GlobalMacro                                                                                                               ...
30 November 2010               Exchange Rate PerspectivesTable of ContentsCurrency Forecasts.................................
30 November 2010                    Exchange Rate PerspectivesCurrency ForecastsIndustrialized Countries                  ...
30 November 2010                 Exchange Rate Perspectives                                                      G10 FX Fo...
30 November 2010      Exchange Rate PerspectivesFX ViewsG10 ViewsEuroThe single currency has been weighed by continuous vo...
30 November 2010      Exchange Rate PerspectivesNorwayNorges Bank rhetoric/projections remain committed to maintaining pol...
30 November 2010      Exchange Rate PerspectivesKoreaGeopolitical concerns, and global risk-aversion have weighed on the w...
30 November 2010      Exchange Rate PerspectivesEMEA ViewsCzech RepublicAs with the rest of CE-3, the Czech economy is ben...
30 November 2010      Exchange Rate PerspectivesIsraelTrend appreciation (vs USD) has picked up from around 1% per month, ...
30 November 2010                    Exchange Rate Perspectives                                                      10 Les...
30 November 2010               Exchange Rate Perspectives                                          3% compared to expectat...
30 November 2010   Exchange Rate Perspectives                              inception. So it would appear to us that market...
30 November 2010    Exchange Rate Perspectives                               due to an elevated perception of counterparty...
30 November 2010   Exchange Rate Perspectives                              hedge its portfolio outflows to major markets l...
30 November 2010    Exchange Rate Perspectives                               Latvia 5yr CDS vs Periphery – past 2yrs      ...
30 November 2010             Exchange Rate PerspectivesChange in Headline Inflation Across G10                            ...
30 November 2010    Exchange Rate Perspectives                                   6.   Small Perceived High-Beta FX Do the ...
30 November 2010   Exchange Rate Perspectives                              No Signs of Stress in European Financials      ...
30 November 2010    Exchange Rate Perspectives                               Since then, however, the economic recoveries ...
30 November 2010            Exchange Rate Perspectives                                       as we write this, but the wil...
30 November 2010             Exchange Rate PerspectivesDebt/GDP across the G10                                            ...
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  1. 1. GlobalMacro Special Report 30 November 2010 Exchange Rate Research Team Global Markets Research Bilal Hafeez Perspectives Strategist (+44) 20 754-70354 bilal.hafeez@db.com Alan Ruskin Macro strategist (+1) 212 250-8646 alan.ruskin@db.com 10 Lessons From 2010 Henrik Gullberg Strategist (+44) 20 754-59847 henrik.gullberg@db.com George Saravelos Strategist (+44) 20 754-79118 george.saravelos@db.com Mirza Baig Strategist (+65) 64235930 mirza.baig@db.com Dennis Tan Strategist (+65) 6 423-5347 dennis.tan@db.com John Horner Strategist (+61) 2 8258 2130 john.horner@db.com Foreign Exchange Deutsche Bank AG/London All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 007/05/2010
  2. 2. 30 November 2010 Exchange Rate PerspectivesTable of ContentsCurrency Forecasts............................................................................................................................................................ 3FX Views ............................................................................................................................................................................ 5The Big Picture: 12 Lessons From 2010 ...................................................................................................................................10Monitors: G G10 FX Valuation Monitor: Lines in the sand .........................................................................................26 Capital Flows and Basic Balances................................................................................................................29 Commodity Price and Currency Monitor. ...................................................................................................39 U.S. Trade Balance Monitor..........................................................................................................................44 Central Bank Reserves Currency Composition Monitor ............................................................................50Page 2 Deutsche Bank AG/London
  3. 3. 30 November 2010 Exchange Rate PerspectivesCurrency ForecastsIndustrialized Countries Asia Spot 3M 6M 12M Spot 3M 6M 12M Cu rre n cy Rate Cu rre n cy Rate U S $ Ex ch an ge Rate s China CNY/USD 6.66 6.57 6.49 6.35 U.S. DB US$ Index 68 66 64 69 (Fwd. Rates) - 6.65 6.61 6.54 - - - - Euro US$/Euro 1.31 1.38 1.45 1.30 Hong Kong HKD/USD 7.77 7.80 7.80 7.80 (Fwd. Rates) - 1.31 1.31 1.31 (Fwd. Rates) - 7.76 7.76 7.76 Japan Yen/US$ 84 80 75 78 India INR/USD 45.9 43.6 43.0 42.4 (Fwd. Rates) - 84 84 84 (Fwd. Rates) - 46.7 47.3 48.3 U.K. US$/£ 1.56 1.59 1.58 1.53 Indonesia IDR/USD 9,028 8,880 8,820 8,700 (Fwd. Rates) - 1.55 1.55 1.55 (Fwd. Rates) - 9,091 9,209 9,403 Canada C$/US$ 1.02 1.03 1.05 1.10 (Fwd. Rates) - 1.02 1.03 1.03 Malaysia MYR/USD 3.16 3.05 3.02 2.95 Australia US$/A$ 0.96 0.96 0.95 0.85 (Fwd. Rates) - 3.18 3.18 3.18 (Fwd. Rates) - 0.95 0.94 0.92 Philippines PHP/USD 44.31 42.0 42.0 41.5 N.Z. US$/NZ$ 0.75 0.75 0.72 0.67 (Fwd. Rates) - 44.3 44.3 44.3 (Fwd. Rates) - 0.74 0.73 0.72 Singapore SGD/USD 1.32 1.27 1.26 1.23 Switzerland Sfr/US$ 1.00 0.98 0.93 1.08 (Fwd. Rates) - 1.32 1.32 1.32 (Fwd. Rates) - 1.00 1.00 1.00 South Korea KRW/USD 1,165 1,110 1,070 1,050 Eu ro Cross Rate s (Fwd. Rates) - 1,170 1,170 1,170 Japan Yen/Euro 110 110 109 101 Taiwan TWD/USD 30.4 29.8 29.5 29.3 (Fwd. Rates) - 110 110 109 (Fwd. Rates) - 30.3 30.1 29.8 U.K. £/Euro 0.84 0.87 0.92 0.85 Thailand THB/USD 30.3 29.5 29.3 29.0 (Fwd. Rates) - 0.84 0.84 0.84 (Fwd. Rates) - 30.3 30.3 30.3 Switzerland Sfr/Euro 1.31 1.35 1.35 1.40 Source: Datastream, Reuters, Bloomberg Finance LP, DB forecasts (Fwd. Rates) - 1.31 1.31 1.30 Norway Nkr/Euro 8.11 8.00 7.80 7.60 (Fwd. Rates) - 8.14 8.17 8.23 Emerging Europe Sweden Skr/Euro 9.18 9.00 8.50 8.20 Spot 3M 6M 12M (Fwd. Rates) - 9.20 10.17 10.16Source: Datastream, Reuters, Bloomberg Finance LP, DB forecasts Cu rre n cy Rate Czech Rep. Koruna/Euro 24.9 25.2 25.0 24.5 (Fwd. Rates) - 24.9 24.9 24.9 Koruna/US$ 19.0 18.7 18.5 18.3Latin America (Fwd. Rates) - 19.1 19.1 19.1 Spo t 3M 6M 12M Hungary Forint/Euro 284 275 275 275 Cu rre n cy Rate (Fwd. Rates) - 287 290 295Argentina ARS/USD 3.93 4.04 4.16 4.41 Forint/US$ 217 190 192 206 (Fwd. Rates) - 4.02 4.15 4.42 (Fwd. Rates) - 219 221 225Brazil BRL/USD 1.72 1.65 1.70 1.75 Poland Zloty/Euro 4.11 3.87 3.82 3.72 (Fwd. Rates) - 1.76 1.79 1.87 (Fwd. Rates) - 4.13 4.15 4.20Chile CLP/USD 487 495 500 505 Zloty/US$ 3.13 2.67 2.69 2.82 (Fwd. Rates) - 491 495 502 (Fwd. Rates) - 3.15 3.17 3.21Colombia COP/USD 1,922 1,810 1,790 1,780 Russia Ruble/US$ 31.36 30.3 29.8 28.7 (Fwd. Rates) - 1,920 1,923 1,941 (Fwd. Rates) - 31.7 32.0 32.7Mexico MXN/USD 12.5 12.6 12.7 12.8 Turkey Lira/US$ * 1.51 1.45 1.55 1.60 (Fwd. Rates) - 12.6 12.6 12.6 (Fwd. Rates) - 1.53 1.55 1.59Venezuela VEF/USD 4.29 4.30 5.50 5.50 South Africa Rand/US$ 7.16 7.05 7.15 7.51 (Fwd. Rates) - - - - (Fwd. Rates) - 7.26 7.35 7.54Source: Datastream, Reuters, Bloomberg Finance LP, DB forecasts Source: Datastream, Reuters, Bloomberg Finance LP, DB forecastsDeutsche Bank AG/London Page 3
