Forget for a moment the possibility that today’s ‘Europhoria’ doesn’t really make a great deal of sense, when looked at in the round.
Something quite detailed about the EUR/GBP cross was mentioned which seems to have some fundamental and technical weight.
I’ll put it simply though, as that’s the only way I can.
As I type, the rate is pivoting around 0.8977, the odd tick or two lower on the session, but its recent major leg say since June 15th took it from the low 0.88s to near 0.90.
Even without what looks like the beginnings of retracement right now, there’s good reason to regard current prices as overvalued on a short-term valuation basis.
Some players at a major house at The Wharf regard fair value as closer to 0.8860 at present.
Short–term fair value is calculated using a regression model predicated on rate differential and relative credit spread.
Don’t worry, I will try to explain graphically.
The specific sum is derived by taking the spread of UK 5-year CDS and subtracting from it the French 5y CDS spread.
(Hint ‘peek’ the image, no need to download it.)
Extremity of over-valuation is measured by looking at the discrepancy between FX spot and model prediction and comparing it to the largest deviation over the last 3-months using a 3-month Z-score.
The deviation between the two tends to correct fairly swiftly over time.
So the idea is to enter short/long positions in the cross based on the model.
It was decided that the cross has to spend at least two days in overbought or oversold territory to trigger a Sell or Buy signal. The trigger levels are defined by values of the deviation Z-scores – 1.96 on the upside for a sell and -1.96 on the downside for a buy.
After the signal is triggered the position is held for a month. The position increases if extreme deviation of spot from model persists.
The average return from all trades (excluding carry) has been 1.5% since January 2010.
Now you know. (Too).