantly and Swiss leading indicators have fallen to the lowest level since the 2008 recession. Combined with a strong currency and weak foreign demand the result has been falling consumer prices – and more so than expected. In its September monetary policy report, the SNB forecast inflation to bottom at minus 0.5% in 2012. However, the latest CPI report showed inflation falling to minus 0.5% in November, with core inflation even falling below minus 1% y/y.
We expect the SNB to address the increased deflation risks by loosening monetary policy at either the 15 December meeting, or during H1 12. The most obvious policy tools left in Switzerland are: (i) a higher floor below EUR/CHF, (ii) further liquidity injections and (iii) administrative measures. Of these, a hike of the 1.20 minimum target appears the most likely response, in our view.
The Swiss franc has already weakened slightly to reflect the increased probability of a higher SNB floor but this is still not fully priced in. There are naturally also arguments against further SNB action, with concerns centred on the risk that a higher minimum target could trigger speculative flows. Our G10 PPP model puts EUR/CHF fair value at 1.38 and a hike of the minimum target, to say 1.25 or 1.30, would thus take the Swiss franc back in more neutral territory. These are important concerns but will probably not keep the SNB from addressing higher deflationary risks.
We recommend buying EUR/CHF spot at 1.2325 for a 1.30 target with a 1.2050
stop/loss. The key risk to this trade is a significant deterioration of the EMU crisis and the return of CHF buying as a euro hedge.
Alternatively, we recommend positioning for a higher EUR/CHF via options. Consider buying a EUR/CHF call option strike 1.29 with 15 June expiry (covers the coming three SNB meetings) financed by a sold 3M 1.15-1.23 put spread with 1.75 × notional on the bought 1.15-strike put option. This strategy can be entered at zero cost (indicatively) and leaves potential to benefit from a hike as well as a break of the 1.20 floor.
The two key downside risks to the 1.20 minimum target are: (i) a euro tail-risk event and (ii) a sudden spike in Swiss inflation forcing the SNB to abandon FX intervention. The latter is not an important risk on a 12-month horizon, however, which leaves euro tailevents as the main risk. This is the reason for having a higher notional on the bought 1.14 put option. Should a euro tail-risk event cause a break of the 1.20 floor then we would expect EUR/CHF to trade much lower and not just settle at say 1.18. Moreover, we would expect volatility to spike and the option skew to turn very negative. This would all benefit the bought 1.14 put option and we estimate in a best case leave a net profit.
# 3: NOK/SEK – breaking-up is easy
In last year’s top trades, we recommended to sell vol in NOK/SEK through a leveraged pivot to benefit from similar monetary policies and economic development. However, we now argue that 2012 will be the year that NOK/SEK breaks out of its stable-trading range. However, we are uncertain where the cross is going and recommend buying a butterfly to benefit from a possible big move in the cross in either direction on a 6M horizon.
We have skewed the butterfly to the upside to express our view that after all risk is skewed on the upside in NOK/SEK. The strategy has break-even at maturity at 1.1300 and 1.2450, allowing NOK/SEK to trade in a wide trading interval without causing a loss.
Business cycle and monetary policy point to higher NOK/SEK...
One of the main drivers for NOK/SEK throughout 2011 has been relative rates. Both the Riksbank and Norges Bank hiked rates in H1 11 and policy rates are now almost equal in Norway and Sweden. However, looking forward, the market is pricing in a somewhat divergent development in policy rates in the two countries. In Sweden, market pricing indicates that the refi rate will be lowered well below 1% with the Mar13 RIBA future trading at 0.78%. In Norway, calculating central bank market pricing is a bit more difficult, as there is no OIS market but the FRA-curve indicates that 3M NIBOR is expected to fall approximately 75bp over the same period. In our view, risks are skewed towards an even more divergent monetary policy between Norway and Sweden.
The Swedish export-oriented economy will inevitably be hit hard when the most
important export market, the eurozone, is engaged in heavy austerity measures at a time when it is struggling to avoid a deep recession. In our view, Swedish policy rates will have to be reduced significantly during the next six months. Norway, on the contrary, has not really felt the pain and it almost seems as though the Norwegians have not realised that a financial crisis is unfolding. The economy is powering ahead on the back of recordhigh oil investments and a red-hot housing market, with prices up close to 10% YTD. The latest regional network report from Norges Bank showed that the outlook for the economy – contrary to Sweden – has not weakened towards the end of 2011.
...but expect the unexpected
The monetary and cyclical outlook is the reason why we favour the upside for NOK/SEK and have skewed our butterfly accordingly. However, 2012 might easily turn out to be very different. If we look at the current rhetoric from Norges Bank and the Riksbank, it is not a done deal that monetary policy will develop according to market expectations. Norges Bank has in fact sounded more concerned about the global economy than the Riksbank. Norges Bank is also highly concerned that the NOK might turn into a true safe haven and plans to fight such a development eagerly. Remember, Norway experienced a severe erosion of its competiveness after EUR/NOK dropped to a record low of 7.21 in
2003. Norges Bank has repeatedly voiced concern about the NOK strength, whereas Riksbank Vice Governor Lars Nyberg last week said that he is not “worried about krona strength”.
Valuation is also stretched in respect to NOK/SEK. Our PPP estimate for the cross is now as low as 1.05 reflecting a severe SEK undervaluation. Another two important factors that could potentially induce volatility in NOK/SEK are positioning and commodity prices.
The NOK in particular is exposed to an unwinding of long speculative positions if risk aversion explodes or if Norges Bank steps up its purchases of foreign currency. Unpredictable oil price swings could also increase volatility in NOK/SEK.
#4: China avoids hard landing
Position for a soft landing of the Chinese economy and continued appreciation of CNY by selling a 12M USD/CNY NDF. Albeit we expect the pace of appreciation of CNY against USD to slow, this strategy looks very favourable as the market now discounts a slight depreciation of CNY over the next year.
In our view, this strategy offers limited downside risk as the policy response from China in a scenario with a sharp slowdown in the economy is likely to be to keep CNY broadly unchanged against the USD, just as China did in the wake of the global financial meltdown in late 2008.
Appreciation of CNY continues, albeit at a slower pace
We expect a relative soft landing of the Chinese economy next year in the sense that inflation should gradually decline without growth slowing sharply. Inflation is already declining relatively quickly and we believe it could fall below 3% y/y in mid-2012 after peaking above 6% y/y in Q3 11. However, we are unlikely to end up in deflationary territory as China did in the wake of the financial meltdown in 2008. Since China abandoned its peg to the USD in 2005, there has been a very close relationship between inflation and the pace of the appreciation, in the sense that the pace of appreciation against the USD tends to decline when inflation declines. Our expectations of lower inflation in China suggest that the pace of appreciation of CNY against the USD should slow to around 3% over the next year from more than 5% over the past year – however, the market prices no appreciation.
