Preliminary signal: our model expects month-end flows to be strong USD selling across the board :
Global market risk sentiment has remained firm this month and equity markets have traded higher across the board. The USD has also recovered modestly, making gains mainly against the European currencies, likely reflecting market fears around the European political outlook. The US equity outperformance, when adjusted for market capitalisation and FX moves, suggests month-end portfolio rebalancing flows are likely to be strong USD selling across the board.
Based on our back-testing, as detailed in our report Introducing our FX Month-End Rebalancing model, we find the optimal strategy is to take positions only when the signal is strong (lower than -4.0 or greater than +4.0).
The FX Month-End Rebalancing model explained
The model is based on the concept that global portfolio managers have set benchmarks for currency hedge ratios and, as the value of their assets within their portfolio changes over the course of the month, portfolio managers will need to re-hedge their currency exposure, so that their currency benchmarks are maintained. Typically, these FX rebalancing flows are seen at the end of the month and usually their impact is felt most near the 4pm London fix on the last trading day of the month.
We look at the change in equity performance by market capitalisation for all G10 currencies, and we adjust this for monthly FX spot moves. This provides an indication of how the value of assets has changed over the course of the month and thus the extent of portfolio rebalancing flows that will likely take place at the end of the month. We generate a signal for all USD/G10 currency pairs indicating the expected direction and strength of FX month-end flows. The strength of the signal is dependent on the size of equity/FX moves over the course of the month, relative to previous history (from 2002). The signal is on a scale from +5 to -5. A signal of +5 indicates month-end flows are expected to be strongly USD/CCY positive, while -5 indicates flows are projected to be strongly USD/CCY negative.