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Fx markets weekly

  1. 1. Global FX Strategy October 18, 2010 FX Markets Weekly • FX Outlook: Hedging a trade war John NormandAC As the dollar declines, the G-20’s unwritten currency accord becomes (44-20) 7325-5222 clearer: QE will weaken the dollar indirectly, and the rest of the world john.normand@jpmorgan.com will manage the consequences through whatever tactics suit domestic Paul Meggyesi circumstances. An unintended consequence may be a trade war – a low (44-20) 7859-6714 probability event but one which previously exacerbated declines in paul.meggyesi@jpmorgan.com USD/JPY (autos) and rallies in EUR/USD (steel). The most effective Tohru Sasaki hedges for serious trade conflict in 2011 would be short USD/JPY and (81-3) 6736-7717 USD/CHF, or long USD/CNY. The euro and commodity currencies are tohru.sasaki@jpmorgan.com the wrong hedges for this tail risk. Arindam Sandilya (1-212) 834-2304 • FX Derivatives arindam.x.sandilya@jpmorgan.com The dollar will remain front and center of FX markets, which bodes well Niall O’Connor for long USD-correlation trades. Stay long USD-vol vs. short EUR-cross (1-212) 834-5108 vol in CHF, but take profits on AUD and NZD. Options are not re-rating niall.oconnor@jpmorgan.com G10 skews in favor of USD puts at the same rate as before. High and rising USD-correlations also suggest caution around an unfettered Contents extension of the dollar downtrend. CAD/JPY vs. USD/CAD is on our radar as a long/short gamma spread; entry levels are 0.7-0.8 vols way. FX Outlook 2 CAD/JPY is an interesting wing option buy in its own right, with var Global FX carry trade monitor 8 swap vs. vol swap strike differentials at historical lows. FX Derivatives 10 • Trade Recommendations Trade Recommendations 14 The prospect of QE-II is proving more toxic for the dollar than QE-I. Technical Strategy 22 Stay short against a broad basket of currencies (AUD, EUR, SEK, INR FX alpha strategies & performance 24 and KRW) to reflect the Fed’s willingness to debase its currency. Similar Research Notes 26 arguments justify a broad short in GBP vs CHF, EUR, NOK and SEK, Market movers 30 especially as fiscal reality bites through next week’s Comprehensive Event risk calendar 32 Spending Review. J.P. Morgan Forecasts • Technical Strategy FX vs forwards & consensus 34 The USD bear trend has broken through the next line of key supports Rates, credit, equities & commodities 35 suggesting further weakness. Importantly, the trend has broadened as Global growth and inflation forecasts 36 laggards such as USD/CAD and NZD/USD have pushed through Global central bank forecasts 37 important levels. The key focus is now on the 1.4375 area for EUR/USD Sovereign credit ratings and actions 38 and the 76 zone for the DXY which should define the next extension. Government bond and bank redemptions 39 Asia FX trends are approaching a number of critical resistance levels, but corrective retracements remain buying opportunities. Stay short Research Notes on morganmarkets.com 40 USD/JPY, USD/KRW, GBP/JPY, EUR/PLN and long EUR/GBP. Global FX Strategy contact page 44 • FX alpha strategies & manager performance Rate momentum has become mixed for the dollar after a month of recommending an across-the-board sell. Currency and global macro funds are having a strong October, up 0.25% to 1% so far. • Research note US-Japan trade war and USD/JPY – implications for USD/CNY (Tohru Sasaki and Junya Tanase) www.morganmarkets.com/GlobalFXStrategy J.P. Morgan Securities Ltd. The certifying analyst is indicated by an AC. See page 42 for analyst certification and important legal and regulatory disclosures.
