currency strategy february 2020 - seb group · fx market overview 6 — currency strategy the fx...

Currency Strategy

February 2020

Research Reports

Currency Strategy — 3

Contents

4 Forecasts 5 Trade recommendations 6 FX market overview 10 EUR/USD 12 USD/JPY 14 EUR/GBP 16 EUR/CHF 18 EUR/SEK 20 EUR/NOK 22 USD/CAD 24 USD/CNY 26 Themes 27 Buying insurance in the currency option market 30 NOK-negative capital flows 34 Risk as an FX driver 36 Spring seasonality 38 The case for EM FX 40 Contacts 41 Disclaimer

FX forecasts

4 — Currency Strategy

FX forecasts

Fwd Consensus* SEB vs 12 feb 3M 6M 12M Q2 21 12M 6M consensus

EUR/USD 1.09 1.08 1.10 1.13 1.15 1.11 1.14 -3.6%EUR/JPY 120 118 120 125 129 120 123 -2.7%EUR/GBP 0.84 0.86 0.87 0.84 0.84 0.85 0.86 1.8%EUR/CHF 1.06 1.07 1.08 1.11 1.13 1.06 1.11 -2.7%EUR/SEK 10.51 10.45 10.35 10.25 10.15 10.57 10.45 -1.0%EUR/NOK 10.06 10.00 9.95 9.85 9.75 10.28 9.80 1.5%USD/SEK 9.63 9.69 9.41 9.07 8.83 9.48 9.17 2.6%USD/NOK 9.22 9.27 9.05 8.72 8.48 9.22 8.60 5.1%GBP/USD 1.30 1.26 1.26 1.34 1.37 1.31 1.33 -5.4%USD/CAD 1.33 1.32 1.31 1.30 1.29 1.33 1.31 0.0%USD/CHF 0.98 0.99 0.98 0.98 0.98 0.95 0.97 0.8%AUD/USD 0.67 0.69 0.68 0.66 0.66 0.68 0.70 -2.9%NZD/USD 0.65 0.66 0.65 0.63 0.63 0.65 0.66 -1.5%USD/JPY 110 109 109 111 112 108 108 0.9%GBP/SEK 12.49 12.21 11.86 12.15 12.09 12.41 12.19 -2.8%JPY/SEK 8.75 8.89 8.63 8.17 7.88 8.79 8.49 1.7%CHF/SEK 9.87 9.77 9.58 9.23 8.98 9.96 9.41 1.8%NOK/SEK 1.04 1.05 1.04 1.04 1.04 1.03 1.07 -2.5%EUR/DKK 7.47 7.46 7.46 7.46 7.46 7.45 7.46 0.0%EUR/PLN 4.26 4.28 4.28 4.23 4.20 4.35 4.30 -0.5%USD/CNY 6.97 7.03 7.08 7.16 7.18 7.03 7.00 1.1%USD/RUB 63.1 62.1 62.2 65.4 66.5 65.6 64.5 -3.6%USD/TRY 6.02 6.42 6.65 6.86 7.30 6.66 6.28 5.7%

Trade recommendations


How to trade it

Reflecting the low volatility environment, most FX forecasts are pointing sideways while outlook for global growth rather than traditional drivers like carry or monetary policy seems to determine the outlook for currencies. This is clearly a challenging environment to benefit on FX-trades, but there are always opportunities in the FX market.

USD/CAD: Sell 3m forward at 1.3286, spot 1.3285.

The data during the past month has come in on the strong side as the BOC was expecting in the January meeting, leaving very little reason for the bank to cut rates. USD/CAD has largely followed the BOC rate cut expectations during the past year and further improvement in economic data should ease the expectations of the policy easing. Given that the spot rate is close to the highs seen post mid last year, we recommend selling the currency pair in forward space aiming 1.31 take profit level, with a stop at 1.3410.

EUR/GBP: Too early to be complacent, Buy EUR/GBP

The UK is out of the EU and our main scenario is that negotiations with EU will result in some sort of comprehensive trade deal being reached that will avoid trade on WTO terms in 2021. So far signals from the UK government suggest they will not accept just anything. Another risk is that one or several member states fail or struggle to approve the trade deal as it has to be accepted unanimously by all member states Altogether, the departure from the EU may continue to undermine the GBP this year or until it is absolutely certain that the risk of failing to get a deal in place in time is completely eliminated. The nature of political negotiations is likely to raise concerns of a failure in talks this year and weaken the GBP.

Global growth: Sell the ‘Risk-off’ FX basket

For more than a year the global growth outlook and political risks have dominated the FX market. Although the outcome for FX is almost binary relative the global growth situation, we would use the following currency basket to reflect its development. In our world global growth will shrug off viruses, political uncertainty and weak manufacturing and hence we would prefer to short this basket for 2020.

Seasonality: Buy NOK/SEK early April and switch to short NOK/SEK in May

As shown in the theme article on seasonality, higher NOK/SEK in April and lower in May is two very robust seasonal pattern having occurred 9 versus 8 of the past 10 years. The main reason is that there tend to be large SEK outflows in April due to dividend distributions from Swedish firms while the same, though to a lesser extent, is true for Norwegian firms in May. In Currency Strategy Feb 2019 we recommended a long NOK/SEK in April based this seasonality pattern which resulted in a 2.1% gain. A short position in May would in 2019 have added another 1.4% to the gain.

EUR/JPY: Buy 6m 119.45/116.35 put spread @ EUR 0.78%, spot ref. 120.00

We continue to be constructive on the performance of small cyclical currencies going forward as we think the global economy will continue to recover this year. But as we wrote in the theme article “Buying insurance in the currency option market” the current equity and credit valuations are increasing the risk of a market correction if the low growth turns out to be more persistent. Current low volatility, positive put skew and carry together with high and stable correlation with equity market returns offer an attractive opportunity to buy exposure to a possible market turbulence in the coming six months via EUR/JPY puts.

FX market overview


The FX market remains challenging as traditional drivers for currencies are not working. Instead currencies seem to continue to trade on the outlook for global growth, which is binary. Despite the outbreak of the coronavirus, we stick to a base scenario where the global economy will slowly improve this year. Then smaller currencies will have the chance to outperform and the USD is likely to be among the weakest. However, if are we wrong on global growth, we are likely wrong on most currencies as well. With global growth risks elevated, we recommend considering cheap insurance in the FX option market.

Global growth concerns dominate. Since the end of 2018 and until December 2019 sentiment in the US manufacturing sector fell constantly. However, it recovered strongly in January this year. In the Eurozone the manufacturing sector has been weak for several years and there are still few signs of a recovery, although the situation has stabilised. Historically, the manufacturing ISM has done well as a forward-looking indicator for the US and the global business cycle (see also article published on the SEB research web page “Why US manufacturing matters more than you think”). Since 1988 there have been nine periods with sharp falls in the ISM reflecting a significant slowdown in the global economy, just like the one that started in December 2018. Clearly, this has implications for the FX market and our findings show that it usually benefits traditionally defensive currencies such as the USD, the JPY, and the CHF. In the nine slowdowns on record since 1988 the USD has on average appreciated by 7% against the other G10 currencies – more against smaller currencies and less against other major currencies like the JPY or the EUR.

Probably the global slowdown is the best way to explain the FX market performance in 2019, where defensive currencies outperformed more procyclical currencies until Q4, only to reverse towards the end of the year when risk appetite improved on the back of reduced political risks, the Fed liquidity injection and some signs of stabilisation in growth related indicators in the Eurozone. Usually this kind of fall in ISM goes on for slightly more than a year (on average 13 months), and the recovery in ISM in January was in line with its traditional behaviour. While the manufacturing sector has been weak, sentiment in the service sector has not at all dropped in the same way according to PMIs from the US and the Eurozone. In our base case scenario we expect that the stability in the service sector, persistently low unemployment rates, and expansionary monetary policy will help the global economy to shake off the weakness in the manufacturing sector and recover in the coming years.

Will the coronavirus hurt global growth? This year the global economy has to deal with a new potential threat - the outbreak of the coronavirus in China. There are several implications for growth and the global economy from the outbreak. The most obvious ones are:

- Reduced travel in general and particularly traveling to Asia/China and Chinese people traveling abroad.

- A significant part of the mainland production in China has been closed. This will hurt Chinese and global supply chains. However, inventories were generally well filled when production was closed so there is some resilience before the production stop will cause shortages.

If Chinese authorities manage to get control of the outbreak within the next month or so the outbreak will most likely have limited economic consequences. Then it will probably be more of intertemporal effects where most of the lost production/spending will show up later. The slowdown in Q1 will then probably be completely offset by a recovery in Q2 or Q3. In this case we do not see the outbreak having any severe consequences for the global growth scenario. However, it might be a completely different story if the disease goes on for longer before Chinese authorities manage to get it under control. Then it could result in a more severe supply shortage which will affect the rest of the world and hurt global production and growth. That would of course have more severe consequences for the global economy and the already weak manufacturing sector. In a worst-case scenario this could hurt risky assets, particularly equities that seems to be discounting a growth acceleration ahead, and tip the world into a completely different and weaker growth regime than what we have in our main scenario and therefore have huge implications for exchange rates and will most likely push currencies in the opposite direction compared with our main scenario.

Domestic drivers are secondary. In 2019 it was quite clear that currency specific factors like interest rates, monetary policy or fundamentals generally were of little importance for the performance of G10-

https://webapp.sebgroup.com/mbs/research.nsf/0/cae9e7b3b74a498dc12584cf0033e374/$file/20191213_us_unemployment.pdf

https://webapp.sebgroup.com/mbs/research.nsf/0/cae9e7b3b74a498dc12584cf0033e374/$file/20191213_us_unemployment.pdf

FX market overview


currencies. Instead growths concerns, the trade war between the US and China, Brexit, and other political events determined the FX performance.

The chart below shows the performance of four smaller G10 currencies since February 2019, each against an equally weighted basket of the three major currencies, the USD, JPY, and the EUR. Since February 2019 these smaller currencies have all underperformed the major G10 currencies by 4-7%. What is striking though is that not only have these currencies underperformed major currencies, but they have essentially done it simultaneously despite several differences in domestic factors like monetary policy, interest rate levels, the growth outlook or where these belong geographically.

In 2019 the New Zealand central bank and the Australian central bank both lowered rates to 1.00%. In contrast, Norges Bank delivered three rate hikes, while the Riksbank hiked rates once in December. This suggests that the global themes rather than domestic factors continue to dominate in the foreign exchange market.

All these currencies also recovered simultaneously in Q4 last year when risk appetite improved on the back of reduced political risks and some signs of stabilisation in growth related indicators. In the beginning of this year the same behaviour has persisted when all currencies fell on concerns related to the outbreak of the coronavirus in China. There is currently little which suggests that these market drivers are about to change and consequently global risks and outlook for global growth are like to continue to determine the direction for G10 currencies.

The support for currencies with defensive qualities, and particularly the USD should persist as long as the slowdown in the global economy continues. The manufacturing ISM and PMIs in general recovered in January making the growth outlook a little more optimistic. After the phase 1 trade deal between the US and China last year and Brexit in January, political uncertainty has eased. Indeed, it is always difficult to predict political risks, but overall these have declined. We do not know yet the economic consequences of the coronavirus outbreak but based on past experiences we should probably not worry too much about the long-term impact, which the financial market should be concentrating on.

Smaller and smaller reactions. Implied 3M FX volatilities have fallen significantly in the last couple of years and in the beginning of this year implied volatilities reached new all-time lows in several G10 exchange rates. This means that daily or weekly changes in exchange rates are only around half of the average historical changes. The low volatility environment in the FX market may in fact benefit many businesses with cross-border trade creating exposures in foreign currencies as it reduces uncertainty about the future exchange rates and hedging costs. However, low volatilities are at the same time a negative factor for financial market players and speculative accounts providing liquidity, as it makes it increasingly difficult to generate positive returns in the FX market unless the size of exposures is increased.

Low volatilities have not just happened “by accident”. A decade ago when world leaders worked hard to address the consequences of the global financial crisis, part of their efforts was to introduce measures explicitly addressed to reduce excess volatility in the FX market. This objective is for instance included in the declaration from the G20 meeting in Toronto in June 2010. It said; “excess volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability”. Moreover, the declaration expressed that “We need to build a more resilient financial system that serves the needs of our economies, reduces moral hazard, limits the build-up of systemic risk and supports strong and stable economic growth”. The way it was done was by introducing new financial market regulations and the low volatility is probably partly an outcome of this. However, in addition to regulations small rate differentials between currencies and synchronised monetary policy are also contributing to lower FX volatility.

Although the trend with lower volatilities includes all G10 currencies the implied volatility in some widely traded exchange rates like EUR/USD, USD/CHF or USD/CAD are essentially half of the implied volatility in 2016, when volatilities were more in line with their historical averages. There are few reasons to expect any material change in the way currencies fluctuate. There are essentially no signs that normal FX-drivers would amplify volatility. Not even the outbreak of the coronavirus caused more than a brief increase in longer-dated volatilities, which makes us really wonder what it actually would take to turn the trend from 2015

FX market overview


of constantly falling volatilities in the FX market. The conclusion is that although volatilities are low, there is nothing which suggests the trend of falling volatilities is about to end.

Use FX options to buy insurance against possible market turbulence. As noted above, we are still holding the base view that after the global growth slowdown experienced last year, the economic activity is stabilising and we will see a modest growth this year. Recessions and sharp market turns are difficult to predict, but we think that the current high equity and credit valuations, while the slow growth may persist longer than the markets anticipate, have increased the risk of larger asset price corrections. As low implied volatilities currently offer cheap insurance against a possible market turbulence, we have looked at which currency pairs offer the most attractive exposure against sharply higher equity market volatility and a general increase of risk aversion in the currency option market. The chart below ranks the currency pairs in terms of efficiency (correlation with the equity returns) and the price (implied volatility and carry). It indicates that EURJPY is the most attractive currency pairs in terms of 6m option hedge. AUD/USD ranks high as well, but correlation with the equity market has not been highly consistent. We have also looked at put spreads where EUR/JPY comes out ahead of the others G10 currencies as well.

Carry is out of fashion among G10 currencies. In the previous edition of Currency Strategy in September last year we observed that traditional FX drivers like rate differentials had done a poor job in guiding the FX market. The impression is that this development has just continued since then. For instance, correlations

between relative monetary policy expectations and exchange rates remain low. Expectations on relative monetary policy are usually well captured by 2-year rate differentials and it used to be one of the dominant drivers for exchange rates for several years after the financial crisis. But signals of unchanged policy from most global central banks and policy rates close to zero in most cases are creating few opportunities for the FX market to trade and has almost killed this driver.