Worst case appears to be a temporary re-peg to USD
Over the past 15 years, there have been two cases where the market expected a devaluation/depreciation of CNY against the USD: first, in the wake of the Asian crisis in 1997 and, second, in the wake of the global financial meltdown in late 2008. In the wake of the Asian crisis, China chose not to devalue and maintained its USD peg. In the wake of the global financial crisis in 2008, China chose not to depreciate its currency but instead temporarily “re-pegged” to the USD until the spring of 2010, when the gradual appreciation policy was resumed. In our view, keeping the CNY broadly unchanged against the USD will continue to be the policy response in an adverse scenario with a relatively hard slowdown in China. First, the Chinese leadership believes that there could
be substantial political costs, including a possible trade war with the US, if it allows its currency to depreciate. Second, in both 1997 and 2008, the Chinese leadership acknowledged that a devaluation/depreciation would probably be counterproductive for the Chinese economy, as it would contribute to destabilising global financial markets.
Position for continued CNY appreciation
For the first time since the spring of 2009, the market discounts a slight depreciation of CNY against USD. Hence, we recommend selling a 12-month USD/CNY nondeliverable forward (NDF). This strategy would benefit if China managed a soft landing and continued to appreciate its currency. However, with a slight depreciation already discounted in the market, we also see limited downside risk for this strategy in a more adverse scenario where the Chinese economy slows substantially more than we currently forecast.
The main risk is that the market will price even more expected CNY depreciation, even if that never materialises. In addition, if the slowdown is substantially more severe than in 2008, China could eventually be forced to depreciate its currency to shore up the economy.
#5: USD/JPY – stuck in a range
We expect USD/JPY to remain within a range in H1 12, as potential BoJ intervention keeps the downside floored and the sluggish outlook for global economic growth should cap USD/JPY upside by capping global bond yields. We recommend entering a USD/JPY put butterfly to position accordingly.
Base scenario is for USD/JPY to edge modestly lower
One of our core themes is for global central banks to respond to the poor growth outlook by applying further monetary easing. While US economic data has surprised on the upside recently, further stimulus is likely if growth falters again. The BoJ has so far lagged behind its peers, easing policy far less aggressively than the Fed. Unless the BoJ introduces new aggressive measures, we would thus expect USD/JPY to trade lower going forward. Further downside risks include the US fiscal situation, where the paralysis of the US political system in dealing with the long-term budget issues is likely to trigger
further US credit rating downgrades in 2012. Also, the large US current account deficit remains a USD risk. Japan has its own debt problems to tackle but as most of the debt is domestically held, the issue is much less acute.
BoJ to intervene aggressively if USD/JPY falls towards 75
While the downside pressure in USD/JPY has eased in recent months, the most recent BoJ policy statement pointed to fears over slowing exports and a possible adverse impact from the strong JPY. In our view, the BoJ‟s fixation with the level of the exchange rate will continue in 2012; we expect Japan to defend aggressively the 75 level against the USD and we cannot rule out the possibility that the BoJ will eventually expand its balance sheet aggressively to avoid a stronger JPY. While the most recent round of intervention at the end of October saw USD/JPY lifted by four big figures, long JPY positioning has since been scaled back somewhat (currently at 21% of open interest) and as a result the spot reaction is likely to be less fierce. Our main scenario is not, however, for the BoJ to follow in the footsteps of the Swiss National Bank, setting an explicit target for the USD/JPY exchange rate. Still, we expect BoJ intervention to cap the downside, without triggering a breach of the recent trading range on the upside.
Sluggish global growth to cap upside in USD/JPY
While the global economy is slowing, our core view is that the world economy will escape recession. If the improvement in the US cyclical picture continues, this could imply modest upside for US rates. However, much depends on how the European debt crisis evolves and whether stress in the financial system persists. Even in a positive scenario, the current recessionary outlook for the European economy and the fragility of the recovery in the world economy are likely to cap the upside in US rates.
Profiting from USD/JPY trading in a wide range in H1 12
While aggressive BoJ intervention is likely to cap the downside in USD/JPY if the trend for JPY appreciation resumes, sluggish global growth is likely to cap the upside in the pair. Hence, we look for USD/JPY to continue range trading during H1 12.
To position for this view, we recommend entering a 6M USD put/JPY call butterfly spread. Specifically, we recommend buying a 79.5 put, selling a 77.5 put with double notional and buying a 74.0 put – at a combined zero cost (indicative prices, spot/fwd ref. 77.95/77.60). We calculate this structure would give a profit of two big figures if spot trades 77.5 at maturity, while capping the potential loss at 1.5 figures if the spot trades at or below 74. The strategy has break-even at 75.5, yielding a profit if the spot at maturity is above this level but below 79.5.
#6: EUR/TRY – Turkish delight
The rapidly expanding Turkish economy is entering a challenging period going into 2012, with large external imbalances and high inflation keeping pressure on the lira. The lira has already suffered a significant depreciation, however, and with the economy showing signs of rebalancing, we see value in positioning for a stronger lira on the 12-month horizon.
Taking advantage of the currently high 12M option skew, we recommend purchasing a one-year EUR/TRY out-of-the-money put option with strike 2.30.
Turkish economy to rebalance in 2012
The Turkish economic performance has been very good in recent years with near 9% growth in 2010 followed by an average of close to 10% y/y growth in the first three quarters of this year. Growth has, however, come at a rather heavy price, as credit-fuelled domestic demand has resulted in ballooning external imbalances, with the current account deficit currently hovering around an unsustainable 10% level, up from 6.5% in 2010.
While external conditions have deteriorated and cross-border capital outflows pose a key danger, inflationary pressures have been rather sticky, with the generally volatile Turkish inflationary readings hitting 9.5% y/y in November. A far cry from the 5% that the Turkish central bank (TCMB) targets at year-end 2012.
Since cutting policy rates by 50bp at the interim rate setting meeting in August to 5.75% to shore against slowing growth against the backdrop of very dovish rhetoric, the TCMB has taken an almost 180 degree turn and embarked on a rather hawkish stance in the face of lira depreciation that it now views as excessive and accelerating inflation. To this effect, since October the TCMB has utilised a rather unorthodox approach of resetting the o/n rates on a daily basis within a wide corridor, which – while not improving the already poor visibility of central bank policy – has proven yield supportive to the lira.
Going into 2012, it is very clear to us the Turkish economy is entering a rather challenging period, during which further deterioration of external conditions and any slacking in the speed of rebalancing pose the key dangers, keeping the lira under pressure and both comprising key risks to our strategy. Having said this, however, the lira has already seen a significant depreciation, taking it closer to its fundamental fair value level. Aided now by hefty carry, with TCMB‟s firm hawkish bias, we now see scope for lira appreciation in the medium to long term (see Emerging Markets Briefer, 16 November 2011).