  4. 4. 30 November 2010 Exchange Rate Perspectives G10 FX Forecasts: End of Quarter La tes t 2010 2011 2012 2013 29 No v , 10 end - Q4 end - Q1 end - Q4 end - Q4 end - Q4 USD-crosses EU R/U SD 1.31 1.38 1.45 1.30 1.25 1.20 U SD /JPY 84 80 75 78 90 90 G BP/U SD 1.56 1.59 1.58 1.53 1.49 1.45 U SD /CH F 1.00 0.98 0.93 1.08 1.14 1.21 AU D /U SD 0.96 0.96 0.95 0.85 0.73 0.70 N Z D /U SD 0.75 0.75 0.72 0.67 0.61 0.58 U SD /CAD 1.02 1.03 1.05 1.10 1.10 1.18 U SD /SEK 7.00 6.52 5.86 6.31 6.48 6.67 U SD /N OK 6.19 5.65 5.31 5.85 6.00 6.25 EUR-crosses EU R/JPY 110 110 109 101 113 108 EU R/G BP 0.84 0.87 0.92 0.85 0.84 0.83 EU R/CH F 1.31 1.35 1.35 1.40 1.42 1.45 EU R/SEK 9.18 9.00 8.50 8.20 8.10 8.00 EU R/N OK 8.11 8.00 7.80 7.60 7.50 7.50 Source: Deutsche BankPage 4 Deutsche Bank AG/London
  5. 5. 30 November 2010 Exchange Rate PerspectivesFX ViewsG10 ViewsEuroThe single currency has been weighed by continuous volatility in the Eurozone peripheral bond markets, reversing all the gainsseen since the market began pricing quantitative easing from the Federal Reserve. With Ireland now having resorted toIMF/EU financing and European policymakers providing greater clarity on the European Stability Mechanism after 2013, ourbase case remains that peripheral worries will subside, allowing EUR/USD to regain some footing on the back of a supportiverate differential environment and aggregate fiscal fundamentals that exceed those of the US. The risks to our constructiveEUR/USD view have clearly risen since the publication of our previous round of forecasts, and we will be re-evaluating ourview more thoroughly in the last Exchange Rate Perspectives publication to be released before year-end.JapanWe maintain our bullish yen stance. A back-up in US yields did occur over the past month, but has since stalled. Indeed, ratedifferentials now clearly point to a stronger yen. Japanese stock markets have also moved to new highs for the second half ofthe year. This may result in less Japanese buying of foreign bonds, which appears to be occurring and possibly more foreigninterest in Japanese stocks, which is only happening very slowly so far.United KingdomThe autumn rally in EUR/GBP has been reversed helped by peripheral European worries and as UK data has been strongerthan expected, reversing quantitative easing expectations from the Bank of England. On a head-to-head comparison withother G10 currencies sterling does not fare well, so we view next years risks as skewed towards further sterling weaknessbefore the cross eventually returns to levels more compatible with long-term fair value.CanadaThere has been a notable improvement in the US data in recent weeks, especially labour market indicators such as joblessclaims. History would suggest the currency this should be most positive for is CAD (not surprisingly given over 70% ofCanadas exports go to the US). For the near-term this should offset downside risks from concerns over policy tightening inChina and resulting weakness seen in key commodity prices.Australia and New ZealandWith the multi-month uptrend in many key commodity prices having broken down the near-term outlook for NZD, andespecially AUD, has materially deteriorated in recent weeks. We also see AUD as particularly vulnerable to concerns overpolicy tightening in China given Australia’s strong trade links with China and the common use of AUD as a “China play”. Incontrast, the better numbers in the US in recent weeks, especially the improvement in the jobless claims data, should seeCAD outperform NZD and especially AUD.SwitzerlandOur forecasts reflect a neutral view on EUR/CHF in the near-term. On the negative side, continued Eurozone peripheralworries and the strong performance of the Swiss economy will mean that the cross will struggle to rally beyond the highsseen earlier this summer. On the positive side, persistent strength below 1.30 is unlikely as it will likely delay any tighteningfrom the Swiss National Bank and as valuation constraints become more of a headwind. Our long-term forecasts foreseeEUR/CHF gradually returning to long-term fair value, aided by an easing of peripheral worries and a normalization of European-Swiss interest rate differentials which for now continue to remain at historical lows.Deutsche Bank AG/London Page 5
  6. 6. 30 November 2010 Exchange Rate PerspectivesNorwayNorges Bank rhetoric/projections remain committed to maintaining policy stable over the near-term. This suggests there willbe limited rate support for the NOK over the next couple of months, leaving the Norwegian unit at the vagaries of swings inrisk appetite and oil. Though still constructive in terms of the risk outlook, the approaching year-end, ongoing peripheralconcerns and Chinese policy tightening represent an initial barrier to a more significant risk rally, in turn limiting the upside inthe NOK. Nonetheless, positioning is light, and there are prospects of favourable MA flows, which should be sufficient tomaintain a positive trajectory in the NOK. We move our year-end target up to 8.00 from 7.80 previously, but maintain end-Q1and end-Q4 2011 forecasts at 7.70 and 7.60 respectively.SwedenLike the NOK, near-term gains in the SEK are undermined by a more fragile risk environment. However, the Riksbank remainscommitted to a gradual normalisation of policy going forward, in response to strong domestic growth dynamics and a desireto lean against rising property prices and further household indebtedness. External surpluses and strong fiscal finances (debt-to-GDP projected to fall to 21.1% in 2014, from 34.6% currently) add to the longer-term appeal of the SEK, with the re-electedcentre-right government also committed to continued privatisations going forward, albeit dependent on market conditions.We continue to forecast a sustained appreciation in the SEK, and stick to our 9.00 end of year forecast for EUR/SEK, followedby 8.50 by the end of Q1 and 8.20 at the end of next year.Asia ViewsChinaEconomic activity and inflation have been stronger than expected, while policy tightening has also turned more aggressive inthe past month. We expect PBoC to introduce further liquidity tightening measures as well as interest rate hikes over the nextsix months. Chinese authorities typically tighten macro-economic policies using four basic tools, broadly in this sequence:First, they use administrative hikes, second they use liquidity tightening