As you know, every week, Splendid Exchange looks at seven major currency pairs in search of the evidence of popular delusions and the madness of crowds. The idea is to find anomalies and forex ranging pair or bearish divergences that will break the trend, not prolong it. It is a painful exercise, but also highly rewarding. In order to find the most overbought and oversold currency, I conduct four econometric studies: over-extension analysis, secular performance analysis, oil correlation and economic divergence.
Additionally, I look at traders’ positioning to understand the psychological state of the market. Latest Results Recently, I decided to expand the coverage of currencies. The main focus is still on the majors, but I will also briefly look at 18 other currencies. I will not go through the results of each of the studies, but instead illustrate the final ranking.
If you want to see the individual results of each of the studies, scroll down to the charts section below. I have ranked the currencies on the scale of -11. 5 for each of the studies, where -11. Therefore, the overall minimum score that any currency can have is -46. However, South African rand and the Japanese yen are not far behind, with 26 points each, followed by Chinese renminbi and Norwegian krone with 23 and 22 net points, respectively. British pound also stands out among overvalued currencies with 21 net points.
The most “underrated” or undervalued currencies are the Turkish lira and the Brazilian real with a total net score of -40 each. These two currencies are far behind their counterparts. The next closest currency in terms of undervaluation is Israeli new shekel with only -22 net point. Judging by the results of four econometric studies, the most contrarian trade is to buy Turkish lira or Brazilian real against Czech koruna or the British pound.
Concurrently, the decline in Brazilian real has been less severe. Is it risky to go long TRY and BRL against GBP and CZK? Absolutely, and not only because it is a contrarian trade, but also because these currencies are exotic. I am not recommending these trades and I am not going to comment on their fundamentals.
I am just saying that statistically, these are two most contrarian trades among 25 currencies that I analyze. When looking at the major currencies, we see that the picture has not changed quite noticeably since the previous update. British pound is now the most overrated currency among the majors, followed by Japanese yen and the euro. However, just as previously, all three currencies are relatively “expensive” for different reasons. GBP appears relatively undervalued in the over-extension study. The overall ranking picture is still quite mixed. If you are a contrarian investor, you will want to short the most overvalued currency against the most undervalued currency.
However, at this point in time, there are no clear leaders and no obvious laggards. That is why I decided to refine the results by applying two additional indicators: effective exchange rate and monetary sentiment. The most recent weights are based on trade in the 2011-13 period, with 2010 as the indices’ base year. As you can see from the chart below, Swiss franc has appreciated the most among its peers, while Canadian dollar is lagging behind. Monetary Sentiment The majority of central banks around the world pursue an inflation targeting approach to monetary policy.