Currency Strategy June 2020...Forecasts Currency Strategy — 3 FX forecasts Fwd Consensus* SEB vs...

Currency Strategy

June 2020

Research Reports

2 — Currency Strategy

Contents

3 Forecasts 4 FX market overview 7 EUR/USD 9 USD/JPY 11 EUR/GBP 13 EUR/CHF 15 EUR/SEK 17 EUR/NOK 19 Themes 20 FX Positioning & Seasonality 22 FX Drivers 24 QE and the dollar 26 Contacts 27 Disclaimer

Forecasts

Currency Strategy — 3

FX forecasts

Fwd Consensus* SEB vs 09 jun 3M 6M 12M Q4 21 12M 6M consensus

EUR/USD 1.13 1.13 1.15 1.18 1.22 1.14 1.12 2.6%EUR/JPY 122 123 128 132 138 122 120 6.3%EUR/GBP 0.89 0.91 0.88 0.86 0.83 0.90 0.88 0.3%EUR/CHF 1.08 1.09 1.10 1.13 1.14 1.07 1.08 1.8%EUR/SEK 10.42 10.33 10.22 10.02 9.75 10.46 10.50 -2.7%EUR/NOK 10.55 10.49 10.37 10.04 9.90 10.62 10.70 -3.1%USD/SEK 9.22 9.14 8.89 8.49 7.99 9.18 9.38 -5.3%USD/NOK 9.34 9.28 9.02 8.51 8.11 9.32 9.55 -5.8%GBP/USD 1.27 1.24 1.30 1.38 1.47 1.27 1.27 2.3%USD/CAD 1.35 1.31 1.30 1.29 1.28 1.35 1.36 -4.5%USD/CHF 0.95 0.96 0.96 0.96 0.93 0.94 0.96 -0.8%AUD/USD 0.69 0.63 0.60 0.61 0.63 0.69 0.66 -9.5%NZD/USD 0.65 0.58 0.55 0.55 0.57 0.65 0.63 -13.6%USD/JPY 108 109 111 112 113 107 107 3.7%GBP/SEK 11.68 11.34 11.55 11.72 11.75 11.65 11.91 -3.0%JPY/SEK 8.54 8.39 8.01 7.58 7.07 8.56 8.76 -9.0%CHF/SEK 9.66 9.48 9.29 8.87 8.55 9.73 9.72 -4.5%NOK/SEK 0.99 0.98 0.99 1.00 0.98 0.98 0.98 0.4%EUR/DKK 7.46 7.46 7.46 7.46 7.46 7.45 7.46 0.0%EUR/PLN 4.44 4.38 4.32 4.21 4.17 4.48 4.45 -3.0%USD/CNY 7.08 7.27 7.27 7.19 7.10 7.20 7.03 3.4%USD/RUB 68.8 68.1 67.2 67.0 66.0 71.6 71.0 -5.5%USD/TRY 6.80 6.87 7.30 7.23 7.40 7.77 6.97 4.6%

FX market overview


Even before the outbreak of COVID-19 early this year we noticed that traditional drivers for currencies were working badly. We then concluded that one of few common drivers for currencies was simply the outlook for global growth, which is a binary factor. In times of increased optimism related to the global economy, smaller currencies outperform more liquid currencies with defensive qualities, while it is the other way around when pessimism dominates. While normal drivers for currencies like rate differentials remain more synchronised than ever before we pay more attention to long-term valuations as a guide for the future direction.

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 before the global outbreak of the COVID-19 pandemic. Since 1988 there have been nine periods with sharp falls in the ISM reflecting a significant slowdown in the global economy, similar to 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 and this year, where defensive currencies outperformed more procyclical currencies until Q4 last year, only to reverse towards the end of the year when risk appetite improved on the back of reduced political risks and positive signs related to global growth. Then everything suddenly changed again in a dramatic way as sentiment and financial markets crashed completely amid the global outbreak of COVID-19. Once again more liquid and defensive currencies and particularly the USD outperformed smaller and less liquid currencies, albeit the size of the reaction differed between these smaller currencies.

However, as optimism once again dominates financial markets, despite huge uncertainty about the long-term consequences of the lockdown of economies for months, these smaller currencies have recovered rapidly against the defensive currencies. The ones falling the most during the market crash in February and March are now recovering relatively more.

Currently it seems that as long as major central banks continue to awash financial markets with new liquidity from extensive asset purchase programmes and various facilities to provide new credit and liquidity for businesses and banks the underlying strength of the economy is not an issue. What matters seems to be liquidity and to get back into equity markets to join the rally. We have been and we remain doubtful that a complete lockdown of economies, showing signs that growth was exhausted already 6 months ago, can just pass without any negative long-term consequences for growth and company profits. In many countries and particularly the US unemployment rate has reached the highest since the GFC as businesses closed. So far peoples’ incomes have been saved by very generous government rescue packages, but this is not sustainable ahead as it is too expensive to maintain. What will happen then?

The fact that the recovery and optimism have dominated financial markets and the FX market for months, while we remain sceptical this is sustainable, makes predictions over the next 3-6 months highly uncertain. If optimism and recovery continue to dominate the direction of financial markets, this should be combined with further recovery for smaller and less liquid currencies as these are still undervalued compared with their long-term fair values. In contrast currencies with traditionally defensive qualities and particularly the USD are likely to underperform. However, if it turns out that this scenario was too good to be true and different and more undesirable scenario knocks on the door, then currencies collectively will react in the opposite way.

FX market overview


Are there any domestic drivers left? Already last year it was quite clear that currency specific factors like interest rates, monetary policy or fundamentals like the debt level or national growth generally were of little importance for the performance of G10-currencies. Instead growth concerns, the trade war between the US and China, Brexit, and other political events determined the FX performance. For one reason the differences in these traditionally important factors for exchange rates were tiny. In fact, even prior to the COVID-19 outbreak there was little suggesting a shift in these FX drivers and following the COVID-19 pandemic differences between economies have disappeared almost completely.

Today most countries try to fight the consequences of the lockdown and social distancing by keeping economies going artificially on government grants to protect businesses and jobs until the situation normalises. This probably means that growth will be roughly the same everywhere this year, while deficits in government budgets and public debt are rising sharply everywhere, at the same time. Probably trade between countries will fall as companies now realise the risks and the problems with outsourcing and by having production plants concentrated far away from where consumption will take place. In addition, almost all central banks now have policy rates around 0% and conduct massive bond purchases, which essentially eliminates rate differentials between currencies and makes monetary policy highly synchronised everywhere. This can clearly be seen in the maximum annualized 3M carry achievable among all G10 currencies. Prior to the GFC this was as high as 7-8% and in the last decade is has been around 3-4%. However, after the COVID-19 crisis it has now dropped to almost 1% making the expected profitability in carry trades for these currencies extremely tiny. Unless rate differentials begin to widen again, carry now seems unlikely to be a driver for exchange rates going forward.

Lacking country specific factors currencies will probably continue to trade closely linked to global events rather than on domestic factors. Of course, there will always be exceptions, like the GBP and Brexit, but generally it will be difficult to predict the direction of exchange rates as it will have little to do with country specific factors. However, this may open up for one FX-driver becoming more important and that is the long-term fair values.

Moving towards fair value. Lacking normal drivers that would cause moves in exchange rates valuation could become more important and guide currencies. Indeed, this is what is going on right now after the COVID-19 crisis pushed currencies away from their long-term equilibrium exchange rates. Currencies are usually seen deviating from their long-term fair values when there are other differences between countries that become more important for the short-term outlook of exchange rates. However, lacking these differences, which seems to be the case ahead, and without any strong opinion what will happen to currencies over the coming 6-12 months it might be case that currencies more generally are heading towards their long-term fair values, which then could be a reasonable target.

Our fundamental long-term fair value model (SEBEER) shows that the USD is gravely overvalued against all G10-currencies except the CHF. Of the G10-currencies several of them trade between 15% and 20% off their long-term fair value estimates against the USD. These are the GBP (for good reasons), the SEK and the NOK. Among the remaining G10-currencies there are also several currencies deviating by more than 10% from the equilibrium exchange rate. Therefore, if a gradual move back towards long-term fair values will dictate the direction in the FX market it will be another USD-negative factor, while it will be positive for Scandies and the GBP, if some of the risks are removed.

