Inside this issue Big Picture... 1-2 GBPUSD... 3 GBPEUR... 4 Risk Insight Volume 9, Issue 10 6 th March 2017 EURUSD... 5 USDCAD... 6 Economic Data and Market Indicators... 7 Appendix... 8 Does a flattening yield curve signal pain for the dollar? The latest news from the FOMC indicates a March hike of the Fed s policy rate would likely be appropriate so long as employment and inflation are continuing to evolve in line with [their] expectations. This news has increased the market implied probability of such a hike a further 5% to 94%, continuing the ramp up from just under 40% a little over a week ago. What are the chances.....that GBPUSD will remain below 1.30 for the remainder of 2017? 46.2%..that GBPEUR will fall below parity by the end of Q4? 5.8%..that USDCAD will touch 1.40 by the end of Q2? 31.1% Source: Bloomberg As expectations for short term interest rates continue to rise, we are beginning to once again observe a flattening of the US yield curve (short term rates rising disproportionately more than long term rates). This flattening can be illustrated by overlaying the current yield curve with curves from 1, 2, and 3 years ago, as shown below. We are happy to announce that out of 80 contributors (including all major banks), Validus Risk Management has been the most accurate forecaster for GBPUSD and third-most accurate forecaster for GBPEUR in 2016, according to Bloomberg rankings. Validus Risk Management Ltd (FRN: 555972 is authorised and regulated by the FCA) +44 (0) 1753 386 548 info@validusrm.com www.validusrm.com
Source: FRED Source: Bloomberg Stepping back to look at the bigger picture, many ask what does a flattening yield curve mean for investors, and more specifically, might such a flattening mark the end of the dollar bull-market we ve been observing since late 2011? For starters, using the slope of the yield curve as a leading indicator for predicting economic recessions is not a new phenomenon (see here for a short list of literature on the topic). Generally speaking, a flattening of the yield curve can be interpreted as a warning sign that overall economic activity is starting to slow, and that expectations of future inflation are beginning to dwindle. A negatively sloping yield curve takes this warning one step further. In terms of broad dollar performance against a basket of the other major currencies, Treasury spreads appear to show little to no historical correlation in the data, suggesting they serve as a poor predictor of whether dollar strength will continue as the curve flattens (shown above). This is unsurprising, for a couple of reasons. Firstly, the factors which drive currency markets are relative rather than absolute; it also matters what the yield curves are doing in other countries and currency areas. Secondly, as the world s reserve currency, the US dollar can often act in very idiosyncratic ways - for example, it strengthened during the 2008 financial crisis as investors viewed the currency as a haven in a time of global financial upheaval. Due to the particular circumstances of the current USD bull market, the current flattening of the US curve may prove to be a warning signal worth keeping an eye on. As the USD is already in overvalued territory, and because the dollar s strength is being driven primarily by an expectation of continuing monetary policy divergence, the current USD appreciation could be limited by a flattening yield curve placing limitations on how quickly the Fed can continue to hike. Furthermore, it is worth highlighting the fact that the euro yield curve has steepened compared to a year ago. Could it be that monetary policy divergence is reaching its limits? Source: FRED We see above that an inverted yield curve (defined as a negative spread between long term and short term interest rates) has been a precursor to all three economic recessions observed in the US since 1986 (which are indicated by the grey shaded areas on the chart). But what does this mean for the dollar? Author: Josh Macdonald
GBPUSD GBPUSD GBP slipped against USD throughout last week, as the release of February s Markit PMI data for the manufacturing and service sector read below analyst expectations. Services PMI came in at 53.3, lower than the previous month s 54.5, and below expectations for 54.1. Manufacturing PMI read at 54.6, below market s expectations for 55.6 and the previous month s 55.9. The disappointing set of data might signal that the UK economy is slowing down faster than anticipated. Drastically increased odds for a March hike in the US, following Yellen s speech last Friday, have put further pressure on the pair. Key events for this week are: Mar 10: UK Consumer Inflation Expectations Mar 10: UK NIESR GDP Estimate Mar 10: US Nonfarm Payrolls and Unemployment Rate Horizon Primary