  2. 2. Global FX Strategy FX Markets Weekly October 18, 2010 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd. Chart 1. Global trade disputes have been ebbing over the past FX Outlook: Hedging a trade decade but are always in play Number of trade disputes filed annually with World Trade Organisation vs global war real GDP growth 60 -3% • As the dollar declines, the G-20’s unwritten 50 number of WTO trade disputes, lhs -2% currency accord becomes clearer: QE will weaken global real GDP growth inverted, rhs -1% the dollar indirectly, and the rest of the world will 40 0% manage the consequences through whatever tactics 30 1% suit domestic circumstances. 2% 20 • An unintended consequence may be a trade war – a 3% low probability event but one which previously 10 4% exacerbated declines in USD/JPY (autos) and rallies 0 5% in EUR/USD (steel). 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 • The most effective hedges for serious trade conflict in 2011 would be short USD/ JPY and USD/CHF, or Source: J.P.Morgan, WTO long USD/CNY. The euro and commodity Chart 2. USD/JPY’s undershoots of fair value in 1993 and 1995 could currencies are the wrong hedges for this tail risk. reflect a risk premium for auto dispute Actual USD/JPY rate vs predicted (model) based on regressing spot on US –Japan • Strategy: stay short baskets of USD and GBP rate spreads (1-mo rates 12 months forward), daily data, 1990-95 sample period • Trades: In cash, stay short USD vs EUR, SEK, 170 AUD, INR and KRW; stay short GBP vs EUR, 160 USD/JPY CHF, SEK & NOK. Model 150 • Next week: US earnings, European PMIs, UK 140 spending review, G-20 build-up 130 120 With each week that the dollar declines, the G-20’s 110 undershoot unwritten currency agreement becomes more apparent. The 100 US will weaken its currency indirectly though Fed easing, 90 undershoot and the rest of the world will manage the consequences through whatever policies suit domestic circumstances 80 (acquiescence, intervention, rate cuts or transaction taxes). 1990 1991 1992 1993 1994 1995 1996 The only rule of the road is that countries cannot peg their Source: J.P.Morgan currencies or drive the dollar higher, since doing so could invite a trade war. (See Consequences of a unilateral Plaza over 400 trade disputes with the WTO since its launch in Accord, FXMW, October 8). Since core views are 1995 (chart 1) and the US has been involved in half of unchanged this week, the Outlook examines how to hedge those, equally as plaintiff and defendant. These cases range tail risk around a trade war in 2011. from the universally memorable (US vs Japan on autos) to the seemingly trivial (US vs EU over bananas). Most fail to War is rare, conflict is a constant impact major asset classes since they concern a minor Trade wars are very black swans. If trade wars are defined product, or because they are settled before escalating into as unilateral restrictions on economically significant goods broader categories or retaliatory actions. which impact growth and financial markets, then the world Probably the most significant cases of the past twenty years has not experienced one since the Smoot-Hawley tariffs of are the US-Japanese auto dispute and the US-EU steel 1930. The closest approximation would be the US-Japan conflict, because they involved iconic sectors and because auto dispute twenty years ago, and prior to that, the Nixon the US threatened or imposed unilateral sanctions. Table 1 Administration’s tariff hikes of 1971. But trade conflict, lists the key events in each saga, from which a simple point defined as restrictions on narrower classes of goods with no emerges: trade conflict does not erupt suddenly. Trade market impact, are always underway. Countries have lodged relations deteriorate over several years starting with investigations, the proceeding through negotiation, threat of 2
  3. 3. Global FX Strategy FX Markets Weekly October 18, 2010 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd. sanction, sanction then dispute resolution (within or outside Japanese purchases of US goods), and February to May the WTO). 