After the most recent update of the SEBEER fair value model there have been a few changes. The long-term fair value of the USD has weakened generally and for instance against the euro it is now back above 1.20. Long-term fair value for the SEK also improved and is not below 8.00 against the USD, at 9.65 against the euro and below parity against the NOK.

USD Long-term valuationCcy pair LTFV Spot Dev. LTFV*EUR/USD 1.22 1.13 -7%USD/CHF 0.99 0.96 4%USD/NOK 7.87 9.29 -17%GBP/USD 1.55 1.27 -20%USD/JPY 104 114 -9%AUD/USD 0.80 0.70 -14%NZD/USD 0.67 0.65 -3%USD/CAD 1.25 1.34 -7%USD/SEK 7.93 9.21 -15%USD TWI -9%*Positive value = USD is undervalued

FX market overview


No differences suggest volatility will continue to fall. The experience from the GFC was that when differences between countries declined the FX volatility fell simultaneously. In the beginning of this year FX volatility for G10 currencies hit a new all-time low. Then daily or weekly changes in exchange rates were only around half of the average historical changes. Although volatility rose sharply as markets panicked when COVID-19 spread across the world and forced drastic measures from governments and central banks, it has now fallen back below the historical average and seems to continue to decline to where it was prior to the pandemic.

But it is not just the fact that most normal FX drivers are synchronised that contributes to lower FX volatility. A decade ago in the attempts to address consequences of the global financial crisis, part of the effort 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”. This was done by introducing new financial market regulations and the low volatility is probably also partly an outcome of this strategy.

We see few reasons to expect volatility to stabilise at a higher level in the future. There are essentially no signs that normal FX-drivers would amplify volatility. Not even the outbreak of the coronavirus caused more than a short-term spike in volatilities. Therefore, it seems like today there is nothing suggesting that the trend of falling volatilities is about to end.

The FX market remains challenging to say the least as traditional drivers for exchange rates are not working. Instead currencies seem to continue to trade on the outlook for global growth and the global risk sentiment. On top of this, daily or weekly changes in exchange rates seem to continue to decline as a result of synchronised monetary policy, financial market regulations and generally very small differences between countries and currencies. This suggests that a forecast for exchange rates over the next 6-12 months will depend mostly on the global growth story and if the global economy continues to recover steadily then maybe long-term valuations could be a good guide for where currencies will head. In this scenario smaller and undervalued currencies will have the chance to continue 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 currency forecasts as well as it probably would be combined with moves in the opposite direction.

EUR/USD


EUR/USD Upside risks mounting

After the Fed rate cuts earlier this year, the carry is not a tailwind anymore. Continued large US twin deficits may lead euro investors to increase their Treasury holdings again, putting marginal upward pressure on the dollar. However, improving risk appetite and the fiscal expansion from Germany as well as the EU long-term budget together with the EU Recovery Instrument should attract capital from safe dollar assets into Europe and drive the EUR/USD higher this year.

After the Fed rate cuts the positive carry is almost gone. The Fed cutting policy rates close to zero eliminated the considerable carry in the EUR/USD. Before the rate cuts, euro based fixed income investors faced a higher currency hedging cost than the underlying long treasury bond yields (Figure 1). We argued last year that the dollar strength is likely a result of foreign investors financing the increasing US public deficits while keeping their dollar exposure largely open due to negative carry. At the same time US investors, holding negative yielding German government bonds, were able to enjoy 2-3% annual positive FX carry, making the combined bond and FX carry on Bunds higher than the 10y Treasury yield. This created a situation where the US based investors had an incentive to be largely FX hedged while EUR based investors, like most foreign investors, piled up US debt unhedged, resulting in a downward pressure on the EUR/USD in the spot market.

Consequently, the EUR/USD rallying sharply during the Fed rate cuts and risky asset sell-off late February was not a surprise, as unhedged dollar positioning made EUR/USD vulnerable on the top-side (as we argued previously here). Sharply lower hedging costs and increasing risk aversion resulted in euro-based investors rushing to hedge their dollar exposure, which is evident in the sharply declining cross-currency basis and the implied EUR rate in the FX forwards during the spot market rally in late February (Figure 2). On the back of this, we believe that the EUR/USD market is now much more balanced in terms of hedging flow risks.

Euro-based investors may start increasing their Treasury holdings again, putting marginal upward pressure on the dollar. One-year EUR/USD FX forward provide some 0.9% positive carry for dollar buyers, which in a historical perspective, seems very low. Undoubtedly the biggest carry-tailwind for the US dollar seen in recent years is gone, but given very low bond yields, FX carry may still be relevant, especially if euro investors start to increase their US treasury holdings. US investors may still prefer to hold on to their euro denominated bonds currency hedged, at least until there are clear signs of European economy getting back on its feet. At the same time EUR based investors may opt to keep their dollar exposure open as FX hedged Treasury bonds carry close to zero.

The increasing US budget deficit requires foreign funding due to negative current account (see the theme article: QE and the dollar). Euro based investors have been financing the increasing US public spending during the past decade, but interestingly, the US Treasury holdings of euro-based investors have not really increased since last October (Figure 3). The Fed re-starting the expansion of its balance sheet again in October 2019 may have crowded out foreign Treasury purchases, which may partly explain why the dollar has ceased to appreciate against the euro since then. It may also be the case that the euro-based investors´ appetite for buying USTs offering just a small yield pick-up vs. Bunds and the USD becoming overvalued has curbed dollar buying. The Fed is currently decreasing its monthly treasury purchases and considers imposing yield curve control like the BOJ and the RBA. This would fix short yields at a certain level. If credible, it may reduce the need for Treasury purchases by the Fed significantly while the Treasury supply is expected to remain sizeable. We expect the Treasury supply, excluding the Fed purchases, to start increasing again (Figure 3), but perhaps then without upward pressures on UST yields. How this would affect foreign investors is difficult to say. It may be the case that they increase their treasury holdings again, which could then be positive for the USD, but it could also exert downward pressure on the EUR/USD if the offered yields are not attractive enough.

09 jun 3M 6M 12M Q4 21 LTFV*

EUR/USD 1.13 1.13 1.15 1.18 1.22 1.23

EUR/SEK 10.42 10.33 10.22 10.02 9.75 9.60

EUR/NOK 10.56 10.49 10.37 10.04 9.90 9.69

USD/SEK 9.23 9.14 8.89 8.49 7.99 7.80

USD/NOK 9.35 9.28 9.02 8.51 8.11 7.88

ECB -0.50 -0.50 -0.50 -0.50 -0.50

Fed funds 0.25 0.25 0.25 0.25 0.25

*Based on the SEB LTFV model

https://research.sebgroup.com/macro-ficc/reports/190517120317


https://webapp.sebgroup.com/mbs/research.nsf/0/1946f3b14cb52dabc12583fd00375bc4/$file/20190517_eurusd.pdf

https://webapp.sebgroup.com/mbs/research.nsf/0/1946f3b14cb52dabc12583fd00375bc4/$file/20190517_eurusd.pdf

EUR/USD


New EU budget and the recovery plan should attract foreign capital, lifting the euro. Equity flows, which tend less often to be currency hedged than fixed income investments, potentially have a large impact on the EUR/USD going forward. Continued improvement in risk-appetite should attract money from safe dollar assets back into Europe. The overall policy response in the US has so far been much larger than in Europe and therefore it is not a surprise that the US equities have performed better, and the dollar has remained strong until recently. However, the upcoming long-term EU budget for 2021-2027, together with the EU Recovery Instrument (EUR 1.85tn in total) and national fiscal expansions (e.g. Germany) could add to European debt and equity market optimism.

In practise, the ESM is the only EU wide fiscal tool. Under the ESM, a member state facing economic difficulties has been able to request loans if the country commits to undertake badly needed, often painful and politically difficult reforms. However, Italy for instance has been very reluctant to tap the ESM during the Covid-19 crisis despite very few strings attached.