Purchase OTM put on EUR/TRY to capitalise on lira up moves
To take advantage of the potential sharp down moves in EUR/TRY in 2012, we
recommend purchasing an out-of-the money EUR put/TRY call option, with a strike at 2.30. From a technical point of view, EUR/TRY is near completion of a double-top (DT) formation, with the 2.59 resistance having twice repelled euro advances against the lira. The neckline support for the DT formation comes in around the 2.4150 level, a break of which would technically pave the way towards the 2.20 area. Given the current positive option skew where OTM put options are significantly cheaper than comparable calls, we find good value in purchasing this option at a premium cost of below 1% of EURnotional amount. Long gamma exposure from the bought put option also benefits from a high volatility environment, which is set to remain elevated going into next year.
As a more risk-willing alternative, this strategy can also be constructed as a zero-cost option structure that takes advantage of the current and steep term structure of the positive option skew. In particular, we would recommend financing the above put option with a bearish call spread consisting of a sold call, strike 2.60, and a bought call, strike 2.68. The loss in this structure is limited to the 8 TRY figure distance between 2.60 and 2.68 strikes.
#7: Northern star vs the ugly couple
Compared with the eurozone and the US, Norway stands out in the G10 FX universe with very strong fundamentals illustrated by huge surpluses on almost all thinkable accounts. Even though the Norwegian krone has already appreciated significantly over the past two years, we still believe that the northern star has some potential left.
We recommend selling 12M USD/NOK forward and selling 12M EUR/NOK forward equally weighted. We prefer the forwards to lock in the carry today. We see a risk that Norges Bank will cut rates more than currently priced if the NOK appreciates as we forecast.
NOK: The northern star
Over the past two years, we have promoted long Norwegian krone strategies in our Top Trades. However, we still believe the “northern star” has some potential left in 2012. The Norwegian economy is still powering ahead, despite all the concerns about a global slowdown and the European debt crisis. The Norwegian economy is being boosted by high oil prices in particular. The latest oil investment survey from the Statistical Office pointed to new record-high oil and gas investment activity in 2012. The newest estimate from the current quarter points to nominal growth in total investment of 21% in 2012 compared with a similar estimate for 2011. However, the housing market also continues to boom, with prices up close to 10% year-to-date. The strong economy is the reason why we see the potential for less monetary easing from Norges Bank than currently priced. However, note that Norges Bank would react to an excessive strengthening of the currency – in that case, we would close the forwards before expiry.
The Norwegian krone is a relatively small currency, which means that speculative and portfolio flows can have a profound impact. In 2011, we have in general seen long speculative positions being built in the currency market. According to the weekly flow data from Norges Bank, foreign banks – which we see as a proxy for speculative money – have added NOK118.6bn to long positions so far in 2011. This underlines that the Norwegian krone could be exposed to profit taking. The Norwegian government bond market has traditionally been very small and it has been difficult for large investors to buy
into the strong AAA of Norway. Hence, Norway has not seen the same bond inflows that Denmark and Sweden, for example, have experienced in 2011.
However, in 2012 the Norwegian bond market will be much more liquid as issuance will pick up dramatically, by NOK30bn to about NOK50bn. The reason is that the government has taken over the responsibilities of banking owned Export Finance. The higher issuance is expected to attract foreign investors adding further to Norwegian krone appreciation.
EUR and USD: an ugly couple
Under the theme Structural dollar headwind earlier in this document we argue why we believe the dollar will still be in decline in 2012. Even though we do not forecast a euro break-up the euro is expected to be under severe stress in 2012 and we are reluctant to be long in the euro despite the stretched positioning with many short positions in EUR/USD.
However, the euro is actually one of the prime risks in the suggested strategy. If the euro crisis, or the global growth concerns, intensify it could tend to strengthen the dollar, which would tend to push EUR/USD and therefore also EUR/NOK and USD/NOK higher. However, as we argue in the theme excessive recession fears financial markets are already positioned accordingly.
#8: GBP/PLN gone too far
GBP/PLN is one of the clearest examples of the eurozone crisis having a violent impact on neighbouring countries’ exchange rates; the pair has soared more than 20% in H2 11 without relative rates moving much or global equities suggesting a big move. With Poland set to outperform the UK on almost all fronts in 2012, we recommend taking advantage of the latest price developments by selling GBP/PLN spot. Option strategies can also be considered as the skew is favourable in GBP/PLN.
Timing may be tricky though as the pair is currently in a strong technical uptrend with no signs of levelling off. However, we perceive risk/reward to be favourable for 2012 as a whole. The biggest risk to the trade is an escalation of the EMU crisis with the subsequent Central Eastern European countries deleveraging.
‘Safe-haven’ sterling lower in 2012 due to anaemic growth and QE
Sterling is in many ways a paradox; despite being significantly undervalued from a fundamental perspective, the consensus forecaster does not project a comeback for the pound against the sorely tried euro even in the medium term. We dealt with this issue in FX Strategy: Sterling’s fall from grace (9 June 2011), in which we argued that sterling was weak because of structural economic underperformance and in GBP Research: New regime, new forecast (17 August 2011), where we questioned sterling‟s alleged undervaluation. Sterling has been seen as a safe-haven option in the eurozone crisis where investors have hoarded Gilts and pushed down yields. However, the UK has significant challenges in terms of controlling government spending and curbing the debt burden, as we have pointed out a number of times, see, for example, UK Research: How long can the UK maintain its AAA-rating? (7 September 2011). Recently, the government had to acknowledge that the deficit reduction plan was not on track and that the debt burden is set to grow for most of this decade.
We believe the UK will see very low economic growth in 2012, GDP will expand less than 1% and the country is probably in recession by now. The Bank of England plans to buy Gilts throughout most of 2012 and the assets bought under the total QE programme are set to amount to £400bn by end-2012. These efforts are likely to have a limited economic impact as suggested by recent independent research but surely have a depreciating effect on sterling, which might not be a bad thing when looking at the stillbleeding trade balance.
Poland still the strongest link in CEE
Our most recently updated macro forecasts for Poland see somewhat weaker growth in 2012 than we previously expected. In particular, we see the Polish economy expanding by about 2% next year, down from around 3% in our latest Macro Monitor, Poland, 26 October 2011. Despite this downward revision, however, Poland remains the most robust economy in its Central and Eastern European peer group in terms of growth potential and is set to grow at twice the pace of the UK. Furthermore, a significant weakening in the zloty since the summer has allowed for an implicit loosening of monetary conditions, which, in tandem with above-target inflation, has curbed the Polish central bank‟s need and room for large-scale monetary easing in 2012.
Moreover, Poland is currently undergoing a range of serious austerity measures following the re-election of Prime Minister Donald Tusk‟s governing party. While these measures exert an adverse impact on domestic demand levels, Poland is now broadly perceived to be on the right road in terms of reining in its public debt and balancing its budget. The general deleveraging of CEE countries poses the key danger to the entire region‟s banking and financial markets and, in our view, Poland will almost certainly not emerge unscathed. However, in this respect, Poland, with its better diversified foreign bank involvement, stands somewhat better protected than its peer countries, such as Hungary.