1995, the months between the US’s proposed tariffs and an eventual compromise. Although another factor may explain Isolating a trade war’s impact on FX the residual, a risk premium for trade conflict could account Isolating the currency impact of a trade war requires for the divergence. In some months this premium was as separating the dispute from the cyclical trend. Consider the high at 15%. The same modeling exercise for EUR/USD case of USD/JPY. As discussed in the research note US- during the 2002 steel dispute also yields a decent residual – Japan trade war and USD/JPY on page 26 (Sasaki and the euro was some 6% stronger than cyclical conditions Tanase), US-Japan trade tensions persisted from the mid- would have predicted. This overshoot could also reflect the 1980s to mid 1990s, when Japan constituted 40% to 60% of US accounting scandals which unfolded over the same the US’s total trade deficit. Over those ten years USD/JPY period, but trade frictions may have aggravated the trend. declined every year but one (1989), which should be Note that now, neither the trade-weighted dollar nor unsurprising in view of cyclical conditions and G-7 policy. individual dollar pairs are far from fair value, suggesting 1985 to 1986 delivered the Plaza Accord to weaken the little risk premium for possible trade conflict. dollar; 1989 to 1992 was a major Fed easing cycle; 1993 Hedging the next trade war was the year of a near-record Japanese trade surplus; and 1994 to early 1995 was a period of broad dollar weakness Whether 2011 delivers a trade war is largely conjectural, due to dislocations from unexpected Fed tightening and the but there are four reasons why China looks the likely target Mexican peso crisis. for any serious conflict: (1) it accounts for the majority of the US’s trade deficit (chart 4); (2) the US and China have As an attempt to isolate the trade war’s impact on been involved in at least 20 low-level tariff confrontations USD/JPY, chart 2 regresses USD/JPY on rate spreads as a over the past two years; (3) China’s exchange rate is the proxy for cyclical conditions. There are two major most managed of any major trading partner; and (4) its undershoots: January to August 1993 (Clinton’s retaliatory weapon of selling – or not buying – US inauguration through his G-7 summit proposing targets for Treasuries is less effective when the Fed substitutes as a Table 1: Characteristics of US-Japan auto and US-EU steel disputes Product Countries Key dates Economic significance of involved products autos US vs Japan January 1993: Clinton inaugurated and raises trade issues as a means of boosting In 1993 US exported the US economy. $50bn of autos and auto parts and imported July 1993: Clinton announces at G-7 summit the Framework for a New Economic $100bn. The $50bn annual Partnership to open Japanese markets for autos and auto parts, as well as trade deficit in autos was insurance and telecoms. the second highest February 1994: Talks deadlock over US demands that Japan commit to sectoral deficit, after the quantitative targets for US goods. $75bn annual deficit in consumer goods. Oct 1994: US proposes 100% tariffs on Japanese autos to retaliate for alleged unfair trade practices in Japanese auto parts market May 1995: Japan files claim with WTO. June 1995 Compromise agreement reached under which Japan agrees to increase purchases of autos and auto parts steel EU (later 2000: Presidential candidate Bush promises voters in Ohio and West Virginia that In 2002, US imported joined by his Administration would aid the steel industry. $12bn and exported $8bn Japan, Korea, of steel and steel products. Brazil and June 2001: US launches investigation into European trade practices for steel The deficit in steel others) vs US sector. October 2001: US publishes preliminary findings. Feb 2002: US publishes final report. March 2002: US imposed 8% to 30% tariffs on steel imports for three years. EU immediately requests WTO consultation. Five other countries join EU complaint against US. July 2003: WTO rules against US. December 2003: US repeals tariffs. Source: J.P.Morgan 3
  4. 4. Global FX Strategy FX Markets Weekly October 18, 2010 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd. buyer of last resort. The obvious currency hedge would be Osborne laid out the broad deficit targets in his June to buy USD/CNY, since the market discounts 3.3% emergency budget (£149bn in FY 2010-11, £116bn in 201- appreciation over the next near when the authorities would 12, £89bn in 2012-13), and his speech Wednesday should probably fix the currency if subjected to excessive US focus on departmental details. There is some risk that he pressure. Due to hedging demand forwards and vols would backs away from the previously-proposed broad targets in move significantly even without a change in spot, as view of the economy’s slowdown, though we doubt he occurred in 2008 when forward points moved from discount would tempt the gilt market vigilantes so carelessly. to premium and vols spiked from 5% to 25%. Three central banks meet next week: the Bank of Canada The difficulty with this position is highlighted by the US- on Tuesday and the central banks of Brazil and Thailand on Japan and US-EU disputes, however. Hedging directly Wednesday. We expect Canada and Brazil to stay on hold though