measures (RRR hikes, aggressive sterilization), thirdthey turn to interest rates, and finally they allow a faster currency appreciation. In that context, we think China may be willingto let the currency appreciate more readily in coming months, particularly vs. its NEER basket of currencies.IndiaIndia is running a current account deficit, which, net of FDI, requires financing of roughly USD80-100m per day from portfolioand debt capital inflows. Not surprisingly, USD/INR is trading as a high beta play on global risk-sentiment. The positive factorsfor INR are: strong domestic growth (8.9% in 2010), and relatively high inflation that will likely force RBI to lift rates furtherearly next year. In addition, the government has an ambitious privatization plan in place which will bring roughly USD9bnworth of deals to market in Q1 next year. There remains scope for further inflows to Indian corporate bonds. Finally, withoffshore borrowing costs for Indian much lower than onshore, there is scope for External Commercial Borrowing toaccelerate in coming months. On the negative side, rising oil prices could put a dent in Indias Balance of Payments. And anongoing political scandal that has gridlocked parliament may stall the governments reform agenda, including the privatizationpipeline.IndonesiaIndonesia is enjoying strong growth (6% in 2010), supported by robust trade, credit growth and strong investor/consumerconfidence. However the asset markets sharp rise and capital inflows have become key issues. Specifically, with bond andequity ownership by foreigners at an all time high, the main risk to the currency is of an externally driven rise in global risk-aversion which could trigger substantial capital outflows from local markets. However given the largely real-money nature ofthe investor base, we think most of the recent inflows will tend to be sticky and will not reverse in a disorderly manner. BankIndonesias comfort zone for USD/IDR is between 8900-9300 - and we would look to sell USD/IDR in the 9100-9200 range.Page 6 Deutsche Bank AG/London
  7. 7. 30 November 2010 Exchange Rate PerspectivesKoreaGeopolitical concerns, and global risk-aversion have weighed on the won in recent days. However Koreas strong currentaccount surplus (USD35bn in 2010), cheap valuations and central bank tightening stance still argue in favor of a stronger won.Bank of Korea is likely to cap USD/KRW at 1200, but will also try to prevent the pair from falling below 1100 in the near-term.We would also be wary of a USD funding squeeze over the next couple of months coming from either an escalation ofEuropes sovereign crisis, or Bank of Korea not fully rolling over roughly USD20bn worth of FX swaps that are maturing overthe next 1-2 months.MalaysiaMalaysia is running a strong current account surplus (12.2% of GDP). The export sector is well diversified between industrialproducts (chiefly electronics) and commodities. Partly thanks to the governments reform initiatives, the local stock marketscene has also livened up of late, with 2010 seeing record IPOs, and 2011 likely to continue on that trajectory. Domestic fixedincome also continues to receive inflows from EM real money investors. Recent government comments have also playeddown the prospects of imposing capital controls. Thus, a fundamentally bullish view on MYR is warranted in our view. A breakof the key support level of 3.08 in USD/MYR may set the stage for another trend lower in the cross.PhilippinesSteady growth in remittances and outsourcing income underpins the Balance of Payments. However, the central bank hasengineered a sharp collapse in FX yields by not rolling over maturing FX swaps, which has made the currency less attractivefrom a carry perspective. We look to re-establish fresh PHP longs when money markets normalize. Meanwhile the economyis in a sweet spot, characterized by strong inflation and low growth. But there are key challenges ahead, particularly related tothe potential impact of rising food prices, and the governments commitment to a fiscal reform agenda.SingaporeThe Singapore dollar is supported by several factors, including strong economic growth momentum (+16% YoY in 2010 -though this is likely to slow to a more modest trajectory next year), current account surplus (17% of GDP), perceived safehaven status of the currency, AAA sovereign rating and strong condition of public finances. Moreover, MAS tightening bias ofan estimated 3% per annum vs. NEER is not priced in its forward curve. Thus we would be keen to buy SGD NEER on dips.TaiwanCBC has become less aggressive in its FX intervention lately, and has allowed a modest appreciation of the exchange rate.And given its status as a funding currency for carry trades, TWD may benefit - or at least outperform - during the currentconditions of risk-aversion. Fundamentally, a large current account surplus, rapid reserve accumulation, and cheap valuationsargue strongly in favor of a stronger exchange rate.ThailandBank of Thailand continues to guide THB in line with movements in regional currencies. Capital inflows have weakened afterthe government imposed a 15% withholding tax on investment in government bonds, though history suggests these controlswill not reverse the trajectory of capital flows. That said, the government has made it clear that if THB appreciates faster thanits regional peers, then they would be willing to impose more restrictions on capital inflows, including measures like Tobintaxes.Deutsche Bank AG/London Page 7
  8. 8. 30 November 2010 Exchange Rate PerspectivesEMEA ViewsCzech RepublicAs with the rest of CE-3, the Czech economy is benefitting from a strong German economy, but is less vulnerable to ongoingperipheral concerns than its neighbours, primarily due to a more conservative fiscal policy stance. While we continue to see avery gradual trend appreciation vs the EUR, we also anticipate underperformance relative to the PLN, reflecting moremoderate growth dynamics in the Czech economy.HungaryRemains the most risk sensitive CE-3 currency, with the governments fiscal plans for the next few years underpinning addingto the risk bias. Political pressure on the central bank to raise its inflation target is also not helping the HUF, and although wecontinue to like valuation, cheap is currently not enough to continue to call for HUF appreciation.PolandHeadline inflation picking up at the same time as core CPI is remaining subdued have led to a highly divided NBP board, splitlargely down the middle between hawks and doves. However, this will only impact on the timing of the Banks tighteningcampaign, with strong growth dynamics and ongoing state privatisations adding to prospects of higher rates in Q1 to providesupport for the PLN.RussiaThe underperformance over the past few months has materialised against a backdrop of relatively strong domestic growthdynamics, budget outperformance and more recently also intervention (verbally and directly) in support of the RUB. Despitethis the Russian unit has struggled, in turn causing the CBR to request several commercial banks to