It is the same story with carry. G10 currencies do not seem to react in the same way as in the past on the actual rate differentials between currencies. Normally a low volatility environment like the current one would benefit carry strategies as low FX volatilities reduce the risk for larger setbacks in the exchange rate that would wipe out returns from rate differentials. Although short-term interest rates are compressed, when monetary policy is increasingly aligned across countries, the rate differentials offered from forward exchange rates are in fact not that bad compared with for instance government bond yields 3M rate differentials between the USD and the other G10 currencies, with the carry currently almost 2.5% in annual terms against the CHF and around 0% between the USD and the CAD.

This illustrates there are in fact several carry alternatives that offer a reasonable annual return in this low yield environment. In addition, considering the risk (implied volatilities) being long the USD against for example the EUR offers an annual carry return that currently is more than 50% of the implied volatility. The CHF offers almost the same risk adjusted carry and being short both the JPY and the SEK offer a positive carry against the USD that exceeds the “rule of thumb” threshold value of 0.25 of the implied FX volatility. Hence, starting to shuffle around with other currency pairs it is possible to create a carry basket of exchange rates where the risk adjusted carry return can almost match market conditions from before the financial crisis, when carry dominated in the FX market.

A simple carry portfolio with three currencies being bought and shorting three currencies has generated a total return of 1.3% in the last year with spot return at -1.1%. Indeed, this performance reflects that currencies with higher yields have not strengthened and funding currencies have not depreciated, which typically means that carry is irrelevant for exchange rates.

The chart below is another way to illustrate this. It shows average 3M annualised carry being long the USD against other G10 currencies for the past 6 months and the USD price performance against these currencies over the same period. Although rate differentials differ significantly between currencies the performances of the USD against these currencies have essentially been the same over the last 6 months, irrespective of the carry. This is another indication that rate differentials (carry) are irrelevant for the performance of currencies.

FX market overview


The FX market remains challenging to say the least as traditional drivers for exchange rates such as rate differentials and monetary policy do not explain the moves. Instead currencies seem to continue to trade on the outlook for global growth and the global risk sentiment, which have supported currencies with defensive qualities in the past year. On top of this daily or weekly changes in exchange rates continue to decline as a result of synchronised monetary policy and financial market regulations, and this is unlikely to end today. This suggests that a forecast for exchange rates over the next 6-12 months will depend mostly on the global growth story. Although the outbreak of the coronavirus has increased uncertainty, we believe the impact on global growth will be limited if China can get the disease under control. Therefore, we stick to a scenario where the global economy slowly improves this year. In this scenario smaller currencies will have the chance to outperform major currencies and the USD is likely to be among the weakest. However, if we are wrong on the global growth story, we are likely to be wrong on most currencies as well as it would render the opposite effect. Therefore, as we are constructive in terms of cyclical currencies, the prevailing large uncertainty and low volatilities makes us to favour buying cheap insurance against an unfavourable global growth scenario.

EUR/USD


EUR/USD Trend remains down

The EUR/USD is in a downtrend with little to interrupt at present. The US economy has defied recent concerns of a sharper slowdown and the spreading of the coronavirus has given an extra tailwind to the Greenback. 2020 is a presidential election year and Donald Trump stands a good chance of being re-elected. This would likely result in more USD friendly policies in the form of reflationary fiscal policies and sharper focus on trade frictions. We have increased our USD forecasts.

USD outlook The global FX market is currently rewarding countries promoting growth friendly policies. Therefore, it is perhaps not that surprising that the US dollar continues to attract buyers as US asset markets and the economy continue to outperform peers. The US president has signed a trade deal with China which will enable the US to improve its external balances slightly. But the growth policies are making the long-term fundamentals deteriorate if you consider the fiscal budget balance and the poor net international investment position (at close to -50%/GDP). Consensus and SEB expect the USD to trade weaker over time as both fundamentals and valuation are negatives for the dollar.

However, in the short-term the US re-election campaign and reflationary policy proposals in combination with weak EM markets/other developed economies are paving the way for more USD strength. Therefore, we have increased our short-term USD forecasts. It remains to be seen whether Donald Trump stays true to the threat of FX interventions if the USD continues to appreciate (likely to be around 1.05 in EUR/USD). In broad nominal trade-weighted terms the USD is trading a record high, which comes on the back of weak EM currencies. But against the G10 currencies and the euro, the USD is not that far above its historical averages.

Relative monetary policy and rate differentials remain less important for currency markets. The Fed is on hold awaiting the completion of its revision of future policy target set-up. It seems the expectations are for the central bank to take a more symmetric approach to policy, meaning that inflation cannot be allowed to undershoot the target the way it has in the past 10 years. This in turn means that the monetary bias in the coming year is skewed towards the downside. Within the G10 currency space no central bank is expected to increase interest rates anytime soon and certainly not during 2020. In fact, if you look at what markets are discounting, almost nothing will happen in the next two years (the Fed is priced the most dovish with near two rate cuts expected). As short-term interest rates are parked close to zero with little prospect of changing anytime soon, anywhere, the question is how low can US rates fall before investors and companies reconsider their decision whether to keep open USD exposures or park their deposits elsewhere as the USD loses its “carry” status? With poor economic performance elsewhere and an inertia to use fiscal policies to boost growth in Europe, plus weak Chinese growth in H1 2020 as a result of the coronavirus, the Fed can continue to cut rates a couple of times without distorting the USD “carry” attractiveness.

The coronavirus is a USD-positive. Political uncertainty normally plays in the hands of the USD bulls and this time is no different. Since the outbreak of the coronavirus the USD has outperformed all other G10 currencies with the classic defensive currencies such as the Japanese yen and Swiss franc also doing well. The currency developments are perhaps not that different from how equity markets have responded: emerging market equities and FX (Chinese markets perhaps not that surprising) have done poorly compared with US markets. The spread of the virus is difficult to predict: as a base case most analysts seem to count on limited economic effects from the coronavirus with the Chinese economy worst affected in Q1. Once markets are reassured, we should see a return of EM currencies on the expense of the USD.

11 feb 3M 6M 12M Q2 21 LTFV*

EUR/USD 1.09 1.08 1.10 1.13 1.15 1.17

EUR/SEK 10.52 10.45 10.35 10.25 10.15 9.74

EUR/NOK 10.09 10.00 9.95 9.85 9.75 9.36

USD/SEK 9.63 9.69 9.41 9.07 8.83 8.31

USD/NOK 9.24 9.27 9.05 8.72 8.48 7.99

ECB -0.50 -0.50 -0.50 -0.50 -0.50

Fed funds 1.75 1.75 1.50 1.50 1.50

*Based on the SEB LTFV model

EUR/USD


Growth near-trend expected. Early 2020 has been dominated by continued optimism about the US economy. Sentiment indicators in other countries, especially China, have stabilised. The deceleration that occurred in the fourth quarter of 2019 also seems to have been milder than expected. What remains is the picture of an economy that will slow to just below trend. SEB expects 2019, 2020, and 2021 GDP growth at 2.3%, 1.8%, and 1.9%, respectively It is still too early to sound the all-clear when it comes to recession risks; historically, it has taken an average of 10 months after the curve inverted until a recession has begun (and the US curve inverted in August 2019). But Fed rate cuts, in a situation where the labour market is still strong, has decreased the risk of policy mistakes of the kind that have historically triggered downturns. Looking at the labour market there are still signs of modest wage growth despite the record low unemployment, and the participation rate making the supply side of the labour market work in favour of keeping a lid on wages. In addition, there are still few apparent financial imbalances in the credit and real estate markets. Meanwhile the economy remains sensitive to political and market shocks. The focus is again on geopolitical risks as the US-Iran conflict escalates. The outlook is difficult to assess, but one difference compared with earlier Middle Eastern crises is that the US is now self-sufficient in oil and negative GDP effects from high fuel prices are largely offset by rising investments in oil production. In relative terms the growth outlook for the US is dollar neutral to slightly positive.

Capital flows. The US current account deficit is improving as a percentage of the total economy. And as the US has the global reserve currency and attractive yields in a relative sense there is obviously no problems for this country to find financing. The large and increasing budget deficits on the contrary are likely causing the big issuance of US T-bills and bonds to create demand for dollars. Therefore, the long-term structural issues with large budget and current account deficits are currently overseen by investors happily buying USD. Furthermore, the flat US yield curve inhibits the incentives for foreign investors to hedge their US assets purchases. Capital flows are a USD positive but in the long-term the US twin deficits should be dollar negative.

Long-term valuation. Since 2016 our estimate of the EUR/USD long-term equilibrium exchange rate has slowly fallen from above 1.22 in mid-2016 to 1.17 today. On the one hand, growth in ULC and CPI inflation are higher in the US than in the Eurozone, exerting upward pressures on the equilibrium exchange rate in EUR/USD. On the other hand, this is more than fully offset by the real yield and relative ToT, which exerts downward pressure on the EUR/USD equilibrium exchange rate. Altogether, our valuation approach suggests that the EUR/USD currently trades slightly below its equilibrium exchange rate, which means the USD is marginally overvalued. On a broad-trade weighted basis the USD is more overvalued vs the euro alone.

USD/JPY


USD/JPY Still safe

The shifting sentiment regarding the COVID-2019 virus will keep the yen within the 108-110 range in the short-run. As the panic-like risk aversion eased, markets should focus on the timing of the resumption of production in China. The sooner production activity normalises, the risk of a significant rise in the yen will diminish further. Meanwhile, structural shifts in the Japanese economy have diminished some of the yen’s safe haven characteristics.

Short-term The yen has been more volatile since the start of 2020, although moves against the greenback remain within the 108-110 range. For now, we continue to expect USD/JPY to end 2020 at 110. Risk on sentiment following the signing of the Phase 1 deal was quickly overshadowed as the FX market focussed on the effects of COVID-2019 or the novel coronavirus outbreak. Recent declines in the daily increase of new infections eased the panic-like risk off sentiment. Indeed, US equities hit fresh highs. Although the disease is more contagious than the SARS, the mortality rate has stabilised at a much lower level than the SARS. Markets will be focussing on the efforts of the Chinese government to resume economic activity amidst ongoing travel restrictions. The timing of the resumption of production is critical in determining the negative impact of the outbreak on global growth. The sooner production in areas outside Hubei province returns to some level of normalcy, the risk of a significant rise in the yen will diminish further, in our view.

Global economic data remained encouraging, even as the market focussed on the daily increase of infections of the new coronavirus. In the US, January ISM manufacturing sentiment rose above 50, the highest print since last July. Further recovery in global manufacturing, and ultimately global growth should be negative for the yen, as a safe-haven currency. Although we expect sentiment to pull back due to the virus shock, we also expect a rebound in sentiment as soon as the virus is definitely contained. However, considering the elevated uncertainties regarding the duration and severity of the impact of the virus on supply chains, we flag downside risks to USD/JPY until the outbreak is conclusively contained.

Net long JPY positions topped out in recent months. Our favoured indicator for speculative long positions suggested that some reversal in positioning. With the negative carry associated with being long yen, we have been of the view that holding on to long positions had a short runway. This limits the space to intensify long positions. The risk off sentiment environment immediately after the news of the virus outbreak hit the market led to some re-opening of trades. However, that failed to gain momentum as the market was buoyed by the decline in daily increase of infection.

Meanwhile, Bank of Japan (BOJ) will likely remain on hold this year. With an expansionary fiscal policy, the burden on the BOJ to do the heavy lifting has eased. The current monetary policy framework of QQE and yield curve control is an essential support to the fiscal push. However, the risks remain for further monetary easing if the disruption to global supply chains due to the virus proves to be deep. Beyond the containment of infection rate, further extensions to the travel restrictions within China will lead to supply shocks across various sectors around the globe.

USD/JPY fix vs US 10y Yield

95

100

105

110

115

120

125

1.0

1.5

2.0

2.5

3.0

3.5

2016 2017 2018 2019 2020

USD

/JPY

US

10y

Yie

ld, %

US 10yr yield JPY

12 feb 3M 6M 12M Q2 21 LTFV*

USD/JPY 110 109 109 111 112 98

EUR/JPY 120 118 120 125 129 115

JPY/SEK 8.77 8.89 8.63 8.17 7.88 8.47

JPY/NOK 8.41 8.51 8.30 7.85 7.57 8.14

GBP/JPY 142 137 137 149 153 145

Fed funds 1.75 1.75 1.50 1.50 1.50

BOJ -0.10 -0.10 -0.10 -0.10 -0.10


USD/JPY


Import Prices vs CPI ex food and energy

Balance of Payments

USD/JPY vs Net Long Yen Positions

Long-term We expect Japan’s growth to ease to 0.9% in 2020 and 0.6% in 2021. The easing of external policy uncertainty, specifically trade, should see net exports providing support to overall GDP growth in the next 12 months. Before the end of 2019, the government passed a stimulus package around JPY26 trillion (~USD240 billion).

Recycling of external surpluses is here to stay. Goods trade surplus in 2019 had been supported by a larger than expected decline in imports despite the weak exports. The expected cyclical recovery in the regional trade should be supportive of export growth in 2020. While the spread of the COVID-19 virus puts short-term downside to Japan’s tourist receipts, we are more cautious of the effect on Japanese exports to China if the disruption in Chinese production is prolonged. Moreover, the structural shift in the composition of the current account surplus has made the yen less sensitive to changes in risk sentiment. The shift towards greater dependence on net investment income from massive trade surpluses provides much less buffer to the yen. The inclination of pension fund managers to recycle their dividend proceeds into investments overseas takes some of the yen’s shine off.

Two-way capital flows will limit a sustained rise in JPY. Trust accounts at Japanese banks, typically the proxy for foreign investments of Japanese pension funds, posted a record purchase of foreign bonds in January. The net amount of JPY 2.02 trillion was the biggest monthly increase, widely overtaking the JPY1.24 trillion figure in November 2018. The stronger yen likely allowed pension funds to intensify unhedged positions in foreign credit. Recent data show that Japanese investors favoured US and French sovereign bonds, while unloading positions in German and UK debt.

Moreover, the yen’s sensitivity to risk aversion has been structurally curtailed following the decision of the Government Pension Investment Fund (GPIF) adjust its investment mandate. In 2014, the GPIF initiated a multi-year shift away from Japanese government bonds in favour of foreign bonds and equities. Since then, there has been a secular re-allocation towards high risk and high yields assets. As of Q3 2019, GPIF’s assets were worth JPY162 trillion (~USD 1.5 trillion). Also, other pension funds followed the secular re-allocation.

In the last three years, Japanese firms have been active in overseas M&A deals. As deal-making activity in China waned due to stricter rules in the mainland, Japanese firms were free to purchase foreign firms that would otherwise have been snapped up by Chinese competitors. These deals have limited the rise in the yen, even during bouts of risk aversion.

