Short-term valuation models signal upside risk for the JPY, AUD & SEK - MUFG

Lee Hardman, Currency Analyst at MUFG, suggests that the foreign exchange market can be driven more by year end flows and positioning during the less liquid holiday period at the expanse of traditional fundamental drivers.

Key Quotes

“The euro’s sharp move higher overnight which lifted EUR/USD from just below the 1.0500-level to an intra-day high of 1.0653 has provided another good example of the potential for outsized moves in less liquid markets. There has been no clear fundamental trigger for the euro’s sharp adjustment overnight. Bloomberg has reported that “a rush of computer-generated orders caught traders of guard”.”

“At this time of year, we always find it useful to update our short-term valuation models to assess if any G10 FX spot rates have diverged materially from traditional short-term fundamental drivers. One of the largest divergences which has opened up is between the current spot rate for USD/JPY and our short-term valuation model estimate which comes in between the 110.00 and 115.00 levels. The spot rate is currently trading at around two standard deviations above our model estimate. The current spot rate is very stretched signalling significant downside risk for USD/JPY in the near-term. Yen weakness appears to have overshot short-term fundamentals during December which helps to explain why USD/JPY has started to trade more heavily this week. A fresh fundamental catalyst will likely be required to justify an extension of USD/JPY’s recent upward momentum towards the 120.00-level. All eyes will be on President elect Trump’s inauguration on the 20th January.”

“In contrast, the scale of the euro’s recent decline appears more in line with short-term fundamental drivers. Our model estimate signals that risks for the euro are still skewed to the downside in the near-term with the sharp move higher overnight more likely to prove temporary. A potential test of parity for EUR/USD may even occur sooner than we are currently anticipating during Q2 of next year.”

“The other main divergences which have opened up between the current G10 spot rates and our short-term valuation model estimates is for the Australian dollar and Norwegian krone which both appear significantly weaker than implied by fundamental drivers. The supportive impact of higher commodity prices does not yet appear to be fully reflected in current spot rates. Our short-term valuation models estimate that AUD/USD should be trading just above the 0.7400-level and EUR/NOK just above the 8.8500-level based on short-term fundamental drivers signalling upside risks for the Aussie and krone in the near-term.”