disclose informationabout their FX operations in attempt to identify the source capital outflows. Regardless of whether the Banks search forspeculators is successful, the greater problem has been the lack of inflows. This is in stark contrast with the rest of the EMworld, where authorities are trying to stem the tide of liquidity flowing in. While part of the explanation include factors such asminimal transparency and a highly politicised legal system, the lack of investable assets is key. However, the more detailedprivatisation plan and Russias accession to the WTO (possibly in 2011) should translate into a better investment climate and astronger RUB.TurkeyStrong domestic growth and rising inflation expectations are pressurising the CBT into a number of different measures in anattempt to tighten domestic liquidity. Meanwhile the Bank tries to avoid hiking its key policy rate in order to avoid attractingfurther capital inflows. In our view the CBT have two options, either tighten policy and accept nominal appreciation, ormaintain policy at levels which are too expansionary for the economy, in turn generating an overheated domestic economyand real appreciation. A scenario in between the two is the more likely, ie that the CBT will fall behind the curve, but will haveto start tighten policy earlier than what is currently signalled. The bottom line, carry will continue to be favourable, andconsistent with continued appreciation.South AfricaAuthorities want a weaker currency in response to a moderation in growth and inflation prospects. However, with the capitalaccount to a large extent made up of portfolio inflows, focus is less on controlling capital inflows, and more more on matchinginflows with outflows. So far these measures have had a very limited impact, with the ZAR instead responding increasingly toswings in risk appetite. Policy wise focus very much on rate cuts, in contrast to much of the rest of EM, and combined withsignificant overvaluation, we continue to look for underperformance in the ZAR going forward.Page 8 Deutsche Bank AG/London
  9. 9. 30 November 2010 Exchange Rate PerspectivesIsraelTrend appreciation (vs USD) has picked up from around 1% per month, to around 1.5% over the past 4-5 months. Withreserves accumulation having slowed noticeably, the BoI might also be growing more comfortable with a continuedappreciation, in particular with inflation picking up and with the economy projected to run above potential by 2012 (accordingto the IMF). On balance therefore we continue to see appreciation in ILS, underpinned by a need for continued tightening inresponse to signs of overheating in some segments of the economy.LatAm ViewsBrazilThe economy has been growing strongly (7.6% expected this year) on the back of solid domestic demand. Good monetarypolicy management has helped to control inflation and maintained large interest rate differentials. These factors have helpedto attract sizable inflows, exerting considerable appreciation pressures on the BRL. The government reacted by increasing taxon fixed-income inflows and FX derivatives. While further exchange controls or quantitative constraints cannot be ruled out,we continue to favor a short USD/BRL position. We consider that those risks are more than compensated with attractivecarry, which could likely increase if inflationary pressures materialize.ChileStrong domestic demand driven growth (7% YoY in 3Q10) paired with low inflation and high commodity receipts (copper backto pre-crisis peaks and rising) continue to attract inflows. Healthy government and banking institutions also help to reassureinvestors. The government recently announced measures aimed at broadening the capital account and increasing thecompetitiveness of the exporting sector, which could have only some mild effects in the long term equilibrium exchange ratebut they are innocuous in short-term movements. There is a very low risk of low risk of exchange controls and the CentralBank is strongly against direct FX intervention; it would be the last resort after verbal intervention and moderation ofmonetary policy, but since both have already occurred, intervention cannot be completely ruled out if the currency appreciatesconsiderable from current levels. We maintain a neutral position for the moment but would consider adding a short position ifthe currency gets closer to 500 due to global factors.MexicoEconomic growth is still unimpressive (reflecting ties with US) but the sizable output gap helps to contain inflation. Mexico issingled out as one the countries in EM where exchange controls could be practically discarded. Additionally, the Central Bankwould reluctantly intervene in the FX market, and only as a response to very strong, temporary, capital flows. Thisconsiderations, along with decent carry, makes the MXN relatively more attractive than other EM peers. We continue to beconstructive on the MXN, and consider that the recent sell-off (originated in external conditions) offer an opportunity to enter ashort USD/MXN position. Bilal Hafeez London, +44 (20) 754-70354 George Saravelos London, +44 (20) 754-79118 John Horner Sydney, +61 (2) 8258-2130 Henrik Gullberg London, +44 (20) 754-70354 Mirza Baig Singapore, +65 6423-5930 Dennis Tan Singapore, +65 6423-5347 Mauro Roca New York, +1 (212) 250-8609Deutsche Bank AG/London Page 9
  10. 10. 30 November 2010 Exchange Rate Perspectives 10 Lessons From 2010 Before writing our outlook for 2011 (we plan to in mid-December), we thought we would take stock of 2010 and draw out the 10 most important lessons we learnt (and two extra lessons we could not keep out): Know The Herd, But Dont Follow It If Europe Goes Down, So Does EM AUD and JPY Can Rally Together Remember Latvia Inflation Dominos Have Started to Fall Small Perceived High-Beta FX Do the Best: MYR, THB, COP Extreme Positioning Matters Forget G20 Co-ordination, But Dont Under-Estimate Euro-Area Co-ordination Where Was the Fiscal Crisis in the UK and Japan? The True Star of 2010: Mongolia NOK: From Hero to Zero Anti-Climatic Parity Parties 1. Know The Herd, But Don’t Follow It Growth Surprises Were Seen Outside of the US 2010 was going to be the year when we would finally see the consequences of the extraordinary policies implemented by the Fed and others during the credit crunch in late 2008. Would we see a double-dip, hyperinflation or a return to boom? Well, we ended up with almost exactly what consensus was expecting for 2010 at the start of the year. US growth was expected by the Bloomberg survey of economists to be 2.6%for 2010, inflation was expected to be 2% and the unemployment rate was expected to settle at 10%. The actual outcomes (using consensus estimates for data not yet published) were 2.7%, 1.6% and 9.6%. So growth turned out very close to expectations, while inflation was lower, but so was unemployment. The surprise, though, was Fed policy, where easings occurred over 2010, rather than tightenings. In fact, across the developed world, central banks were more dovish than expected.GDP Surprises Over 2010 C/A Surplus Countries Surprised Most on Growth Jpn 20 Swed Nor 15 Expected current account balance Germany GDP Surprises … Switz Switz Swe Portugal 10 Can Euro 5 Aus Ger UK France 0 Jpn (% GDP) for 2010 US NZ Spain -5 Italy Ireland -10 Greece Gre NZ -15 Nor -2 -1 0 1 2 -2 -1 0 1 2 GDP surprise for 2010Source: Deutsche Bank; latest consensus estimates for 2010 GDP growth versus consensus estimates taken Source: Deutsche Bank. IMF.at the end of 2009 On growth outside of the US (again using consensus estimates for data not yet published), the largest upsides surprises were seen in Japan, which turned out to have growth of overPage 10 Deutsche Bank AG/London