#9: Return flight of the loonie
We forecast that a repricing of global recession fears will push USD/CAD lower in 2012, as the CAD will benefit from a recovery in the US economy and higher oil prices. USD/CAD is closely correlated with risk and the cross could be pushed significantly on better risk appetite – not least as the market, according to the so-called IMM data, is speculatively long on the cross.
We recommend selling USD/CAD spot at 1.0340 for a move lower to 0.9640. We set our stop/loss at 1.0665 – just above the October high.
Position for a repricing of global recession concerns...
We expect the Canadian economy to continue to benefit from the expected pickup in the US economy in 2012. US growth has been a key factor driving the Canadian economy, given the close ties between the two economies. Canadian growth has already rebounded in Q3, posting growth of 3.5% (q/q annualised), albeit following modest contraction in the second quarter.
A long Canadian dollar position is one of our favourite ways of positioning for growth in the US economy in 2012. It might sound counter-intuitive but due to negative correlation between risk appetite and the US dollar, stronger US numbers tend to push USD/CAD lower. Currently, the US numbers are surprisingly strong compared with market expectations. So-called “surprise indices” that measure economic surprises – in the US – relative to consensus expectations are at the highest level since March this year.
The Canadian dollar is in general expected to benefit from a repricing of global recession fears as USD/CAD has one of the highest correlations with risk among the major G10 crosses.
If a repricing of global recession fears unfolds, we would expect to see a significant short covering in the Canadian dollar. According to the weekly CFTC data, speculative short CAD positions against the US dollar are above 13% of open interest. Among the commodity currencies, the CAD clearly stands out as the market is still speculatively long on both the AUD and NZD, against the USD. Consequently, if the market is hit by a new wave of risk aversion, long CAD positions should be more resilient than AUD and NZD, for example. See the latest IMM Positioning Update, 12 December 2011.
...and a rising oil price
Our commodity analysts forecast that the oil price could stay elevated in 2012 and forecast an average Brent oil price of USD112/bl with a rising profile during the year. See Commodities Forecast Update: Global growth still supportive for commodities in 2012, 21 November. USD/CAD has a high correlation with oil prices and the cross is one of the best ways to express a view on the oil market in the FX market.
Oil prices have been well supported over the past couple of months, despite the global financial jitters. In our view, it reflects that demand growth is still strong in the oilintensive non-OECD area. In this respect, it is crucial that our macroeconomists argue that the US and China in 2012 can decouple from the current recession in the eurozone.
Furthermore, our commodity analysts argue that oil will be supported by Opec in 2012. In 2008/09 Opec showed strong commitment to defending prices and slashed production aggressively. Therefore, the market would be reluctant to push oil prices significantly lower, as this would risk a forceful Opec response. Finally, we still expect geopolitics to support oil prices in 2012. The only difference is that the focus has now moved from Libya to Iran.
#10: The cherry-picked carry basket
We expect an unwind of stretched ‘risk-off’ positions to support moderately FX carry strategies during 2012. However, given a weak macro backdrop and continued focus on fiscal balances, we recommend giving up part of a potential carry pickup in order to gain exposure to currencies backed by relatively stronger fundamentals.
Buy equally weighted long AUD, MXN, SGD versus short USD spot at index 100 for 111 target with a 95 stop/loss. This strategy yields an annualised carry of about 2% and reduces downside risks compared with standard carry maximising strategies by making the currency selection subject to macroeconomic criteria.
Carry with a macro fundamental overlay
This has been a surprisingly decent FX carry year considering the sell-off in risk assets during H2. A simple G10 carry basket (long three highest yielding versus short three lowest yielding) with weekly rebalancing has lost only about 1% and has thus outperformed stocks significantly – MSCI world equity index is down more than 6% (total return). Long NOK positions explain part of this carry performance enigma and for 2012 we recommend keeping long carry positions limited to currencies backed by relatively stronger fundamentals.
We doubt that 2012 will prove a strong carry year but, nonetheless, see value in selected carry baskets to benefit from a potential unwind of stretched „risk-off‟ positions once macroeconomic data stabilises. In other words, we prefer cherry-picked carry strategies over simple carry maximising strategies.
The properties that we would like to buy into are: (i) currencies that have already seen a large spot sell-off, (ii) currencies backed by relatively sound external and budget balance projections for next year, (iii) currencies backed by a central bank where significant easing is already priced and (iv) currencies offering a decent carry-to-risk.
No currencies fulfil all of the above criteria but, based on a weighted score and a subjective screening, we recommend buying an equally weighted basket of long MXN, AUD, SGD versus short USD at index 100 for a 110 target and with a 95 stop/loss.
Both AUD and MXN have some of the soundest public balances among the high yielding currencies and while both Australia and Mexico run a current account deficit we expect their terms of trade to remain supported by resilient commodity prices (see Commodity Forecast Update: Global growth still supportive for commodities, 21 November 2012). Although the long SGD position in the basket reduces the positive carry that could be enjoyed purely by holding Mexican and Australian currencies, it works both to reduce the overall volatility of the basket and to allow exposure to the ongoing Asian rebalancing theme as well as our expectation of Asian macro stabilisation later in 2012.
We recommend selling a six-month 35D EUR/SEK strangle. Sell an 8.95 EUR/SEK put option and a 9.40 EUR/SEK call option for a premium of 2,660 SEK pips upfront – equivalent to 2.92% EUR notional. Break-even levels are 8.68 and 9.67.
The upside
The growth outlook continues to deteriorate and we expect Sweden to join the euro area in a mild recession. We expect exports to be hit and commercial Swedish krona demand to decline. A flow factor that was clearly krona supportive in 2011 would thus be reduced. We expect slower global growth to weigh on the inherently pro-cyclical Swedish currency but considerably less than after Lehman Brothers. Swedish exporters are not over-hedged, which limits downside in the krona this time around. Also, we do not see a full collapse in GDP.
We project CPIF inflation below 1% for most of 2012, with risks being skewed on the downside. We expect falling resource utilisation and low inflation to force the Riksbank to cut 25 basis points in December, thereby initiating an easing cycle taking the repo rate to 0.50% in H2 12, i.e. more cuts than the market is currently pricing in. While relative yields might not be a very strong argument, it is still an argument for higher levels in EUR/SEK. Despite the ECB moving lower as well, the removal of a SEK-EUR positive rate gap could reverse previous carry-related krona demand.
The downside
However, the upside in EUR/SEK is capped by strong fundamentals, savings surplus, low public debt, low default risk (CDSs) and a stable AAA rating.
Foreign demand for Swedish high-quality assets remains intact – as illustrated by foreign holdings of Swedish government bonds being close to an all-time high, above 50%. Between March and September foreigners have net bought Swedish government bonds for close to SEK100bn. Given the very poor fundamental backdrop abroad, we do not expect significant unwinding of Swedish assets in coming months. The recent warning from Standard & Poor‟s to downgrade even core euroland economies leaves only nine stable AAA countries in the world, one of which is Sweden. Given the challenging outlook for the euro area, with (further) downgrades threatening the UK and the US, it is difficult to see why investors should flee Swedish assets unless we get a full-fledged riskoff environment. We believe investors should realise that the krona is still slightly undervalued.
