It will surprise few that EUR/USD has significantly underperformed the gold price (expressed in US dollars). The result has been a decreasing price of the commodity pair: long EUR/USD:short gold.
The graph below shows the performance of a pair ratio of EUR10,000 of EURUSD (long) to 10 oz gold (short).
The gold price has been fairly flat since early 2014: the decrease in the price of the pair has reflected steep falls in EUR/USD.
Over the last week, EUR/USD rose 3.7% (to $1.0964) whilst gold firmed 2.9% (to $1,188) to give a 0.8% increase in the price of the pair. This was accompanied by a 5.7% increase in its fair value, driven by the factors analyzed in the table below:
The excess of fair value increase over price increase would normally be a signal to buy the pair (buy EURUSD:sell gold). Following this signal over the last 90 days would have provided an annualized gain (on gross – long plus short - exposure) of 40.8% with volatility of 9.8%.
We have also applied this methodology to a number of other pairs of related securities – oil/natural gas, DAX/S&P 500, palladium/copper, ASX 200/FTSE and CAC 40/Nikkei. The portfolio of all these pairs traded using the disparity between price and fair value change (as above) has returned an annualized 32.3% with volatility of 8.1% over the 90 day backtest period.
We find a fair value of the EUR/USD:gold pair below the current price, suggesting that the pair is overvalued and providing the opposite signal to that analyzed above. Trading the pair using this indicator over the 90 day backtest period showed an 18% annualized return with volatility of 10%. For the portfolio of pairs described above, the annualized return was 10% with volatility of 9%. Hence, we note the signal, but tend to discount it in favor of the stronger performing price/fair value change disparity indicator.
Relationship to drivers and volatility
The graph below shows the sensitivity of the pair’s fair value to its drivers:
The long EUR/USD:short gold pair is on balance negatively correlated to the US dollar (despite the gold price being negatively correlated to USD). Our fair value indicators now suggest some short term downside in the US dollar index which would assist the pair trade recommended above.
The USD may undergo some volatility this week if any of the US February CPI (tonight), durable goods orders and/or Q4 GDP reads come in some distance from consensus. Given the sensitivity of the pair to the USD evident in the above graph, this could translate into volatility in EURUSD and the gold price.
However, the historical volatility of the pair over the last 90 days, at 9.8%, is lower than the volatility for either EUR/USD (13.4%) or gold (16.0%) individually. This reflects some positive correlation between the two and hence risk netting by pairing them.
Held in combination with a US equity portfolio, lower volatility and higher return may be achieved. A portfolio of 5% allocated to the pair (traded as recommended in this article) and 95% allocated to the S&P 500 index had a volatility of 12.1% over the last 90 days vs 12.8% for 100% in the S&P 500. The annualized returns were 9.2% (5% allocated to pair) vs 8.2% (100% S&P 500).