2014 Annual Conference in International Finance, London

I’ll be at the Annual Conference in International Finance at Imperial College London on Tuesday, 1 July 2014.

This is the second time Imperial College Business School hosts this excellent FX conference on recent academic findings relating to international finance. The event is sponsored by BlackRock and the Royal Economic Society. Topics covered include, inter alia, the forward premium puzzle, FX risk premia and investing in a post-QE world.

I’m going to write about the papers presented when I’ll be back, so watch this space over the next few weeks if you’re into FX research.

USDJPY at the crossroads

USDJPY 27/06/2014

The Japanese yen showed strength this month as it gained against both the euro and the US dollar. The USDJPY exchange rate today broke through the 200-day moving average at 101.71 to trade at 101.38 as of this writing. Breaks through significant SMAs are usually followed by an extension of the trend until the next support level is reached, which in this case is in the 100.70/.75 area. That would give the JPY about 60 more pips to cover before possibly bouncing back. We note, on the other hand, that USDJPY hit the lower bollinger band today, which has described the FX rate’s 2014 range trading rather well so far. This should only represent a weak buy signal which we believe will not stop traders from going long the Japanese currency during the next few trading sessions.

If we had to formulate a trade idea it would be USDJPY short with a target at 100.75 and a stop loss just above the SMA 200 at 101.80. If the 100.70 level were to be eroded too, we would then add to the short position. Otherwise, we would probably take the profit and buy the dip considering that we are actually bullish the USD and bearish the JPY for the medium term based on Fed tapering.

EURUSD implied volatility drops below 4.6%

EURUSD 1M Implied Volatility 25/06/2014

Volatility implied by one-month at-the-money EURUSD options dropped below the 2007 low of 4.65% today, hitting a new record low just above 4.5%.

FX volatility has decreased continuously over the past three years. Although there was a brief blip after the June 5 meeting of the ECB’s governing council, it came as no surprise that implied vol resumed its fall below 5% rather quickly. The continued decline of FX volatility this week contrasts with an increase in the VIX after the S&P 500 bounced off a new all-time high yesterday.

The pronounced period of low volatility is a result of highly accommodative central bank policies in the United States, United Kingdom and Europe, in light of which many analysts sound a note of caution, reminding investors that past periods of such extreme complacency were usually followed by a sharp sell-off. While this may be true, a strong trend reversal can only be triggered by an important event in the market. As long as central banks hold their protecting hands over asset markets, this is unlikely to happen. Markets cannot reliably be timed based on low levels of volatility anyway. Investors afraid of a volatility comeback may therefore prefer to purchase options, which are generally cheaper when implied vol is low, instead of outright exiting the market.

Low levels of implied volatility are supportive of carry trade strategies, because moves in the exchange rate tend to be lower and the risk of FX losses eating up the profits from interest rate differentials are perceived to be lower. We might thus see more interest in trades such as NZDJPY long or EM currencies, especially when taking into account that satisfactory returns are increasingly hard to be found in DM assets, unless you are willing to bear the risk of keeping equity investments despite arguably high valuations. Traders seeking to exploit the interest parity condition via the carry trade must not lose sight of the fact that this is nevertheless a highly speculative bet whereby you are basically “picking up pennies in front of a steamroller”, i.e. carry strategies tend to blow up suddenly.

Long GBP futures positions highest since 2011

GBP Long Positions 24/06/2014

This week positions in long GBP futures reached the highest level since the first quarter of 2011 as reported by the CFTC. Long Sterling positions are highly correlated with subsequent moves in the GBPUSD exchange rate, i.e. turns in long futures positions are often followed by correspondent changes in the FX rate.

Although we do not see a reversal of the positioning build-up just yet, the British pound fell versus most of its peer currencies during London trading hours today after new comments by Bank of England Governor Mark Carney, who apparently decided that the recent appreciation of the GBP was a tad too sharp and consequently mitigated his earlier warning that UK interest rates could rise sooner than had been expected. Fresh numbers on the development of wages in the UK suggest that wages were not rising as quickly as the BoE anticipated, making impending interest rate hikes less likely. The GBPUSD rate fell slightly from above $1.7 (its highest level in almost six years) to an intraday low of $1.6966. The FX pair currently trades at $1.6983.

EURGBP marked a high of 0.8024 during early European trading; it is now at 0.8008. We stick to yesterday’s short-term EURGBP buy recommendation, noting that hedge funds may be about to cover some of their long GBP futures positions. We already saw an increase in short GBP positions today but would require an additional reduction in long positions for a more pronounced move in GBP rates. Alternatively, traders can speculate on GBP weakness via GBPUSD shorts based on extreme momentum (GBPUSD temporarily overbought, EURGBP temporarily oversold).

EURGBP oversold after Carney comments

EURGBP Chart 23/06/2014

The British pound posted impressive gains versus the currencies of Britain’s major trading partners following comments by Bank of England governor Mark Carney from June 12 that UK interest rates could rise sooner than expected.

While the GBP will most likely continue to appreciate versus the US dollar and the euro in the medium term, we note that EURGBP entered oversold territory at the end of last week, as shown in the Bloomberg chart above.

The Relative Strength Index (RSI) posted its lowest levels since May 2012. The RSI is still at 27.5 as of this writing, well below the level of 30 indicating that the currency pair may be temporarily oversold. The exchange rate failed to push through the May 2012 and November 2012 intraday lows in the 0.7950 range; it currently trades at 0.7991.

We expect a push back above 0.8000 during the next few days with a target at 0.8200 just below the SMA 100, but recommend setting a close stop loss limit below the November 2012 low. This view is supported by record GBP long positions that market participants have begun to cover. If EURGBP rallies to 0.8200 we will enter new short positions.

For investors who wish to hold positions for more than just a few days we confirm our bearish EURGBP view and consequently recommend keeping EURGBP shorts.

FX Market Trends