The new EUR 750bn EU Recovery Instrument is a very welcome proposal due to the severity of the current economic crisis and the limited fiscal capacity of some countries. The EU Recovery Instrument proposal includes EUR 500bn of grants and EUR 250bn of loans that would be spent during the coming seven-year budgetary period. The proposal is important not only due to its fiscal impulse but because Germany is now more open for fiscal transfers. This could be the beginning of a more credible, common European fiscal strategy. The current economic crisis has the potential to lead to further fragmentation of the economic conditions among the EU countries, which the EU-wide fiscal policy could mitigate. The most importantly, it could provide leverage for the EU to achieve the badly needed reforms; the EU Commission would continue to require countries to commit to economic reforms and productive investments, but the chances of succeeding in reforming Europe would be better with stronger incentives and cooperation.

Some studies have suggested that the very low neutral rate of interest in the euro area is partly due to a considerable increase in risk premium required by investors since 2010 and low productivity growth. The lack of structural reforms in many European countries may well explain the rise in risk premium, relatively cheaper stocks, weak investments and slow growth in Europe during the past decade. Gross capital formation excluding residential investments in the Euro area has indeed been very slow (Figure 4). Excluding depreciation, the capital stock in the Euro area is barely above the 2008 level, while in the US it is nearly 40% higher. This illustrates the urgent need for reforming the European economy and reviving investments. While the negotiations on the new budget and the Recovery Instrument are still in their infancy, better fiscal and economic cooperation within the EU could decrease the risk premium, encourage investments in Europe and lift long-term growth outlook. This would support the outlook for euro, equities and European long-term interest rates.

Long-term valuation. Our estimate of the EUR/USD long-term equilibrium exchange rate has increased to 1.22, which is the highest level in almost five years. While the fundamental factors tend to change more slowly, the main reason for the long-term fair value now moving higher is that the gap in relative real rates between the US and the euro area is now closing. Moreover, growth in ULC and CPI inflation have also been higher in the US than in the euro area, also exerting upward pressures on the equilibrium exchange rate in EUR/USD. Altogether, our valuation approach suggests that the EUR/USD currently trades around 8% below its long-term fair value.

https://ec.europa.eu/info/live-work-travel-eu/health/coronavirus-response/recovery-plan-europe_en

https://ec.europa.eu/info/live-work-travel-eu/health/coronavirus-response/recovery-plan-europe_en

https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op217.en.pdf

https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op217.en.pdf

USD/JPY


USD/JPY JPY is undervalued but it will fall anyway

According to our fair value model the JPY is undervalued against the USD and it would be reasonable to see it strengthening now. However, its status as a defensive currency will attract capital outflows if the global situation continues to improve. Therefore, we expect it to follow the USD lower over the next 6-12 months.

Volatile in the beginning of the year The USD/JPY showed extreme volatility when the COVID-19 outbreak scared financial markets from around mid-February. In just a few weeks of turmoil the USD/JPY moved from 112 down to 103.5, all the way back to above 111 and then down again to 107-08. The behaviour of the JPY during the COVID-19 crisis was somewhat different from the reactions seen in the past. However, when compared against currencies other than the USD the JPY has once again demonstrated its defensive qualities, probably related to permanently low Japanese interest rates and repatriation flows, which again made it one of the strongest performing currencies during a global crisis. We expect its future performance to be closely tied to how the pandemic will evolve and how it affects financial markets. As long as risk appetite remains strong this should go with a weaker JPY.

Falling GDP in Q1 but not as bad as the GFC Japan’s economy was weak even before the COVID-19 crises started and GDP declined by 1.8% q/q in Q4 after household spending had dropped sharply as a reaction to the increase of the consumption tax from 8% to 10% in October 2019. Although there were signs the economy had begun to recover early this year the outbreak of COVID-19 in February rapidly changed the situation for the worse again. In Q1 GDP declined by 0.9% from the final quarter of 2019. All sectors of the Japanese economy have been negatively affected by the lockdown in Japan and in the rest of the world. Household spending decelerated and in recent months exports have also fallen when overseas economies and businesses have been closed, which also is seen in a slowdown in Japanese business investments. However, the overall impression is that the COVID-19 crisis has hurt the Japanese economy less than other countries in Europe and the US. Growth data only covers Q1, but so far, the negative impact on the Japanese economy was much worse during the GFC in 2008/09.

More stimulus from the government this year In April the Japanese government announced Emergency Economic Measures including various support for households and businesses like cash payments, easing of requirements for employment adjustment subsidies, tax and social security contribution deferrals and lending programmes, which will support private demand in the coming quarters. Overall, the government support announced so far is estimated to affect the budget negatively by around 3.5% of GDP in 2020. This turned out to be much less than the USD 990bn stimulus package which was unveiled earlier this year. However, combined with the fact that GDP is likely to fall in 2020 and some automatic stabilisers kicking in, the budget deficit is likely to end up at around 8% of GDP in 2020. The gross government debt ratio was already 230% of GDP by the end of 2019 and may grow further this year to almost 240% of GDP, which is among the highest in the world. However, Japan has for a long time generated large current account surpluses and today the country has large net claims on the rest of the world of around 65% of GDP. This means that despite this enormous government debt the government can fund itself internally, which means that neither the Japanese position nor the JPY is that vulnerable.

09 jun 3M 6M 12M Q4 21 LTFV*

USD/JPY 108 109 111 112 113 95

EUR/JPY 122 123 128 132 138 117

JPY/SEK 8.54 8.39 8.01 7.58 7.07 8.18

JPY/NOK 8.66 8.52 8.12 7.60 7.18 8.26

GBP/JPY 137 135 144 155 166 149

Fed funds 0.25 0.25 0.25 0.25 0.25

BOJ -0.10 -0.10 -0.10 -0.10 -0.10


USD/JPY


BOJ With the policy rate at -0.1% and yield curve control focused on holding the 10-year bond yield at 0% the key features of BOJ monetary policy remain the same as have been for many years. In addition to unlimited purchases of JGBs the BOJ will actively purchase exchange-traded funds (ETFs) and Japan real estate investment trusts (J-REITs) for the time being. As for CP and corporate bonds, the Bank will conduct additional purchases until March 2021 with the objective of increasing holdings to around 3 times the amounts previously held.

C/A-composition turning less JPY-positive Goods trade surplus in 2019 had been supported by a larger than expected decline in imports despite the weak exports. We had expected a recovery in trade in 2020, but following the COVID-19 outbreak this is uncertain today. The structural shift in the composition of the current account surplus towards greater dependence on net investment income from massive trade surpluses provides much less buffer to the yen in the future. The inclination of pension fund managers to recycle their dividend proceeds into investments overseas takes some of the yen’s shine off.

Reducing FX exposures on US securities? Like most investors outside the US the shape of the US yield curve has made it very expensive for Japanese investors to remove the currency exposure on holdings of UST in recent years. This has probably exerted some downward pressure on the JPY as Japanese investors at the same time have increased holdings of UST securities by almost USD 300bn since the second half of 2018. Most likely these holdings have had an open currency exposure as the annual return otherwise would have been much lower than what the domestic alternative would have offered. Since the beginning of this year these conditions have changed rapidly as the shape of the US yield curve and rate differential between the US and Japanese bond yields have changed significantly. The excess return offered by US bonds is much lower than what has been the case for the past 5 years and the appetite for these bonds should be smaller. Moreover, removing the currency risk has also become an alternative for Japanese investors lately, which will reduce the impact on the JPY from these kinds of flows.

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 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 in the USD/JPY. 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.

EUR/GBP


EUR/GBP Without a deal upside risks dominate

Time is running out and negotiations on a new trade deal with the EU has not moved forward since the COVID-19 outbreak in Feb. There are no signs the UK would opt for an extension of the withdrawal period to get more time and this will weigh on the GBP short-term. As one of few central banks the BOE has started to flirt with the possibility of moving into negative rates. Otherwise the GBP is already significantly undervalued and should recover as these risks fade.