the currency in conflict must respect cyclical until Q1 2011, but the BoT should hike 25bp next week. conditions, since trade wars can require years to evolve, G-20 finance ministers gather on Friday in Seoul ahead of even once specific sanctions are mentioned. In the US- the leader’s summit on November 11. Within such a diverse Japan and US-EU cases, cyclical conditions favored a group, the only likely consensus is their opposition to higher yen and euro as tensions built. In China’s case, volatility, an expression which accommodates the US desire cyclicals favour a weaker USD/CNY for the next several for a weaker currency and the rest of the world’s burden of months, resulting in losses on the hedge if trade war is a managing that decline. A communiqué could lift this very long term event risk. language from previous G-7 statements, but should not have As a proxy hedge, the best options are to sell USD/JPY or much market impact other than confirming that countries USD/CHF. These currencies are biased lower in any event will continue to conduct smoothing operations in the forex due to cyclical conditions (QE in the US, trade surpluses in market as the Fed’s QE program sustains excessive capita Japan and Switzerland), and would benefit from any flows. investor deleveraging which accompanies an escalation in Chart 3. The US’s trade deficit with China exceeds that of Japan, trade tensions. Owning the euro or commodity currencies Mexico and Canada combined are poor hedges since both would decline with equities. US trade deficit by major trading partner, $bn, 12-mo rolling sum This impact would counter any bid for euros which might 50 come from China’s shift away from Treasuries during trade conflict. We are not tactical sellers of either USD/JPY or 0 USD/JPY today given how far the dollar has moved (see -50 Trade Recommendation on page 14), but we intend to add on pullbacks. -100 China Japan -150 Next week: US earnings, European PMIs, G-20 China's trade surplus exceeds Mexico build-up, UK CSR -200 Japan's by 2000 Canada Next week is heavy on all fronts: earnings, data and policy -250 announcements. Nearly 20% of the S&P500 reports -300 earnings next week (see Earnings calendar on page 6), and 93 95 97 99 01 03 05 07 09 we expect this week’s string of better-than-expected releases to extend into November. So if QE were not sufficient propellant for non-dollar currencies, earnings Source: J.P.Morgan would be. In the US, the key data releases are the TIC and industrial production on Monday, housing starts on Tuesday and the Philadelphia Fed on Thursday. In the Euro area, watch the Zew on Tuesday, flash PMIs on Thursday and Ifo and BNB on Friday. The monthly batch of Chinese data due Thursday – GDP, CPI, retail sales and industrial products – will be scrutinised given hopes that China will reaccelerate into 2011 after its apparent soft landing. In the UK, retail sales prints on Thursday, but it will be anticlimactic following release of the Chancellor’s Comprehensive Spending Review on the day before. 4
  5. 5. Global FX Strategy FX Markets Weekly October 18, 2010 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd. Main recommendations Closed/new trades ⎯ None. Existing trades ⎯ In cash, stay long AUD/USD from 0.9385 opened September 17, and short GBP/SEK from 11.19, opened September 10. ⎯ Stay long EUR/USD from 1.3720, long EUR/GBP from 0.8680, short USD/SEK from 6.7100 and short USD/KRW from 1130, all opened October 1. ⎯ Stay short GBP/ CHF from 1.5479, and short GBP/NOK from 9.3081, all opened September 24. ⎯ Stay short USD/INR from 46.17 opened June 18. ⎯ In options, keep a 12-mo at-expiry EUR/CHF 1.25 digital. 5
  6. 6. Global FX Strategy FX Markets Weekly October 18, 2010 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd. Earnings calendar Date Time Company Name Company Ticker Estimate-JPM Estimate-Cons Oct 18 (Mon) 13:00 Citigroup C US n.a. 0.06 Aft-mkt IBM IBM US n.a. 2.74 Apple AAPL US n.a. 4.07 Oct 19 (Tue) Bef-mkt Coca-Cola Co/The KO US n.a. 0.90 11:30 Bank of New York Mellon BK US n.a. 0.55 12:00 Bank of America BAC US n.a. 0.14 13:00 Goldman Sachs GS US n.a. 2.25 Occidental Petroleum Corp OXY US n.a. 1.38 EMC Corp/Massachusetts EMC US n.a. 0.30 Johnson & Johnson JNJ US n.a. 1.15 Yahoo! Inc YHOO US n.a. 0.15 Oct 20 (Wed) Bef-mkt Abbott Laboratories ABT US n.a. 1.04 Bef-mkt US Bancorp USB US n.a. 0.43 Bef-mkt United Technologies Corp UTX US n.a. 1.28 12:00 Altria Group Inc MO US n.a. 0.52 12:30 Boeing BA US n.a. 1.00 13:00 Wells Fargo & Co WFC US n.a. 0.56 21:15 Fidelity National Financial FNF US n.a. 0.30 eBay EBAY US n.a. 0.37 US Airways LCC US n.a. 1.11 SanDisk Corp SNDK US n.a. 1.05 Oct 21(Thu) Bef-mkt United Parcel Service UPS US