Long-term valuation. The JPY has been undervalued against the USD for several years since the JPY depreciated in 2013 and 2014. Long-term fair value according to our approach is just below 100 in USD/JPY today. The widening difference between spot and fair value is partly related to the spot rate rising, but also a lower fair value. Historically it has not been unusual with the USD/JPY deviating by more than 20% from the fair value, which means today’s deviation is not extreme. As long as the exchange rate is not exposed to any external shock it is reasonable with more of a sideways move going forward. In recent years the nominal ULC in Japan has increased, which has not been the case for a long time as the country has suffered from deflation. Deflation and falling nominal wages have always been supportive for Japanese competitiveness, which is why a stronger nominal JPY exchange rate over time is reasonable.

-40

-30

-20

-10

0

10

20

30

-4

-3

-2

-1

0

1

2

3

09 10 11 12 13 14 15 16 17 18 19

Import P

rice, %

yoy

CP

I ex f

ood a

nd e

nerg

y,

% y

oy

CPI ex food and energy, yoy Import Price, yoy (RHS)

-8

-6

-4

-2

0

2

4

6

09 10 11 12 13 14 15 16 17 18 19

Japan, B

OP

12m

rolli

ng s

um

, %

GD

P

Current Account FDI Portfolio Inv Other Inv

-150

-100

-50

0

50

100100

102

104

106

108

110

112

114

116

118

120

Feb 16 Feb 17 Feb 18 Feb 19 Feb 20

Net L

ong Y

en P

ositio

ns, T

h

(Inverte

d)U

SD

/JP

Y

USD/JPY Net long Yen Positions

EUR/GBP


EUR/GBP Brexit woes still weigh on the GBP

The GBP is undervalued because of the departure from the EU. Brexit is likely to continue to weigh on the GBP this year until there is a successful trade deal with the EU. Moreover, the BOE is moving towards a rate cut and this could weaken the GBP as well. However, with a trade deal in place we expect the GBP to recover in 2021.

Brexit may still weaken the GBP On 31 January the UK departed from the EU. If you did not live in the UK you may barely have noticed when it happened. The reason is the transition period stretching until 31 December this year, which effectively leaves the UK a member state (but without political influence) for another 11 months. This time will be used to negotiate a comprehensive trade agreement that will replace the transition period by the end of this year.

Since the beginning of 2016 the GBP exchange rate has pretty much been determined by probabilities for different outcomes in the talks between EU and the UK on the withdrawal agreement. The risk of a hard Brexit is what has frightened financial markets and particularly the FX-market. Although the UK has departed on a withdrawal deal the risk remains that negotiations on a trade deal fall apart and lead to a situation where the UK would risk leaving the transition period in December without a trade deal. This would be a hard Brexit all over and that kind of scenario would probably weaken the GBP significantly if it materialises.

Indeed, PM Boris Johnson has been tough against the EU in his first comments after the departure and he has threatened to walk away from negotiations unless the UK gets a reasonable deal. So far the EU has offered a deal including “zero tariffs and zero quotas on all goods entering the single market”, but it comes with some tough conditions as the UK would have to stay fully inside the EU’s state-aid regime. The UK would also need to make legally binding commitments not to roll-back protections for workers’ rights, or standards of environmental protection. These commitments are unlikely to be accepted by the Johnson government. However, our main scenario is an outcome with some sort of comprehensive trade deal being reached that will avoid trade on WTO terms in 2021. Another risk is that one or several member states fail or struggle to approve the trade deal. As it has to be accepted unanimously by all member states, this could cause a delay beyond the current deadline. Altogether, the departure from the EU and the design of the future relationship may continue to undermine the GBP this year or until it is absolutely certain that the risk of failing to get a deal in place in time is completely eliminated.

Monetary policy might be marginally negative for the GBP Facing at least the beginning of the end of the withdrawal process it is time to shift focus to more normal factors in determining the outlook for the GBP, like the BOE monetary policy.

The BOE has been on hold since interest rates were raised in August 2018. In January comments and speeches by several BOE MPC-members were seen by market players as signals that a rate cut was looming, and some saw it coming already at the January meeting. If the BOE begins to lower rates from today’s 0.75% towards the historical lows of 0.25%, this would probably affect the GBP negatively. However, current market pricing indicates at least one rate cut by August this year and a little bit more until December, which means that lower rates might already be partly discounted in the GBP exchange rate.

In recent years the BOE has focused a lot on the tight labour market and the risk that faster wage growth would create an upward pressure on domestic costs. However, wage pressures have eased slightly in recent months, despite a tight labour market, and there are indicators which suggest that unemployment might begin to rise later this year. Moreover, inflation has fallen quickly as the upward pressure from the previous depreciation of the GBP fades and inflation is currently below the target. As uncertainty what will

11 feb 3M 6M 12M Q2 21 LTFV*

EUR/GBP 0.84 0.86 0.87 0.84 0.84 0.79

GBP/USD 1.29 1.26 1.26 1.34 1.37 1.48

GBP/SEK 12.51 12.21 11.86 12.15 12.09 12.31

GBP/NOK 11.99 11.68 11.40 11.68 11.62 11.84

GBP/JPY 142 137 137 149 153 145

ECB -0.50 -0.50 -0.50 -0.50 -0.50

BOE 0,75 0.50 0.5 0.50 0.50


EUR/GBP


happen by the end of this year and the risk of a hard Brexit will continue to weigh on the economy, the BOE decision to remove its tightening bias in January was reasonable. This opens up a rate cut later this year and we expect the BOE to deliver it in May, which might weaken the GBP slightly in Q2, although there should already be a cut premium in today’s price.

Capital flows are very volatile. The departure from the EU has done little to reduce net capital flows into the UK related to investments. In fact, it seems that the sharp depreciation of the GBP following the Brexit referendum attracted large net capital inflows related to portfolio investments in bonds and equities, which more than compensated for a further deterioration of the structural current account deficit. However, data related to trade show that trade balance has been very volatile in recent years. Negotiations with the EU on a new trade deal will be important for future trade related flows. It seems that a deal will focus on trade with goods, where the UK has a large deficit against the EU, while there may be some restrictions in trade with services where the UK in contrast has a large trade surplus with the EU. This could lead to a net effect where the trade deficit widens again and demand ongoing capital inflows into the UK to fund the lack of domestic savings. However, if the GBP recovers further, that may also reduce the attractiveness of foreign investments in the UK economy as financial assets will be more expensive for overseas investors. Capital flows related to trade and investments may have an increased negative pressure on the GBP in the long-term but hardly in the next 6 to 12 months.

Long-term valuation indicates the GBP has more upside potential Since the fall in the GBP after the Brexit referendum in 2016 the GBP is undervalued by around 10% against the euro. Long-term fair value estimate based on our model is currently at 0.77. This is probably where the EUR/GBP would have traded today if it was not for Brexit, as suggested by the 2-year rate differential between the UK and EU. The low valuation of the GBP is there because of concerns for how the economy will react when the UK finally replaces the terms of the transition period with a new trade deal by the end of this year or fails to reach an agreement. If the economy shows resilience and the trade talks lead to a deal that can be accepted by the EU and the British parliament, there is clearly room for the GBP to recover from today’s level.

EUR/CHF


EUR/CHF Very gradual rise as risk appetite returns

The Swiss franc has strengthened by around 5% versus the euro since the start of 2019, falling below levels where the Swiss central bank previously would have been expected to act. However, among other things, as the depreciation versus the USD is far smaller (0.5%) such action has not been taken. With our scenario of returning risk appetite in H1, we expect a very gradual correction leading to somewhat higher EUR/CHF, targeting 1.08 at the end of June 2020.

Strong CHF in 2019 and at the start of the new year. EUR/CHF has fallen by about 5% since the start of 2019. The major part of this took place between May and August on the back of safe haven flows. From September to November the CHF weakened slightly as some optimism returned to the market mainly due to progress in the trade war negotiations and regarding the Brexit process. However, in December EUR/CHF began falling quite sharply again, which continued throughout January.

Risk appetite the main CHF driver, but not the only one. The mix of defensive qualities, low interest rates and high valuation best explains the behavior of the CHF. Whenever a negative event or concern hits the financial markets the CHF tends to appreciate, especially if the concern is centered on a European level. However, in periods of improving risk appetite its stretched valuation and low interest rates have not caused the CHF to weaken as much as one would expect. Thus, there seems to be some underlying CHF positive flows in the background providing a slow but steady support, which have contributed to the EUR/CHF fall that has been ongoing since April 2018. As we expect a more positive risk sentiment in the market H1 2020, we expect the CHF overvaluation do decrease. But given the slow development in previous periods of risk-on we only see a very gradual increase in EUR/CHF.

Can the SNB really do anything if CHF continues to strengthen? The CHF has been viewed as too strong by the Swiss National Bank (SNB) for a long time. However, they have not done much to prevent its appreciation in 2019 and the question is what they could do in 2020 if the strength continues. The easiest thing to do is to is to replace the phrase “highly overvalued” and go back to the previous and stronger wording “severely overvalued” in their March rate decision statement. However, as the CHF appreciation is very limited versus the USD (+0.5 since 2019) it is highly questionable if they will change wording. Another way would be to cut the policy rate and a third option is to intervene directly in the currency market.

We do not expect a rate cut from the current -0.75% to -1.0%, but the risk is clearly for a cut rather than a hike. SNB President Jordan stated in an interview on Feb 4 that the SNB had room to cut rates further and would do so if they thought it necessary after a thorough cost-benefit analysis. However, we believe that the threshold is set high for such an analysis to show that the benefits of a cut outweigh the cost. There are more and more indications that negative rates come with a cost and Switzerland already has the lowest policy rate among the G10 countries. On top of that Switzerland also has sharply rising housing prices where even lower borrowing costs could fuel a bubble. Furthermore, inflation has rebounded from a low in Sep 2019 making the need for a cut lower.

There have been no interventions in the currency market yet. Furthermore, we do not expect interventions in the currency market even though Mr. Jordan also said in the Feb 4 interview that the US decision to put Switzerland back on its watch list for currency manipulators would not stop the SNB from intervening in the currency market. The main reason is that, as mentioned above, the CHF has not strengthened significantly versus the USD. Any intervention to weaken the CHF would not only drive EUR/CHF higher but also USD/CHF. This should cause some concern as the US is one of Switzerland’s most important, and fastest growing, export counterparties.

12 feb 3M 6M 12M Q2 21 LTFV*

EUR/CHF 1.07 1.07 1.08 1.11 1.13 1.22

USD/CHF 0.98 0.99 0.98 0.98 0.98 1.04

CHF/SEK 9.86 9.77 9.58 9.23 8.98 8.00

CHF/NOK 9.44 9.35 9.21 8.87 8.63 7.70

GBP/CHF 1.26 1.25 1.24 1.32 1.35 1.54

ECB -0.50 -0.50 -0.50 -0.50 -0.50

SNB -0.75 -0.75 -0.75 -0.75 -0.75


EUR/CHF


b

In the long term we believe the CHF will have to weaken and EUR/CHF at around 1.20 is a reasonable long-term target.

How is the Swiss economy doing? The economy is far less important for the setting of Swiss monetary policy than for most other central banks and thus our focus is also more on the international development and its impact on the CHF. The Swiss economy is strongly linked to the general economic development in the euro zone. PMIs for both the euro zone and Switzerland reached a trough in Sep 2019 but while euro zone PMIs have trended higher since then the Swiss PMI has stalled over the past three months and still trades around the level (48) seen after a sharp rise from Sep to Oct. One explanation could be that the sharp CHF strengthening seen since early Dec is limiting the optimism among Swiss companies.

Inflation is also following the development in the rest of the Europe but is at an even lower level, which supports the notion of cutting the rate. But it is questionable how much a reduction from the already extremely low rate would help inflation higher. Also, as inflation has rebounded from a low in Oct 2019 its support for a cut is currently lessening.

House prices have continued to increase and pose a threat to yet lower rates as this could fuel further rises risking inflating and causing more of a bubble.

Long-term valuation. During the financial crisis in 2008 and during the euro area debt crisis in 2010-2012 the CHF served as a safe haven currency. It then attracted vast capital inflows from across the world, which caused it to appreciate significantly. The situation altered quite rapidly: previously the CHF had been significantly undervalued against the euro since the early 2000s, but now it appears rather overvalued according to our valuation approach. Today our estimate for the equilibrium exchange rate in the EUR/CHF is around 1.20, where it has been quite stable since 2012. It suggests that EUR/CHF is trading more than 10% away from fair value. Considering relative competitiveness it looks a little different. After the financial crisis the ULC-development in Switzerland was moving alongside the euro area ULC. However since 2015 things are back to normal, which mean a much faster growth in the euro area ULC. The difference since 2015 suggest that nominal EUR/CHF should trade roughly 10% lower compared to 2015, for the euro area to maintain its competitiveness, which is at 1.10.

EUR/SEK


EUR/SEK Headwinds are fading

Some of the headwinds for the SEK such as negative rates, an aggressive central bank and the global trade war between the US and China are now gone, while the Swedish current account has improved. These things should benefit the krona. But the krona seems to get hit whenever there is increased concern for the global economy. This is not the time to buy the SEK, although most likely the krona will manage to recover when there are signs that the coronavirus in China is under control.

Short term In recent weeks financial markets and exchange rates have been dominated by concerns related to the outbreak of the coronavirus in China, which has now far passed the SARS-outbreak in 2003. How severe this epidemic will eventually be and its consequences for the global economy is currently difficult to predict. From a SEK perspective it appears that as long as these concerns dominate in financial markets it will be negative for the SEK and could easily lead to further depreciation of the SEK short-term. For the same reason, the SEK is likely to be one of the winners among G10-currencies on signs that authorities in China manage to get the outbreak under control before it hurts the Chinese economy too badly. This means that the short-term outlook for the SEK is closely tied to the epidemic, which is very uncertain. Long term The global environment in 2019 with falling growth indicators and increased political uncertainty was challenging for small and less liquid currencies like the SEK and the NOK. In fact, commodity currencies like the AUD and the NZD also suffered. However, towards the end of last year, these forward-looking indicators began to stabilise, while the US and China finally reached a partial trade deal which stopped further escalation of the trade war. This caused smaller currencies to recover on the back of improving risk appetite. The tight correlation where smaller G10-currencies apparently trade similarly against major currencies and where the direction is determined by the global risk sentiment has continued in the beginning of this year. Our base case for the macro development in 2020 in the Nordic Outlook report suggests stabilisation in global growth this year, which should be positive for global risk appetite if the disease in China gets under control. That would create a global environment, where smaller currencies in general and the SEK particularly are likely to recover and outperform major currencies.

It takes time for the SEK to recover. The krona has been badly beaten in recent years, which took it from being significantly overvalued in 2013, following the Eurozone debt crisis, to being long-term undervalued nowadays. One of the key reasons for its bad performance is undoubtedly related to the treatment by the Riksbank from 2014 an onwards, where a hostile attitude towards the SEK and where the introduction of massive bond purchases and negative rates in 2015 were used to weaken it to boost domestic inflation. This created a setup where the speculative community suddenly faced a one-sided SEK-bet sweetened by a positive carry. At the same time domestic real money investors could benefit from significant rate differentials between the SEK and other currencies like the USD.