Brexit may still weaken the GBP Since the beginning of 2016 the value of the GBP has pretty much been determined by probabilities for different outcomes in the talks between the EU and the UK. The risk of a hard Brexit is what frightens financial markets, particularly the FX market, and has kept the GBP weak. On 31 January the UK departed from the EU and moved into the transition period stretching until 31 December this year, which effectively leaves the UK a member state (but without political influence) for another 6 months. The intention was to have time to negotiate a comprehensive trade agreement with the EU which will replace the withdrawal deal by the end of this year. The COVID-19 pandemic has now delayed these negotiations by several months and what seemed like a difficult task now seems as an illusion. Until the end of June the UK has the option to buy more time by extending the transition period by up to two years and if they do it will be accepted by the EU. The only reason this hasn’t been done yet is pride as the government and PM Boris Johnson then would fail on the promise to deliver Brexit by the end of this year. Moreover, it takes a change in the withdrawal act to allow for an extension of the transition period as it is explicitly banned. The question is whether the promise to leave the EU completely already this year is worth fulfilling no matter the cost and essentially the risk leaving the EU without a trade deal. This would be a hard Brexit all over and that kind of scenario would probably weaken the GBP significantly.

Prior to the COVID-19 outbreak PM Boris Johnson held a tough position against the EU and threatened to walk away from trade negotiations unless the UK was offered a reasonable deal. So far the EU has suggested a deal including “zero tariffs and zero quotas on all goods entering the single market”, but it comes with conditions like 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 includes a limited trade deal being reached this year which will avoid trade on WTO terms in 2021, or alternatively that the UK asks for a 1-year extension. Altogether, the departure from the EU and the design of the future relationship has partly undermined the GBP and is likely to continue to do so until the risk of failing to get a deal in place in time is eliminated completely.

The BOE flirts with NIRP The BOE acted swiftly in March by rate cuts to 0.1%, the introduction of new facilities, kick-starting old facilities to provide liquidity and restarting the bond purchase programme with the target of buying GBP 230bn of government bonds this year. In contrast to his predecessor the new BOE governor since March Andrew Bailey seems to be more open minded about using negative interest rate policy as an option and a few other members of the MPC have also discussed it as one possible option. Therefore, the BOE currently seems like one of few central banks which in fact considers pushing interest rates below zero in the future. Although the BOE is unlikely to cut rates below zero in the short-term as there are still other options available these comments have triggered renewed expectations about even lower rates in the UK. In fact, market pricing indicates a small probability of moving into negative rates in 2021. These comments from MPC members have contributed to weakening the GBP in recent weeks and if the BOE take this step it will weaken the GBP further.

How deep will it fall? After years of Brexit uncertainty growth has been weaker in the UK than elsewhere. Prior to the COVID-19 outbreak we had expected

09 jun 3M 6M 12M Q4 21 LTFV*

EUR/GBP 0.89 0.91 0.88 0.86 0.83 0.79

GBP/USD 1.27 1.24 1.30 1.38 1.47 1.56

GBP/SEK 11.67 11.34 11.55 11.72 11.75 12.16

GBP/NOK 11.82 11.51 11.72 11.74 11.93 12.28

GBP/JPY 137 135 144 155 166 149

ECB -0.50 -0.50 -0.50 -0.50 -0.50

BOE 0.10 0.10 0.10 0.10 0.10


EUR/GBP


the economy to remain weak this year and next as uncertainty on Brexit prevailed. This had put the British economy in an already vulnerable position to handle the COVID-19 crisis and we now expect the British economy to be more badly hurt this year than other economies. One reason for this is that much of the contribution to growth in recent years has been coming from household spending amid a strong labour market and wage growth. However, on an aggregated level it seems that the households have exhausted much of their reserves and the savings rate has remained low for several years. As households begin to face rising unemployment at the same time as the economy has been locked-down, this is likely to limit household spending significantly, which will hurt growth in the UK. This is seen in the data, such as retail sales, which declined in March, but the huge drop came after the lockdown in April, when retail sales declined by more than 15% from March. In Q1 GDP did not decline as much in the UK as for instance in the Eurozone. However, compared with the previous quarter UK GDP declined by 2% in Q1 as contributions from household spending and net exports were very negative. One reason why the UK economy may have done slightly better than the Eurozone in Q1 could simply be because the UK delayed the lockdown by a couple of weeks, which probably will be reflected in April data instead. We have to admit that lacking past information from any situation similar to the COVID-19 crisis makes forecast unusually uncertain on the impact on growth from the lockdown and how fast the economy can recover.

Undervalued, but for good reasons The GBP has been undervalued against the euro and most other G10 currencies since it began to fall following the Brexit referendum in 2016. Today there are no G10 currencies being undervalued against the GBP. According to our long-term fair value model the equilibrium exchange rate for the EUR/GBP is 0.79, while it has moved to 1.55 in the GBP/USD. This suggests that the GBP is undervalued by around 20%. These results also match the nominal valuation of the GBP from a competitive perspective, based on relative ULC between the UK and the Eurozone and US. Since the Brexit referendum the GBP has traded with a risk premium related to the probability that the UK would leave the EU without a deal in place that will guarantee free trade between the UK and its most important trading partner. Some progress has been made towards such a deal, but with much valuable time now lost due to the COVID-19 crisis this risk premium on the GBP is still reasonable. On top of this the fact that the UK economy may end up taking a bigger hit of the COVID-19 lockdown and with a central bank now more open minded about using negative rates, the undervaluation of the GBP seems justified.

EUR/CHF


EUR/CHF SNB fighting those strong fundamentals

The Covid-19 crisis has put an appreciation pressure on the safe-haven currencies including the Swiss franc. But the fast rebound in risk appetite is helping the Swiss National Bank in its quest to cap the CHF from rising further. Right now, the line in the sand is drawn at 1.05 by the SNB, the ultimate question is to what extent the currency is driven by strong fundamentals and decent valuation rather than safe-haven flows. Quite much we think.

A low in EUR/CHF for now. EUR/CHF started the year in a falling trend and the appreciation of the franc has continued despite rallying risk appetite since mid-March. We are awaiting data on the Swiss National Bank FX interventions for the second quarter, but it is clear the central bank has intervened heavily in the currency to stem any further appreciation. With a very strong initiative from both the ECB (expanded QE of EUR 600bn at the June meeting) and the EU-commission (large economic stimulus package to the EU of up to EUR 750bn) EUR/CHF has likely bottomed for now.

The economy is rebounding from a weak level. The Swiss economy had been doing relatively ok prior to the Covid-19 crisis, despite a strong currency, growing by 2.8% and 0.9% in 2018 and 2019 respectively. Unemployment also was at a very low level (2.3% seas.adj. in February) and the employment rate the second highest in Europe as of late 2019. During Q1 the economy contracted by 2.6% q/q and in its latest update the Swiss National Bank expects GDP to fall during 2020. The Swiss equity market known for its defensive characteristic however, is only down 4% YTD (on June 8th) and has gained additionally as the CHF has started to weaken.

Swiss inflation remains a headache for the SNB. The SNB has been quite far from reaching its inflation target for a very long time and obviously the central bank will not be anywhere near reaching CPI at 2% anytime soon. In the latest Monetary Quarterly Bulletin the SNB projects inflation to fall 0.3% before rising 0.3% next year. Average annual inflation since the financial crisis in 2008/09 has been more or less zero (slightly negative) and hence it is fair to say that the SNB has failed to reach its inflation target despite massive expansionary monetary policy initiatives. The strategy has instead been to “manage” the Swiss franc to prevent it from rising too quickly. Judging by the developments of the sight deposits the SNB has increased its FX reserves by almost CHF 100bn only during March and April. Should European fiscal and monetary policy authorities continue to provide ample support for the recovery of the euro zone, it will also “facilitate” the job of SNB trying to win back its mandate to target inflation again. Clearly the SNB has to be relieved by the latest policy initiatives from Europe as EUR/CHF finally left the “1.05-floor” and trading almost at 1.09. The SNB remains however on high alert as regards the on the level of the CHF which the central bank still labels as overvalued.