n.a. 0.88 Bef-mkt Freeport-McMoRan FCX US n.a. 1.94 Bef-mkt McDonald's Corp MCD US n.a. 1.24 Bef-mkt United Parcel Service UPS US n.a. 0.88 Bef-mkt SunTrust Banks Inc STI US n.a. -0.02 12:00 Philip Morris International PM US n.a. 1.01 12:15 Xerox XRX US n.a. 0.21 12:30 Caterpillar CAT US n.a. 1.09 13:00 AT&T T US n.a. 0.56 Aft-mkt American Express AXP US n.a. 0.83 Swedbank SWEDA SS n.a. 1.22 Morgan Stanley MS US n.a. 0.22 Credit Suisse CS US n.a. 1.03 Eli Lilly & Co LLY US n.a. 1.15 Union Pacific Corp UNP US n.a. 1.48 Credit Suisse CS US n.a. na Oct 22 (Fri) 11:00 Schlumberger SLB US n.a. 0.71 Verizon Communications VZ US n.a. 0.54 Amazon.com Inc AMZN US n.a. 0.48 Bristol-Myers Squibb BMY US n.a. 0.53 6
  7. 7. Global FX Strategy FX Markets Weekly October 18, 2010 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd. This page left intentionally blank 7
  8. 8. Global FX Strategy FX Markets Weekly October 18, 2010 Yoonyi Kim (81-3) 6736-7729 yoonyi.x.kim@jpmorgan.com JPMorgan Chase Bank NA Global FX carry trade monitor Chart 1: Japanese retail -- market capitalisation of 100 largest FX- Chart 2: Japanese retail -- aggregate retail margin shorts in JPY denominated ITs ¥trn; market capitalization of 100 largest investment trusts excluding funds ¥trn, Japanese retail measured by positions in USD, NZD, EUR, GBP and AUD investing in equities; ranked in the order of total asset as of Nov 17th 09 on Tokyo Financial Exchange; positive indicates shorts in JPY 25 70 ¥8 Aggregate margin shorts in JPY, JPYtrn, lhs 70 JPY trade-w td, inv erted rhs 80 ¥6 80 20 90 ¥4 90 100 ¥2 100 15 110 ¥0 110 Market cap of top 100 ITs, JPY trn, lhs JPY trade-w td index , inv erted rhs 10 120 -¥2 120 06 07 08 09 10 07 08 09 10 Source: J.P. Morgan, Bloomberg Source: J.P. Morgan, TFE; • Japanese retail exposure to foreign currency investment trusts • Japanese aggregate margin shorts in JPY reached ¥5.2 trn as slightly declined from ¥17.3 trn as of Oct 7th to ¥17.1 trn as of of Oct 12, the largest since Sep 14th. However, it declined to Oct 8th and has stabilized. This is 11% below this year’s high ¥4.3 trn as of Oct 14th. This is still 32% and 39% below this at ¥19.2trn and 29% below the record high at ¥24.1trn marked year’s peak at ¥6.3trn and record peak at ¥7.1trn respectively. in Aug 08. Chart 3: Japanese retail -- margin position in JPY vs USD, EUR, Chart 4: CTAs -- aggregate IMM position in USD AUD mln local currency. positive indicates long in local currency/short in JPY $ bn as the sum of net speculative positions on the IMM in AUD, NZD, CAD, EUR, GBP, JPY, CHF and MXN. $30 110 40 USD Aggregate IMM position in USD, $ bn, lhs 30 EUR $20 USD trade-wtd index, rhs 105 AUD $10 100 20 10 $0 95 0 -$10 90 -10 -$20 85 -20 -$30 80 -30 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 -$40 75 00 01 02 03 04 05 06 07 08 09 10 Source: J.P. Morgan, TFE Source: J.P. Morgan, CME • Margin longs in USD/JPY marked a new record high at • Aggregate IMM shorts in USD have hit a new all-time high of $35.5bn as of Oct 12, before modestly declining to $33.1bn as $35.9bn as of the October 8 report. Longs are almost evenly of Oct 14th. Short EUR/JPY increased by €1.2 bn to €3.7 bn in spread across euros ($8bn), yen ($8bn) and Australian dollars the past week while long AUD/JPY was largely unchanged at ($7b). Swiss longs total $3bn. around A$12 bn. 8
  9. 9. Global FX Strategy FX Markets Weekly October 18, 2010 Yoonyi Kim (81-3) 6736-7729 yoonyi.x.kim@jpmorgan.com JPMorgan Chase Bank NA Chart 5: Market capitalisation of US-listed currency ETFs Chart 6: Currency managers and global macro hedge funds -- Beta with trade weighted USD Weekly data, $bn. Positive value indicates longs in foreign currency and shorts in HFR used for global macro hedge funds. Barclay BTOP Index used for currency USD managers. 5 75 3.0 Global macro hedge funds 2.0 Currency managers 4 80 1.0 3 85 0.0 -1.0 2 90 -2.0 1 95 -3.0 Market cap of US-listed FX ETFs, $bn, lhs -4.0 USD trade-w td index , inv erted, rhs 0 100 05 06 07 08 09 10 06 07 08 09 10 Source: J.P. Morgan, Bloomberg Source: J.P. Morgan, Bloomberg • US retail exposure to foreign currencies via ETFs was • The returns beta for macro funds with the dollar was stable at unchanged at $3.3bn, which is just a tad lower than the around -0.2 for global macro funds, indicating a small short. year-to-date high at $3.4bn. Compared to the pre-Lehman The beta for currency managers held around -0.4, indicating a peak, however, it is still 35% below. moderate short. Note that betas are still well shy of their 2007/08 lows. Chart 7: Currency managers and global macro hedge funds -- Beta Chart 8: Currency managers and global macro hedge funds -- Beta with G-10 carry strategies with emerging markets carry strategies Positive beta implies a long in carry, a short in dollars HFR used for global macro Positive beta implies a long in carry, a short in dollars HFR used for global macro hedge funds. Barclay BTOP Index used for currency managers. hedge funds. Barclay BTOP Index used for currency managers. 