Range bound
There are only two periods since the euro was launched some 10 years ago when EUR/SEK has traded persistently more than one standard deviation below or above the 9.15 mean exchange rate; the IT era in 2001 and the financial crisis post-Lehman Brothers in 2008-09.
The current market is no doubt turbulent and driven by risk-on/risk-off sentiment. In recent months, (1) the world economy has been repriced for global recession, (2) the eurozone has been considered close to breaking up, (3) stock markets have tumbled, (4) the Riksbank has been priced for significant rate cuts, (5) Sweden has been singled out as one of few countries with a stable AAA rating, (6) foreign holdings of Swedish government bonds have reached close to all-time highs of above 50% and (7) EU summits have failed to deliver, etc. Still, EUR/SEK has not moved outside 8.90-9.40. Our main scenario is that the 8.80-9.50 EUR/SEK trading range is maintained for most of
2012. Hence, the proposed strategy.
#2: The Swiss deflation trade
The European recession and strong Swiss franc have caused deflation risks to rise once again in Switzerland. This is likely to prompt the SNB to ease monetary policy further and is more likely to happen via a higher EUR/CHF floor than via administrative measures. Buy EUR/CHF spot at 1.2325 for a 1.30 target with a 1.2050 stop/loss.
Alternatively, buy a 6M 1.29 EUR/CHF call option financed fully by a sold 3M 1.1500-1.2300 EUR/CHF put spread (with 1.75 × notional on the bought 1.15 put). This zero-cost strategy leaves the potential to benefit from a hike or break of the 1.20 minimum target.
SNB to attempt weakening the franc further
The Swiss National Bank‟s 1.20 floor below EUR/CHF has so far proven a success. Not only has the central bank managed to stop the strong appreciation trend but it has done so with what is likely to be limited intervention. However, while the new currency regime may have gained a high level of market credibility, it has not removed deflationary risks.
Since the 1.20 floor was introduced in early-September, the Swiss economic outlook has deteriorated significantly and Swiss leading indicators have fallen to the lowest level since the 2008 recession. Combined with a strong currency and weak foreign demand the result has been falling consumer prices – and more so than expected. In its September monetary policy report, the SNB forecast inflation to bottom at minus 0.5% in 2012. However, the latest CPI report showed inflation falling to minus 0.5% in November, with core inflation even falling below minus 1% y/y.
We expect the SNB to address the increased deflation risks by loosening monetary policy at either the 15 December meeting, or during H1 12. The most obvious policy tools left in Switzerland are: (i) a higher floor below EUR/CHF, (ii) further liquidity injections and (iii) administrative measures. Of these, a hike of the 1.20 minimum target appears the most likely response, in our view.
The Swiss franc has already weakened slightly to reflect the increased probability of a higher SNB floor but this is still not fully priced in. There are naturally also arguments against further SNB action, with concerns centred on the risk that a higher minimum target could trigger speculative flows. Our G10 PPP model puts EUR/CHF fair value at 1.38 and a hike of the minimum target, to say 1.25 or 1.30, would thus take the Swiss franc back in more neutral territory. These are important concerns but will probably not keep the SNB from addressing higher deflationary risks.
We recommend buying EUR/CHF spot at 1.2325 for a 1.30 target with a 1.2050
stop/loss. The key risk to this trade is a significant deterioration of the EMU crisis and the return of CHF buying as a euro hedge.
Alternatively, we recommend positioning for a higher EUR/CHF via options. Consider buying a EUR/CHF call option strike 1.29 with 15 June expiry (covers the coming three SNB meetings) financed by a sold 3M 1.15-1.23 put spread with 1.75 × notional on the bought 1.15-strike put option. This strategy can be entered at zero cost (indicatively) and leaves potential to benefit from a hike as well as a break of the 1.20 floor.
The two key downside risks to the 1.20 minimum target are: (i) a euro tail-risk event and (ii) a sudden spike in Swiss inflation forcing the SNB to abandon FX intervention. The latter is not an important risk on a 12-month horizon, however, which leaves euro tailevents as the main risk. This is the reason for having a higher notional on the bought 1.14 put option. Should a euro tail-risk event cause a break of the 1.20 floor then we would expect EUR/CHF to trade much lower and not just settle at say 1.18. Moreover, we would expect volatility to spike and the option skew to turn very negative. This would all benefit the bought 1.14 put option and we estimate in a best case leave a net profit.
# 3: NOK/SEK – breaking-up is easy
In last year’s top trades, we recommended to sell vol in NOK/SEK through a leveraged pivot to benefit from similar monetary policies and economic development. However, we now argue that 2012 will be the year that NOK/SEK breaks out of its stable-trading range. However, we are uncertain where the cross is going and recommend buying a butterfly to benefit from a possible big move in the cross in either direction on a 6M horizon.
We have skewed the butterfly to the upside to express our view that after all risk is skewed on the upside in NOK/SEK. The strategy has break-even at maturity at 1.1300 and 1.2450, allowing NOK/SEK to trade in a wide trading interval without causing a loss.
Business cycle and monetary policy point to higher NOK/SEK...
One of the main drivers for NOK/SEK throughout 2011 has been relative rates. Both the Riksbank and Norges Bank hiked rates in H1 11 and policy rates are now almost equal in Norway and Sweden. However, looking forward, the market is pricing in a somewhat divergent development in policy rates in the two countries. In Sweden, market pricing indicates that the refi rate will be lowered well below 1% with the Mar13 RIBA future trading at 0.78%. In Norway, calculating central bank market pricing is a bit more difficult, as there is no OIS market but the FRA-curve indicates that 3M NIBOR is expected to fall approximately 75bp over the same period. In our view, risks are skewed towards an even more divergent monetary policy between Norway and Sweden.
The Swedish export-oriented economy will inevitably be hit hard when the most
important export market, the eurozone, is engaged in heavy austerity measures at a time when it is struggling to avoid a deep recession. In our view, Swedish policy rates will have to be reduced significantly during the next six months. Norway, on the contrary, has not really felt the pain and it almost seems as though the Norwegians have not realised that a financial crisis is unfolding. The economy is powering ahead on the back of recordhigh oil investments and a red-hot housing market, with prices up close to 10% YTD. The latest regional network report from Norges Bank showed that the outlook for the economy – contrary to Sweden – has not weakened towards the end of 2011.
...but expect the unexpected
The monetary and cyclical outlook is the reason why we favour the upside for NOK/SEK and have skewed our butterfly accordingly. However, 2012 might easily turn out to be very different. If we look at the current rhetoric from Norges Bank and the Riksbank, it is not a done deal that monetary policy will develop according to market expectations. Norges Bank has in fact sounded more concerned about the global economy than the Riksbank. Norges Bank is also highly concerned that the NOK might turn into a true safe haven and plans to fight such a development eagerly. Remember, Norway experienced a severe erosion of its competiveness after EUR/NOK dropped to a record low of 7.21 in
2003. Norges Bank has repeatedly voiced concern about the NOK strength, whereas Riksbank Vice Governor Lars Nyberg last week said that he is not “worried about krona strength”.