Indicator Score Short-Term Momentum Extremely Bearish Mid-Term Carry Bearish Long-Term PPP Valuation Extremely Bullish Technical View 1 Last week, GBPUSD broke below the range previously highlighted in the chart to the left. 2 The market tested grounds below 1.2250, but found support around that level, which has already been minor support in the past. 3 As previously discussed, in order to justify a more bullish outlook, the pair needs to hurdle the recent high at 1.2805. Support Resistance Level 1 Level 2 Level 1 Level 2 1.2250 1.2000 1.2700 1.2790 FX Forecasts PPP Valuation Validus Bloomberg Poll Avg 2.2 Q1 17 1.25 (revised 30.01.17) 1.22 Q2 17 1.28 (revised 30.01.17) 1.21 Q3 17 1.30 (revised 30.01.17) 1.22 Q4 17 1.30 (revised 30.01.17) 1.23 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M 98 89 100 62 17 1Y 114 102 114 69 25 3Y 144 121 144 81 29 5Y 147 124 147 83 30 (*Annualised Basis Point impact to sell GBP Forward) 2 1.8 1.6 1.4 1.2 1 2002 2004 2006 2008 2010 2012 2014 2016 Spot Blended Fair Value 20% Band According to Purchasing Power Parity, GBPUSD is currently 15.7% undervalued. 3
GBPEUR GBPEUR As with GBPUSD, GBPEUR dropped throughout the last week, as the release of February s Markit PMI data for the manufacturing and service sector read below analyst expectations. Services PMI came in at 53.3, lower than the previous month s 54.5, and below expectations for 54.1. Manufacturing PMI read at 54.6, below market s expectations for 55.6 and the previous month s 55.9. The disappointing set of data might signal that the UK economy is slowing down faster than anticipated. Eurozone consumer and production inflation data, which came in at 2% and 3.5% (YoY) respectively, surpassed readings from last month, providing further boost to the euro. Key events for this week are: Mar 9: ECB Interest Rate Decision Mar 10: UK Consumer Inflation Expectations Mar 10: UK NIESR GDP Estimate Horizon Primary Indicator Score Short-Term Momentum Bearish Mid-Term Carry Bullish Long-Term PPP Valuation Neutral Technical View 1 GBPEUR pair dropped during the course of the week, falling below the 1.1600 level. 2 The dip below the 100 day moving average at 1.1600 offers a good opportunity for GBP buyers. 3 For now, any rallies towards 1.20 should be seen as a good opportunity for selling GBP. Support Resistance Level 1 Level 2 Level 1 Level 2 1.1450 1.1080 1.1950 1.2000 FX Forecasts Validus Bloomberg Poll Avg Q1 17 1.19 (revised 30.01.17) 1.16 Q2 17 1.24 (revised 30.01.17) 1.16 Q3 17 1.34 (revised 30.01.17) 1.16 Q4 17 1.44 (revised 30.01.17) 1.16 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M -84-85 -83-94 -115 1Y -88-93 -83-98 -119 3Y -93-107 -87-112 -145 5Y -94-113 -91-121 -159 (*Annualised Basis Point impact to sell GBP Forward) PPP Valuation 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1 0.9 0.8 2002 2004 2006 2008 2010 2012 2014 2016 Spot Blended Fair Value 20% Band According to Purchasing Power Parity, GBPEUR is currently 2.8% undervalued. 4
EURUSD EURUSD EURUSD was somewhat volatile during last week but managed to close the week relatively unchanged. The euro received a boost from a positive Eurozone inflation data release. Both consumer and production inflation figures surpassed readings from last month, coming in at 2% and 3.5% (YoY), respectively. On the other hand, the dollar strengthened on the back of Yellen s comments hinting at a March rate hike in the US. The odds of such a move currently stand at more than 90%, as priced in the futures market. Key events for this week are: Mar 9: ECB Interest Rate Decision Mar 10: US Nonfarm Payrolls and Unemployment Rate Horizon Primary Indicator Score Short-Term Momentum Extremely Bearish Mid-Term Carry Extremely Bearish Long-Term PPP Valuation Bullish Technical View 1 EURUSD continued its downward trend which has dominated February s trading back toward January s lows. 2 Nevertheless, the end of the week saw a recovery above 1.0600. If the pair could sustain a recovery back above 1.0700 and find a fresh base, the technical outlook would improve significantly. 3 Regular readers will be all too aware of our bearish forecast and for now, there is little here to alter this view. Support Resistance Level 1 Level 2 Level 1 Level 2 1.0340 1.0000 1.0810 1.0880 FX Forecasts Validus Bloomberg Poll Avg Q1 17 1.05 (revised 21.11.16) 1.04 Q2 17 1.03 (revised 21.11.16) 1.03 Q3 17 0.97 (revised 21.11.16) 1.04 Q4 17 0.90 (revised 21.11.16) 1.05 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M 181 173 199 156 117 1Y 199 194 205 165 129 3Y 231 221 235 187 152 5Y 231 224 244 193 160 (*Annualised Basis Point impact to sell EUR Forward) PPP Valuation 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1 0.9 0.8 2001 2003 2005 2007 2009 2011 2013 2015 Spot Blended Fair Value 20% Band According to Purchasing Power Parity, EURUSD is currently 14.2% undervalued. 5
