Forex: Excessive values and half-lives – Deutsche Bank

Robin Winkler, Strategist at Deutsche Bank, explains that value-based FX strategies have struggled over the past year as the DB FX value index has underperformed their G10 and EM carry indexes at 3% versus 8% and 15%, respectively, and PPP misalignments have widened on average.

Key Quotes

“In G10 in particular, excessive valuations for USD, EUR, AUD, NZD, and JPY have all become more extreme. We argue that this lack of mean-reversion in G10 may be systematic, rather than coincidental, and that value strategies could perform more reliably in EM.” 

“Most value strategies buy and sell what’s cheap and expensive on PPP but ignore that misalignments in some currencies are stickier than in others. A simple strategy might sell CHF, AUD and NZD against GBP, JPY and MXN. But all of these currencies mean-revert extremely slowly and, with the exception of the peso, we cannot be statistically certain they mean-revert at all. By contrast, Asian EM currencies such as IDR, KRW, INR and MYR are less strongly misaligned, but the pull toward PPP is significantly stronger. One measure of the optimal mix between misalignment and speed of mean reversion is the expected correction over the next year. This measure currently ranges from 7% upside in MYR to 7% downside in IDR.  For G10 currencies, the largest expected correction is only 3% upside in SEK.”

“This sort of overlay may become more important as misalignments in real exchange rates—i.e. PPP overshoots—become more persistent. Over the past decade, the speed of mean reversion to PPP in a panel of the twenty most liquid currencies has fallen by a quarter compared to the previous decade. The best explanation is increasing global value-chain integration. For example, to correct a 10% overshoot in its real exchange rate, an economy needs to see a 10% nominal depreciation; but the more globally integrated the economy, the more this raises (imported) inflation or, if offset by monetary policy, attracts capital inflows. These second-round offsets are particularly strong in developed economies, the US being the obvious case in point.” 

“There are upshots for our macro views. In G10, lacking mean reversion in GBP and JPY supports our view that undervaluation in itself is not a bullish argument, just as it reinforces our caution in holding overvaluation against the Antipodeans. In EM, strong mean reversion supports our bullish views on cheap MYR, MXN, TRY or ZAR but also means that overvaluation is a tangible headwind to our constructive views on IDR and INR (though simple PPP valuations fail to account for high relative productivity growth).” 

“Lastly, pending further analysis, consider that a strategy of buying the three currencies with the greatest expected upside against the three with the greatest downside two-and-a-half years ago—the average half-life across the FX complex—would have yielded an annualized 5.8% return with a 0.88 Sharpe ratio. By contrast, just buying the three cheapest currencies against the three dearest ones would have yielded a negative Sharpe ratio of -0.14.”