The EUR/SEK-floor created by the Riksbank’s hostile policy also made it rational to leave FX-exposures unhedged while natural SEK buyers as Swedish exporters facing negative rates on their Swedish bank accounts had no reasons to repatriate earnings. Although these conditions have changed since the Riksbank stepped down its extreme policy in 2018 and eventually ended its experiment with negative rates by the end of last year, the SEK still seems to suffer from years of abuse. Apparently, a currency earns its reputation and after being so badly beaten for several years in times of good growth it will obviously take time for the SEK to regain its goodwill with a much weaker domestic economy, not the least when inflation now seems to return to levels not far from where the abuse once begun.

11 feb 3M 6M 12M Q2 21 LTFV*

EUR/SEK 10.54 10.45 10.35 10.25 10.15 9.74

USD/SEK 9.67 9.69 9.41 9.07 8.83 8.31

NOK/SEK 1.04 1.05 1.04 1.04 1.04 1.04

GBP/SEK 12.51 12.21 11.86 12.15 12.09 12.31

JPY/SEK 8.81 8.89 8.63 8.17 7.88 8.47

ECB -0.50 -0.50 -0.50 -0.50 -0.50

Riksbank 0.00 0.00 0.00 0.00 0.00


EUR/SEK


A weak SEK has boosted exports? The Swedish current account surplus has decreased constantly since reaching the quarterly record of around SEK 70bn in 2008. It reached lows of around SEK 23bn by the end of 2018. Since then it has improved massively and in Q3 2019 it was almost back to record levels. The reason for the improvement of the current account balance is mostly related to a rapid increase in the surplus in goods trade with the rest of the world. Moreover, there has also been an improvement in the net return on investments, where Swedish overseas investments currently generate a much larger revenue than foreign investments in the country. While the improvement in the trade balance is probably related to the weaker SEK, the net investment income is probably an outcome of low or negative Swedish yields and a much better performance of foreign equity markets than the Swedish equity market. While the former will probably be sustained, the latter is most likely temporarily. The current account balance is therefore likely to continue to generate net positive capital inflows into the Swedish economy. So far it has not helped the SEK as financial outflows offset these flows. Long-term valuation – undervalued but less than thought Over the past few years we have written several articles on how we think the long-term fair value of SEK has steadily been undermined. The primary reason is the past 10 years change in relative unit labour cost vs the Eurozone where Sweden has seen steeper wage increases with the same (poor) level of productivity growth. Long-term fair value in the EUR/SEK has slowly trended higher from 8.00-8.50 in the mid-1990s to 9.75-10.00 in recent years, based on our valuation approach. There are several sources behind this trend higher in the fair-value for EUR/SEK, and one reason is the fact that the Swedish real yields have persistently trended lower vs the Eurozone. In addition, relative terms of trade were unfavourable in the past while Swedish inflation and ULC have increased faster in recent years.

In fact, during the last decade Swedish ULC has increased much faster than in the Eurozone, undermining Swedish competitiveness in a way that has been unusual in the past. Since the end of 2010 the Swedish ULC increased by almost 10% compared with ULC in the Eurozone, which is undermining Swedish competitiveness. Considering that 9.25 in EUR/SEK was seen as a reasonable exchange rate a decade ago, it would be 10.10 today to fully compensate for higher relative ULC. At today’s around 10.50 the krona is undervalued against the euro, but it is probably more like 5-10% and not 10-15%.

Trading strategy Some of the headwinds for the SEK as negative rates, an aggressive central bank and the global trade war between US and China are now gone. Moreover, the Swedish current account surplus has improved rapidly in recent quarters and is back where it was several years ago. All these things should benefit the krona. In contrast the krona seems to be hit whenever there is increased concern for the global economy. This year it has already been illustrated twice, with the US/Iran conflict and more recently by the outbreak of the coronavirus in China. We stick to a more benign global growth scenario in 2020, where a fragile global economy can shake off this stress without being too severely hurt. Although this is not the time to buy the SEK, we are quite certain that the krona, just as other trade-exposed currencies, will manage to recover what it has lost this year and probably more, whenever there are signs that the epidemic in China is under control. We continue to target levels in EUR/SEK around 10.10-10.20 by the end of this year.

EUR/NOK


EUR/NOK Bearish outlook maintained

The NOK has been hit hard by the risk aversion and fall in oil prices from the outbreak of the coronavirus. The short-term outlook is uncertain, but should there be clear signs of containment the NOK has potential to rebound as positioning and short rates are supportive. We maintain our positive NOK-view for 2020 while the long-term outlook is restrained by structural capital outflows and challenging competitiveness outside the petroleum sector.

Short-term The outbreak of the coronavirus in China has dominated financial markets in recent weeks. The krone has been hit hard both as a small risk-on currency and due to its correlation with oil prices. Economic data out of Norway has also surprised on the downside, and the recent move higher in EUR/NOK has thus been justified by its usual drivers reflected in its short-term fair value. In a similar fashion to the Swedish krona, NOK will remain vulnerable until there are clear signs that the virus can be contained, and economic consequences will be limited. However, it will also depend on how much damage the loss in oil demand will have on oil prices. Hence, the short-term outlook is very uncertain.

Lower oil prices weigh on NOK. The correlation between NOK and the oil price is conditional on the size and direction of the changes in oil, where the relationship is strongest when the oil price is falling sharply. However, as we explained in our last NOK Views report, the correlation may also depend on the source of the change in oil price. Supply-driven increases related to geopolitical risks tend not to be positively correlated with the krone. This may explain why the NOK got no material support from higher oil prices during autumn 2019, and why it has followed oil prices lower in January. Since the coronavirus outbreak in China the oil price has declined by 20%. Estimates suggest that Chinese oil demand may decline by around 3m bl/d in February, representing one of the biggest demand shocks since 2008. OPEC+ has so far refrained from making deeper production cuts; the supply-demand balance has weakened, and risks are significantly on the downside for H1 2020. How the NOK will react to developments around containing the virus will depend on how severely it has impacted the oil price outlook.

Positioning is favourable. Proxy positioning indices suggest speculative investors scaled back short positions notably in the final weeks of 2019 and went long NOK in the start of January. Although positioning seemed a bit stretched after the substantial move, the coronavirus outbreak and correction in the EUR/NOK implies that positioning now is more neutral. Our CTA dashboard shows that trend-followers have turned short NOK against USD again. These flows tend to be important for the direction of the krone, as domestic companies have a relatively static FX policy with a high hedging ratio and duration. Hence, positioning should be supportive for the NOK if/when risk sentiment recovers.

An undramatic growth slowdown, Norges Bank firmly on hold. The mainland economy has passed its cyclical peak as growth slowed notably between Q3 and Q4 2019. The slowdown is broad-based but undramatic, with growth expected to moderate from 2.3% in 2019 to a more trend-like pace of 2.0% in 2020. This is not enough to trigger a policy response by Norges Bank. The output gap will remain positive and labour markets tight, underpinning inflation near target. However, as downside risks dominate, Norges Bank is likely to revise its rate path lower before the summer, effectively removing the 10bps upside bias in the path. However, we expect a firm message that rates will remain on hold at 1.50% which should prevent markets from discounting aggressive rate cuts unless driven by a deteriorating global outlook. Hence, relative rate expectations should not be a major driver for the currency pair.

Extra support should FX carry gain interest. If carry would become an attractive investment theme in the FX market, NOK should benefit. Among the G10 currencies, the NOK and the USD currently have the second highest 1-month rate after CAD. However, carry strategies have performed best in times of positive risk sentiment, suggesting growth- and coronavirus uncertainty needs to ease for NOK to get support from carry flows.

11 feb 3M 6M 12M Q2 21 LTFV*

EUR/NOK 10.09 10.00 9.95 9.85 9.75 9.36

USD/NOK 9.24 9.27 9.05 8.72 8.48 7.99

NOK/SEK 1.04 1.05 1.04 1.04 1.04 1.04

GBP/NOK 11.98 11.68 11.40 11.68 11.62 11.84

JPY/NOK 8.41 8.51 8.30 7.85 7.57 8.14

ECB -0.50 -0.50 -0.50 -0.50 -0.50

Norges Bank 1.50 1.50 1.50 1.50 1.50


EUR/NOK


Long term Norwegian oil dependence. The progress party’s exit from the centre-right coalition government in January had no direct implications; minority governments are common in Norway and snap elections are not allowed. The political drama nonetheless reinforced investors’ concerns that the Norwegian petroleum sector may be threatened by the global transition towards renewable energy. The left/green parties (Red, Socialist Left and Green) have urged a gradual shutdown of Norway’s oil industry and opinion polls currently favour a change of government to the centre-left bloc. However, none of the larger parties on either side of the centre are willing to dismantle Norway’s oil industry. Such a scenario thus appears unlikely, regardless of who takes office after the general election in September 2021. A first small shift, however, may be to stop the issuance of new licenses for exploration in controversial areas depending on the composition of parties in the new government.

Structural outflows weighing on NOK. Despite large current account surpluses over the last two decades, the Norwegian setup with the oil-fund (GPFG) have prevented these large export revenues and current account surpluses from strengthening the NOK. Since the current account surplus is transferred and invested outside Norway, it has created a capital outflow that has neutralized the positive impact on the NOK from rising petroleum revenues. In a theme article in the end of this report we have tried to calculate the net capital flows that impact the NOK. The adjusted broad basic balance suggests there is in fact a significant average quarterly net capital outflow of around NOK 80bn. This is largely related to a growing mainland trade deficit and the assumption that dividend related inflows have no impact on the exchange rate (as they predominately relate to the GPFG). These capital flows can never explain every move in the exchange rate. In periods other flows could dominate the direction of the currency. However, as soon as these flows start to dry up or turn around, the underlying NOK-negative capital outflows begin to dominate the direction and will contribute to a weaker currency. These flows seem to continue going forward and will clearly be a headwind for the NOK.

Long-term valuation. The NOK is undervalued against the euro. We have argued this before and will continue to do so. However, today the deviation between spot and the long-term equilibrium exchange rate is not that extreme. Based on our model approach, the deviation is only around 10%, with the long-term fair value currently around 9.40. Since 2019, the fair value has been rising from around 8.50. Alternative approaches, like the relative ULC development, don’t usually make much sense when it comes to Norway as labour costs tend to rise much faster in Norway than anywhere else, with the currency so far not responding accordingly. As long as the country can prosper from petroleum revenues it can probably afford its higher ULC, but competitiveness outside the petroleum sector is clearly a long-term concern that will eventually have to improve from a weaker nominal NOK exchange rate.

Trading strategy. The krone remains vulnerable to setbacks in global risk sentiment related to the global growth outlook. Our benign global growth scenario should thus benefit the NOK when there are signs that the coronavirus is under control. With positioning now neutral or even short NOK, there is potential for a substantial turnaround. Domestic fundamentals should remain solid, as the gradual slowdown in the mainland economy won’t trigger a policy response from Norges Bank. The krone will thus remain a top-3 yielding G10 carry currency. We maintain our positive outlook for the krone this year, targeting EUR/NOK at 9.85 by year-end.

USD/CAD


USD/CAD Bank of Canada to remain on hold, disappointing the market expectations

The Canadian economy hit a soft patch late last year, which made the Bank of Canada more open to a rate cut if the weakness persists. The bank is still very reluctant to deliver a Fed-style pro-active “insurance” cut and as economic activity is likely to rebound higher during the first half of this year, the market is likely to scale back its rate cut expectations and send USD/CAD lower.

CAD likely to strengthen as growth rebounds and market scales back its rate cut expectations During the past year the market has been expecting the BOC to follow the Fed, but the Canadian economy has proven to be surprisingly resilient to the slowdown in global trade and economic activity. With inflation close to the 2% target and the economy operating close to full capacity, the BOC has been able to keep its main policy rate outlook stable at the current 1.75% level. After the December meeting, the market once again had to scale back its rate cut expectations as the BOC continued to see inflation stable close to the target going forward, sending CAD to the strongest level vs. USD since 2018. At the January meeting, however, the BOC did soften its policy stance because economic activity slowed in Q4, leading the bank to revise its estimate on the output gap 0.5%-points wider, tilting inflation risks to the downside.

Following the soft message after the January meeting, the market rapidly increased the probability of a rate cut, indicating a 25bps cut by mid-2020 and sending USD/CAD some 2% higher. But the slowdown was partly due to the temporary factors and therefore the bank expects growth to accelerate back close to the potential growth rate this year. The forecast of a growth rebound obviously is somewhat uncertain and therefore the bank was more vocal about a possible rate cut in the event economic weakness persists. The main scenario, however, is that inflation will remain close to the 2% target throughout the forecasting horizon.

Global uncertainty has led to weakness mainly in exports and investment that spilled over to consumer spending and housing activity in Q4. However, wages are growing solidly – as is Canada’s population – which suggests consumer spending will increase this year. With no further trade war escalation in the near term, international trade is likely to recover in Q1 2020. Activity in housing remains good but there have been some indications that residential investment growth may be slowing. However, January employment and housing data was strong, supporting the view of a growth re-bound. All in all, the weakness experienced late last year is expected to be temporary and if economic activity improves according to the BOC projection, there will be no need for it to ease its monetary policy in the near future, as the market is expecting.

Coronavirus, which was not included in the bank´s January projections, obviously could have some indirect effects on the Canadian economy. Lower equity prices, loss of confidence, and disruptions in supply chains could all postpone the economic recovery. However, so long the virus outbreak is seen as being temporary, the central bank should look through the weakness. It is worth noting that the bank is still reluctant to make “insurance” rate cuts out of fear of fuelling the housing market and pushing household debt higher. Deputy Governor Paul Beaudry said on 30 January that short-term monetary policy easing could cause financial vulnerabilities later on and become a drag on the economy and inflation. Therefore, the short-term benefit may not be worth the potential cost in the long run. Our base case is that the growth outlook will improve during Q1, which should taper the market´s expectations on the rate cuts and send USD/CAD lower once the risk appetite improves.

