Four themes, eight trades - and a wild card
For the seventh time, we present our year-end FX Top Trades for the coming year. The 2016 publication is based on four themes that we think will drive FX performance in 2016: (i) Monetary policy surprises , (ii) Fundamental misalignments , (iii) Carry trades revisited , (iv) Volatility . In addition, we have a ' Wild card ' which is our tail-risk scenario.
Monetary conditions are set to tighten over the coming years. Market pricing leaves scope for hawkish EUR, CZK and AUD surprises. However, the ECB December meeting might spark domino effects of easing even before 2016.
Our Medium-term Valuation (MEVA) model suggests EUR/USD and GBP/USD are very undervalued, while PPP points to EUR/Scandies as overvalued. Fading policy divergence and/or stretched positioning should trigger fundamental corrections higher in GBP/USD, EUR/USD and lower in EUR/Scandies.
We expect implied FX at-the-money volatility to remain high and volatile going into 2016 but to level off throughout the year along with a decline in the US dollar, less macro uncertainty and accommodative monetary policy.
The expansion of ECB and BoJ balance sheets should maintain downward pressure on EUR and JPY funding costs. Improving fundamentals and undervalued exchange rates make carry-to-vol attractive in selective EMs such as TRY, BRL, ZAR, RUB and PLN.
In our wild card scenario, China slows sharply while the Fed is forced to raise rates aggressively as the labour market tightens. This would result in a stronger USD and weaker CNH, BRL, CLP and RUB.
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