Maraging Partners


FX Forecast for Q1 2015: EUR/USD, USD/RUB, EUR/RUB

Ursus arctos marsicanus III

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.

Let us begin by analyzing the previous forecast. We saw that the USD/RUB exchange rate was driven in Q2 and Q3 mainly by the news related to the disintegration of Ukraine. Among the horrors anticipated by investors, there were: Russian troops deployed in the fashion of Czechoslovakia 1968 or even Afghanistan 1979, an escalation of the sanction war, and finally, a hot war between NATO and Russia in Europe. A naive investor who decided to wait for the events to sort themselves out in a nuclear bunker with no access to news other than currency quotes, would be forced to admit, by mid December at the latest, that the events took this course -- and would be totally wrong. Indeed, the entire theme of Ukraine has failed to generate a single piece of news capable of moving the markets for the entire quarter. We take this to mean that Ukraine is merely an instrument of influencing Russia. An instrument among others, and -- and we were accurate on that count -- a nearly exhausted one.

All events of this crisis confirm Donald Rumsfeld's thesis that it is important to separate known knowns, known unknowns, and unknown unknowns, with unknown unknowns making the biggest impact.

The fact that our forecast of Ukraine being an exhausted topic turned out to be the most successful part of our previous issue may indicate that Ukraine now lies somewhere between the known knowns and the known unknowns.

The broadly anticipated economic decline in Russia, whose impact on the value of RUB is, thanks to the ideological orientation of the country's economic leadership, far from certain, also belongs to the group of known unknowns.

Logically, we can not discuss unknown unknowns, but we can try to expand our field of vision in order to at least look at them unknowingly.

We will have to start with the fateful events of mid-seventies. Having closed the gold window, President Nixon gave birth to what became known as petrodollar, based on an agreement with Saudi Arabia. According to the agreement, the US provide protection service to Saudi Arabia, who in turn sells oil for US dollars. In itself, this does not guarantee the client state from the abuse, such as limitless emission of the currency by the protector state. This is unlike the various versions of the gold standard, where money used to be sort of a receipt for the gold on deposit. And even though the exact degree of such baking varied, qualitatively speaking, monetary emission was backed by the emission of gold.

The elegance of the petrodollar lies in the fact that the protection user side can to some extent guarantee itself from the abuse. The reason is that the protection user not only receives dollars in exchange for oil, but also reinvest some profits into the US Treasury papers. And because the normal US dollar emission mechanism consists in exchanging newly made dollars for us treasury bonds in the so called open market, the excess demand created by the protection user increases the price of the bonds, causing, everything else being equal, an excess in the emission of the dollars. Thus the protection client participates in the dollar emission and provides a feedback to the FOMC causing the latter to reckon with the client.

And it is through this feedback loop that the petrodollar is, in a certain very limited and conditioned way, backed by oil. One of the consequences of this backing is the negative correlation between oil price and dollar index. When dollar is expensive, oil is not, and vice versa. The petrodollar mechanism stabilizes oil price in other currencies, but not in dollars. With respect to dollars, there is a positive feedback loop whereby the system being left to itself goes out of equilibrium and can destroy itself. It is up to the regulating body, the FOMC, to prevent that from happening.

The simultaneous rise of the US dollar index and fall in the price of oil in Q4 and the FOMC tightening bias looks, in the light of the above, like a self-consistent story. The US debt overhang requires servicing and that makes the gang of FOMC and US lawmakers very amicable to the idea of continued emission. For that reason we could have underestimated their readiness to make short term sacrifices in the name of long term goals. Let's try to imagine ourselves in their shoes.

While in the seventies the petrodollar was offered Saudi Arabia in exchange for serious security guarantees, in the eighties the same mechanism -- just with Chinese mass market goods instead of oil, the sneaker dollar rather than petrodollar -- was sold to the Chinese without such guarantees. And in the nineties the same thing was installed in Russia, one is inclined to think, on even worse terms. As the protection market was being consolidated under the monopolistic hegemon, the US, the protection was getting more and more expensive... up to a certain point.