12 feb 3M 6M 12M Q2 21 LTFV*

USD/CAD 1.33 1.32 1.31 1.30 1.29 1.29

EUR/CAD 1.45 1.42 1.44 1.47 1.48 1.52

CAD/SEK 7.25 7.34 7.18 6.98 6.84 6.42

CAD/NOK 6.96 7.02 6.90 6.71 6.57 6.17

GBP/CAD 1.72 1.66 1.65 1.74 1.77 1.92

Fed funds 1.75 1.75 1.50 1.50 1.50

BOC 1.75 1.75 1.75 1.50 1.50


https://www.bankofcanada.ca/2020/01/how-vulnerabilities-can-affect-interest-rates/

https://www.bankofcanada.ca/2020/01/how-vulnerabilities-can-affect-interest-rates/

USD/CAD


Short-term model: domestic monetary policy outlook dominates Since the summer, the Canadian dollar has been driven largely by expectations of a BOC rate cut (see chart on the previous page). The short-term outlook for the CAD is therefore driven by momentum mainly in the domestic economy, which drives expectations on the anticipated growth recovery and the monetary policy outlook. Canada’s close connection to the US economy obviously makes the US growth outlook important as well. USD/CAD has not responded much to the increasing interest rate differential and improving carry, which is clearly shown in our short-term model on the left. Historically, the short-term model – including the 2y IRS rate spread, oil price and the VIX index – was able to explain the moves in USD/CAD exchange rate very well until early 2019. Since mid-2019, when the market started to speculate on the Fed rate cuts, the policy easing and widening of the short rate spread has had a limited impact on the Canadian dollar. The short-term outlook for the USDCAD is therefore driven largely by the domestic monetary policy outlook and thus to some extend the US economy rather than the Fed.

Long-term outlook for USD/CAD is stable In Canada, multi-year trends in capacity utilisation and CPI inflation are moving largely in the same direction (chart on the left). The BOC seems therefore to be better placed than many other central banks because economic activity, and therefore monetary policy, is having a material impact on consumer prices in the medium term. Core inflation in Canada has averaged close to 2% over the past two years, with capacity utilisation moving in tandem at around 82%. Relative to the US, cumulative consumer price inflation in Canada has been less than 0.5% lower than the US since January 2015. Similarly, unit labour costs in Canada have followed the US development closely and currently ULCs in both countries are increasing at the similar rate, putting very little pressure on the USDCAD exchange rate.

Long-term valuation The USD/CAD spot rate has followed changes in the long-term fair value for a long time and is currently trading close to “fair value”. Our long-term valuation approach indicates a long-term fair value of around 1.30, which is basically where it trades today. Since 2013 the long-term fair value estimate has risen from around 1.10 to 1.30, and in this sense the move higher in USD/CAD is quite reasonable. As noted above, the ULC in Canada has followed closely the US development, which is normally the case with the exception being in the wake of the financial crisis that hit the US economy more severely. With a much weaker nominal exchange vs. USD (around 30% since 2013) competitiveness vs. the US should not be an issue for Canada. In fact, Canada could probably afford a stronger currency.

USD/CNY


USD/CNY Novel Coronavirus takes centre stage

The relief rally from the signing of the Phase 1 deal did not last long. News of the 2019-nCoV coronavirus is limiting downside to USD/CNH. Our base case for the outbreak is to reach a peak in March with normalcy returning by April. Even so, we flag downside risks to full year growth outlook for 2020, while expecting annual growth to rise in 2021. As soon as growth normalizes, we expect fundamental drivers of the yuan to prevail, keeping CNY on the back foot against the greenback.

Short-term Overshadowing the relief rally from the signing of the Phase 1 trade deal in mid-January, news of the spread of the 2019-nCoV coronavirus has gripped financial markets since 20 January. Risk sentiment quickly turned against both onshore and offshore yuan when USD/CNH surged up, briefly touching 7.01 from 6.86 before the news broke. Our base case is for the daily increase of infections to peak in March and normalcy is restored by April. In this case, a full recovery will be in place by Q3. Full year GDP growth for 2020 could decline to a range of 5.5-5.7%. Considering the determination of the Chinese authorities to provide a backstop to growth, we are keeping our 5.7% growth outlook for now. Thus, we continue to expect the pair to track higher to 7.15 by end-2020.However, amidst elevated uncertainties, our conviction in any particular forecast is lower than usual.

As of 11 February, the virus has now spread to 28 countries and territories infecting over 43,000 people and claiming 1,018 lives. Hubei province, the epicentre of the outbreak, accounts for 73% of cases. The severity and economic impact of the outbreak depends on how far the virus spreads and how dangerous it is as measured by the fatality rate. Reported data suggest that the new virus is more infectious but less fatal than the severe acute respiratory syndrome (SARS) outbreak in 2003.

In an effort to contain the outbreak, Chinese authorities rolled out unprecedented measures such as travel restrictions and extensions of the Lunar New Year holidays. Although businesses for most of mainland China were expected to get back to work on 10 February, there have been mixed reports about some Chinese factories re-opening and others extending further the Lunar holiday period, leaving markets treading water for now. Indeed, travel restrictions still hinder people from returning to work. As of Day 23 from the news of the outbreak, markets have been comforted by smaller daily increases in reported coronavirus cases. However, we note that the spread of the virus is easing because so many people remain shut in their houses and have not gone back to work. In the short term, there is a direct trade-off between how fast workplaces re-open, and how well the virus can be contained. Emergency policy support is already being rolled out. Even as authorities remain focussed on containing the outbreak, we expect more effort to re-start production in the coming weeks.

Amidst the news of the virus, foreign equity flows remained sizeable, on the assumption that Chinese assets would recover as soon as the number of infections top out. Meanwhile, we expect the reliance on the counter cyclical factor (CCF) to be sustained, along with active participation of the state banks, to keep USD/CNH around 7.0 during the outbreak. Even so, we expect significant volatility on both sides of the 7.0 handle as risk sentiment adjusts to news of infections.

The People’s Bank of China (PBoC) will continue to provide support with adequate liquidity injections and guiding interest rates lower. On 3 February, the central bank cut its 7-day and 14-day reverse repo rate by 10 bps each, on top of a CNY1.2 trillion liquidity injection as the onshore market opened after the extended Lunar New Year holidays. Re-lending efforts have targeted industries in heavily-hit areas and sectors and industries critical to containing the outbreak. We expect other policy interest rates to be lowered in the coming weeks eventually leading to a cut in the Loan Prime Rate (LPR). We also stand by our expectations of a broad-based cut in the reserve requirement ratio in Q1.

2019-nCoV vs 2003 SARS

Confirmed

Cases Deaths

Fatality

Rate, %

Confirmed

Cases Deaths

Fatality

Rate, %

Total 43,091 1,018 2.4 8,460 813 9.6

China 42,638 1,016 2.4 5,327 349 6.6

Thailand 32 0 0 9 2 22.2

Hong Kong 42 1 2.4 1,755 299 17.0

Singapore 45 0 0 238 33 13.9

South Korea 27 0 0 3 0 0

Japan 25 0 0 5 0 0

Taiwan 18 0 0 346 37 10.7

Malaysia 18 0 0 5 2 40.0

Vietnam 13 0 0 63 5 7.9

India 3 0 0 3 0 0

Philippines 3 1 33.3 14 2 14.3

Indonesia 0 0 0 2 0 0

SARS (Nov 2002-Jul 2003)2019-nCoV (19 Jan- 11 Feb)

12 feb 3M 6M 12M Q2 21

USD/CNY 6.96 7.03 7.08 7.16 7.18

EUR/CNY 7.60 7.58 7.79 8.09 8.26

CNY/SEK 1.38 1.38 1.33 1.27 1.23

CNY/NOK 1.33 1.32 1.28 1.22 1.18

GBP/CNY 9.03 8.86 8.92 9.59 9.84

Fed funds 1.75 1.75 1.50 1.50 1.50

PBOC 2.40 2.35 2.30 2.30 2.30


USD/CNY


Hypothetical USD/CNY To Offset Higher Tariffs

USD/G10 vs USD/CNY

USD/CNY vs CFETS RMB Index

USD/CNY vs Rate Differential

Long-term Risk aversion and travel restrictions could linger until Q2. Assuming the peak of viral infections occurs in March, the negative impact of the 2019-nCoV virus will likely lead to below-trend sequential growth in H1. So long as the disruption in activity is short, no matter how deep, we do not expect long-term economic damage related to permanent shifts to the supply chain. If the experience of the SARS is any indication, economic recovery could be firmly in place by Q3 2020. Overall, this will put downside risks to full year 2020 GDP growth. Once the outbreak is definitively contained, we expect policy support to shift towards stimulating growth. Thus, the momentum of recovery could lead to above trend expansion in 2021.

As growth expectations turned south, government bond yields headed towards multi-year lows. Thus, the rate differential with the US narrowed substantially. Although we expect a recovery in activity within two quarters of hitting a peak in the virus outbreak, the uncertainty with regard the severity and the duration of the disease will keep downward pressure on bond yields.

Once the growth outlook normalizes, we expect fundamental drivers of the yuan to prevail. Higher US tariffs on most Chinese exports remain, keeping the upside risks to USD/CNH until Chinese production fully adjusts to the reality of higher tariffs for longer. More weakness in the yuan is to be expected as the Chinese economy continues to ease, in our view. Further monetary easing, no matter how targeted, is also not supportive of the yuan.

Fiscal support is coming. The announcement of the Ministry of Finance that the general fiscal deficit would likely rise to the ceiling of 3% of GDP in 2020, from 2.8% in 2019, is further indication of more fiscal support. Meanwhile, the release of the second batch of early-approved local debt quota to the tune of CNY 848 billion by the central government indicates the determination of the authorities to generate a recovery as soon as the outbreak is contained. The latest bond quota includes CNY558 billion for the general budget and CNY290 billion of special debt. The early release provides flexibility to local governments to roll out their investment plans. Moreover, we expect more fiscal support via temporary tax relief in the coming months.

As trade tensions ease and investment-related demand improves, we expect capital imports to recover in the medium term. We are pushing back our expectations of export growth peaking to Q3 in light of the virus-related disruptions. Even so, supportive policies by the government will likely lead to stronger than initially expected recovery in capital imports. Overall, this should lead to a narrower trade surplus through 2021.

Foreign portfolio flows will likely remain strong, providing a partial offset to the weakness in the yuan. Global bond benchmarks continue to raise the weighting on Chinese debt issues. Even as MSCI completed its final phase of weight increase on China A-shares to 20% from 5% by November 2019, there will likely be more substantial increases to the A-shares weights among the other major global indices in the coming years.

6.0

6.2

6.4

6.6

6.8

7.0

7.2

7.4

7.6

7.8

Jan 18 Apr 18 Jul 18 Oct 18 Jan 19 Apr 19 Jul 19 Oct 19 Jan 20

US

D/C

NH

Estimated USD/CNH to offset tariffs USD/CNY

6Jul '18:25% on $34bn

23Aug'18:25% on $16bn

24Sep'18:10% on $200bn

10May'19:25% on $200bn

1Sep'19:15% on $130bn

15 Jan '20:Phase 1 deal

5.9

6.1

6.3

6.5

6.7

6.9

7.1

7.3

85

87

89

91

93

95

97

99

101

103

105

2016 2017 2018 2019 2020

US

D/C

NY

US

D/G

10

Cu

rre

ncie

s

USD/G10 USD/CNY

90

92

94

96

98

100

1026.20

6.30

6.40

6.50

6.60

6.70

6.80

6.90

7.00

7.10

7.20

2016 2017 2018 2019 2020

CF

ET

S R

MB

(In re

ve

rse

)

US

D/C

NY

USD/CNYCFETS RMB Index (RHS, in reverse)

-400

-300

-200

-100

0

5.70

6.00

6.30

6.60

6.90

7.20

2010 2012 2014 2016 2018 2020

Ra

te D

iffere

ntia

l, bps

US

D/C

NY

USD/CNY US-CH 5yr bond Differential

Themes


FX market themes


Buying insurance in the currency option market What is the most attractive currency pair against a possible market turbulence?

We have looked at which currency pairs offer effective exposure to the deteriorating market sentiment and higher equity market volatility at the best possible price. Taking in to account the correlation with the equity returns, implied volatility and carry, we find that EURJPY puts give the most bang for the buck among G10 currencies. Taking put skews into account, EUR/JPY continues to come ahead of the competing currencies.

Volatilities across the asset classes are low and the equity indices are breaking new records with increasing valuations. With S&P500 earnings growth close to zero in 2019, the rallying equity market seems to be pricing in a growth acceleration. We still hold the view that after the global growth slowdown experienced last year, the economic activity is stabilizing and we will see a modest growth this year. Recessions and sharp market turns are difficult to predict, but we think that the current high equity and credit valuations, while the slow growth may persist longer than the markets anticipate, have increased the risk of larger asset price corrections. As low implied volatilities currently offer cheap insurance against a possible market turbulence, we have looked at which currency pairs offer the most attractive exposure against sharply higher equity market volatility and a general increase of risk aversion in the currency option market.

We have two core criteria for the attractive option hedge: the effectiveness and price. If the negative shock hits the market, we need to be confident that the currency pair performs as expected, so the correlation with the equity market returns need to be high and consistent. Given a required efficiency, we want to get the exposure as cheap as possible. In other words, we are looking for a currency pair that has a high and persistent correlation with equity market returns and at the same time a high positive carry and low implied volatility. We have chosen the six months option tenor to get a large sensitivity to volatility (vega) and low decay of the time value (theta). A relevant question is though if rolling a shorter option would be a more effective strategy as it allows faster acceleration in option price relative to the underlying price (gamma) and it allows for re-adjusting the strike closer to the current forward level more frequently in case the spot drifts away from the strike level.

Theme: Buying insurance in the currency option market


A longer option however offers a larger sensitivity to volatility (vega), compensating the lower gamma. Further, slower time decay offers the possibility to restructure the position before maturity without the option losing value too much. In general, the price of a longer option is more stable in terms of delta and gamma profile.

Large differences in volatilities and carry. The chart below illustrates the 6M ATM volatilities and their high-low ranges for a the most common G10 currency crosses since January 2018. Implied volatilities are close to the two-year lows across all the chosen currency pairs, indicating that the market is expecting very little surprises during the coming six months. In terms of the outright volatility levels, and therefore ATM option prices, there are fairly large differences between the currency pairs. The most expensive options trading at above 8% implied volatility is almost double as high as the lowest volatilities like EUR/USD and EUR/CHF trading close to 4%.

The carry is equally relevant cost for the option because it defines the ATM strike level relative to the current spot price. A currency pair with a positive carry enables an investor to buy a put option with a strike above the current spot price. Put it differently, a put option in two different currencies with the same volatility and strikes equal to the spot level, the one with higher carry is cheaper.

The ranking below shows a large dispersion in carry costs between the currency pairs as well. From the pure carry perspective EUR/USD is the most attractive currency and together with the extremely low implied volatility it is clearly the cheapest hedging currency alternative. USD/JPY for instance, which is a traditional safe-haven currency pair during a market turbulence, has almost 1% negative carry affecting the total price picture despite its very low volatility.