  11. 11. 30 November 2010 Exchange Rate Perspectives 3% compared to expectations of 1.3%. Large upside surprises were also seen in Sweden and Germany (see first chart). At the other end, both Norway and New Zealand disappointed on growth. Despite the Euro-area bond crisis, Euro-area growth surprised to the upside. Interestingly, growth surprises appeared to follow current account balances, with surplus countries, except Norway, surprising to the upside, and deficit countries surprising the least (see second chart). This could reflect that deficits were a symptom of countries that were still grappling with the unwind of consumption binges from earlier years. In EM, growth surprised to the upside almost across the board. Singapore saw the largest upside surprise (16% versus an expected 6.5%), and there were no downside surprises in any of the major EM economies. JPY, THB, MYR, ZAR Surprise Winners of 2010 On the currency front, the largest surprise in G10, was the strength in the yen, which was the second strongest G10 currency of the year. This came despite it being expected to be the worst performing currency of 2010 at the start of the year (see third chart). Both AUD and NZD were expected to perform well, but did even better than expectations. The Euro was not expected to do much over 2010, but turned out to be the worst performing currency of the year. Interestingly, the euro range for the year (17%) and the change over the year were both around the average since the inception of the euro in 1999, and this despite the crisis seen in the euro-area.G10 FX Surprises Over 2010 EM FX Surprises ZAR AUD THB COP JPY MYR IDR MXN NZD BRL TRY CAD ARS SGD CHF PHP CLP Actual changes INR Actual change SEK ILS Expected changes PEN Expected GBP KRW change RUB CNY NOK TWD HKD Euro CZK PLN HUF -10% -5% 0% 5% 10% 15% -10% -5% 0% 5% 10% 15%Source: Deutsche Bank. Source: Deutsche Bank. IMF. Peripheral Vision Needed There a few lessons to be learnt from analyzing consensus expectations. First, the areas of intense focus tend to deliver the smallest surprises. The focus on US and Chinese growth resulted in analysts missing the German and Japanese growth stories. The focus on the euro- area crisis and the euro resulted in an average range year for the euro, but missed the clear yen strengthening trend. In EM, there was a big focus on some of the Asian bellwethers, KRW and INR, yet it was THB and MYR that performed. And yet again, everyone missed the impressive ZAR gains. Second, some of the extreme outcomes contemplated by market participants over the past two years; hyperinflation, double-dip, Euro break-up, have not materialized. Instead, outcomes have been more benign; US growth this year was in line with its 20-year average, inflation has not spiraled out of control and the euro has traded in a normal range since itsDeutsche Bank AG/London Page 11
  12. 12. 30 November 2010 Exchange Rate Perspectives inception. So it would appear to us that market participants having failed to anticipate the tail events of Lehmans and the associated credit crunch are now over-anticipating tail events. Bilal Hafeez London, +44 (0)20 7547 0354 bilal.hafeez@db.com 2. If Europe Goes Down, So Does EM When European peripheral sovereign concerns began to escalate in late 2009, they first looked unlikely to spill over to rest of the world. Greece was on the verge of default, but there was hope that the core would step in and a (weakened) Eurozone would muddle through. Few EM countries (other then CE4) rely on Europe for growth or financing, and thus prospects for their currencies seemed unaffected. Short Euro vs. long EMFX became a popular trade in the macro community. But by late April, the Greek crisis had spread to Portugal and even the hitherto stable Spanish bond spreads were widening. CE4 currencies came under pressure at this point, though the short EUR vs. Asia and high yielding EMFX trade continued to work. EM was insulated from Europe… right until the crisis went global 5yr CDS (bps) PIGS CDS (LHS) EUR/USD (inverted) 650 EUR/USD (RHS) 1.10 550 1.16 450 1.22 350 1.28 250 1.34 1.40 150 1.46 50 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan 2010=100 ZR+TR+BR funded in EUR Asia FX funded in EUR 121 CE 4 FX funded in EUR 116 111 106 101 96 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Source: Deutsche Bank The unravelling occurred in early May when the inter-bank money markets began to seize up. In a mini-run of the post-Lehman panic, USD LIBOR spiked as banks began to hoard liquidityPage 12 Deutsche Bank AG/London
  13. 13. 30 November 2010 Exchange Rate Perspectives due to an elevated perception of counterparty risk. Markets were gripped by fears of a systemic failure of the international financial system stemming from a feared collapse of Europe’s government bond markets and banking sector. It was 2008 deja’vu – the financial market equivalent of a “Minsky moment”, when no assets – even the good ones – are spared. Asia, LATAM and the high yielding ZAR and TRY all came under pressure as investors rushed for the exit. The lesson here is that EM is not safe when European (or G3 for that matter) sovereign concerns escalate into fears of a systemic crisis. Investors should monitor global money markets – which are the plumbing of the financial system – for signs that contagion is spreading. Mirza Baig Singapore, +65 6423-5930 mirza.baig@db.com 3. AUD and JPY Can Rally Together Because AUD/JPY is often considered the G10 currency bellwether for risk appetite, it is usually assumed that the Aussie and Yen historically move in opposite directions. The 2008 crisis left many scars, including the association that the AUD/USD collapse at the same time as a USD/JPY slide lower, was normal. Chalk this down as a popular misconceptions, for over the last 10 years, AUD/USD and USD/JPY have show a strong (-0.65) negative correlation, with the broader USD trend typically dominant, driving both the Aussie and Yen in the same direction. 3m Rolling Correlation of AUD/USD and USD/JPY Source: Deutsche Bank The 90 day rolling correlation for AUD/USD vs USD/JPY hit a peak of +0.96 in December 2008, but at the time of writing stands at -0.84. This correlation reflects more than the yen and Aussie being caught in the USD slipstream of late. Firstly, in 2010, Japan has tended toDeutsche Bank AG/London Page 13