USDCAD USDCAD USDCAD finally broke higher last week (as per our view), although it took far longer than expected to occur. The driver was the Fed s hawkish commentary. Frequent readers of this note may be aware that the interest rate differential is a key driver behind the fundamental foundation of our USDCAD view. Key events for this week are: Mar 10: Canadian Employment data for Feb. After two strong readings in a row, the potential for a disappointing number is high in this volatile series Mar 10: US Nonfarm Payrolls and Unemployment Rate Horizon Primary Indicator Score Short-Term Momentum Extremely Bullish Mid-Term Carry Neutral Long-Term PPP Valuation Bearish Technical View 1 The bounce from the strong support at the 1.2970 level has taken us to the declining trendline at 1.3400. A close above there is required to signal the next move higher. 2 The next level on the topside is the double top at 1.3590. 3 The RSI s (not shown) are in overbought territory which is most often followed by a corrective move lower, so patience is the key for USD buyers. Expect a corrective selloff to the low 1.22 s before the next leg up. Support Resistance Level 1 Level 2 Level 1 Level 2 1.3310 1.3210 1.3400 1.3590 FX Forecasts Validus Bloomberg Poll Avg Q1 17 1.35 (revised 21.11.16) 1.34 Q2 17 1.37 (revised 21.11.16) 1.35 Q3 17 1.39 (revised 21.11.16) 1.36 Q4 17 1.40 (revised 21.11.16) 1.36 Hedging Cost* Tenor Today 1M Ago 12M Low 12M Avg 12M High 6M 47 37-1 22 49 1Y 58 46 2 26 58 3Y 75 62 1 34 75 5Y 73 62 6 35 73 (*Annualised Basis Point impact to sell CAD Forward) PPP Valuation 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1 0.9 0.8 2001 2003 2005 2007 2009 2011 2013 2015 Spot Blended Fair Value 20% Band According to Purchasing Power Parity, USDCAD is currently 7.5% overvalued. 6
Economic Data & Market Indicators Economic Matrix GDP CPI Unemployment Industrial Production Retail Sales Current Account % GDP Budget Balance % GDP 10 Year Yield US 1.90% 2.50% 4.80% 0.01% 5.60% -2.55% -3.10% 2.50% EUR 1.70% 2.00% 9.60% 2.00% 1.20% 3.23% -1.60% 0.34% UK 2.00% 1.80% 4.80% 4.30% -0.20% -5.06% -3.01% 1.20% CAN 2.59% 2.10% 6.80% 2.27% 4.30% -3.34% 0.10% 1.70% Central Bank Bias Current Rate Last Change Date of Change Next Meeting Likely Next Move UK 0.25% -0.25% 4 th August 16 16 th March 17 Unchanged US 0.50% - 75% 0.25% 14 th December 16 15 th March 17 Hike CAN 0.50% -0.25% 15 th July 15 12 th April 17 Unchanged EUR 0.00% -0.05% 10 th March 16 9 th March 17 Unchanged 7
Appendix - Primary Indicator Methodology 1. Momentum The momentum indicator is based on four metrics - 1 week change, 1 month change, 8/15 day moving average and 10/25 day moving average of the spot rate. We look at the direction of movement of each metric in the previous week (increase or decrease) and then assign a final score. For example, if all metrics moved up, we assign an Extremely Bullish score. Movement in metrics Score Extremely Bullish Bullish Neutral Bearish Extremely Bearish 2. Carry We calculate carry based on the difference between interest rates in two respective countries for each currency pair. See below for score assignment: Carry Score > 1% Extremely Bullish < 1% and > 0.5% Bullish < 0.5% and > -0.5% Neutral < -0.5% and > -1% Bearish < -1% Extremely Bearish 3. PPP Valuation In order to determine whether a currency pair is over or undervalued, we use CPI, PPI, OECD, Goldman Sachs and IMF fair values, calculate their average, and compare it with the spot price. Depending on the magnitude of divergence of the spot from the fair value, we assign a specific risk score (see table below): Valuation Score > 15% Extremely Bearish < 15% and > 5% Bearish < 5% and > -5% Neutral < -5% and > -15% Bullish < -15% Extremely Bullish Disclaimer: The Information is not intended to be a complete statement or summary of securities, markets or developments referred to in the document. Validus does not undertake to update or keep current the Information. Any opinions expressed in this document may change without notice and may differ or be contrary to opinions expressed by other business individuals or groups of Validus. Any statements contained in this report attributed to a third party represent Validus's interpretation of the data, information and/or opinions provided by that third party either publicly or through a subscription service, and such use and interpretation have not been reviewed by the third party. Nothing in this document constitutes a representation that any investment strategy or recommendation is suitable or appropriate to an investor s individual circumstances or otherwise constitutes a recomendation. For advice, trade execution or other enquiries, clients should contact their representative. 8