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FX Strategy

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Go short EUR/USD , EUR/CHF − long GBP/CAD

Tue, Nov 18 2008, 17:52 GMT
by Kasper Kirkegaard, John Hydeskov

Danske Bank A/S

• We recommend selling EUR/USD spot at 1.2650 for a move to 1.2050 (our short-term financial model estimate, see chart 1) and with a stop at 1.2850. The recent decline in oil prices has not been reflected in a lower EUR/USD spot rate (see chart 2). Moreover, we believe relative yields will move in favour of the dollar, as markets, in our view, still price too high a probability for just a moderate slowdown in the euro zone. While we see the Fed as close to the end of its monetary easing cycle, the ECB still has a long way to go. The USD has strong defensive characteristics and has historically fared well in times of trouble - the correlation between the USD and safe-haven darling CHF has risen dramatically since August (see chart 3). It is, furthermore, our expectation that repatriation flows, deleveraging and unwinding of speculative investments will continue to benefit the USD relative to the EUR.

• We recommend buying GBP/CAD spot at 1.8450 for a move to 1.9350 (our implied short-term financial model estimate, see charts 4 and 5) and with a stop at 1.82 The pound took a beating in a massive gilt sell-off - net outflows of foreign investment from UK fixed income instruments seen over the past two months wiped out about 75% of the net purchases that were seen between November 2004 and mid-September 2008. Furthermore, the BoE's downbeat Inflation Report did not provide much relief. We acknowledge that much of the weakness in the pound can be accounted for by the grim UK growth prospects - the UK economy will probably contract by as much as 1.5% y/y in Q109 - and the interest rate outlook, where the base rate will likely be lowered to around 1.5% within the coming months. That said, sterling is now meaningfully undervalued against most currencies: According to REER analysis (post- 1993, see chart 6), GBP/CAD is some 15% undervalued. With oil prices plummeting due to the global recession unfolding and near-term prospects still soft, the CAD has not been sold off to the extent we would expect given the country's oil extraction costs. Furthermore, the loonie has historically tended to suffer in global slowdowns. We advise establishing the position prior to the BoE Minutes on Wednesday at 10.30CET, as we expect the BoE was not as unified as generally perceived by the markets when it slashed rates by 150bp at its latest meeting. Note that GBP/CAD is a EUR/USD in disguise: Combining a short EUR/USD with a long GBP/CAD will most probably reduce potential reward/risk.

• We recommend selling EUR/CHF spot at 1.5160 for a move to 1.4600 (our short-term financial model estimate, see chart 7) and with a stop at 1.5360. The CHF has not benefitted as much against the EUR as we would expect when comparing to movements in other relevant asset prices, and even though a new spike in risk aversion is not our main scenario - which most likely would send the Swiss franc substantially stronger - we believe EUR/CHF will gradually correct towards its fair short-term level. Alternatively, we recommend preparing for a lower move in EUR/CHF via options: One way to position for a fall in EUR/CHF that is not driven by a new blow-up in the financial crisis (i.e. implied volatilities remain contained), would be through a reverse knock-out put-option with the barrier placed just below a support level (2 Week maturity, strike 1.51, barrier 1.44). Given the extreme risk reversal, this comes at a low price of105 CHF pips relative to the vanilla (190 CHF pips, indicative prices only), meaning that the break-even is just below 1.50.

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Published on  Tue, Nov 18 2008, 17:52 GMT