  14. 14. 30 November 2010 Exchange Rate Perspectives hedge its portfolio outflows to major markets like the US, given USD/JPY forward rates that are very close to spot. The combination of near zero rates in the US limiting unhedged Japanese C/A recycling (yen positive), in combination with a global recovery (Aussie positive), provided some macro context for both Aussie and Yen going up in 2010. Secondly, there is some belief that at least now that the USD is more popular than the yen as a carry financing vehicle, it is logical that the USD rather than the yen is the anti-pole of the carry trade. This should impart more volatility on AUD/USD relative to AUD/JPY and explains much of the post crisis convergence in volatility as AUD/JPY has moved down toward AUD/USD (realized and implied) vol. History shows we have gone through long periods (for example in 2003-2006) when AUD/USD vol was far higher than AUD/JPY vol. We have just come through a similar period to 2003 where lower 10yr yields (after Bernanke’s first flirtation with deflation) and higher equities, are associated with increased global growth and a stronger Aussie. Because yields are more important than equities/risk for the yen, it has also been associated with a stronger yen. Back in H1 2004, the environment swung to a mix of higher bond yields and flattish equities, which is a more common environment, that hurt the yen, but hurt the Aussie even more. 2004 (or 1994) would be the kind of market we might expect when the Fed eventually exits QE2, which creates major headwinds for AUD/USD and AUD/JPY spot and marks the end of the convergence in AUD/USD and AUD/JPY vol because the yen starts to take over from the USD as a carry financing vehicle. Alan Ruskin New York, +1 (212) 250-8646 alan.ruskin@db.com 4. Remember Latvia Given all the pessimism regarding peripheral Eurozones ability to grow themselves out of the recession it might be worth remembering Latvia. The country was seen as the economy with the biggest crisis earlier in this cycle, with the 5yr CDS widening out to a high around 1180bp. But things have improved, with the 5yr CDS now trading below 300bp in response to fiscal consolidation and a credible recovery in the Latvian economy. Also, Latvia managed to maintain the currency peg to the EUR, instead achieving the necessary improvement in competitiveness through [painful] internal devaluation. A good illustration of this is the development in net public sector wages, which contracted by more than 30% from the end of 2008 to the beginning of 2010, and the unemployment rate which rose from around 5% to 18% over that same period. Signs of life after fiscal pain While wages have rebounded somewhat and unemployment declined, they are still far away from pre-crisis levels. However, the economy has still been able to stage a recovery, with retail sales and industrial production currently running at 6.1% and 19% YoY, and Q3 GDP comfortably beating expectations at 2.7% YoY. The trade balance is back to pre-crisis levels, not due to depressed imports (around 30% YoY), but thanks to strong exports (also around 30% YoY), and in spite of no devaluation of the LAT. Sure, the 2011 budget will have to deliver further fiscal consolidation (budget bill to be submitted on Dec 9th), but so far in 2010 the budget has outperformed and seems largely on track for the targeted “below 8.5%” of GDP. Next year, and based on the government’s forecasts, the deficit will be reduced to 5.6%. Also, despite prospects of continued hardship the incumbent coalition government was re-elected on Oct 2, bringing political stability and a strong mandate for further consolidation.Page 14 Deutsche Bank AG/London
  15. 15. 30 November 2010 Exchange Rate Perspectives Latvia 5yr CDS vs Periphery – past 2yrs 1200 1100 1000 900 800 Basis point 700 600 500 400 300 200 100 0 O ct Jan Apr Jul O ct Jan Apr Jul O ct 08 09 10 L a tv ia Ire la n d G re e c e P o rtu g a l Source: Deutsche Bank Likely to continue to resist devaluation Apart from bringing down the deficit, it seems increasingly likely that its ability to tolerate pain means Latvia will be able to continue to resist devaluation. FX reserves currently more than cover M1 money supply (LATs in circulation demand deposits), and the Finance Ministry have even suggested it can now stop drawing funds from bilateral lenders (Nordics, Estonia, Czech and Poland). This means only using funds from institutional lenders (IMF, EU and the WB). So far, Latvia has received some EUR4.2bn out of the EUR7.5bn programme, of which EUR1.1bn has been provided by the IMF and EUR2.7bn by the EU. The bottom line is that while it might still be too early to cry victory on Latvia, it potentially offers a template for a way out of the current crisis/imbalances in the Eurozone in our view Henrik Gullberg London, +44 (0)20 7549 9847 henrik.gullberg@db.com 5. Inflation Dominos Have Started To Fall In 2009, inflation rates fell in most G10 and EM countries. However, in 2010, the picture was more mixed with around half seeing inflation rates pick up. In G10, core inflation rates picked up in Canada Australia, Japan and the Euro-area, while they fell in Switzerland, Sweden, US and Norway (a similar picture can be seen in headline inflation, see first and second charts). Both Norway and Switzerland have seen core inflation rates falling for two years in a row. In EM, China continued to see rising headline inflation rates, while Singapore, Turkey, Brazil and Korea saw inflation rates rise in contrast to the previous year. Meanwhile inflation rates fell in Russia, South Africa and India. Both Russia and South Africa have seen inflation rates fall two years in a row (see third chart). While we prefer to look at headline inflation for EM as food and energy form much larger weights in their price indices, core inflation trends look similar, though Turkey looks more disinflationary, while Russia looks more inflationary (see fourth chart).Deutsche Bank AG/London Page 15
  16. 16. 30 November 2010 Exchange Rate PerspectivesChange in Headline Inflation Across G10 Change in Core Inflation Across G10 3.0 headline CPI rates 2.0 core CPI rates Change from 2008 to 2009 Change from 2008 to 2009 1.5 2.0 Change from 2009 to 2010 Change from 2009 to 2010 1.0 1.0 0.5 0.0 0.0 -0.5 -1.0 -1.0 -2.0 -1.5 -3.0 -2.0 Jpn Can. Eur Aus Swe UK Nor Swi NZ US Can. Aus Jpn Eur UK NZ Swi Swe US NorSource: Deutsche Bank; Source: Deutsche Bank; The first lesson from 2010 is that the global disinflationary trend of 2009 has ended and now inflation trends have become more regional. Indeed, it appears that countries still experiencing disinflationary forces are primarily in the EMEA region. This could be a result of the Euro-area crisis imparting a disinflationary shock to the region, much like the global disinflationary shock imparted by the US credit crunch of 2008/2009. The other lesson is that once crises are overcome as in the US, easy monetary policy may not result in domestic inflation, but may support inflation abroad. Indeed, neighbouring Mexico and Canada appear to be experiencing more inflationary pressures than the US. This also suggests that once the Euro-area crisis abates, EMEA could face a more inflationary shock from the Euro-area. Finally, China continues to see rising inflation rates. It would appear that relative inflation rates between the US and China may end up being as important as movements in the nominal exchange rate in bringing about an adjustment in the real exchange rate.Change in Headline Inflation Across EM Change in Core Inflation Across EM 8.0 headline CPI rates 3.0 core CPI rates 6.0 Change from 2008 2.0 to 2009 1.0 4.0 Change from 2009 0.0 2.0 to 2010 -1.0 0.0 -2.0 -2.0 -3.0 -4.0 -4.0 Change from 2008 -6.0 -5.0 to 2009 -8.0 -6.0 Change from 2009 -7.0 to 2010 Chin Sing Tur Bra. Kor Mex Taiw Pol Rus S. India Afr Chin Bra Tai Rus Kor Mex Tur Pol S.AfrSource: Deutsche Bank; IMF Source: Deutsche Bank; Bilal Hafeez London, +44 (0)20 7547 0354 bilal.hafeez@db.comPage 16 Deutsche Bank AG/London