Putting it all together – the final ranking. The chart below plots the currency pairs in terms of the hedge efficiency and price. Efficiency is measured as the weekly return correlation with the S&P500 index during the past two years. The price is a 6M ATM volatility adjusted with the 6M carry. Note the 6M ATM option price effect (with 6% vol) of a 1% change in volatility is around 0.3%. Therefore, in order to get an equal price effect from a carry, the ATM strike level needs to be 0.6% more favourable. In other words, to put volatility and carry in to comparable units, we have subtracted 1.67 x carry from the ATM implied volatility. In this way an option with 6% volatility with 0% carry gets an equal price score as an option with 7% volatility and 0.6% positive carry. In the chart below, the currency pairs are plotted according to the effectiveness and price, with the most attractive one being closest to the upper-left corner marked green (USDSEK and USDNOK correlations multiplied by -1).

As noted above, EUR/USD for instance is very affordable given its high carry and low volatility, but the correlation with the equity market returns is way too low for it to be considered as an effective hedge against an adverse equity market shock. We can see that the usual safe-haven suspects such as the US dollar and the yen vs. more cyclical currencies like NOK, SEK and AUD rank the highest (closest to the upper-left corner). AUD/USD, EUR/JPY, SEK/JPY and USD/NOK all have 0.4 – 0.5 correlation, but they have fairly large differences in price (carry adjusted volatility). NOK/JPY and AUD/JPY in turn are very efficient in terms of hedging, but they are clearly more expensive. USD/JPY, which is the usual safe-haven currency pair is also suffering from a somewhat higher price due to the negative carry even though volatility is low.

Theme: Buying insurance in the currency option market


The stability of the correlation with risk-off events is a complex problem due to the time variation nature of correlations in the financial markets. A quick look at the annual correlations (table below) reveal that only JPY crosses and to some extent AUD/USD have had fairly stable and high correlation with the equity market (see also the theme article “Risk as a currency driver”). A clear conclusion here is that the EUR/JPY put options are getting the best overall score in terms of efficiency and price. While the correlation during the past two years has been higher in EUR/JPY, USD/JPY has had a higher average correlation during the past five years.

How about put spreads? A plain vanilla put option leaves a lot of degrees of freedom for re-structuring the position later. For instance, the market rallying higher gives an opportunity to buy a new put option with a higher strike while financing the purchase by selling the existing put option twice, leaving the investor with a 1x1 put spread. Further, a single put option has a higher delta, gamma and vega, which make the profit taking possible well before the maturity. Buying a put spread is certainly cheaper, but the hedging capacity is limited, leaves less room for re-structuring and the full p/l impact will be realised only at the maturity. Those who are looking for a cheap, limited downside exposure with no need for early profit taking or restructuring, a put spread is an attractive alternative due to its cheaper price.

The chart below shows the put skews, implying how cheap the put spreads are in relative terms. JPY crosses rank the top five currency pairs here and AUD/USD is the sixth most attractive. This ranking however tells only a part of the total picture about what the most attractive currency pair is in the put spread space.

What is missing from the put skew ranking above is obviously the currency pair’s exposure to the market turbulence, carry and the level of volatility. Despite the put spread involving buying and selling a put option with equal nominal amounts, the put skew does not indicate accurately the total cost. The ATM option has larger vega, meaning that given two currency pairs with equal put skews, the one with the lower ATM volatility is cheaper. The chart below plots the currency pairs in terms of put skews and the carry adjusted volatility. The net carry (delta) and volatility (vega) sensitivities in put spreads are lower, but the ratio is largely the same as above in the one option case. Therefore, our carry adjusted volatility measure can be applied to the put spreads as well. The currency pairs that have 0.35 or lower correlation with the equity returns during the past two years are marked red, meaning they are irrelevant due to their low efficiency. We can see that EUR/JPY once again is the most attractive currency pairs, being closest to the upper-left corner in the chart below. USD/JPY with a high put skew is also an attractive alternative.

Annual correlations with weekly SP500 returns

2019 2018 2017 2016 2015 Avg.

AUDJPY 58% 60% 40% 62% 55% 55%

NOKJPY 65% 55% 26% 41% 44% 46%

USDJPY 48% 27% 43% 43% 38% 40%

SEKJPY 48% 48% 26% 51% 21% 39%

EURJPY 51% 40% 26% 30% 19% 33%

AUDUSD 34% 53% -5% 39% 39% 32%

*USDNOK 43% 41% -14% -5% 22% 17%

NZDUSD 23% 38% -7% 11% 16% 16%

GBPUSD 22% 28% -1% 6% 22% 15%

EURCHF 34% 18% 3% -1% 9% 13%

*USDSEK 22% 29% -10% 5% -1% 9%

EURUSD 11% 19% -22% -33% -4% -6%

*opposite sign in correlation


NOK-negative capital flows Despite strong fundamentals the NOK is under pressure. It seems like there is an underlying structural capital outflow, which is negative for the NOK and this capital flow is unlikely to shift any time soon.

The NOK has been a favourite currency among analysts and market players for some time, given the strong fundamentals of the Norwegian economy. At the same time the NOK has traded weaker and weaker. Obviously, there is something happening below the surface that has had a negative impact on the NOK exchange rate. In this article we dig into balance of payments data to try to find an explanation and we use an approach where net capital flows related to trade, and investments are adjusted to the unique setup in Norway with the petroleum fund. What these calculations illustrate, if correct, are that underlying net capital flows related to trade and investments that affect the NOK have been negative for a long time. This may address the issue of why the NOK has performed so badly since 2014. Looking ahead it would take a shift in these capital flows to expect a more sustained strengthening of the NOK but that is unlikely to happen as long as the spending rule remains intact.

The NOK has been a favorite currency among analysts and market players for some time, given the strong fundamentals of the Norwegian economy. In addition, the Norges bank that has moved against the stream among global central banks and tightened monetary policy several times in recent years. Together this would usually suggest a strengthening of the NOK. Instead the NOK has depreciated significantly in recent years. In fact, its downward trend has been ongoing since 2014 and although it recovered during the last two months of 2019, this was certainly not enough to break the weakening trend against currencies like the USD or the EUR. To call the weakness of the NOK a conundrum may be to take things one step too far, but it has been going on for so long it is time to find the reason why the NOK continues to underperform.

As always there is probably no single factor that explains the NOK weakness, it almost never is. Instead we believe there is a combination of factors, both structural and more temporary, that have contributed the NOK weakness in recent years. Some may eventually disappear while some could continue to weaken the NOK for years to come. To us the conundrum of the NOK weakness seems to be related to a structural shift in balance of payments flows, a stretched nominal valuation of the NOK, which is unsustainable, and uncertainties related to global growth and the geopolitical situation, which has been bad for smaller currencies in general. While there is no reason to believe that the structural factors will shift any time soon a different global sentiment could at least stop the downward trend.

Structural capital flows. For more than three decades rising exports of crude oil and natural gas, combined with sharp increases in the prices have generated significant current account surpluses for Norway. The current account surplus peaked at almost 20% of GDP in 2006. However, rising imports and lower export revenues have slowly but persistently changed this situation and in Q3 last year Norway in fact generated its first quarterly trade deficit in more than 20 years. Despite these large current account surpluses over the last two decades, the Norwegian setup with the oil-fund (GPFG) have prevented these large export revenues and current

Theme: NOK-negative capital flows


account surpluses from strengthening the NOK in the past. A significant part of the government petroleum revenues has thus been saved for future generations and invested in financial assets (mostly stocks and bonds) outside Norway, which created capital outflows that neutralized the positive impact on the NOK from rising petroleum revenues. Even now the setup with the oil-fund improves the current account balance for Norway as the return on these assets generates a large investment income, which goes into the country’s primary income balance, offsetting some of the decline in trade balance.

However, the current account flows are only one part of the balance of payments flows that are usually important for the exchange rate. Net capital flows related to direct investments (FDI) and portfolio investments also tend to have an impact on the currency.

As mentioned earlier the setup with the petroleum fund, where a significant part of government oil revenues is being transferred to the fund and invested in financial assets outside the country, has historically generated large capital outflows. These outflows show up in the balance of payments data as net portfolio investment outflows, amounting to as much as 20-25% of GDP when the oil price peaked in 2008, which is why it so effectively eliminated the positive impact on the NOK exchange rate from large petroleum revenues. In recent years there are still net portfolio outflows, but these are far from as dominant as they were back in the hay-days. What has happened?

The explanation is once again related to the set-up with the petroleum fund. According to the spending rule the government is allowed to generate an annual structural

budget deficit (the non-oil budget surplus) of as much as 3% of the nominal value of the oil fund. The idea is simply to canalize all government petroleum revenues to the oil-fund to be saved for future generations, but to allow current generations to spend the annual real return on the oil-fund investments. The spending rule was changed slightly a couple of years ago as the government assumption of the annual real return was lowered to 3% from 4%.

However, the value of the petroleum fund has increased rapidly over the last 20 years due to large inflows of oil revenues in the past and more recently because of exceptional returns on investments and the depreciation of the NOK. The depreciation of the NOK has since 2008 roughly increased the NOK-value of the petroleum fund by around NOK 1000bn or 10%. Today the valued of the petroleum fund is around NOK 10trn or 3.2 times (320%) GDP of the mainland economy. As the budget deficit according to the spending rule is based on the market value of the petroleum fund in NOK, the sharp rise of its market value has boosted the annual budget deficits. In recent years over NOK 200bn a year (6-7% of the mainland GDP) has therefore flooded into the Norwegian economy through the government’s budget. Naturally this will have consequences.

One consequence of using this much oil-money in the government budget every year from the return on foreign assets is that it creates a large capital inflow that normally should strengthen the NOK. This means that one of the benefits of saving petroleum revenues outside the country, namely offsetting the impact from large export revenues on the NOK, is now gone. This is one reason why we have been bullish on the NOK for some time when the market value of the petroleum fund has been steadily growing year by year. However, as price action in NOK in recent years clearly illustrates this is not the dominant force for the NOK exchange rate.

A second consequence of generating large budget deficits each year is that domestic spending, and therefore imports, will increase faster than exports. Norway has generated large trade deficits for decades if petroleum export revenues are excluded. Currently the non-petroleum trade deficit is 13% of mainland GDP. Hence, while the capital flow situation is positive as the return on the petroleum fund finds its way into the economy it is the opposite when the money is spent



on consumption and investments, as this boosts the non-petroleum imports. This may have contributed to the poor performance of the NOK in recent years.

Isolating NOK-related capital flows. Norway continues to generate current account surpluses and remains a net lender to the rest of the world. As such, the overall capital flow situation should be positive for the NOK. However, the setup with the petroleum fund where much of the current account surplus is transferred and invested outside the country makes it difficult to determine the size of the actual net capital flows that will determine the exchange rate. On the one hand a large chunk of export revenues is transferred into the petroleum fund and the return on the fund’s holdings of foreign financial assets ends up there as well. Consequently, these capital flows that normally should have an impact on the exchange rate as they pass through the market will not affect the NOK. In contrast, the government now brings back a significant amount from the petroleum fund to finance the annual budget deficit. What is the net effect on net capital flows of all these special arrangements?

The basic balance is one way to reflect total net capital flows that largely will have an impact on the exchange rate. Basic balance is normally defined as the current account balance, equity related net portfolio flows and net direct investment flows (FDI). Including net portfolio flows related to debt instruments, we receive the broad basic balance. Here we use the broad basic balance approach to calculate the net capital flows for Norway. However, as we have highlighted, Norway is a special case with the petroleum fund and the spending rule having a significant impact on the actual net capital flows. To better reflect this particular setup and the way petroleum revenues may affect the NOK exchange rate, we have made several adjustments to the original capital flows:

1. Trade balance has been adjusted for the fact that petroleum export revenues are transferred to the petroleum fund. These flows have simply been removed from the trade balance, reducing the current account surplus significantly.

2. Capital flows related to the primary income have been adjusted so that investment income related to the petroleum fund is removed. This has simply been done by eliminating all dividend income, while reinvested earnings have been added back.

This will further reduce the current account surplus over the last decade.

3. However, the government generates a significant budget deficit, which is financed from the return on the petroleum fund. This creates a NOK-positive capital inflow. Therefore, we simply add the annual budget deficit or the non-oil budget surplus as a capital inflow.

4. The financial accounts capture capital flows related to portfolio investments and FDI, including capital flows related to the activity of the petroleum fund. As these capital flows are funded by revenues in foreign currencies there will be no impact on the NOK exchange rate from these capital flows. Therefore, government portfolio investment flows have been removed.

The net result of these different adjustments suggests that capital flows related to FDI and portfolio investments in fact seems to have been almost NOK-neutral, with respect to the flows having an impact on the exchange rate, in recent years after previously generating a NOK-positive net inflow.

Since 2014, net FDI flows have persistently been negative (NOK-negative net outflows) while portfolio investments continue to generate net capital inflows of roughly the same size. Excluding dividend income and petroleum export revenues the quarterly current account deficit rises to around NOK 130-140bn. Part of it, however, is offset by the funding of the fiscal budget deficit, which generates an average quarterly capital inflow of more than NOK. Calculating the net capital flows that reasonably would have an impact on the NOK exchange rate using this approach suggests there is in fact a significant average quarterly net capital outflow of around NOK 80bn. Removing all dividend income may lead to an exaggeration of the total net outflows. Nonetheless, this outcome still offers an explanation why the NOK has performed so badly in recent years, despite strong fundamentals and higher interest rates. The underlying and structural net capital flows that largely will affect the NOK exchange rate simply seems to be negative.

So how well fits the adjusted basic balance calculation with the NOK exchange rate? Since 2007 our calculated measure of adjusted broad basic balance suggests a persistent and growing NOK-



negative capital outflow. This is largely related to a growing mainland trade deficit and the assumption that dividend inflows have no impact on the exchange rate. Moreover, considering only net capital flows related to non-government portfolio investments and net FDI there has been a NOK-negative net capital outflow since 2014 until just recently. This net capital outflow seems to have correlated with the behavior of the trade weighted NOK-index. Interestingly, this net outflow seems to have turned into a net inflow in 2019. Yet the NOK-index has not reacted positively in the same way as would have historically. One explanation might be that the adjusted current account related deficit is much larger today than what it was before 2014.

The NOK will remain under pressure. What these calculations illustrate are that underlying capital flows related to trade and investments may partly explain the weak performance of the NOK since 2014. However, these net capital flows can never be expected to explain every single move in the exchange rate as other flows like short-term speculative flows, rate differentials or what may there be, could dominate the direction of the currency now and then. However, as soon as these short-term capital flows start to dry up or even turn around the underlying and structural NOK-negative net capital outflow seem to dominate the direction of the NOK again, contributing to a weaker currency. Moreover, if our calculations are fairly close to reflect the actual structural capital flows that affect the NOK, there is no reason to turn optimistic on the NOK. Indeed, net capital flows related to non-government portfolio investments and FDI may have improved or even turned into a small net inflow in recent quarters, but it is far from enough to neutralize

the net capital outflows related to trade and the current account balance. It would probably take a shift in these flows to expect a more sustained strengthening of the NOK. Moreover, the trade related deficit seems to continue grow year by year and this is unlikely to change while the spending rule remains intact and allows the economy to be doped by large annual revenues from the petroleum fund. Apparently not even the Norwegian strategy to save petroleum revenues for future generations could prevent the negative consequences of being too rich, only delaying them.


