Maraging Partners

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FX Forecast for Q1 2016: EUR/USD, USD/RUB, EUR/RUB

Ursus arctos marsicanus IV

The brown bear from the Apennines, Ursus arctos marsicanus, is chosen to personify the quarter and this means we expect EUR to get weaker in this quarter.

In Q4, the FRS raised the Fed Funds Rate, a key interest rate, for the first time since summer 2004. A number of measures had been tried by the Fed after the panic of 2008 in order to stimulate resumption of the economic growth by monetary means; those included keeping the Fed Funds Rate at a record - setting low level along with three rounds of quantitative easing, or campaigns to buy treasury paper using newly printed money.

During the period of low rates, investors took advantage of the cheap money to invest for the long haul, and entered the resource sector, including shale oil. While the credits were still cheap and dollar already expensive during and after QE3, natural resources became cheap, in a peculiar macroeconomic environment, helping foster economic growth through consumption. In Q4, shale oil companies were losing money but credit was still available, helping them to stay in business. As the rate hikes began, time is not working in favor of unprofitable resource extractors. It is possible that the recent investment theme of cheap resources is exhausted.

The growth in the official US employment figures, being chiefly due to low income occupations, those not contributing to long term value creation, while demand for high income ones flags, casts doubts on the thesis of the Main Street recovery, despite the phenomenal growth on the Wall Street.

Stagnation or a downward trend for the US stock market, this sole, so far, beneficiary of the quantitative easing, will become, in 2016, the last chance to jump start real consumption and real global multiplier, if the public converts the paper wealth of this market into cash to spend, in a hopefully gradual and controlled process. It's worth noting that for a global investor, purchasing US stock requires buying dollars, whereas under hypothetical conditions of broad global growth, it makes sense to diversify into international and perhaps emerging markets, which involves selling the US dollar. Stagnant US stock market will undermine the dollar bull's standing.

The point we made in the last issue about a possibility of ISIS (or whatever is left of it) turning south, toward the holy sites of Mecca and Medina and big Saudi oil, is believed to remain valid. In case of success, Russia's actions in the Middle East, can result, in Russia's objective interests, in creating a Shia buffer, consisting of Syria, Iraq, and Iran between the Sunni areas in Russia and Sunni monarchies of the Gulf, creating conditions for such a turn. The upward risk for oil under such a scenario is not, in our opinion, fully realized by the oil market.

Saudi Arabia's budget deficit threatens to destabilize internal politics of this country. A possible coup d'etat with the help of ISIS or without such help can threaten stability of the political mechanism known as petrodollar, as well as oil production as such.

In Europe, the inflow of migrants nurtures xenophobia. These "greater fools" in the job market drive down the salaries and thus create deflationary pressure that helps governments mitigate inflationary consequences of own inflationary activities (of managing own liabilities). However, the mechanics of that require that the immigrants be accepted in the society at least on some level as "new Europeans" with a eurodream. Xenophobia impedes this, turning the newcomers into mere users of the social "safety net". In that case their role is rather inflationary, weakening the euro.

The interest rate differential between the euro and the USD turns the former into a funding currency for global speculation and carry trade. For EUR/USD, this implies volatility and high degree of correlation with other sources of passive income, and puts EUR/USD under downward pressure (unless there is a risk off tide in the market, in which case the money flies back to the safety of the funding currency). Chinese renminbi joining the reserve currency club is a bad news for euro.

As far as RUB is concerned, we expect that the correlation between RUB/USD and oil will stay in place in Q4. Among the topics we discussed, only the thesis of the lack of success in the monetary restart of the US economy works for cheaper oil. But this thesis is not new. Betting for still cheaper oil looks risky. Strong dollar -- a key theme of 2015 -- will most likely be with us for one more quarter.

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 (October 5, 8 pm, Moscow time), the spot quotes were: EUR/USD: 1.088; USD/RUB: 76.11; EUR/RUB: 82.81.

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.

EUR/USD below 1.05 from 1.05 to 1.09 from 1.09 to 1.12 above 1.12
probability, % 39 26 20 15
USD/RUB below 74.50 from 74.50 to 77.40 from 77.40 to 80.40 above 80.40
probability, % 24 25 25 26
EUR/RUB below 79.20 from 79.20 to 82.40 from 82.40 to 85.70 above 85.70
probability, % 34 26 22 19