The joy of forex – introducing the currency sutra
Make love not (currency) war, courtesy of Société Générale's new "sexy" currency index, based on economic growth, interest rates and the current account balances.
Let’s face it, risk on-risk off(RORO) was dull – everything swung in the same direction – but in the new world where currencies move to their own beat, it is time to look at FX movements from a new angle.
Step forward Société Générale, whose head of FX strategy Kit Juckes has devised the sexy currency index.
“One of the biggest challenges after a long period of RORO tradingis that the assets which are attractive are expensive and the ones that are cheap are cheap for a reason,” says Juckes.
“One way to describe this in FX is to say that sexy currencies are generally overvalued.”
Juckes’ first attempt at comparing currency sexiness with valuation in G10 is shown in the chart below. He constructed a sexy currency index based on rates, growth and the current account balance, and plotted those against purchasing power parity currency valuations form the OECD.
As can be seen, expensive currencies – the Norwegian krone, Australian dollar, Swiss franc, Swedish krona, New Zealand dollar and Canadian dollar – are also the sexy ones. Meanwhile, the pound and the euro have no sex appeal at all, with low rates, and little or no growth prospects.
On this measure, Juckes says the dollar, which has much better growth prospects than Europe in 2013, and is undervalued on a PP basis against the rest of G10 currencies, is the standout of unsexy currencies.
At the other extreme, he notes, the Swiss franc and the Australian dollar are too expensive relative to their obvious appeal, and the Norwegian krone is, surprisingly, cheap.
“I’m not going to blindly throw out trading strategies on the basis of these conclusions, but the picture helps to explain why in a risk-off market we want to sell the Australian dollar – indeed, short AUDNOK and short AUDSEK both appeal on this basis,” says Juckes.
“The Swiss franc is overvalued on almost any metric, notably against the Norwegian krone, and long USDJPY works.”
So, some food for thought from the early stages of sexy currency theory, but Juckes concedes it needs some work. He plans to introduce fundamental equilibrium exchange rates into the analysis and expand it to EM currencies.
Still, even in its infancy, sexy currency theory looks more attractive than currency wars.