3.0 2.0 Currency managers Global macro hedge funds Currency managers Global macro hedge funds 2.0 1.5 1.0 1.0 0.5 0.0 0.0 -1.0 -0.5 -2.0 -1.0 05 06 07 08 09 10 05 06 07 08 09 10 Source: J.P. Morgan, Bloomberg Source: J.P. Morgan, Bloomberg • Both returns beta for macro funds and currency managers • Macro funds’ returns beta with EM carry jumped notably to with G-10 carry continued to show little change with the beta +0.1 from close to year-to-date low at -0.5, turning positive for former staying flat since mid-July and the latter since mid- for the first time since early June. The beta for macro funds July. also advanced further to record a new year-to-date high at +0.3. Historical high for each beta stands at +1.8 and +0.8 respectively. 9
  10. 10. Global FX Strategy FX Markets Weekly October 18, 2010 Arindam Sandilya (1-212) 834-2304 arindam.x.sandilya@jpmchase.com JPMorgan Chase Bank NA Chart 1. Option markets are currently not re-rating USD-skews in FX Derivatives favor of USD-puts at the pace at which it was in previous weeks USD-skews defined as average 3M 25D USD call vol – USD put vol across 9 G10- • The dollar will remain front and center of FX currencies. Beta is calculated as the slope of regressing hourly vol pt. changes in the average USD-skew on hourly % changes in DXY over rolling 1-week windows. markets, which bodes well for long USD-correlation Beta (vol pts per 1% DXY move) trades. Stay long USD-vol vs. short EUR-cross vol in 0.15 82 DXY CHF, but take profits on AUD and NZD. 0.10 81 • Options are not re-rating G10 skews in favor of USD puts at the same rate as before. High and 0.05 80 rising USD-correlations also suggest caution around an unfettered extension of the dollar downtrend. 0.00 79 • CAD/JPY vs. USD/CAD as a long/short gamma RV -0.05 78 is beginning to look interesting. Entry levels are 0.7- Rolling 1-w eek beta of av g. -0.10 77 0.8 vols away from current implied spreads. G10 USD-skew s w .r.t. DXY • CAD/JPY is an interesting wing option buy in its -0.15 76 own right, with var swap vs. vol swap strike basis at 15-Sep 20-Sep 26-Sep 2-Oct 8-Oct 14-Oct historical lows. Source: Bloomberg Chart 2. Higher ex-ante USD-based correlations have historically Another week, another bout of dollar selling. Dovish Fed yielded larger returns from long DXY positions, whether the exit minutes on Tuesday nipped any impending trend correction point is determined by a threshold drop in correlation… in the bud, and the surprise MAS move to increase the slope Average ex-post returns (since ‘99) from long DXY positions contingent on various and width of the SGD NEER policy band on Thursday ex-ante USD-based correlation buckets, where corrs are computed as the average pairwise 3M implied correlation between USD-majors within G10. Exit points from accelerated the downdrift in the greenback. Option markets DXY longs are marked by a threshold drop in USD-corrs. This is a low-frequency have however not re-rated the dollar’s prospects lower with signal, with the average holding period corresponding to a 5% drop being a year. as much enthusiasm lately as spot markets. Chart 1 Av g. long DXY returns highlights this nascent divergence by overlaying the beta of 8% Current correlation average G10-USD skews wr.t. DXY on the dollar index Ex it DXY longs w hen correlation drops: bucket itself. Even as the DXY has pushed lower, the rate at which 6% 1.0% 2.5% 5.0% G10 skews have re-priced in favor of USD puts has come 4% off the boil over the past week. This dovetails well with a prior analysis that suggested dollar bearishness as measured 2% by option skews was approaching a historical extreme, a 0% set-up that has typically preceded a 1%-2% correction in the DXY over the following month (FXMW, Oct 8). While this -2% does not in itself mark the end of the spot trend, it does 40% 43% 45% 48% 50% 53% 55% 58% 60% 63% 65% 68% suggest that gains for dollar shorts could come at a Correlation bucket mid diminishing pace in the days ahead. Source: J.P. Morgan A similar read is provided by the relationship between the Chart 3. … or by a pre-defined holding horizon USD-based G10 correlations and the DXY. Intuitively, Av g. long DXY returns since the dollar explains around 60% of the variation in all 5% Current correlation majors taken together, pronounced dollar trends should drag Ex it DXY longs after holding for: bucket USD-based correlations