Valuation is also stretched in respect to NOK/SEK. Our PPP estimate for the cross is now as low as 1.05 reflecting a severe SEK undervaluation. Another two important factors that could potentially induce volatility in NOK/SEK are positioning and commodity prices.
The NOK in particular is exposed to an unwinding of long speculative positions if risk aversion explodes or if Norges Bank steps up its purchases of foreign currency. Unpredictable oil price swings could also increase volatility in NOK/SEK.
#4: China avoids hard landing
Position for a soft landing of the Chinese economy and continued appreciation of CNY by selling a 12M USD/CNY NDF. Albeit we expect the pace of appreciation of CNY against USD to slow, this strategy looks very favourable as the market now discounts a slight depreciation of CNY over the next year.
In our view, this strategy offers limited downside risk as the policy response from China in a scenario with a sharp slowdown in the economy is likely to be to keep CNY broadly unchanged against the USD, just as China did in the wake of the global financial meltdown in late 2008.
Appreciation of CNY continues, albeit at a slower pace
We expect a relative soft landing of the Chinese economy next year in the sense that inflation should gradually decline without growth slowing sharply. Inflation is already declining relatively quickly and we believe it could fall below 3% y/y in mid-2012 after peaking above 6% y/y in Q3 11. However, we are unlikely to end up in deflationary territory as China did in the wake of the financial meltdown in 2008. Since China abandoned its peg to the USD in 2005, there has been a very close relationship between inflation and the pace of the appreciation, in the sense that the pace of appreciation against the USD tends to decline when inflation declines. Our expectations of lower inflation in China suggest that the pace of appreciation of CNY against the USD should slow to around 3% over the next year from more than 5% over the past year – however, the market prices no appreciation.
Worst case appears to be a temporary re-peg to USD
Over the past 15 years, there have been two cases where the market expected a devaluation/depreciation of CNY against the USD: first, in the wake of the Asian crisis in 1997 and, second, in the wake of the global financial meltdown in late 2008. In the wake of the Asian crisis, China chose not to devalue and maintained its USD peg. In the wake of the global financial crisis in 2008, China chose not to depreciate its currency but instead temporarily “re-pegged” to the USD until the spring of 2010, when the gradual appreciation policy was resumed. In our view, keeping the CNY broadly unchanged against the USD will continue to be the policy response in an adverse scenario with a relatively hard slowdown in China. First, the Chinese leadership believes that there could
be substantial political costs, including a possible trade war with the US, if it allows its currency to depreciate. Second, in both 1997 and 2008, the Chinese leadership acknowledged that a devaluation/depreciation would probably be counterproductive for the Chinese economy, as it would contribute to destabilising global financial markets.
Position for continued CNY appreciation
For the first time since the spring of 2009, the market discounts a slight depreciation of CNY against USD. Hence, we recommend selling a 12-month USD/CNY nondeliverable forward (NDF). This strategy would benefit if China managed a soft landing and continued to appreciate its currency. However, with a slight depreciation already discounted in the market, we also see limited downside risk for this strategy in a more adverse scenario where the Chinese economy slows substantially more than we currently forecast.
The main risk is that the market will price even more expected CNY depreciation, even if that never materialises. In addition, if the slowdown is substantially more severe than in 2008, China could eventually be forced to depreciate its currency to shore up the economy.
#5: USD/JPY – stuck in a range
We expect USD/JPY to remain within a range in H1 12, as potential BoJ intervention keeps the downside floored and the sluggish outlook for global economic growth should cap USD/JPY upside by capping global bond yields. We recommend entering a USD/JPY put butterfly to position accordingly.
Base scenario is for USD/JPY to edge modestly lower
One of our core themes is for global central banks to respond to the poor growth outlook by applying further monetary easing. While US economic data has surprised on the upside recently, further stimulus is likely if growth falters again. The BoJ has so far lagged behind its peers, easing policy far less aggressively than the Fed. Unless the BoJ introduces new aggressive measures, we would thus expect USD/JPY to trade lower going forward. Further downside risks include the US fiscal situation, where the paralysis of the US political system in dealing with the long-term budget issues is likely to trigger
further US credit rating downgrades in 2012. Also, the large US current account deficit remains a USD risk. Japan has its own debt problems to tackle but as most of the debt is domestically held, the issue is much less acute.
BoJ to intervene aggressively if USD/JPY falls towards 75
While the downside pressure in USD/JPY has eased in recent months, the most recent BoJ policy statement pointed to fears over slowing exports and a possible adverse impact from the strong JPY. In our view, the BoJ‟s fixation with the level of the exchange rate will continue in 2012; we expect Japan to defend aggressively the 75 level against the USD and we cannot rule out the possibility that the BoJ will eventually expand its balance sheet aggressively to avoid a stronger JPY. While the most recent round of intervention at the end of October saw USD/JPY lifted by four big figures, long JPY positioning has since been scaled back somewhat (currently at 21% of open interest) and as a result the spot reaction is likely to be less fierce. Our main scenario is not, however, for the BoJ to follow in the footsteps of the Swiss National Bank, setting an explicit target for the USD/JPY exchange rate. Still, we expect BoJ intervention to cap the downside, without triggering a breach of the recent trading range on the upside.
Sluggish global growth to cap upside in USD/JPY
While the global economy is slowing, our core view is that the world economy will escape recession. If the improvement in the US cyclical picture continues, this could imply modest upside for US rates. However, much depends on how the European debt crisis evolves and whether stress in the financial system persists. Even in a positive scenario, the current recessionary outlook for the European economy and the fragility of the recovery in the world economy are likely to cap the upside in US rates.
Profiting from USD/JPY trading in a wide range in H1 12
While aggressive BoJ intervention is likely to cap the downside in USD/JPY if the trend for JPY appreciation resumes, sluggish global growth is likely to cap the upside in the pair. Hence, we look for USD/JPY to continue range trading during H1 12.
To position for this view, we recommend entering a 6M USD put/JPY call butterfly spread. Specifically, we recommend buying a 79.5 put, selling a 77.5 put with double notional and buying a 74.0 put – at a combined zero cost (indicative prices, spot/fwd ref. 77.95/77.60). We calculate this structure would give a profit of two big figures if spot trades 77.5 at maturity, while capping the potential loss at 1.5 figures if the spot trades at or below 74. The strategy has break-even at 75.5, yielding a profit if the spot at maturity is above this level but below 79.5.
#6: EUR/TRY – Turkish delight
The rapidly expanding Turkish economy is entering a challenging period going into 2012, with large external imbalances and high inflation keeping pressure on the lira. The lira has already suffered a significant depreciation, however, and with the economy showing signs of rebalancing, we see value in positioning for a stronger lira on the 12-month horizon.
Taking advantage of the currently high 12M option skew, we recommend purchasing a one-year EUR/TRY out-of-the-money put option with strike 2.30.
