Maraging Partners


FX Forecast for Q4 2014: EUR/USD, USD/RUB, EUR/RUB

Ovibos Moschatus II

The Ovibos Moschatus, a tough inhabitant of high latitudes, is again chosen to personify the quarter, which means we are going to justify our bullish stance on the Russian rouble.

The QE tapering conducted by the US Fed reminds us of the old "good guy -- bad guy" negotiation strategy. The Fed is playing both good and bad guys. By tapering the US Treasury debt purchases, the "bad" Fed is provoking the yield increase (recall that the yield is the higher, the lower is the price, which is formed by the balance of supply and demand with Fed being the buyer of the last resort.) Thus, a risk of yield increases across the entire spectrum of durations, down to short term ones, is created. The Fed appears on the stage wearing the good guy hat and, acting within its traditional mandate, purchases as much short term US debt as is needed to overcome this risk, maintaining the Fed Funds Rate on the target level of 0.25%. One is led to suspect that without the bad guy, this would have taken a lot less liquidity. Thus, the cash injection continues by combined efforts of good and bad guys.

Note that there has been no real growth in the yields of the 10 year US bonds in the Q3, despite all the talk about the effects of tapering. By forming and maintaining the expectations of rises in yields with no correspondence in reality, the US Fed is able to maintain faith in the world reserve currency while pumping up the supply of the currency. Meanwhile, strong dollar is not as dangerous to the US economy as strong euro is to the European one, strong yen is to the Japanese one or strong rouble is to the Russian one. That is because unlike the named economies, the US is an import - based economy having a current account deficit with the rest of the world.

By comparing the S&P500 stock market index with Russell 2000, the broader market one, we conclude that the US are not believed to be the cradle of economic growth: the Russell 2000 in which domestic companies dominate has shrunk for the quarter, while the S&P500 whose companies are large enough to sell worldwide has continued to grow. Apparently investors place their hopes in the emerging markets. Indeed, these countries, with the exception of Russia, have seen their stock markets grow.

The impact of the civil war in Ukraine and the sanction exchange between Russia and the West deserves a special analysis. Having annexed Crimea, Russia has put Ukraine in a situation of having territorial claims on Russia. These claims on the neighbour's land make Ukraine a potential pain in the neck and a source of security risks for any defensive alliance the country may want to join in the future -- with the exception of pro - Russian ones, of course, thus guaranteeing the non-allied status at least as far as the NATO is concerned. The price Russia is paying for that is the existence of an excuse for putting political and economic pressure on her. The existence of the pro-Russian Donbass as a frozen conflict or as an unrecognized state changes nothing in this balance, while generating a stream of traumatic news fanning the flames of the information war.

The goal of the American provocation with Ukraine's "European choice" was gaining an excuse for putting pressure on Russia. This goal is now accomplished, but it must be credited to the Kremlin that Russia now has real -- not to be confused with legal ones -- guarantees of Ukraine being outside the NATO as long as the Crimea is Russian. Therefore Ukraine has become unable to conduct "multivector" foreign policy, the pro - NATO vector, outside PR actions, is disabled, thus the resulting vector sum has also changed. And Z. Brzhezinski was not offering Russia any concessions at all when he offered to agree on a "finlandization" of Ukraine. On the contrary, this international relations experts, who is believed to belong to the realistic school, was bluffing, suggesting to negotiate an issue which is strongly predetermined to be resolved to Russia' s satisfaction in the due course of time without such talks. All of this explains such a limited level of Russia's involvement in the civil war in Ukraine. The Kremlin acts in the true Machiavellian spirit: overt forceful actions (they were limited to Crimea) must reach their goals quickly, while deliveries of humanitarian aid can continue for a long time.