That external surplus machine Switzerland continues to show very sizable external surpluses in its trade balance and its current account. The fact that the trade surplus is growing faster than the economy despite what is perceived by most models as an overvalued Swiss franc is frankly fascinating. Switzerland posted its highest ever trade surplus in 2019, pharmaceuticals exports increased the surplus to CHF 37.3 bn, overall exports rose 3.9% to CHF 242 bn francs driven almost entirely by companies such as Novartis and Roche. Net exports to the US is almost as big as the overall trade surplus making Switzerland qualify for one of the critieras as a “currency manipulator” (trade surplus vs the US above USD 20bn). Still the SNB is forgiven for intervening in the FX market, but the external surplus is clearly again a sign that the CHF perhaps is not overvalued, at all.

09 jun 3M 6M 12M Q4 21 LTFV*

EUR/CHF 1.08 1.09 1.10 1.13 1.14 1.21

USD/CHF 0.95 0.96 0.96 0.96 0.93 0.98

CHF/SEK 9.68 9.48 9.29 8.87 8.55 7.93

CHF/NOK 9.80 9.62 9.43 8.88 8.68 8.01

GBP/CHF 1.21 1.20 1.24 1.32 1.37 1.53

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 1.15 is a reasonable long-term target. The constant/continued CHF-appreciation in combination with large external surpluses holding up makes the long-term risks skewed towards stronger swiss franc for longer. Switzerland is also running the risk of being labelled a currency manipulator by the US, something which may not matter much on face value but is indicative of the ability of the country to combine a strong (not weak) currency with strong external competitiveness.

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 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. The chronic 10% Current account surplus is a signal again that the swiss franc is perhaps not as overvalued as most models point to.

EUR/SEK


EUR/SEK Heading below 10

The COVID-19 crisis in Feb and Mar caused smaller currencies to fall heavily. However, this time the SEK was much more resilient than in the past. Late last year the Riksbank removed negative interest rates and now interest rates outside the country have dropped. This has removed some of the headwinds for the SEK. If the global economy continues to improve in line with current market expectations the SEK should strengthen further this year and next.

Much more resilient this time Although the SEK weakened, as it usually does, against major currencies and particularly the USD at the height of the COVID-19 panic in March, it was clearly much more resilient this time than for instance during the GFC in 2008/09. There are a couple of reasons why this was the case:

1) Due to its relatively low rates it had probably worked as a funding currency in recent years, which created SEK positive flows as investors rapidly cut back on positions.

2) With the key interest rate raised to zero in December and the Riksbank closing the door for renewed NIRP the SEK did not suffer from expectations of rate cuts like other smaller G10-currencies.

3) Low Swedish interest rates and flat yield curves have made it expensive for Swedish financial institutions and corporates to hedge their foreign currency exposures for several years. Therefore, these key players probably had much more open FX risk in their books this time compared to the GFC in 2008.

4) Due to persistent current account surpluses for decades the Swedish net investment position is positive today, which means a net repatriation inflow when savers reduced their equity holdings.

5) The SEK was already weak and significantly undervalued at the outbreak of the coronavirus, which probably reduced the downside potential this time.

While some of these factors seem to be permanent and would suggest a similar behaviour in the future, some of them were coincidences. For instance, with a different monetary policy in the past, which people generally argued for, Swedish rates would have been higher, the SEK then wouldn’t have been used as a funding currency and therefore stronger, and domestic players would probably have had less open FX risk. You could easily imagine this would have generated a different reaction. Although the SEK probably will be less procyclical in the future than it used to be, it could still react differently the next time global financial markets end up in panic mode if conditions are different.

Finally, conditions are in place for a stronger SEK It is probably still too early to conclude that the swift reactions from policy makers across the world have been successful and that the global economy and financial markets will just continue to recover. We have already seen the SEK strengthen as risk appetite has improved since April. If it continues it will most likely benefit the SEK ahead as well, although probably less than for other smaller currencies that were punished more severely in March. However, one consequence of the COVID-19 crisis is much lower global interest rates, which have closed much of the gap between Swedish and global interest rates and this is an instrumental change for the future.

Previous Riksbank policy with NIRP and bond purchases probably had significant impact on hedging decisions for a Swedish real money investor. Buying a naked US 10Y treasury then offered between 200-300bps a year of excess return compared with negative return if the USD/SEK-risk was removed. At the same time the Riksbank was guaranteeing a weak SEK, which made it pointless to hedge foreign assets. Now the situation is completely different:

1) The negative carry in the USD/SEK based on 3-6M rates are now almost gone. With Swedish interest rates now almost the same as in most countries the SEK is unlikely to be used as a funding currency. This suggests that negative SEK-flows related to speculative accounts are likely to decline, disappear or even turn positive.

09 jun 3M 6M 12M Q4 21 LTFV*

EUR/SEK 10.42 10.33 10.22 10.02 9.75 9.60

USD/SEK 9.23 9.14 8.89 8.49 7.99 7.80

NOK/SEK 0.99 0.98 0.99 1.00 0.98 0.99

GBP/SEK 11.68 11.34 11.55 11.72 11.75 12.16

JPY/SEK 8.55 8.39 8.01 7.58 7.07 8.18

ECB -0.50 -0.50 -0.50 -0.50 -0.50

Riksbank 0.00 0.00 0.00 0.00 0.00


EUR/SEK


2) The cost of hedging the SEK against other currencies and particularly the important USD is significantly lower (3-4 instead of almost 30 figures in 12M). Given that the SEK remains at a long-term undervalued level this should render increased hedging activities from Swedish exporters and domestic financial institutions.

3) The return on unhedged exposures in longer dated treasury bonds is not that attractive for Swedish bond investors today, while the return on currency hedged holdings of 10Y US treasuries have turned positive. Suddenly there is an opportunity to receive excess return on a US 10Y bond compared with a domestic bond without any open currency risk. Hedging activity is likely to increase ahead and that should create a SEK-positive flow from domestic institutional investors.

4) Sweden has used a different and more liberal approach to limit the spread of the coronavirus than most other countries. Consequently, the negative impact on the domestic part of the economy should be less severe than for other countries. However, with exports an important part of the Swedish economy growth is likely to suffer from restrictions imposed elsewhere. Overall, the downturn in Q2 should be shallower than elsewhere, which should support the SEK on a relative basis.

5) By the end of last year Sweden’s public debt was much lower than in most other countries in the western world. The low debt puts Sweden in a much better position than most other countries as it offers the Swedish government the ability to increase spending significantly to support the economy and businesses suffering from the pandemic and to achieve a recovery without ending up in a difficult position related to a huge public debt.

A weak SEK has improved trade balance In recent years the Swedish current account surplus has improved significantly. 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 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 the 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.

Long-term valuation – SEK is undervalued 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 higher trend 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. However, we now see a shift in the valuation model as the real gap yields between Sweden and the Eurozone has recently moved in favour of the SEK. Our latest estimate for EUR/SEK is now 9.60.

Since the end of 2010 the Swedish ULC has 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.

EUR/NOK


EUR/NOK Regaining lost ground

The NOK has recovered since the collapse in mid-March. Rebounding oil prices and the positive flow outlook will support the krone in the short-term. There is still an undervaluation gap vs. the euro suggesting EUR/NOK will continue to grind lower throughout the year contingent on the positive market sentiment being sustained.

An unprecedented collapse The krone has been on somewhat of a rollercoaster over the past few months. The NOK was double-hit by the collapse in oil prices and general risk-off sentiment following the coronavirus outbreak, which favoured more defensive and liquid currencies. The NOK thus crashed completely in mid-March as liquidity dried up and the market turned one-sided, pushing NOK to an all-time-low and EUR/NOK above 12.50. The krone stabilized somewhat after Norges Bank threatened to intervene in the FX market. The central bank has confirmed that it made extraordinary NOK purchases in the market totalling NOK 3.5bn in March, to provide liquidity to the dysfunctional market. Norges Bank does not have any target in EUR/NOK as such but has stated that it will monitor developments going forward. The bank’s willingness to defend the krone should prevent any similar liquidity-driven collapses in the NOK ahead.