Turkish economy to rebalance in 2012
The Turkish economic performance has been very good in recent years with near 9% growth in 2010 followed by an average of close to 10% y/y growth in the first three quarters of this year. Growth has, however, come at a rather heavy price, as credit-fuelled domestic demand has resulted in ballooning external imbalances, with the current account deficit currently hovering around an unsustainable 10% level, up from 6.5% in 2010.
While external conditions have deteriorated and cross-border capital outflows pose a key danger, inflationary pressures have been rather sticky, with the generally volatile Turkish inflationary readings hitting 9.5% y/y in November. A far cry from the 5% that the Turkish central bank (TCMB) targets at year-end 2012.
Since cutting policy rates by 50bp at the interim rate setting meeting in August to 5.75% to shore against slowing growth against the backdrop of very dovish rhetoric, the TCMB has taken an almost 180 degree turn and embarked on a rather hawkish stance in the face of lira depreciation that it now views as excessive and accelerating inflation. To this effect, since October the TCMB has utilised a rather unorthodox approach of resetting the o/n rates on a daily basis within a wide corridor, which – while not improving the already poor visibility of central bank policy – has proven yield supportive to the lira.
Going into 2012, it is very clear to us the Turkish economy is entering a rather challenging period, during which further deterioration of external conditions and any slacking in the speed of rebalancing pose the key dangers, keeping the lira under pressure and both comprising key risks to our strategy. Having said this, however, the lira has already seen a significant depreciation, taking it closer to its fundamental fair value level. Aided now by hefty carry, with TCMB‟s firm hawkish bias, we now see scope for lira appreciation in the medium to long term (see Emerging Markets Briefer, 16 November 2011).
Purchase OTM put on EUR/TRY to capitalise on lira up moves
To take advantage of the potential sharp down moves in EUR/TRY in 2012, we
recommend purchasing an out-of-the money EUR put/TRY call option, with a strike at 2.30. From a technical point of view, EUR/TRY is near completion of a double-top (DT) formation, with the 2.59 resistance having twice repelled euro advances against the lira. The neckline support for the DT formation comes in around the 2.4150 level, a break of which would technically pave the way towards the 2.20 area. Given the current positive option skew where OTM put options are significantly cheaper than comparable calls, we find good value in purchasing this option at a premium cost of below 1% of EURnotional amount. Long gamma exposure from the bought put option also benefits from a high volatility environment, which is set to remain elevated going into next year.
As a more risk-willing alternative, this strategy can also be constructed as a zero-cost option structure that takes advantage of the current and steep term structure of the positive option skew. In particular, we would recommend financing the above put option with a bearish call spread consisting of a sold call, strike 2.60, and a bought call, strike 2.68. The loss in this structure is limited to the 8 TRY figure distance between 2.60 and 2.68 strikes.
#7: Northern star vs the ugly couple
Compared with the eurozone and the US, Norway stands out in the G10 FX universe with very strong fundamentals illustrated by huge surpluses on almost all thinkable accounts. Even though the Norwegian krone has already appreciated significantly over the past two years, we still believe that the northern star has some potential left.
We recommend selling 12M USD/NOK forward and selling 12M EUR/NOK forward equally weighted. We prefer the forwards to lock in the carry today. We see a risk that Norges Bank will cut rates more than currently priced if the NOK appreciates as we forecast.
NOK: The northern star
Over the past two years, we have promoted long Norwegian krone strategies in our Top Trades. However, we still believe the “northern star” has some potential left in 2012. The Norwegian economy is still powering ahead, despite all the concerns about a global slowdown and the European debt crisis. The Norwegian economy is being boosted by high oil prices in particular. The latest oil investment survey from the Statistical Office pointed to new record-high oil and gas investment activity in 2012. The newest estimate from the current quarter points to nominal growth in total investment of 21% in 2012 compared with a similar estimate for 2011. However, the housing market also continues to boom, with prices up close to 10% year-to-date. The strong economy is the reason why we see the potential for less monetary easing from Norges Bank than currently priced. However, note that Norges Bank would react to an excessive strengthening of the currency – in that case, we would close the forwards before expiry.
The Norwegian krone is a relatively small currency, which means that speculative and portfolio flows can have a profound impact. In 2011, we have in general seen long speculative positions being built in the currency market. According to the weekly flow data from Norges Bank, foreign banks – which we see as a proxy for speculative money – have added NOK118.6bn to long positions so far in 2011. This underlines that the Norwegian krone could be exposed to profit taking. The Norwegian government bond market has traditionally been very small and it has been difficult for large investors to buy
into the strong AAA of Norway. Hence, Norway has not seen the same bond inflows that Denmark and Sweden, for example, have experienced in 2011.
However, in 2012 the Norwegian bond market will be much more liquid as issuance will pick up dramatically, by NOK30bn to about NOK50bn. The reason is that the government has taken over the responsibilities of banking owned Export Finance. The higher issuance is expected to attract foreign investors adding further to Norwegian krone appreciation.
EUR and USD: an ugly couple
Under the theme Structural dollar headwind earlier in this document we argue why we believe the dollar will still be in decline in 2012. Even though we do not forecast a euro break-up the euro is expected to be under severe stress in 2012 and we are reluctant to be long in the euro despite the stretched positioning with many short positions in EUR/USD.
However, the euro is actually one of the prime risks in the suggested strategy. If the euro crisis, or the global growth concerns, intensify it could tend to strengthen the dollar, which would tend to push EUR/USD and therefore also EUR/NOK and USD/NOK higher. However, as we argue in the theme excessive recession fears financial markets are already positioned accordingly.
#8: GBP/PLN gone too far
GBP/PLN is one of the clearest examples of the eurozone crisis having a violent impact on neighbouring countries’ exchange rates; the pair has soared more than 20% in H2 11 without relative rates moving much or global equities suggesting a big move. With Poland set to outperform the UK on almost all fronts in 2012, we recommend taking advantage of the latest price developments by selling GBP/PLN spot. Option strategies can also be considered as the skew is favourable in GBP/PLN.
Timing may be tricky though as the pair is currently in a strong technical uptrend with no signs of levelling off. However, we perceive risk/reward to be favourable for 2012 as a whole. The biggest risk to the trade is an escalation of the EMU crisis with the subsequent Central Eastern European countries deleveraging.
‘Safe-haven’ sterling lower in 2012 due to anaemic growth and QE
Sterling is in many ways a paradox; despite being significantly undervalued from a fundamental perspective, the consensus forecaster does not project a comeback for the pound against the sorely tried euro even in the medium term. We dealt with this issue in FX Strategy: Sterling’s fall from grace (9 June 2011), in which we argued that sterling was weak because of structural economic underperformance and in GBP Research: New regime, new forecast (17 August 2011), where we questioned sterling‟s alleged undervaluation. Sterling has been seen as a safe-haven option in the eurozone crisis where investors have hoarded Gilts and pushed down yields. However, the UK has significant challenges in terms of controlling government spending and curbing the debt burden, as we have pointed out a number of times, see, for example, UK Research: How long can the UK maintain its AAA-rating? (7 September 2011). Recently, the government had to acknowledge that the deficit reduction plan was not on track and that the debt burden is set to grow for most of this decade.
