Risk aversion is likely to extend through February in the forex markets, with fundamental trends suggesting to buy the Japanese Yen and sell the Australian Dollar.

Although the Yen is highly overvalued, it is not burdened with substantial rate cut expectations and was the best performing currency against USD last month. Further, continued deleveraging across financial markets will bring yet more unwinding of Yen-funded carry trades. This means it will be some time before the dire state of the Japanese economy meaningfully weighs on the low-yielding currency. While the Canadian Dollar scores equally well, the Loonie is now marginally undervalued against its implied “fair” exchange rate and still faces meaningful downward pressure from adjustments in the yield spread.

Looking at the other end of the spectrum, the Australian Dollar is the weakest of the bunch. Although the currency is undervalued, a bullish correction in the near to medium term seems very remote. The Aussie was the second-worst performing currency against the US Dollar in January and remains threatened by comparatively large interest rate cut expectations. Finally, a trade-weighted index of the Aussie’s value now shows a whopping 98% correlation with the MSCI World Stock Index, suggesting that any move away from risky assets will weigh heavily on the antipodean currency.  If you are looking for more information about online trading, please check out this Online Trading Guide. It has some great free resources.
*** The basis for the concept of currency valuation using yield, value, and momentum was originally proposed by Bilal Hafiz of Deutsche Bank AG.

How we rank currencies:

Value – Purchasing Power Parity (PPP)

One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by the Organization for Economic Cooperation and Development (OECD). We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar, then rank them from 1-7 based on the idea that we want to buy the cheapest (most under-valued) and sell the most expensive (most over-valued) currencies vis-à-vis the greenback. Currencies overvalued against the Dollar are denoted in RED, while those that are undervalued are denoted in GREEN.

Yield – 12 Month Interest Rate Expectations

Central bank interest rates reflect the return an investor can earn by owning the corresponding currency. This typically drives up demand for currencies that pay higher interest and reduce demand for those that do not. Because markets are forward-looking, traders tend to focus on interest rate expectations as indicative of future demand for a given currency, with higher rates tending to cause appreciation and vice versa. For the purposes of relative ranking, we look at overnight index swaps to gauge the market’s expectations for changes in the difference between the US Fed’s interest rates and those of the top 7 major currencies over the next 12 months. We then rank them 1-7, assigning the lowest (least favorable) scores to those that will see the yield gap shift the farthest in favor of the US Dollar. Changes in favor of USD are denoted in RED, while those in favor of the currency in question are in GREEN.

Performance – Monthly % Change vs. US Dollar

It is important to recognize that sometimes currencies make significant moves without a clearly defined catalyst. Rather, price action feeds on its own inertia to pick up strong directional momentum. To capture this and include it in our valuation, we rank each currency based on its accomplishments against the US Dollar in the previous week and assign a score of 1-7 with the highest marks going to the best performer.

Ilya Spivak is a Currency Analyst for DailyFX.com. Please send your questions and comments to ispivak at dailyfx dot com.

This entry was posted on Wednesday, February 4th, 2009 at 6:57 pm and is filed under Australian Dollar, British Pound, Canadian Dollar, Currency Trading, Euro, Japanese Yen, US Dollar. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.