NOK recovering in line with oil prices Unprecedented fiscal and monetary policy support have improved market sentiment, and the reopening of economies has boosted markets’ belief in a speedy recovery. This helped oil prices to reach a trough in late April and the NOK has been the best G10 performing currency since then. What’s interesting is that this has happened simultaneously with first defensive currencies outperforming and latter with offensive ones. It thus appears as NOK is disconnected from the traditional risk-on/risk-off theme that drives other G10 currencies.

For the krone oil matters. Developments in the NOK is strongly dependent on changes in oil prices; the correlation is currently very high regarding both the significance and the size of the impact from oil prices. Bullish forces in the oil market are still in place. Demand is ticking higher and OPEC+ has agreed to deep cuts also for July and is likely to extend it to August if needed. This has taken away the short-term downside risk to oil prices and thus the NOK. The long-term outlook is more uncertain as OPEC+ wants to avoid stimulating longer-dated Brent prices which risks fuelling US shale production. For now, however, a further rise in Brent crude oil price to USD 50/bl should support a continued correction lower in EUR/NOK.

Domestic factors are secondary With oil in the driving seat, domestic factors have become less important for the NOK like for most other currencies. The coronavirus outbreak resulted in an instant shut down of the economy as the government implemented extensive infection control measures on Mar 12. Since late April, Norway has gradually opened society, restarting schools and lifting restrictions on many businesses as contagion has been under control. Mainland GDP growth declined 11.3% from February to April, but there are signs of activity having picked up towards the end of the period. Hence, the recovery is materializing somewhat earlier than expected and we will thus revise our -7.4% growth forecast for 2020 higher. Low oil prices will nonetheless accelerate the spending downturn in petroleum and will hamper the economic recovery. Unemployment has trended steadily lower since the peak in March as people have returned to work, but the overall jobless rate remains high at 12.0% of which 60% reflects furloughs. The output gap is thus likely to remain negative in the coming year, enabling Norges Bank to overlook temporary high inflation driven by previous krone weakness. The tool box has been emptied as Norges Bank has voiced it is reluctant to cut to negative and the effectiveness of a QE programme would be limited in Norway. Hence, we expect Norges Bank to maintain the policy rate at 0% until end-2021 while fiscal

09 jun 3M 6M 12M Q4 21 LTFV*

EUR/NOK 10.56 10.49 10.37 10.04 9.90 9.69

USD/NOK 9.34 9.28 9.02 8.51 8.11 7.88

NOK/SEK 0.99 0.98 0.99 1.00 0.98 0.99

GBP/NOK 11.82 11.51 11.72 11.74 11.93 12.28

JPY/NOK 8.65 8.52 8.12 7.60 7.18 8.26

ECB -0.50 -0.50 -0.50 -0.50 -0.50

Norges Bank 0.00 0.00 0.00 0.00 0.00


EUR/NOK


policy assumes the main responsibility in the stimulating demand in the economic recovery. Fiscal measures so far have been extensive; the direct contribution is estimated to 5.3%-points of mainland GDP in 2020 as the non-oil budget deficit will increase by NOK 243bn.

Optimistic market sentiment poses a risk The main threat to the ongoing recovery trend in the NOK is the optimistic market sentiment. Market sentiment has remained surprisingly positive even as political uncertainty and risks have increased. USD/NOK usually works as a high-beta EUR/USD. Heavy reflation due to expansionary fiscal- and monetary policy, normalizing risk appetite and rising asset markets have started to weigh on the dollar. The double massive US deficits must be financed and due to smaller interest rate differentials, there are few benefits nowadays to hedge purchases of Treasuries. Should markets prove too optimistic, a larger setback triggering a reversal in EUR/USD could halt the recovery in the NOK. However, the risk of a new collapse like we saw in mid-March should be limited as Norges Bank stands ready to intervene in the market to support liquidity in the NOK if necessary. NOK flows turning very positive Tourism: Although some of the travel restrictions is currently being lifted ahead of the upcoming summer holiday season, which will allow for some traveling inside Europe, we expect a huge decline in tourism expenditures this year as people stay home. For some countries in southern Europe this will be another hit to economy. However, for some countries like Norway net tourism expenditures is usually highly negative as Norwegians tend to spend much more money outside the country than what foreign tourists spend in Norway. Therefore, the lack of holiday traveling will improve the NOK flows by potentially as much as 2% of GDP this year.

FX purchases: Funny enough the oil price collapse together with the sharp increase in government spending have had another positive consequence for the NOK. Since lower oil prices have reduced the government’s net cash flow from petroleum, and the fiscal spending has increased to whether the coronavirus crisis, petroleum revenues will not be enough to cover the non-oil budget deficit. The government must thus make a record-large net transfer of NOK 382bn from the GPFG to fund the budget. Since the oil fund only invests in assets abroad, the government needs to exchange a large amount of revenues and assets currently in FX into NOK to fund the budget. Norges Bank is currently buying NOK 2.3bn per day on behalf of the government, which is a substantial volume which gives underlying support to the krone. Unless the government increases spending further purchases are likely to be lowered slightly towards the end of the year.

NOK’s valuation gap persists The NOK is one of the currencies being most undervalued against other G10-currencies. That was the situation prior to the Covid-19 crisis, but after the oil price shock and the market panic earlier this year, which took the NOK to super weak levels, it is certainly the case today. However, while the exchange rate is still far off the long-term level in EUR/NOK the fair value estimate has also been grinding higher in recent years and today the long-term fair value for EUR/NOK is almost 9.70. Yes, the NOK is undervalued against the euro, but perhaps not as much as generally regarded. Valuation will remain a positive force for the NOK going forward.

Themes


FX market themes

Theme: FX Positioning


FX Positioning Seasonality

Risk-on moves but exposures are small

Positioning in the FX market indicates that speculative exposures are small and the risk-on euphoria seen in equity markets and to some extent in currency developments are not really followed with any large conviction. CTAs seems to have been quicker in changing views during the crisis as compared to more discretionary investors. For EUR/SEK our positioning indicator based on client flows shows current levels as a bit too low and argues for a shorter-term correction higher.

Cautious return to the FX market Sharp decline in FX exposure among hedge funds during the Covid-19 crisis has been noted. Activity has increased again but it is quite much smaller than e.g. the corresponding surge in risk appetite according to VIX or the level of S&P 500, which has recovered fully since the correction started in February. Are normal drivers working in this market?

Looking at asset under management (AUM) it also seems that AUM for traditional macro/discretionary hedge funds (though not specifically only trading in FX) has declined the past years while it has increased for systematic funds. This further supports the notion we already made in Currency Strategy Feb 2020 that understanding how systematic funds as well as hedgers operate is becoming increasingly important when interpreting market moves and estimating future ones.

The SEB CTA Dashboard provides us with indications of how CTAs (i.e. systematic trend-followers) probably are positioned and how their positioning is changing. The dashboard is based on a systematic signal designed to replicate trend-follower models and should thus provide us with good intelligence on what they are doing in the markets.

Currently the Dashboard (picture next page) indicates a general turnaround from having been short offensive/risk-on currencies vs the USD a month ago into being long these currencies. The largest positioning/strongest signal is in short USD/SEK. The only G10 currency CTAs did not buy versus the USD last week was the JPY (a safe-haven currency). So clearly CTAs are adopting to the environment with increasing risk appetite the same we see in how VIX and the equity markets are trading.

Looking instead on how FX speculators in general are position we have used CFTC weekly Commitment of traders’ report (see table on next page). This shows a much more defensive positioning as the net position is long USD vs AUD, CAD, GBP and NZD (i.e. the offensive currencies) while still short vs EUR, JPY and CHF (i.e. the defensive currencies). This is a bit puzzling. Why are not FX speculators like most other market participants positioned for risk-on? Admittedly they do not seem to be overly confident in the view/positions they have given the very low exposure they use but still why do we not see the same shift towards a more recovery-oriented positioning?