  17. 17. 30 November 2010 Exchange Rate Perspectives 6. Small Perceived High-Beta FX Do the Best: MYR, THB, COP Risk-sensitive currencies like IDR, KRW, ZAR, BRL and CLP outperformed in 2009. The consensus expectation for 2010 was that these currencies would continue to do very well. As it turned out, these high beta plays haven’t quite lived up to their promise. By contrast, currencies like MYR, THB and COP, which were initially off investors’ radar screens are topping the league tables of EMFX performance. There are some common reasons for their outperformance: initial light positioning, exports/growth surprises, a shift in central bank behaviour and positive domestic catalysts that led to renewed foreign interest. In Malaysia, the key trigger was Bank Negara’s rate hike in March. This made Malaysia the first EM central bank to embark on a rate hike cycle, sparking a whole new focus on the monetary policy divergence between the developed and developing world. Bond flows into Malaysia surged on anticipation of higher yields, while BNM’s surprising hands off approach to FX management meant that the ringgit had ample room to run. For the baht, the pains of the 2006 capital controls remain deep in the memories of foreign investors. Most prefer to shun the THB in their Asia reval trades, not to mention that the political situation at one point turned quite hairy. Nevertheless, the economic impact of the political chaos in Bangkok was short-lived. Trade and consumption remained robust and so foreign investors were caught underweight in both equities and bonds in H2 after having shunned the country earlier. Colombia was a virtuous re-rating story triggered by a favourable political outcome (presidential elections) which led to renewed FDI and portfolio inflows. Interestingly, at this juncture, central banks in each of these countries are getting uncomfortable with currency strength. BoT has imposed a 15% withholding tax on bonds, Malaysia is holding the line of 3.08 in USD/MYR, while Colombia is looking to other measures to complement its dollar purchase program. The key lesson would be to NOT pick this year’s winners as next year’s trades. Dennis Tan Singapore, +65 6423-5347 dennis.tan@db.com Mirza Baig Singapore, +65 6423-5930 mirza.baig@db.com 7. Extreme Positioning Matters The announcement of quantitative easing on November 3rd almost perfectly coincided with the bottom in the trade-weighted dollar for this year. While part of the dollar rally was aided by the re-emergence of peripheral Europe concerns, the strongest lesson one can draw from this is that - in the near-term at least - extreme positioning matters. The aggregate US dollar short as measured by our own internal positioning data had reached a record, while market opinion had universally turned – and for good reason – bearish US dollars. But with the Fed decision one of the most widely anticipated and talked about policy decisions in FOMC meeting history, the EUR/USD range on the day of the announcement was one of the narrowest of the year (2nd percentile), subsequently accompanied by an across-the-board rally in the USD. In contrast, the rally in EUR/USD in mid-summer is an example of the same dynamics played out in the opposite direction. Continued fears about a break-up of the Eurozone led to a sharp build-up in EUR shorts, which in absolute value reached the highest levels in the history on the IMM. Risk-reversals similarly saw extremes not seen since the peak of the financial crisis in 2008 (see chart). The combination of extreme sentiment and positioning was what marked the turn in the EUR rather than any fundamental policy developments in the Eurozone. The latter took place in May in the form of the EFSF mechanism and ECB bond purchase program, a month before EUR/USD eventually bottomed.Deutsche Bank AG/London Page 17
  18. 18. 30 November 2010 Exchange Rate Perspectives No Signs of Stress in European Financials 10 IMM EUR/USD positions/open interest (lhs) 2 8 EUR/USD 1-m Risk Reversal (ths) 2 6 1 4 1 0 2 -1 0 -1 -2 -2 -4 -2 -6 -3 -8 -3 -10 -4 03 04 05 06 07 08 09 10 Source: Deutsche Bank George Saravelos London, +44 (0)20 7547 9118 george.saravelos@db.com 8. Forget G20 Co-ordination, But Don’t Under-Estimate Euro-Area Co-ordination Prior to most recent multilateral congregations (G7, G20, IMF/World Bank meetings) there has been speculation as to some form of coordinated response to the challenges facing the post –crisis recovery. In particular there has been talk of some form of coordinated currency response to ongoing global imbalances. In part these expectations are a result of the greater coordination that was seen in the depths of the global downturn, with the major economies coming together to agree to stimulus policies (see for instance the G20 statement following the November 2008 meeting). Given the global nature of the downturn such coordination was relatively easy to obtain, as it was in each country’s individual interest to try and stimulate their economies. Variability of recoveries has meant global coordination on stimulus has ceased - unemployment rates from pre-crisis lows 6 5 4 3 Nov-09 2 This year 1 0 US Ger UK Jpn Fr Chi -1 Source: Deutsche BankPage 18 Deutsche Bank AG/London