Risk as an FX driver Risk-off has clearly been a driver of FX while risk-on seems to have had less of an impact in 2019

Looking back at times of stress and relief in the financial markets during 2019 clearly shows an asymmetrical impact on most currencies. However, during times of stress it is the usual suspects that have strengthened (JPY, CHF) as well as weakened (AUD, NOK, SEK, NZD). One difference from 2018 is that the EUR showed defensive qualities in 2019.

We have revisited a risk-off/risk-on study conducted in Currency Strategy in late 2018 where we analyse how equal weighted G10 currencies have behaved during times of stress compared with relief. The times of stress (risk-off) are defined as when VIX has begun to head higher forming a spike and the time of relief is the time from the VIX peak to its valley. There have been six such spikes in VIX during 2019 and one in 2020 which started Jan 17 and where there is a tentative peak on 31 Jan.

Usual suspects during times of stress in 2019

When VIX has spiked higher the reaction in G10 currencies has generally reacted along its usual patterns with the JPY and CHF appreciating and the AUD, NOK, and SEK depreciating. However, two things stand out from the ordinary: (1) the NZD has not depreciated as much as usual (it tends to be around the AUD, NOK, and SEK in impact) and (2) the EUR has appreciated more than usual, at least, in 2018. For the EUR it might be the case that in 2018 some of the VIX spikes were caused by direct related Eurozone reasons (e.g. Italian elections) while the spikes in 2019 has been more general in nature. When separating the general from the Eurozone induced VIX spikes in 2018 we found that the EUR worked as a safe haven during general spikes, but as a risky currency for the other ones. Therefore, its safe haven status in 2019 seems natural given the source of the spikes (more trade war related).

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

AUD NOK SEK GBP CAD NZD USD EUR CHF JPY

Average weekly currency reaction during VIX spikes (%)

Theme: Risk as an FX driver


Early 2020 stress

Looking instead at the most recent VIX spike which started on 17 Jan and potentially peaked on 31 Jan, the general picture is the same. However, there are some differences when it comes to the rank in size of the impact and the GBP shows up differently which has less to do with a change of pattern and more that it was during the period more directed by the Brexit process than the general international environment of the time.

One thing that stands out is that the NOK quite clearly turns up as the currency which was hit the hardest this time. This is interesting as it strengthened in the beginning of the period and only began weakening at the turn of the year, when it otherwise tends to be strong. One reason for the extra impact on the NOK this time could be that it was slightly stretched on the upside with to strong positioning as the coronavirus increased the stress. Another partial explanation is that the oil price severely hit in January and that the NOK received a double impact from lower oil prices (usually a major NOK driver) and sharply falling risk appetite at the end of January. However, in that context one could wonder why the CAD was not hit harder than it was in January. One potential explanation may be found in the theme article on structural NOK outflows flows.

Where is the relief rally?

Turning to how currencies have behaved when risk appetite is returning to the financial markets shows a less intuitive result. For many of the currencies that suffered during the risk-off period there were no significant relief rallies when risk came back on.

There are three important conclusions that one can draw from the asymmetrical impact during risk-on and risk-off periods, which this analysis identifies: (1) Currencies in 2019 were driven mostly by the negative sentiment. (2) When looking into positioning for relief

rallies one has to bear in mind that these generally tend to be smaller than the reactions during the stressed times. Finally, (3) the currency weakening the most during the time of stress is not always the one that corrects most during the relief period.

Stress and relief periods

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

NOK AUD NZD CAD SEK USD EUR CHF GBP JPY

Weekly currency reaction during the latest VIX spike (%)

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

AUD NOK SEK GBP CAD NZD USD EUR CHF JPY

Currency reaction during times of stress versus relief (%)

Risk-offRisk-on

Rise Peak BottomStress

durationRelief

duration1 12/3/2018 12/25/2018 4/12/2019 22 108

2 4/12/2019 5/13/2019 7/24/2019 31 72

3 7/24/2019 8/5/2019 9/13/2019 12 39

4 9/13/2019 10/2/2019 11/26/2019 19 55

5 11/26/2019 12/3/2019 12/16/2019 7 13

6 12/16/2019 12/30/2019 1/17/2020 14 18

7 1/17/2020 1/31/2020 14

Stress periods are rise to peakRelief periods are peak to bottom


Spring seasonality Higher EUR/SEK and NOK/SEK are the most common patterns during spring

Most currencies display seasonal patterns. We have analyzed both monthly patterns and patterns for the entire spring and conclude that there are especially two patterns, higher EUR/SEK and NOK/SEK, that one should be aware of and that there are more patterns in April and May than March.

Spring Going back the past 10 years there only seem to be two patterns that have been robust: higher NOK/SEK and higher EUR/SEK. NOK/SEK has risen nine out of the past 10 years with a sharp fall in 2017 being the only exception. EUR/SEK has risen eight out of the past 10 years and besides 2016 one has to go back to 2010 to find a year where it headed lower. The main reason for this is that the dividend season for Swedish equities is during these months and because of this there tends to be a quite large SEK outflow.

March In March the most robust pattern is lower USD/CNY but the main contribution to that pattern was four straight years at the beginning of the sample. For the past four years USD/CNY has headed higher only every second year, so this pattern is not so robust anymore. More interesting then are two newer patterns: USD/JPY has fallen in March for four straight years and USD/CAD has risen the past three years.

EURCHF EURGBP EURNOK EUR S EK EURUSD USDCAD USDJPY USDCNY NOK S EK2010 -2.9 -5.6 -1.2 -1.2 -10.4 -0.8 3.0 0.0 0.42011 -4.3 2.9 0.2 1.7 4.1 -0.4 -0.4 -1.3 1.62012 -0.3 -4.4 1.6 2.0 -7.4 4.5 -3.5 1.1 0.32013 1.5 -0.7 1.8 2.0 -0.5 0.6 8.2 -1.3 0.12014 0.7 -1.1 -1.6 3.0 -1.1 -1.9 0.2 1.7 4.52015 -3.0 -0.9 -0.5 0.2 -1.8 -0.2 3.7 -1.3 0.62016 1.9 -1.6 -1.4 -0.3 2.4 -3.5 -1.6 0.6 1.02017 2.3 2.0 6.6 2.4 5.9 1.5 -1.7 -0.9 -4.22018 0.2 -0.5 -0.7 1.9 -4.2 1.0 2.0 1.0 2.62019 -1.7 3.0 0.4 1.0 -1.8 2.6 -2.8 3.2 0.5

10 years: % rising 50 30 50 80 30 50 50 60 90% falling 50 70 50 20 70 50 50 40 10

Average change (%) -0.6 -0.7 0.5 1.3 -1.5 0.3 0.7 0.3 0.7Risk-adjusted -0.3 -0.3 0.3 0.7 -0.5 0.1 0.3 0.3 0.4

Spring pattern: March to May

EURCHF EURGBP EURNOK EURSEK EURUSD USDCAD USDJPY USDCNY NOKSEK2010 -2.7 -0.5 -0.3 0.3 -1.0 -3.7 5.1 0.0 0.82011 1.5 3.9 1.5 2.5 2.5 -0.1 1.6 -0.3 1.02012 -0.1 -0.5 1.9 0.1 0.1 0.9 2.1 0.0 -1.92013 -0.5 -2.1 0.1 -0.9 -1.8 -1.3 1.8 -0.2 -0.92014 0.5 0.4 -0.4 0.7 -0.1 0.0 1.6 1.2 1.02015 -2.0 -0.1 0.9 -0.8 -4.2 1.6 0.5 -1.2 -1.62016 0.8 1.4 -0.5 -0.8 4.6 -4.0 -0.1 -1.4 -0.42017 0.5 -0.7 3.2 0.0 0.7 0.1 -1.2 0.2 -3.02018 2.0 -0.8 0.3 1.7 1.1 0.5 -0.4 -0.9 1.42019 -1.7 0.4 -0.6 -0.8 -1.4 1.3 -0.5 0.3 -0.2

% rising 50 40 60 50 50 50 60 30 40% falling 50 60 40 50 50 50 40 70 60

Average change (%) -0.2 0.1 0.6 0.2 0.1 -0.5 1.0 -0.2 -0.4Risk-adjusted -0.1 0.1 0.3 0.1 0.0 -0.2 0.4 -0.3 -0.2

Monthly changes: March

Theme: Spring seasonality


April In April there are more robust patterns to be found. The most robust, occurring nine out of the past 10 years, is higher NOK/SEK. Followed by higher EUR/CHF, which has occurred eight out of the past 10 years, and for seven straight years. Also, EUR/SEK tends to head higher, seven out of 10 years, and USD/CAD tends to fall. Regarding the weaker SEK, the main reason is that the Swedish equity dividends chiefly are distributed in April and May usually leading to large SEK outflows.

May In May the most robust pattern is lower EUR/USD, which has occurred nine out of the past 10 years. The second most robust pattern is higher USD/CAD, occurring eight out of the past 10 years. However, also interesting is that the April pattern for higher NOK/SEK now is reversed and NOK/SEK has fallen five straight years in May. One reason could be that the Swedish equity dividends season is coming to an end during May and that during this time some of the larger Norwegian firms are instead distributing dividends.

Monthly seasonality as an FX factor We have since August 2018 tracked FX seasonality in a systematic fashion by designing and recommending a monthly G10 currency baskets based on the seasonality properties of different G10 currency pairs. This approach has proven successful with an accumulated profit of 11% and a 78% hit ratio, which serves to illustrate that monthly seasonality patterns are clearly a factor to consider when dealing with G10 currencies.

EURCHF EURGBP EURNOK EURSEK EURUSD USDCAD USDJPY USDCNY NOKSEK2010 0.6 -2.2 -2.2 -1.1 -1.6 0.3 0.4 0.0 1.12011 -1.5 0.3 -0.9 -0.1 4.5 -2.7 -2.4 -0.9 0.82012 -0.2 -2.2 -0.2 0.9 -0.7 -0.9 -3.7 -0.3 1.02013 0.6 0.5 1.3 2.2 2.6 -1.0 3.4 -0.7 0.82014 0.2 -0.5 0.1 1.2 0.7 -0.8 -1.0 0.7 1.12015 0.2 0.9 -2.3 1.0 4.5 -4.9 -0.6 0.1 3.32016 0.3 -1.1 -2.0 -0.4 0.6 -3.5 -5.5 0.2 1.62017 1.4 -1.0 1.9 1.0 2.1 2.6 0.1 0.1 -0.92018 1.9 0.1 0.2 2.8 -2.0 -0.4 2.9 1.0 2.52019 2.2 -0.1 0.0 2.1 0.0 0.3 0.6 0.4 2.0

% rising 80 40 40 70 60 30 50 60 90% falling 20 60 60 30 40 70 50 40 10

Average change (%) 0.6 -0.5 -0.4 0.9 1.1 -1.1 -0.6 0.1 1.3Risk-adjusted 0.3 -0.2 -0.2 0.6 0.4 -0.4 -0.2 0.1 0.7

Monthly changes: April

EURCHF EURGBP EURNOK EURSEK EURUSD USDCAD USDJPY USDCNY NOKSEK2010 -0.8 -2.9 1.3 -0.4 -7.8 2.6 -2.5 0.0 -1.52011 -4.2 -1.3 -0.4 -0.8 -2.9 2.4 0.4 -0.1 -0.22012 0.0 -1.6 -0.1 1.0 -6.8 4.5 -1.9 1.4 1.12013 1.4 0.9 0.4 0.7 -1.3 3.0 3.0 -0.3 0.32014 0.0 -1.0 -1.3 1.1 -1.7 -1.1 -0.5 -0.2 2.42015 -1.2 -1.7 1.0 0.0 -2.1 3.1 3.9 -0.2 -1.02016 0.8 -1.9 1.1 0.9 -2.8 4.1 4.1 1.7 -0.22017 0.4 3.6 1.4 1.4 3.1 -1.2 -0.5 -1.1 -0.32018 -3.7 0.2 -1.2 -2.5 -3.2 0.9 -0.5 0.9 -1.32019 -2.2 2.7 1.1 -0.3 -0.4 1.0 -2.8 2.5 -1.4

% rising 30 40 60 50 10 80 40 50 30% falling 70 60 40 50 90 20 60 50 70

Average change (%) -1.0 -0.3 0.3 0.1 -2.6 1.9 0.3 0.5 -0.2

Monthly changes: May

-113579111315

-113579

111315

2018

:720

18:8

2018

:920

18:1

020

18:1

120

18:1

220

19:1

2019

:220

19:3

2019

:420

19:5

2019

:620

19:7

2019

:820

19:9

2019

:10

2019

:11

2019

:12

2020

:120

20:2

Aggregated return Monthly seasonality basket (%)

LossGainAggregated


The case for EM FX EM carry trades tend to do well in risk-off periods

Correlation between EM currencies during times of falling risk appetite is usually strong. One example is the out-break of the coronavirus when most, if not all, EM currencies weakened against safe-haven currencies such as JPY and CHF. In contrast, G10 currencies tend to show divergent performance with usual funding currencies JPY and CHF streng-thening against target currencies such as the AUD and the NZD. Consequently, carry strategies using EM as both funding and target currencies tend to outperform other strategies in times of falling risk appetite. Yet, the strategy is not without risk as some of the most attractive EM target currencies, e.g., the TRY, are also the ones most susceptible to crises.

We believe that three key forces will drive EM FX over the next 3–6 months. First, the spread of the corona-virus; second, the growth and inflation outlook in EM, and third, potential country-specific events. The three elements are interrelated, but they also have a life of their own.

Coronavirus uncertainty. At the time of writing, it appears as if the coronavirus outbreak will be relatively limited, with the pace of the spread showing signs of slowing down. If the lockdown of Wuhan in China turns out to have been effective in containing the outbreak, infections will continue to level off in the coming weeks, i.e., from the second week of February. In this case, the negative effect on Chinese and global GDP growth will be restricted to Q1, and most likely fully compensated for in Q2 and Q3. However, if the virus continues to spread beyond Wuhan and the rate of infections starts to rise again, a global pandemic would drag down growth sharply in both Q1 and Q2 and causing more long-lasting damage. In such a scenario, a prolonged risk-off period would likely weigh on global equities, as well as riskier assets, including EM FX.

Decent growth outlook. Provided that the coronavirus outbreak is contained in time and place, i.e., occurring in Q1 and primarily restricted to China and the Wuhan region, we expect global growth to recover in 2020, albeit gradually compared to 2019. A bottoming out of manufacturing seen in improving PMI readings are signs of an incipient improvement in global growth.

