Maraging Partners

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FX Forecast for Q3 2015: EUR/USD, USD/RUB, EUR/RUB

Bos primigenius

A bull of the prehistorical and now extinct species, Bos primigenius, who used to inhabit Europe, is chosen to personify the third quarter of 2015.

The paradigm of a zero sum game is becoming more and more helpful in making forecasts as the global crisis is unfolding. China’s plan to resurrect the Great Silk Road -- a large scale, long term infrastructure project in Eurasia -- comes with obvious geopolitical content. The cheapening of continental transportation in relation to the maritime alternative pushes the imaginary border between heartland and rimland outwards toward the oceans, redistributing zones of influence. Because globalization was imagined to proceed inward, being an expansion of a maritime power inside the continent of Eurasia, this alone allows us to state that the uncontested phase of americano-centric globalization is over.

Moreover, every dollar, invested by China into continental infrastructure projects, is the dollar directed away from the US Treasury market, the dollar that failed to boost the demand for these instruments, the dollar that did not help depress the US interest rates. Under such circumstances, a good strategy for the US Treasury would be to have the FRS claim that the rates are rising because there is FRS policy behind that. An alternative to that is another round of the QE. The equities bull market in the US has been nothing short of phenomenal and we can not say that the public had not been being prepared to expect higher interest rates. Rather, it is the zero sum nature of the geopolitical game that the public, we believe, does not fully appreciate. On this level of valuation, a 20-30% correction in the US stock market might be the least of the problems decision makers face. On the contrary, it would become a convincing and, more importantly, a politically correct argument in favor of launching another round of QE.

But we are only interested in the stock markets in the context of currency forecasting. In the deglobalizing world, a crash of the developed stock markets might not cause a flight into US dollars this time around, since those who would have done it under old normal conditions, seem to be already in dollars. Instead, such a crash might cause the interest in the currency of the North American country to decline.

Another old normal topic that surfaced recently is the cold-war US habit of curing its current account surplus by deploying military infrastructure, personnel, and related spending abroad. This looks anachronistic today, since the surplus has long time ago given way to a deficit, and to medicine to cure the deficit would look exactly the opposite: German military on the US soil -- something that will not happen in Q3 -- and not US infrastructure in Europe.

The influence of Greek situation on the financial markets -- and according to a German saying, a horrible end is better than endless horror -- is moderated by the active EAPP (European QE program). It seems to us that the broad public coverage of the noisy and scandalous euro - divorce creates what looks more like an opportunity to buy, rather than to sell euro. Any steps by Greece away from the EU will increase risks for Greece and decrease them for the EU. Because euro is above all a European, and only then greek currency, it is logical to buy it.

It is quite interesting to look at the unfolding European scandal from the standpoint of futurology. The break up lines go between protestant countries on the one hand and more traditional Christian confessions -- the infamous PIIGS group -- on the other. And if we recall the recent Scotch referendum, it's between Celts and Germans. Divisions along such old lines are bad news for any progressist, leftist, multiculturalist scenarios of the future, and good news for any ones of the future-as-the-past variety.

We believe that future-as-the-past has a serious constituency among those whose influence is strong enough but who are worried by the growing global unpredictability. If governments "sell" protection services for taxes, these could be large and old buyers -- not to be confused with contractors of those protection services, another large constituency with often different interests. Sometimes we playfully refer to such futuristic project as steam-punk. Asian societies and societies with rudiments of tradition will feel at home in steam-punk, while advanced former colonies without much past, the likes of the US, less so. The alignment of powers around the euro - scandal will shed some light on how much backing there is for the competing versions of the future. But what we see so far does not bode well for the US dollar and globalization which we view as a contractors' project at this point.

By the way, the very name -- Great Silk Road -- makes it hard not to get the hint at future-as-the-past vision behind the Chinese project.

As profitabilities of the Russian OFZ bonds dropped 500 points below the level of inflation, we end the story which we entitled "the collapse of the collapse " just two quarters ago. The OFZ -- who could imagine that back then -- are overbought, and financial repressions gripping the first world have come to Russia. Perhaps rouble is overbought, too. Financial repressions are always a way of forcing to invest, which may not be a bad thing for the oversold Russian equities.

Effective February 2013, our correlation analysis of the Russian future market, called FORTS, has been expanded into a separate analytical product, Market Correlations, to which we refer the interested reader. The review is issued monthly, and since Q4 2013, in English.

In USD/RUB and EUR/RUB, the futures premium (the spread between the futures and spot quotes) makes the profit/loss of the position include (but not be limited to) the profit (if selling USD/RUB or EUR/RUB futures) or loss (if buying the same) caused by the interest rate differential. As time goes on and the contract's expiry date approaches, the futures premium narrows and the buyer of the RUB realizes the futures premium. We always take these facts into account when developing the hedging strategies: given the present level of the interest rate differential, one has to have very strong reasons to buy USD/RUB or EUR/RUB futures for three months. On the contrary, carry trade strategies, those based on the interest rate harvesting, in a combination with intra-day systematic position adjustment, within the constraints of the given risk quota, form the basis of our Active Management service.

Interval boundaries corresponds to quartiles of the distribution, built according to the efficient market hypothesis. Probabilities in the table take into account the expert opinion formulated in the text. When the work on the forecast was over (July 6, 8 pm, Moscow time), the spot quotes were: EUR/USD: 1.108; USD/RUB: 56.58; EUR/RUB: 62.67.

A model position in each currency pair is proportional to the difference between probability sums of two right and two left fields of the table below. So, when the probability sum in the two right fields exceeds the sum in the two bottom ones, the futures contract is bought, in the opposite situation it is sold. The historical track record chart will be updated in the middle of the quarter.

EUR/USD below 1.07 from 1.07 to 1.10 from 1.10 to 1.13 above 1.13
probability, % 22 24 26 28
USD/RUB below 54.70 from 54.70 to 57.70 from 57.70 to 60.70 above 60.70
probability, % 21 24 26 29
EUR/RUB below 59.60 from 59.60 to 62.70 from 62.70 to 65.90 above 65.90
probability, % 19 23 27 32