  19. 19. 30 November 2010 Exchange Rate Perspectives Since then, however, the economic recoveries have been strongly varied, evidence of which can be seen in the chart above which shows the high variation in the changes in the unemployment rates since then, with Germany and China both having unemployment rates around their pre-crisis lows. Associated with this, and as was discussed in lesson 5, there has also been considerable variation in inflation outcomes. All this means that while those countries that have had sub-par recoveries would like to see the coordinated stimulus policies enacted at the depths of the crisis maintained or even expanded on, policy makers in those countries that have experienced stronger recoveries have felt unable to do so and have in contrast started taking back some of these stimulus measures. It could be argued that the differing outcomes in the major economies argue for a realignment of exchange rates. The US economy, with an ongoing deficiency of demand and persistent disinflationary pressures, would by this argument benefit from a lower exchange rate. China, which in contrast is confronting an overheating economy and strong inflationary pressures would benefit from a stronger exchange rate. In the longer run this should also help see a narrowing of the US current account deficit and Chinese current account surpluses. Indeed (as argued in 2005 by economists at the Australian Treasury, and more recently by economists such as Paul Krugman*) the situation in China may be neatly depicted by the Swan diagram developed by Australian economist Trevor Swan 50 yeas ago, with the US in the Northern most “triangle” and China in the southern most triangle. While this clearly argues for a higher real effective exchange rate for China, Chinese policy makers have a clear revealed preference for this to come via an increase in wage and prices rather than via a stronger nominal exchange rate. While the desirability of this approach can be argued, at the very least its more opaque nature does seem certain to lead to ongoing tensions on global imbalances for some time. And while there is an argument for higher real effective exchange rates in surplus countries facing excess demand, this is coming more from higher inflation REER Excess Supply US (Defict, Disinflation) Excess Demand BoP Deficit China BoP Surplus (Surplus, inflation) Internal Balance External Balance Domestic Demand Source: Deutsche Bank The contrast with European policy makers in the past 12 months is interesting. Here there was likely little optimism about the prospect of any coordination, and indeed at times the process of getting this coordination has proved unappealing and led to considerable strains in markets,. Yet when we consider the broad reach of what has actually been achieved - the ESFM, EFSF and now the ESM – it has been quite remarkable. Of course whether these mechanisms are enough soothe market concerns about the ongoing discrepancies between growth in the core countries and strains in the periphery remains a significant question markDeutsche Bank AG/London Page 19
  20. 20. 30 November 2010 Exchange Rate Perspectives as we write this, but the willingness of European policy makers to drop previously entrenched positions for the sake of the European integration project holds out some hope. *Phil Garton and Jennifer Chang The Chinese currency: how undervalued and how much does it matter? Economic Roundup Spring 2005; Australian Treasury) Paul Krugman Swan Songs 17 November 2010 (http://krugman.blogs.nytimes.com/2010/11/17/swan-songs/) John Horner Sydney, +61 2 8258 2130 john.horner@db.com 9. Where Was the Fiscal Crisis in the UK and Japan? It is easy to forget that at the start of this year the Bund – Spain 10yr govt spread was narrower than the 10yr Bund – UK gilt spread. A year ago it was presumed that a fiscal funding crisis emerge in the UK or even Japan as readily as an EMU stalwart. So what happened?Sovereign Debt Risk Metrics C/A Balance Fiscal Balance Net Interest Debt / GDP Foreign Debt Holding Foreign Debt Payments / GDP / Total Liabilities Holdings / GDPGreat Britain -2.6 -9.0 2.4 71.0 21.5 13.3Japan 2.5 -6.5 0.9 189.3 8.4 13.2Spain -5.3 -6.6 1.1 59.3 42.1 26.8OECD Average -0.3 -4.4 1.6 70.2 38.3 31.8Source: Deutsche Bank By many measures the UK and Spain are equals when it comes to fiscal vulnerability. The UK wins on smaller non-resident holdings of debt, and a smaller external deficit. Spain wins marginally on underlying fiscal deficit and measures of general government debt. Where hiding under the umbrella of core EUR policy sobriety was once a virtue, it has now turned into a vice - literally strangling necessary policy flexibility. The UK owns the sterling printing press and has been brave enough to use it. It has currency flexibility and not been shy to let the exchange rate float. In other words the UK’s capacity for reflation through the exchange rate and/or money creation, may err on the side of inflation, but leaves the adjustment path in its own hands. The market’s resounding 2010 judgment, has been that Spain’s credit risk (in bps), far exceeds the UK’s long-term inflation risks from a potential resumption of quantitative easing. This is also evident in the indexed linked sector, with UK 10yr inflation breakevens almost exactly the same as the start of the year, despite some very disappointing price data. This is of course not the end of the story. It is still possible that a UK failure to deliver on promised fiscal cuts; or that the fiscal drag hits growth to the point where it undermines the banking sector ; and/or, for that matter EUR contagion hits the debt outlook as well. These are not the DB team’s central scenarios, not least because the currency should cushion the credit impact, and currency depreciation driving inflation in a vicious cycle is unlikely, given that the pound’s starting point is so weak.Page 20 Deutsche Bank AG/London
  21. 21. 30 November 2010 Exchange Rate PerspectivesDebt/GDP across the G10 Gross Interest Payments on Debt (% GDP)Source: Deutsche Bank; IMF Source: Deutsche Bank; If it is too early to heave a sigh of relief when it comes to the UK, nowhere should the market be more reluctant to sound the all clear on the fiscal accounts than when it comes to Japan. In the summer, the IMF suggested that Japan would need to reduce its structural primary deficit by 1% every year for the next decade merely to stabilize net debt to GDP at 140% and gross debt to GDP at 240% - and this even with the assumption that such consolidation helps rather than hinders growth! That’s the bad news. The good news is that there is plenty of scope for higher taxes since government revenues as a share of GDP remain well below the OECD average. Nonetheless, Japan sits at a critical pivot point, vulnerable to both a deflationary and inflationary/reflationary environment. A deflationary scenario secures low funding costs at the price of increases in real debt and an inability to grow nominal GDP above nominal rates. For the moment that is still probably preferable to a higher rate environment, either because higher growth impacts inflation expectations and/or reduces bank demand for JGBS. One small source of comfort is that any debt crisis sparked by higher yields would presumably hurt growth again and drive yields back down, even if debt to GDP would continue to rise. The Japan debt crisis trade has many twists and turns left in it, but 2011 will likely prove again that this is not a trade for the impatient foreigner, who still holds less than 10% of the outstanding stock, and cannot bolt for the exit expecting the locals will follow. The UK Has the Largest Fiscal Consolidation Planned UK US Norway Euroland Canada Australia Sweden Switzerland Japan -2 -1 0 1 2 3 Fiscal Consolidation 2010 to 2011, % GDP Source: Deutsche Bank Alan Ruskin New York, +1 (212) 250-8646 alan.ruskin@db.comDeutsche Bank AG/London Page 21

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