SEB positioning index shows EUR/SEK a bit oversold Another way to estimate the market positioning and flows is by using our own data from trades with clients. We measure this on a weekly basis and have traditionally focused on the client category foreign financial institutions as they have worked as a good proxy for active macro traders, the category which traditionally have been driving the market. As discussed above, this may not be as true anymore, but they are still a key category to investigate when seeking flow information about currencies. For this analysis we focus on SEK as this is where we have a large enough share of the market to make the analysis statistically sound.

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Broad off-shore financial positioning vs EUR/SEK

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Theme: FX Positioning


CTA positioning (ccy vs USD)

Speculative positioning (ccy vs USD)

June seasonality (monthly change, %)

August seasonality (monthly change, %)

The analysis of these flows aggregated within the client category, over each week and over time reveals a strong relationship with how EUR/SEK has been trading. Looking at the chart above it seems that EUR/SEK is anchored around our positioning index as it doesn’t seem to be able to stray far from it. End of 2019 EUR/SEK falling below our index only to begin 2020 by correcting higher closer to the index. During the financial stress in the beginning of the covid-19 crisis EUR/SEK greatly overshoot our index but once the worst stress was overcome and markets begun to recover EUR/SEK has fallen sharply but is now becoming significantly too low compared to our index. This is an indication of SEK being overvalued at the moment and that a correction higher may be expected.

The larger turnaround which one can see in USD/SEK does not seem to be present when looking at this chart as the index is still in a trend higher meaning a continuation of the long upward move for a higher EUR/SEK.

Summer seasonality – not a biggy for G10 currencies Seasonality worked well as a driver in the less volatile markets seen last year, especially last spring and summer. During the Covid-19 crisis the underlying flows causing such seasonal fluctuations to have been disrupted, e.g. dividends from Swedish firms usually causing SEK outflows were halted or delayed this year, and other more crisis related drivers have taken center stage. However, with volatility coming down and the crisis being less imminent there is a greater chance that especially strong (i.e. long lasting and robust) patterns will came through this year as well. The tables below show the seasonal patterns for the currencies covered in Currency Strategy for June and August. We have omitted July as none of the currencies showed any strong seasonal patterns this month.

June: Higher EUR/USD and lower USD/JPY

In June there are relatively few long-lasting patterns which EUR/USD heading higher 7 out of the past 10 years and USD/JPY falling 7 out of the past 10 years being the most robust ones. However, neither of these have been very consistent the past years which instead a possibly new pattern has been: EUR/GBP has headed higher the past four years. Especially so in 2016 but that is not very representative as this was due to the Brexit vote that year.

August: Higher USD/CAD and lower EUR/CHF

In August there are slightly more seasonal patterns with USD/CAD heading higher being the strongest one having occurred 8 out of the past 10 years and for five straight years. EUR/CHF has a tendency to fall in August 7 out of the past 10 years, and have also done so the past three years. Also, EUR/USD has shown a tendency to fall in August, which it has done 7 out of the past 10 years, but only for two straight years. USD/JPY has in August fallen for three straight years but going back a few years it shows the appositive pattern i.e. a tendency to head higher.

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Now Crisis Bars = 12mths High/Low

EURCHF EURGBP EURNOK EURSEK EURUSD USDCAD USDJPY USDCNY NOKSEK2010 -7.5 -3.3 0.0 -0.8 -0.6 1.8 -3.2 -0.7 -0.92011 -0.9 3.2 0.9 3.2 0.7 -0.5 -1.2 -0.2 2.42012 0.0 0.5 -0.2 -2.5 2.4 -1.6 1.9 -0.2 -2.32013 -1.2 -0.1 3.4 1.3 0.2 1.3 -1.4 0.0 -2.22014 -0.5 -1.6 3.1 0.4 0.4 -1.7 -0.5 -0.7 -2.62015 0.8 -1.3 2.6 -1.4 1.5 0.5 -1.3 0.0 -4.12016 -2.1 8.2 -0.4 1.3 -0.2 -1.3 -7.0 0.9 1.72017 0.6 0.6 0.6 -1.4 1.6 -4.1 1.4 -0.4 -1.92018 0.4 0.6 -0.5 1.4 -0.1 1.3 1.8 3.2 1.82019 -0.9 1.3 -0.9 -0.4 1.8 -3.3 -0.5 -0.5 0.3

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

Average change (%) -1.1 0.8 0.9 0.1 0.8 -0.7 -1.0 0.2 -0.8

EURCHF EURGBP EURNOK EURSEK EURUSD USDCAD USDJPY USDCNY NOKSEK2010 -5.5 -0.8 0.7 -0.6 -3.0 3.5 -2.7 0.5 -1.32011 2.7 1.2 -0.1 1.2 -0.2 2.5 0.0 -0.9 1.42012 0.0 1.1 -1.7 -0.4 2.2 -1.7 0.3 -0.2 1.42013 -0.2 -2.5 3.1 1.0 -0.6 2.5 0.3 -0.1 -2.22014 -0.9 -0.2 -3.3 -0.6 -1.9 -0.3 1.2 -0.4 2.72015 2.1 3.8 3.2 0.2 2.1 0.3 -2.3 2.7 -3.22016 1.3 0.6 -1.4 -0.1 -0.2 0.4 1.3 0.7 1.42017 -0.3 2.8 -0.7 -1.0 0.6 0.0 -0.3 -1.9 -0.32018 -3.0 0.5 2.0 3.1 -0.8 0.3 -0.7 0.1 1.42019 -1.1 -0.8 2.1 0.9 -0.9 0.9 -2.3 3.6 -1.1

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Theme: FX Drivers


FX Drivers Crisis = regime shift

The crisis has caused a correction of misvalued currencies making the valuation investment style the best performing this year. During the recovery phase of the covid-19 crisis G10 carry has worked well based on its inherent risk-on structure. The explanatory power of the general G10 currency drivers, as captured by our short-term fair values, was very high during the height of the crisis but has fallen back since the rate spreads have become smaller and more stable.

Scaling down on excessive positioning in time of crisis benefits the contrarian valuation style Our own smart beta FX indices provides a way to analyze what sort of drivers have been present in the market so far in 2020. Looking at the chart to the left, the market has clearly gone through periods with quite different market environment. Starting off the year: carry headed sideways; valuation gained while; trend strategies did not fare well. The major reason for this was probably that when looking at e.g. our trend-follower signal it shows a general swing in December 2019 to short USD positioning, but the USD begun the year on a strong note.

During the start of the Covid-19 crisis at the end of February all strategies fared bad which probably is a result of most FX traders exiting any positions in order to minimize risk (exposure). Worst of the strategies was G10 carry which also according to theory should be the worst performing strategy in such a complete risk-off period as this strategy tends to be long offensive currencies and short defensive currencies which tends to strengthen during these events. An eventual turn for the better for the valuation strategy also seems natural as the most mispriced currencies also tends to be exited during these markets. What is a bit surprising is that the valuation strategy has continued to perform very well during the recovery which is the reason it is the only strategy with a positive return year-to-date.

The trend strategy had a very short but explosive development on the upside during the financial stress period (9-23 March) which probably is more of a fluke with the strategy happening to be long USD when this outperformed everything else during this special period. Afterwards the trend strategy has been the worst performer of the four strategies: it has clearly not been able to exit its long USD positions quick enough as the USD past the USD squeeze have performed increasingly bad.

EM carry does not tend to be as affected by risk-on/risk-off swings as G10 carry, nonetheless it taken a beating this time. This could be due to the severity of the crisis where really no country has been able to carry on as usual.

During the recovery phase (starting around 23 March) the valuation strategy continued to perform well which also the G10 carry strategy has done. As this strategy tends to be long offensive G10 currencies and short defensive ones it is a risk-on/risk-off strategy when there are large swings in risk appetite as there has been this year. Question is how well this strategy will behave going forward as it relies on the level of the rate differential which have come down significantly in the G10 during the crisis. Thus, it is currently less of a carry strategy and more of a risk-on/risk-off bet.