For at least a decade now the west has been watching Kremlin tightening state control over energy-related assets on the one hand, while Russian presence in these markets has been growing, on the other. This concerns oil, natural gas, the route of their transportation and, which is being much less talked about even though the process has gone even further, uranium and nuclear energy. While the BRICS cooperation mechanisms gain traction with the own development bank, own stabilization fund and dollar-free trade agreements, one can state that a new trend is gaining ground. The BRICS states grow strategically more and more independent, which may lead to a transformation of protection monopoly into protection oligopoly.

Saudi Arabia must have seen the declined influence of the Sunni minority in Iraq after Saddham as a threat, and their attempt to improve the game by using the Islamic state can be seen as part of the same trend of client states taking their own security into their own hands.

Among other Q4 news, Turkey joining the club of Russian gas transit nations will surely change Turkey's position on Syria, for the power change in Syria is in the critical path for supplying europe with cathar gas through a pipeline planned to go through Syria. Most likely, the agreement with Russia signifies new score in the Syria game, 2:0 in Russia's favor.

The multipolar world will imply competition of protection service providers with unavoidable cheapening of the service. Because in the dollar zone part of the protection fee is taken by washing away the value of the dollar, the competition will encourage strong dollar policy. The US will be no longer able to conduct monetary policy according to John Connelly maxim : "the dollar is our currency but your problem".

It is possible that this is behind the dollar strength we have been seeing since the spring of 2013.

Could the US rule out attempts by Russia and China to launch energy rouble or sneaker yuan, respectively? For Russia, the launch of the national payment system seems a necessary precondition. Another precondition is that Russian energy export must be strong enough in the prospective rouble zone.

But there are other necessary conditions. In order for the rouble to become a regional reserve currency, the following will have to happen.

Russian irreplaceable natural resources are sold for roubles which the buyer will first have to purchase in fx market. This means the level of rub demand as if the exporters converted all their revenue.

The trade partners develop a demand for investment instruments to store their strategic rouble reserves. Usually sovereign debt fulfills this role, since the risks are minimal, but stock market blue chips can do as well to some degree. This implies cheapening of credit and a stock market rally.

This demand can be satisfied without overheating the markets only by initiating large scale investment projects in Russia. This can be creation of transportation links connecting east with west across the continent, developing the northern passage infrastructure finally making the shortest sea link between east and west operational, development of Siberia with its vast natural resources. It is this unsurpassed rich agenda of things to do in Russia which makes the country a realistic reserve currency contender.

At the same time, the profitability of much of this agenda is linked to prices of raw materials which are currently set with active participation of the incumbent global reserve currency printer, the FRS. Therefore, credit tightening and deflation, consistent with strong dollar, are, from the point of view of the FRS, the natural remedy for countering such plans. This remedy has just one little downside: it forces the US to pay its bills in full and leave within its means.

Nevertheless, the recently provoked crisis around Ukraine partly solves, for the US, the problem of the bottom two agenda items of the energy rouble, since the appetite for investing in Russia in the west has been reduced down to a record low. We suspect that this was one of the main objectives of the operation codenamed "European choice of Ukraine ".

Even if we do not see any visible progress toward the energy rouble in Q1 of 2015 -- although nothing can be ruled out completely given how rapidly the events unfold -- such a serious elephant in the room may influence markets with its very presence.

Let us be clear, we do not believe that the hypothetical energy rouble is some type of haphazard Kremlin ' s response to the Western pressure. We believe that the pressure, including events in Syria and Ukraine is a response to the multi polarity threat and the suspected threat of the energy rouble, the latter response being so far successful in neutralizing the suspected threat.

As far as oil is concerned, we estimate that $60 per barrel makes deep sea drilling unprofitable (supply down by 6%). Shale oil is dead at the current prices of $50, may be even before that (supply down by 4%). The price of $40 will push the industry back to the technological level of the 1980 (supply down by 30%). Of course, every oil deposit is unique and has own economics, but these crude estimates illustrate what gloomy prospects for the world economy are implied by the current oil prices, if someone believes that these prices are sustainable. The narrative of North American economic recovery just does not hang together with these numbers.