In response to the Western sanctions, the Russians are setting up the stage for import replacement, creating, on their own and within BRICS, the duplicates for the key elements of international financial infrastructure, building up gold reserves, in short, preparing the country to sail in an autonomous regime, which can be described as survivalism on the national level. Indeed the survivalist movement calls on the individuals and families to achieve the level of autonomy sufficient to survive a collapse in social infrastructure, including that of security and material well being. A typical survivalist strategy is for the "sovereign individuals" to form the so called covenant communities, which respond to challenges according to the slogan "one for all, all for one". The character of Russia's response to sanctions sheds new light on the causes of the events, and in this light, the geopolitical fight of dogs under the carpet resembles a struggle for better starting positions for entering some looming calamity which might involve a collapse of the modern americano-centric financial and security infrastructure. One can suspect that it this "prepping" -- which involves, through the BRICS mechanisms, other resource-rich nations -- that became the primary irritant for the US, and the hegemon responded by attempting to single out Russia from the nascent covenant community of BRICS and to beat her up in front of the rest.

One may expect that the survivalist technics, including those of economic survival, will be becoming more and more topical on the level of nations, corporations and even individuals. Survivalist investment tools have been traditionally real assets and diversified currency portfolios biased towards currencies of resource-rich countries, countries with low debt to GDP ratios, and away from USD. But perhaps the time scale of such recommendations exceeds that of a single quarter.

Speaking about Europe and the EUR, we leave our thesis from the past issue intact. Namely, there are two ways out, one is at the expense of the rentiers, the other -- at the expense of the "new fools". As the new fools are getting harder to find, the rentiers prospects deteriorate. The money printing decision is becoming easier to make due to the absence of inflation, while the trend towards the closing of the Russian market is outright deflationary.

Only two reasons make us assume a neutral position on EUR/USD in the coming quarter. First, the record high open interest in the futures market favors a pause in the trend. The second factor is more in favor of EUR/USD, but in our closed portfolio of the three futures contracts, gets passed on to EUR/USD. That is the seasonal growth in foreign trade in Russia, including the purchases of durable goods by state budget related companies at the end of the year. This by the way may work for other countries and not just Russia.

As we noted in the previous issue, investing in Russia brings about risks of own government reprisals for the residents of Euro - Atlantic countries. Investors able to enter Russia under the radars of Euro - Atlantic governments, for example, via Hong Kong or Singapore, find themselves in an exceptional position and, according to market laws, are reaping a peculiar form of rent, known as protection rent. Today's exceptionally low rouble exchange rate reflects not so much the macroeconomic and geopolitical risks to Russia's economy -- after all, these have not gotten worse because of a territorial enlargement -- as they provide the protection rent, creating a super - attractive entry point for such investors. This rent is paid for largely by those who create the artificial entry barriers responsible for the protection rent. The payment is a form of an opportunity cost. The exceptional position of such investors is unlikely to last long, because the laissez faire investment climate of these jurisdictions can easily attract more participants. This is a question of changing the business domicile, and for many investors with interests in Russia, who control, as we know, capitals of Russian origin, already re - domiciled at least once, this is a question of time. In such a scenario, the rouble weakness which is part of the mechanism of the protection rent, will also be short lived. Thus the barriers called upon to create artificial costs for Russia, in fact, amplify and accelerate the Eastbound exodus of wealth and power from the West.

It seems to us that one of the investment themes of the Q4 will be monetization of the protection rent. To be able to take part in this process, one has to begin selling USD and EUR forward already today.

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 6, around 21:00 Moscow time), the spot quotes were: EUR/USD: 1.2595; USD/RUB: 39.82; EUR/RUB: 50.16.

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 1.22 from 1.22 to 1.26 from 1.26 to 1.29 above 1.29
probability, % 25 25 25 25
USD/RUB below 38.60 from 38.60 to 40.00 from 40.00 to 41.40 above 41.40
probability, % 32 26 23 19
EUR/RUB below 48.70 from 48.70 to 50.10 from 50.10 to 51.60 above 51.60
probability, % 33 26 22 19