Are normal drivers working in this market? Next, we have looked at market drivers using our short-term fair value models. First a short explanation of the models. They are multi-factor models using three explanatory variables to explain the dependent variable (the FX rate). The explanatory variables are different for each currency pair and have been determined empirically but common for almost all the currency pairs is that one of the factors is the medium-term rate spread. The chart to the left shows the average Z-score for explanatory power of the G10 models during 2020. A value above (below) 0 indicates that the models explain more (less) than usual i.e. it indicates if the currency pairs have been driven by their general drivers or not. The factors (“general drivers”) are presented in more detail in a table on the next page.

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Average Z-score for explanatory power

Theme: FX Drivers


The factors used in our short-term fair value models

P-value Z-score shows how much more (negative) or less (positive) the factor currently explains the currency rate compared to what it normally does, Model R2 Z-score shows how much more (positive) or less (negative) the explanatory power of the model is compared to its average power.

As may be seen in the bottom chart on the previous page the drivers did not work as well as usual in the beginning of the crisis which is a period we previously have seen was characterised by investors exiting carry trades. With the level of rate spread not really a factor in the short-term models this driver was not captured. However, the models gained in power when the crisis intensified possibly as the change in rates with plenty of Central Bank activism begun to matter and the change in rate spreads is a major factor in the models. But, just before the recovery started (seen in e.g. the equity market and our own risk appetite index from around 23 March) the explanatory power of the models begun to fall again. A major reason for this is probably that most central banks were by now done with adjusting their rates and the rate spreads went from changing a lot to becoming rather flat while the lookback period for the models still covered a period with both large rate and exchange rate changes. This has continued and the explanatory power of the model just recently begun to rise again. As may be seen in the chart to the left coving a long-period of time for the average Z-score of the explanatory power it is quite common with longer time periods with low explanatory power being followed by a return once the model has trained on the new market that has emerged after a regime shift (often caused by large events such as the Covid-19 crisis).

Question is what new regime now establishing will look like? The financial world is a lot different now compared to when the crisis started. First the previous sometimes quite large rate differentials between countries have shrunken considerably and will probably remain quite stable for a longer time than usual. Thus, it seems that one of the main factors, the medium-term rate spread, has been neutralized. Without this as a major factor, currency forecasting will be very different from what most people are used to. One current example of what may happen when the rate spread is flat may be illustrated by the late surge in EUR/USD. This surge is by no means motivated by its rate spread (which has been heading sideways) nor its equity ratio factor (which also has been heading mostly sideways) instead the only factor motivating the move is the intra Eurozone bond spread. Due to this EUR/USD is trading with a large EUR overvaluation according to its short-term fair value but one that will not be corrected by a simple statistical number (such as a deviation above 2.0 st dev etc) but rather it seems that the trigger needs to be a turnaround in the factor which is favored. In this case that could happen if the proposed EU recovery fund falls through. So, before there is a new regime established the best way of using the fair value methods might be to see which factors actually motivate currency moves and then in a more fundamental way investigate what may turn the development of the factor rather than relying on statistical measures such as expecting a correction as soon as specific deviation level is passed.

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Jan-14 Jan-15 Jan-16 Jan-17 Jan-18 Jan-19 Jan-20

Average Z-score for explanatory power

Theme: QE and the dollar


QE and the dollar Will QE shift the trend for dollar flows?

In this article we look at the US balance of payments statistics to determine the flows that have financed the US current account deficit over the last four to five years. Our conclusion is that Eurozone purchases of US debt securities have been the most important. Lower spreads for US yields and aggressive QE imply that US debt securities have become significantly less attractive and that this has contributed to the weakening of the dollar.

Long period with current account deficits The US current account has shown a deficit almost every year since the beginning of the 1980s and the deficit has increased since the mid-1990s, even though the deficit narrowed when US domestic demand collapsed after the financial crisis. The US needs to attract large amounts of foreign capital every year to finance its deficit. In this article we take a look at some of the financial flows the continued deficit is creating. We discuss how these flows could be affected by the crisis caused by coronavirus pandemic and the possible implications for the exchange rate.

The drivers for the negative current account have varied over time, but long periods with low household saving and/or budget deficits have generally been the main drivers. Also, the US has historically attracted a lot of foreign investments. After the financial crisis, large budget deficits have been most important.

Many years of current account deficits have resulted in an increasingly negative net international investment position (NIIP) for the US which in 2019 exceeded 50% of GDP. The countries and assets financing the current account deficits have also varied over time. In the 2000s China was the most important buyer of US assets, but since the financial crisis China has invested significantly less in the US than it did previously, and since 2015 China has even reduced its holdings of US assets. This is interesting considering that China continues to be the main driver for the US current account deficit, but it is no longer an important buyer of US assets. Instead, the Eurozone and, to some extent, Japan and other Asian economies, ex China seem to have taken over financing US borrowing needs. Shifts in current account surpluses, which declined in China but shifted from a deficit to a surplus in the Eurozone is likely to have contributed to the shift. However, restrictions and the trade war that started after Mr Trump was elected President, are likely to be more important after 2015.

The NIIP in the Eurozone has increased from a negative 25% to zero in 2019 and the most important driver seems to be increased net holding of debt securities. US flow data from the financial account imply that Euro area purchases were high during the period 2015-2019.

Large Euro area purchases of US bonds Euro area NIIP-holdings of foreign long-term debt securities increased significantly in 2015-2017. Increased net holdings for both government, corporate and agency bonds contributed. It is interesting to observe that the dollar strengthened significantly in 2015 and temporarily weakened against the euro in mid-2017 when the Euro area bond purchases slowed. There are many other forces affecting the exchange rate, but it gives some support that Euro area purchases of US bonds could have been important for exchange rate movements over the last three to four years as we have previously argued here. We have previously found evidence that the shift in bond flows caused by the combination of rate cuts, aggressive QE and tight supply due to government surpluses were important for the trend weakening of the krona seen between 2014 and the first half of 2019.



Theme: QE and the dollar


Central banks to decide the fate of its currency? To some extent we think that a similar analysis could be applied to the outlook for the dollar in the current situation. Due to a higher Fed funds rate in the starting point, the Fed has closed the gap to other central bank rates significantly. The outlook for bond supply is less clear cut since all central banks are currently taking aggressive QE measures, and also the supply situation is very different with massive increases in government bond issuance. So far, however, aggressive purchases have reduced outstanding bonds not held by the central banks significantly in the US. The ECB’s bond purchases have so far been more modest, lowering the outstanding bonds only marginally. Looking forward, however, our main scenario is that US bonds will increase significantly as the weak government finances will increase issuance, while the Fed is predicted to slow the pace of bond purchases. The ECB is predicted to continue to buy at the current pace at least until YE 2020 and slow purchases somewhat during H1 2021. But a lower public sector deficit means that outstanding bonds will rise significantly less than in the US. Also, the positive current account balance in the Euro area implies that large shares of public deficits can be financed domestically.

Will Eurozone investors continue to fund the US budget deficit? Given that the interest rate spread compared to the average Eurozone government bond has declined to the lowest level since 2015. US rates may need to rise to attract investors and it remains to be seen if the Fed will allow this to happen without purchasing more bonds. A probable scenario is that the Fed will shift to a strategy of interest rate control i.e. targeting the government bond yield at the 2y or 5y point on the curve and thereafter purchasing the amount of bonds needed to bring rates to this level. This could lead to bond purchasing becoming significantly larger than in our main scenario. It also highlights that US interest rates are likely to remain low and that the attractiveness of buying US debt will be significantly lower than has been the case over the last three to four years.

Research contacts


Erica Dalstø NOK +47 2282 7277

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

Ann Enshagen Lavebrink Research Assistant + 46 8 763 80 77

Carl Hammer CHF + 46 8 506 231 28

Olle Holmgren Theme: QE and the dollar + 46 8 763 80 79

Lauri Hälikkä USD, Theme:QE and the dollar + 46 8 639 23 48

Karl Steiner Themes: Positioning & Drivers +46 8 506 231 04

This report was published on June 10, 2020 Cut-off date for calculations and forecasts was June 09, 2020


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