We believe the UK will see very low economic growth in 2012, GDP will expand less than 1% and the country is probably in recession by now. The Bank of England plans to buy Gilts throughout most of 2012 and the assets bought under the total QE programme are set to amount to £400bn by end-2012. These efforts are likely to have a limited economic impact as suggested by recent independent research but surely have a depreciating effect on sterling, which might not be a bad thing when looking at the stillbleeding trade balance.
Poland still the strongest link in CEE
Our most recently updated macro forecasts for Poland see somewhat weaker growth in 2012 than we previously expected. In particular, we see the Polish economy expanding by about 2% next year, down from around 3% in our latest Macro Monitor, Poland, 26 October 2011. Despite this downward revision, however, Poland remains the most robust economy in its Central and Eastern European peer group in terms of growth potential and is set to grow at twice the pace of the UK. Furthermore, a significant weakening in the zloty since the summer has allowed for an implicit loosening of monetary conditions, which, in tandem with above-target inflation, has curbed the Polish central bank‟s need and room for large-scale monetary easing in 2012.
Moreover, Poland is currently undergoing a range of serious austerity measures following the re-election of Prime Minister Donald Tusk‟s governing party. While these measures exert an adverse impact on domestic demand levels, Poland is now broadly perceived to be on the right road in terms of reining in its public debt and balancing its budget. The general deleveraging of CEE countries poses the key danger to the entire region‟s banking and financial markets and, in our view, Poland will almost certainly not emerge unscathed. However, in this respect, Poland, with its better diversified foreign bank involvement, stands somewhat better protected than its peer countries, such as Hungary.
#9: Return flight of the loonie
We forecast that a repricing of global recession fears will push USD/CAD lower in 2012, as the CAD will benefit from a recovery in the US economy and higher oil prices. USD/CAD is closely correlated with risk and the cross could be pushed significantly on better risk appetite – not least as the market, according to the so-called IMM data, is speculatively long on the cross.
We recommend selling USD/CAD spot at 1.0340 for a move lower to 0.9640. We set our stop/loss at 1.0665 – just above the October high.
Position for a repricing of global recession concerns...
We expect the Canadian economy to continue to benefit from the expected pickup in the US economy in 2012. US growth has been a key factor driving the Canadian economy, given the close ties between the two economies. Canadian growth has already rebounded in Q3, posting growth of 3.5% (q/q annualised), albeit following modest contraction in the second quarter.
A long Canadian dollar position is one of our favourite ways of positioning for growth in the US economy in 2012. It might sound counter-intuitive but due to negative correlation between risk appetite and the US dollar, stronger US numbers tend to push USD/CAD lower. Currently, the US numbers are surprisingly strong compared with market expectations. So-called “surprise indices” that measure economic surprises – in the US – relative to consensus expectations are at the highest level since March this year.
The Canadian dollar is in general expected to benefit from a repricing of global recession fears as USD/CAD has one of the highest correlations with risk among the major G10 crosses.
If a repricing of global recession fears unfolds, we would expect to see a significant short covering in the Canadian dollar. According to the weekly CFTC data, speculative short CAD positions against the US dollar are above 13% of open interest. Among the commodity currencies, the CAD clearly stands out as the market is still speculatively long on both the AUD and NZD, against the USD. Consequently, if the market is hit by a new wave of risk aversion, long CAD positions should be more resilient than AUD and NZD, for example. See the latest IMM Positioning Update, 12 December 2011.
...and a rising oil price
Our commodity analysts forecast that the oil price could stay elevated in 2012 and forecast an average Brent oil price of USD112/bl with a rising profile during the year. See Commodities Forecast Update: Global growth still supportive for commodities in 2012, 21 November. USD/CAD has a high correlation with oil prices and the cross is one of the best ways to express a view on the oil market in the FX market.
Oil prices have been well supported over the past couple of months, despite the global financial jitters. In our view, it reflects that demand growth is still strong in the oilintensive non-OECD area. In this respect, it is crucial that our macroeconomists argue that the US and China in 2012 can decouple from the current recession in the eurozone.
Furthermore, our commodity analysts argue that oil will be supported by Opec in 2012. In 2008/09 Opec showed strong commitment to defending prices and slashed production aggressively. Therefore, the market would be reluctant to push oil prices significantly lower, as this would risk a forceful Opec response. Finally, we still expect geopolitics to support oil prices in 2012. The only difference is that the focus has now moved from Libya to Iran.
#10: The cherry-picked carry basket
We expect an unwind of stretched ‘risk-off’ positions to support moderately FX carry strategies during 2012. However, given a weak macro backdrop and continued focus on fiscal balances, we recommend giving up part of a potential carry pickup in order to gain exposure to currencies backed by relatively stronger fundamentals.
Buy equally weighted long AUD, MXN, SGD versus short USD spot at index 100 for 111 target with a 95 stop/loss. This strategy yields an annualised carry of about 2% and reduces downside risks compared with standard carry maximising strategies by making the currency selection subject to macroeconomic criteria.
Carry with a macro fundamental overlay
This has been a surprisingly decent FX carry year considering the sell-off in risk assets during H2. A simple G10 carry basket (long three highest yielding versus short three lowest yielding) with weekly rebalancing has lost only about 1% and has thus outperformed stocks significantly – MSCI world equity index is down more than 6% (total return). Long NOK positions explain part of this carry performance enigma and for 2012 we recommend keeping long carry positions limited to currencies backed by relatively stronger fundamentals.
We doubt that 2012 will prove a strong carry year but, nonetheless, see value in selected carry baskets to benefit from a potential unwind of stretched „risk-off‟ positions once macroeconomic data stabilises. In other words, we prefer cherry-picked carry strategies over simple carry maximising strategies.
The properties that we would like to buy into are: (i) currencies that have already seen a large spot sell-off, (ii) currencies backed by relatively sound external and budget balance projections for next year, (iii) currencies backed by a central bank where significant easing is already priced and (iv) currencies offering a decent carry-to-risk.
No currencies fulfil all of the above criteria but, based on a weighted score and a subjective screening, we recommend buying an equally weighted basket of long MXN, AUD, SGD versus short USD at index 100 for a 110 target and with a 95 stop/loss.
Both AUD and MXN have some of the soundest public balances among the high yielding currencies and while both Australia and Mexico run a current account deficit we expect their terms of trade to remain supported by resilient commodity prices (see Commodity Forecast Update: Global growth still supportive for commodities, 21 November 2012). Although the long SGD position in the basket reduces the positive carry that could be enjoyed purely by holding Mexican and Australian currencies, it works both to reduce the overall volatility of the basket and to allow exposure to the ongoing Asian rebalancing theme as well as our expectation of Asian macro stabilisation later in 2012.