Theme: The case for EM FX


It is being driven by a decent US economy, as well as a pick-up of growth in EM economies such as Russia, India, Turkey, Brazil and South Korea. Hard data on trade and industrial production in EM are also bottoming out, but so far there are no signs of a rapid, V-shaped recovery. Yet, a period of stabilising, albeit sluggish growth would be supportive of global risk appetite and EM assets.

Recent uptick in inflation not beginning of new trend. Inflation has ticked up slightly in EM in the past few months, but it has primarily been caused by rising food prices, especially meat prices on the back of the swine fever in China. The trend is not uniform but, as the case may be, many central banks in EM are still on an easing cycle and the recent increases in headline prices will not change that. The overarching objective in the EM economies is to support growth, prompting central banks to look past what appears to be temporary increases in prices. The point is that while rates in EM have fallen and while they will stay down, the same is true for developed markets (DM). Spreads narrowed in 2019, but remain favourable for EM, despite near record-low yields.

Long-term weakening. With fear of stating the obvious, investors in EM FX should not expect to make much of a profit from long-term increases in EM spot rates. SEB’s EM FX index (20 EM currencies against a basket of USD 40%, EUR 20%, JPY 15%, GBP 12.5% and CHF 12.5%) has fallen by 60% since January 3, 1994. The weakening represents a trend, not a one-off, or event-driven drop. The longest period of appreciation in our index occurred between June 2004 and August 2008, albeit with one large correction in May 2006. The trend is the result of higher inflation in EM compared to the average of our five base currencies. Higher productivity growth could have compensated for higher inflation, but so far, the EM economies in our group have not been able to improve productivity enough to compensate for higher inflation. In short, EM currencies tend to weaken against the big developed market (DM) currencies over time. Nevertheless, they should be part of any FX investors portfolio.

Temporary misalignments, over- or undervaluation of specific currency pairs, can provide attractive buying opportunities. In the absence of those, carry trades in EM currencies offer good chances of seeing positive returns. Our investible EM FX Carry index (Bloomberg ticker “SEBSFXCE Index”) takes long and short positions only in historically liquid and relatively free-floating EM currencies (BRL, CNH, CZK, HUF, IDR, INR, KRW, MXN, PHP, PLN, RUB, SGD, TRY, TWD and ZAR). Correlation between EM currencies tend be high in times of changes in global risk appetite, i.e., when risk appetite weakens, so do both funding and target EM currencies. That makes the index less vulnerable to global risk-off periods than G10 carry strategies where funding currencies such as JPY and CHF tend to strengthen and target currencies such as AUD and NZD tend to weaken when global risk appetite wanes.

Thea case for an EM FX carry trade strategy. As a case in point, our EM FX carry model has outperformed our other FX trading strategies year to date, despite the

coronavirus outbreak having hit EM assets particularly hard. A sudden reduction in the perceived risk of a global pandemic would likely lift our G10 carry index, but given the uncertainty still surrounding the virus it appears too early to make that bet.

In general, we expect the EM economies to experience sluggish, albeit slightly accelerating growth, historically very slow inflation, and low interest rates over the next two years. That kind of environment would be broadly positive for EM currencies and provide a stable background for a relatively steady carry return.

Key risks. The biggest threat to our moderately positive and constructive view on EM currencies is some form of country-specific crisis and sell off. The first candidate that comes to mind is Turkey. The TRY has been remarkably stable since the crisis in July–September 2018, supported by high interest rates, an elimination of the current account deficit and decent global risk appetite. However, to boost growth, the government is encouraging state-owned banks to increase lending and the central bank to ease monetary policy. As a result, inflation has started to pick up again, likely averaging 12% in 2020, and the current account deficit has returned. The government is targeting growth of 5.0% in 2020 but achieving that kind of rate would likely require pushing the current account deficit and inflation to unsustainable levels. The TRY has already come under pressure with the authorities tightening TRY liquidity and pushing up the implied yield on TRY FX forward swaps to 92% before falling back on February 10.

Another potential source of instability in EM is South Africa, which is struggling to contain a swelling budget deficit at the same time as it reforms the state-owned enterprise (SOE) sector, including the electricity company Eskom and South African Airways (SAA). The task is made difficult by a slowing economy and a lack of political consensus in the ruling ANC on how to address chronic losses in SOEs, as well as power outages due to years of insufficient investment and maintenance.

Research contacts


Erica Dalstø NOK +47 2282 7277

Eugenia Fabon Victorino CNY, JPY +65 6505 0583

Richard Falkenhäll Editor, GBP, SEK +46 8 506 23133

Ann Enshagen Lavebrink Research Assistant + 46 8 763 80 77

Carl Hammer EUR, USD + 46 8 506 231 28

Per Hammarlund EM FX +46 8 763 84 41

Lauri Hälikkä CAD + 46 8 763 84 58

Karl Steiner Quant, CHF +46 8 506 231 04

This report was published on February 13, 2020 Cut-off date for calculations and forecasts was February 12, 2020


Important: This statement affects your rights

All research (reports, studies and publications) produced by SEB Merchant Banking, a division of Skandinaviska Enskilda Banken AB (publ) ("the Bank"), is produced for institutional investors only. It is not intended for private clients or Private Customers (as defined by the UK Financial Services Authority, (the "FSA”)) and must not be distributed to private clients or Private Customers.

The Bank has offices in Copenhagen, Frankfurt, Helsinki, London, New York, Oslo, Paris, Singapore and Stockholm. This report is produced for private information of recipients and SEB Merchant Banking's research department is not soliciting any action based upon it. Opinions contained in this research report represent SEB Merchant Banking's research department present opinion only and are subject to change without notice.

All information contained in this report has been compiled in good faith from sources believed to be reliable. However, no representation or warranty, expressed or implied, is made with respect to the completeness or accuracy of its contents and the report is not to be relied upon as authoritative. Recipients are urged to base their investment decisions upon such investigations, as they deem necessary. To the extent permitted by applicable law, no liability whatsoever is accepted for any direct or consequential loss arising from the use of this document or its contents.

Your attention is drawn to the fact that the Bank, a member of, or any entity associated with the Bank or its affiliates, officers, directors, employees or shareholders of such members may from time to time (a) have a long or short position or holding in the securities or options of such companies mentioned herein, (b) buy or sell or participate in an issue of such securities or options, (c) provide corporate finance services to such companies or in relation to such securities or options, (d) be represented on the board of directors or similar supervisory entity of such companies. The Bank may make a market in the securities mentioned in this report.

Authors' statement of independence (Analyst Certification) We, the authors of this report, hereby confirm that notwithstanding the existence of any potential conflicts of interest referred to herein, the views expressed in this report accurately reflect our personal views about the companies and instruments covered. We further confirm that we have not been, nor are or will be, receiving direct or indirect compensation in exchange for expressing any of the views or the specific recommendation contained in the report. We are not registered or qualified as research analysts, representatives or associated persons under the rules of any US exchange, regulatory organization or State.

This statement affects your rights This report is confidential and may not be reproduced, redistributed or republished by any recipient for any purpose or to any person.

Recipients SEB Research is approved and issued by Skandinaviska Enskilda Banken AB (publ) (“SEB”), a bank organized under the laws of the Kingdom of Sweden, on behalf of itself and its affiliates for institutional investors. SEB is not a registered Broker-Dealer under the US Securities and Exchange Act of 1934. This report must not be distributed to retail clients except those of SEB Oslo Branch and, in case of research distributed via SEB Helsinki Branch, to its retail clients located in Finland.

Use This research report is produced for the private information of recipients - if you are not a client of ours, you are not entitled to this research report, and should destroy it. The document is not, and should not be construed as, an offer to sell or solicitation of an offer to buy any securities. Opinions contained in the report represent the author's present opinion only and may be subject to change. In the event that the author's opinion should change or a new analyst with a different opinion becomes responsible for our coverage of the company concerned, we shall endeavour (but do not undertake) to disseminate any such change, within the constraints of any regulations, applicable laws, internal procedures within SEB, or other circumstances.

Good faith and limitations All information, including statements of fact, contained in this research report have been obtained from SEB, Bloomberg or Macrobond and compiled in good faith from sources believed to be reliable. However, no representation or warranty, express or implied, is made by SEB with respect to the completeness or accuracy of its contents, and it is not to be relied upon as authoritative and should not be taken in substitution for the exercise of reasoned, independent judgement by you. Recipients are urged to base their investment decisions upon such investigations as they deem necessary. To the extent permitted by applicable law, no liability whatsoever is accepted by SEB for any direct or consequential loss arising from the use of this document or its contents.

Distribution This research report has been prepared by SEB or its affiliates and is being distributed by SEB offices in Stockholm, Copenhagen, Oslo, Helsinki, Frankfurt, London, Tallinn, Vilnius, Singapore and Hong Kong. Research reports are prepared and distributed in Lithuania by AB SEB bankas and in Estonia by AS SEB Pank in accordance with the requirements of the local laws and Financial Supervision Authority’s conduct of business rules. It is being distributed in the United States by SEB Securities Inc. ('SEBSI'), a wholly owned subsidiary of SEB organized under the laws of the State of Delaware, USA. Any United States institutional investor receiving the report, who wishes to obtain further information or to effect a transaction in any security discussed in the report, should do so only through SEBSI and not its affiliates. Addresses and Phone numbers for each office can be found at the end of the report.


The SEB Group: members, memberships and regulators SEB is a member of, inter alia, Nasdaq OMX Nordic, Oslo Stock Exchange, the London Stock Exchange, NYSE Euronext, Frankfurt Stock Exchange, Tallinn Stock Exchange as well as certain European MTF’s such as BATS-Chi-X, Turquoise, Burgundy, XUBS, POSIT and Sigma-X. SEB is regulated by Finansinspektionen in Sweden and, for the conduct of investment services business, in (i) Denmark by Finanstilsynet, (ii) Norway by Finanstilsynet, (iii) Finland by Finanssivalvonta, (iv) Germany by Bundesanstalt für Finanzdienstleistungsaufsicht, (v) the UK by the Financial Conduct Authority and Prudential Regulation Authority (details about the extent of our regulation by the Financial Conduct Authority and Prudential Regulation Authority are available from us on request), (vi) Estonia by the Estonian Financial Supervision Authority, (vii) Lithuania by the Bank of Lithuania, (viii) Singapore by the Monetary Authority of Singapore, and (ix) Hong Kong by Securities and Futures Commission. SEBSI is a U.S. broker-dealer, registered with the Financial Industry Regulatory Authority (FINRA). SEBSI is a subsidiary of SEB. SEBSI is authorized to engage in the underwriting of securities but does not make markets or otherwise engage in any proprietary trading in any securities. SEB’s research reports are prepared in accordance with the industry standards and codes of conduct applicable to financial analysts in the countries where they are based. In Denmark, Finland, Norway and Sweden, analysts act in accordance with the rules of ethics of each country’s Society of Financial Analysts. Analysts comply with the recommendations and industry standards of the Danish, Norwegian and the Swedish Securities Dealers Associations and with those of the Federation of Finnish Financial Services. Analysts certified by the CFA Institute also comply with the Code of Ethics of the CFA Institute.

Prevention and avoidance of conflicts of interest All research reports are produced by SEB’s Research department, which is separated from the rest of its activities by an Information Barrier; as such, research reports are independent and based solely on publicly available information. Following standard practice, recommendations and target share prices are removed from research on companies which are the subject of public offers on which SEB is advising. The remuneration of staff within the Research department is determined exclusively by research management and senior management and may include discretionary awards based on the firm’s total earnings, including investment banking income; however, no such staff receive remuneration based upon specific investment banking transactions. SEB’s Compliance department monitors the production of research and the observance of the group's procedures designed to prevent any potential conflicts of interest from affecting the content of research.

Your attention is also drawn to the fact that: The current market price of the instruments shown in this report is the price prevailing at the close of the business day preceding the date of publication or when applicable a more recent price than that. Unless

explicitly stated otherwise in this report, SEB expects (but does not undertake) to issue updates to this report following the publication of material new figures or forecasts relevant to the instruments covered, or upon the occurrence of other events which could potentially have a material effect on it. The instruments discussed in this research report may not be eligible for sale in all countries, and such instruments may not be suitable for all types of investors. Offers and sales of instruments discussed in this research report, and the distribution of this report, may be made only in countries where such instruments are exempt from registration or qualification or have been so registered or qualified for offer and sale, and in accordance with applicable broker-dealer and agent/salesman registration or licensing requirements. Additional recommendation history for the instrument is available at http://www.seb.se/research.

Methodology SEB Research & Strategy determines the global economic backdrop and outlook for fixed income, FX and commodity markets using; 1) own analysis and aggregation tools, including proprietary models and indicators and amended by publicly available data providers (free and fee-based) such as Macrobond, Bloomberg and others; 2) input from other research units within SEB; 3) Various research reports (free and fee-based). The various sources being integrated must fulfil the principles of consistency, plausibility and must be backed by fact. Final consideration as to any valuations, projections and forecasts contained in this report are based on a number of assumptions and estimates and are subject to contingencies and uncertainties, and their inclusion in this report should not be regarded as a representation or warranty by or on behalf of the Group or any person or entity within the Group that they or their underlying assumptions and estimates will be met or realized. Different assumptions could result in materially different results. Past performance is not a reliable indicator of future performance. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities, such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk

This report is not intended to be published or distributed in the United States.

The Bank is incorporated in Stockholm Sweden with limited liability and is a member of the Stockholm Stock Exchange, The London Stock Exchange, the IPE, and the OM, EDX, Euronext Liffe, Euronext Paris, Eurex and Pulpex exchanges. The Bank is regulated by Finansinspektionen (the Swedish Financial Supervisory Authority), and, for the conduct of designated investment business in the UK, by the FSA.

Confidentiality Notice This report is confidential and may not be reproduced or redistributed to any person. Skandinaviska Enskilda Banken AB (publ). All rights reserved This page has been left blank on purpose.

SEB is a leading Nordic financial services group with a strong belief that entrepreneurial minds and innovative companies are key in creating a better world. SEB takes a long-term perspective and supports its customers in good times and bad. In Sweden and the Baltic countries, SEB offers financial advice and a wide range of financial services. In Denmark, Finland, Norway, Germany and the United Kingdom, the bank’s operations have a strong focus on corporate and investment banking based on a full-service offering to corporate and institutional clients. The international nature of SEB’s business is reflected in its presence in some 20 coun-tries worldwide. At 31 December 2019, the Group’s total assets amounted to SEK 2,857bn while its assets under management totalled SEK 2,041bn. The Group has around 15,000 employees.

Macroeconomic assessments are provided by our SEB Macro & FICC Research unit. Based on current conditions, official policies and the long-term performance of the financial market, the Bank presents its views on the economic situation − locally, regionally and globally.

Read more about SEB at sebgroup.com.

currency strategy february 2020 - seb group · fx market overview 6 — currency strategy the fx...

Documents