Now to the Russian reasons for the currency panic in Q4. Lack of growth in the Russian stock market during qe3 has masked the fact that some dollar liquidity did get into the country but in the form of loans rather than riskier equity investments. It is vital to the US to launch a steadily working credit multiplier mechanism in the periphery of the capitalist system where the new capital is being created, so that some of it may come back to the US in the form of "safe haven" investment. Behind every panic there are economic actors who underestimated the risks. In this case some Russian borrowers underestimated the currency risks of their liabilities. The paradoxical reaction of the USD/RUB market to the interest rate hikes -- increased USD purchasing -- at first sight looked like madness or expensive extravagant behavior of some unknown owners of limitless liquidity, boundless risk appetite or boundless appetite for boosting own self-esteem at the expense of the Russian Central Bank. One of a few rational explanations, we believe, is that dollar debtors among the large Russian companies responded to the rising price of hedging (against stronger USD) by purchasing the hedging instruments even as those were getting more expensive, anticipating even higher costs of hedging due to possible other interest rate hikes yet to come, but not necessarily expecting the spot exchange rate -- which is just one pricing factor of these instruments -- to get worse.

We believe that the theory of quasi-sovereign debts which finds some supporters in the West is naive and ignores Russian realities. According to that theory, debts of Russian corporations with Russian state among the shareholders have to be added to the sovereign debt proper when analyzing the sovereign debt fundamentals, as if those corporations were some kind of king-makers in Russian politics, able to pull taxpayers money out of government pockets to cover own mistakes. Perhaps such are the political realities in the West and the western practices of 2008. Under modern Russian conditions, it is rather the political elite who are the king-makers in the Russian business, not the other way round.

We see three different scenarios of the events could unfold for the Russian economy in the nearest future. The reality may well become a mix of these.

Scenario 1. The collapse of the collapse.

The EUR/RUB exchange rate formed in the course of the currency panic makes the European import unaffordable for most buyers. Since European import is mostly durable goods, buyers decide to wait till better times. The declining demand for imports causes the demand of EUR (and Russian GDP) to decline. Meanwhile the exporters continue to convert their foreign currency earnings. The resulting lack of balance between supply and demand in the currency exchange market causes RUB to strengthen up the the comfortable level. The better times are back, and business as usual continues.

Scenario 2. Crimson Jackets 2.0

A new class of business emerges in Russia, businesses that successfully adapted to the new conditions. One can suppose that their success is rooted in their ability to replace high-tech European import on the basis of internal Russian resources. Their super-profits allow them (and with time, broader strata of the society who managed to make themselves useful to them) to consume at a totally new level. The GDP decline is not so large as it would be under Scenario 1. The RUB depreciation is significant, because Crimson Jackets are able to consume at the new prices. The Crimson Jacket economy creates RUB credit multiplier under the new conditions and the price inflation is making its way into the economy. A redistribution of wealth in the society takes place, and the refreshed Russian economy continues its growth on the basis of the new accomplishments, with the new RUB exchange rate and the new scale of prices.

Scenario 3. Crimson Jackets in China

Chinese use aggressive pricing to make their way into the Russian market. The consequences for EUR/RUB (and USD/RUB as a consequence) are almost like in Scenario 1. The consequences for the GDP are much better than in Scenario 1.

Shanghai Composite Index is up 40% for the quarter and it is possible that Chinese plants have already got new orders from Russia.

We believe that Scenario 2 is the least likely one, yet it is the scenario for which the majority of Russians are, on the basis of past experience, making themselves ready. The Crimson Jackets of the 1990s were so successful because they were solving a much easier problem: to satisfy demand for the import goods. To replace foreign import on the basis of domestic manufacturing is hard. And if everything boils down to letting the Chinese replace the Europeans, it is the Chinese who earn Crimson Jackets, and we get to Scenario 3.

Scenario 1 is attractive due to its simplicity, efficiency and the minimum of assumptions made.

Our Q1 forecast is that EUR will weaken considerably with respect to the USD and RUB while our outlook for USD/RUB is conservative.

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 (January 9, evening, Moscow time), the spot quotes were: EUR/USD: 1.18; USD/RUB: 61.69; EUR/RUB: 72.79.

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 1.14 from 1.14 to 1.18 from 1.18 to 1.21 above 1.21
probability, % 39 26 20 15
USD/RUB below 60.10 from 60.10 to 43.00 from 63.00 to 66.00 above 66.00
probability, % 24 25 25 26
EUR/RUB below 69.20 from 69.20 to 72.40 from 72.40 to 75.70 above 75.70
probability, % 34 26 22 19