higher as they gather steam, before 3% 2 w eeks 1 month 2 months eventually exhausting themselves and causing correlations to top out. Empirical analysis lends some credence to this 1% hypothesis. Chart 2 and 3 plot the average ex-post returns from entering long DXY positions contingent on various -1% levels of ex-ante USD-based correlations – defined as the average pairwise 3M implied correlation between USD- -3% majors within G10 – using either a threshold drop in corrs 40% 43% 45% 48% 50% 53% 55% 58% 60% 63% 65% 68% (chart 2) or fixed holding periods (chart 3) to mark exit Correlation bucket mid points from trades. The inference is identical from both: high regimes of USD-correlations have typically preceded Source: J.P. Morgan 10
  11. 11. Global FX Strategy FX Markets Weekly October 18, 2010 Arindam Sandilya (1-212) 834-2304 arindam.x.sandilya@jpmchase.com JPMorgan Chase Bank NA 3-4 % corrections in the dollar trend. In light of this, the Chart 4. Long USD-vol vs. short EUR-cross vol spreads in AUD and current correlation level of 57% – at 0.7 std. devs above a NZD have re-priced to levels where taking profits looks prudent long run mean, not quite at a historical peak – does not vol pts. 1.0 AUD/USD - 1.2*EUR/AUD 6M 25D strangle spread justify positioning for a trend reversal in the DXY the way NZD/USD - 1.2*EUR/NZD 6M 25D strangle spread 65%+ buckets do. But the empirical pattern does suggest 0.5 some deceleration in the dollar downtrend going forward, even if a complete reversal maybe some way off. 0.0 Regardless of direction though, the dollar will remain front -0.5 and center of FX markets for some time now – despite all indications that the Fed is set to announce LSAPs on Nov 3, -1.0 any disappointments on this front could turn out to be explosive for markets given current positioning – which -1.5 bodes well for long USD-correlation trades. Our proxy correlation longs in the portfolio in the form of USD-vol vs. -2.0 EUR-cross vol spreads have finally gained traction of late Apr 10 Jun 10 Aug 10 Oct 10 after more than a month of frustrating price action. A Source: Bloomberg number of USD-vols – most notably AUD, EUR and the USD/Scandis – have now transitioned to the rich end of the Chart 5. CAD/JPY is a better gamma buy relative to USD/CAD vol pts. vol scale after a sharp uptick in implieds over the past two 20 CAD/JPY - 1.3*USD/CAD 3M Implied Vol Spread weeks. The move is almost certainly an artifact of CAD/JPY - 1.3*USD/CAD 1M Realized Vol Spread CAD/JPY - 1.3*USD/CAD 3M Realized Vol Spread directional option demand given that realized vols have not 15 firmed up nearly enough to justify the move, and has led our vol spreads to reprice to levels where taking profits on 10 some of them seems prudent (chart 4). That still leaves us with one finger in the long USD-corr. pie through a long 5 USD/CHF vol vs. short EUR/CHF vol spread initiated last week – the only trade of its ilk that still offers value given 0 its stark cheapness in the context of generally elevated dollar corrs. Admittedly, the richening of EUR/CHF vols owes much to the antics of the SNB in the first half of the -5 year and the enormous amount of levered capital that the Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Apr-10 Oct-10 bullish CHF trade attracted to fade CB intervention. But Source: J.P. Morgan with the SNB having now stepped aside, the broad dollar trend should re-assert its influence on the spread and force a stabilizers, absent a large and diverging policy differential relative reassessment higher of USD/CHF vols. between the two central banks; the latter is likely to be less of an issue over the next quarter with our economists In relative value space, one trade that we have begun to pushing back the date of the next BoC hike to March 2011. track closely is buying CAD/JPY gamma as a spread to More critically from the standpoint of trade optics, vol USD/CAD gamma. Generally speaking, we have been compression over the past month has pushed implied loath to buy yen-cross vols against USD-vols given the spreads down to levels that are approaching '09 lows, and grind lower in USD/JPY over the last 3-4 months. The latter are significantly under trailing realized vols (chart 5). This has meant that yen-crosses have underperformed dollar should place a floor under the spread if the softness in the pairs in the direction of currency strength/USD- or JPY- greenback extends further, while exposing the trade to weakness, thereby reducing the incentive to own the more greater upside in the event of a trend correction, or less expensive JPY-cross vol over the USD vol on at least one likely, another round of BoJ intervention. Historical stats side of the spot distribution (FXMW, September 17). That suggest we are 0.7-0.8 vols of cheapening in the beta said, the one currency to which the argument probably does weighted spread away from pulling the trigger on the trade, not apply as forcefully as it does to others, and where by and will remain on our radar for the next couple of weeks. extension the reverse trade is not overly onerous, is CAD. This can be attributed to the fact that a dollar downtrend That CAD/JPY turns up as the long leg of the vol RV above does not usually elicit the kind of runaway moves that one is interesting in the light of a rich/cheap analysis of wing usually associates with other commodity bloc currencies options. One approach to gauging value in owning wings is such as AUD, largely on account of economic linkages to consider the attractiveness of owning variance swaps between US and Canada that tend to act as automatic trend over vol swaps. Because the vol swap product is linear in 11
  12. 12. Global FX Strategy FX Markets Weekly October 18, 2010 Arindam Sandilya (1-212) 834-2304 arindam.x.sandilya@jpmchase.com JPMorgan Chase Bank NA realized vol at expiry while the variance swap payout is in Chart 6. P/L from long var swap vs. short vol swap is quadratic w.r.t. terms of vol squared, the net P/L from a vega-neutral the realized vol at expiry long/short spread between the two is quadratic in at- P/L at ex piry maturity realized vol (chart 6), with long var/short vol combinations out-performing in outsized or extremely Root1 = KVAR - √[2*KVAR*(KVAR-KVOL)] muted market moves when delivered vols end up beyond Root2 = KVAR + √[2*KVAR*(KVAR-KVOL)] the two roots of the quadratic. Currency pairs that usually deliver vol outside these roots should rank as good wing option longs, and CAD/JPY ranks as one of the few that qualify as attractive variance buys on this gauge (chart 7). In addition, the absolute level of the var swap – vol swap strike basis in CAD/JPY is plumbing historical lows (chart Root1 Root2 8), which buttresses the case for overweighting OTM strikes in the cross. In contrast, a number of EUR/high beta crosses Realized v ol at ex piry (EUR/BRL, EUR/MXN, EUR/NZD) require generously wide thresholds of realized vols to be breached before wing Source: J.P. Morgan longs can begin to deliver positive P/L, and therefore appeal Chart 7. CAD/JPY has more often than not clocked realized vols as variance sells. Even though the market for flat vega outside the current roots of a long 1Y var /short 1Y vol swap spread products such as vol and var swaps has widened out Fraction of time since 2002 that 1Y realized vols have ended up within the current considerably from their pre-crisis days and trading spreads lower and upper roots of a long 1Y var swap vs. short 1Y vol swap spread. Rolling between the two is transaction cost prohibitive, rich/cheap 1Y realized vols computed off 252 WMR fixings. rankings like these are useful to track even if the actual 100% Wings cheap Wings rich trade implementation is via simple delta-hedged vanilla butterflies. 80% 60% 40% 20% 0% USD/HUF USD/CHF USD/CZK CHF/JPY USD/SEK USD/NOK CAD/JPY USD/TRY USD/CLP EUR/NZD USD/ZAR CAD/MXN EUR/CHF USD/SGF EUR/JPY GBP/JPY EUR/CZK EUR/BRL EUR/ZAR EUR/MXN Source: J.P. Morgan Chart 8. CAD/JPY var swap strikes are trading at a historically low premium to vol swap strikes, making long wing positions attractive CAD/JPY 1Y var swap – vol swap (mid) strike differential. No transaction costs. v ol pts. 1.8 1.4 1.0 0.6 0.2 -0.2 Feb-07 Nov -07 Jul-08 Apr-09 Jan-10 Oct-10 Source: J.P. Morgan 12
  13. 13. Global FX Strategy FX Markets Weekly October 18, 2010 Arindam Sandilya (1-212) 834-2304 arindam.x.sandilya@jpmchase.com JPMorgan Chase Bank NA Implied volatilities Biggest 3M Implied Volatility Movers Current Implied Vols Avg. Implied Vols Z-Score Implied Vols Weekly Changes Monthly Changes 1M 3M 1Y 1M 3M 1Y 1M 3M 1Y USDCLP USDINR A UDJP Y 16.3 17.0 19.3 24.1 23.9 24.0 -0.88 -1.01 -1.08 USDKRW USDKRW A UDUSD 14.4 14.5 15.5 17.7 17.6 17.4 -0.56 -0.69 -0.71 USDM XN USDTWD CA DJP Y 15.6 16.1 17.9 21.1 20.9 20.8 -0.87 -0.98 -0.92 USDJPY USDSGD USDRUB Vol Vol USDNOK CHFJP Y 1 .1 1 1 .9 1 13.9 15.6 15.5 15.7 -1.07 -1 2 .1 -0.85 USDSGD USDSEK EURA UD 10.9 1 .6 1 13.1 13.4 13.7 14.0 -0.58 -0.63 -0.42 USDARS USDP HP EURCA D 1 .2 1 1 .5 1 12.6 13.1 13.2 13.5 -0.52 -0.56 -0.39 USDTRY A UDUSD Vol EURCHF 10.7 10.3 9.9 7.3 7.0 6.6 1.08 1.26 1.72 USDPHP EURUSD EURGB P 10.1 10.4 1 .4 1 12.2 12.5 12.8 -0.53 -0.64 -0.58 USDINR A UDJP Y EURJP Y 13.3 14.1 16.4 17.7 17.8 18.1 -0.77 -0.80 -0.55 EURCZK USDIDR AUDUSD EURCZK EURNOK 8.7 8.6 8.9 10.9 10.6 10.1 -0.58 -0.62 -0.53 USDCAD EURHUF Vol EURNZD 1 .0 1 1 .6 1 13.2 14.1 14.3 14.6 -0.88 -0.96 -0.77 EURSEK EURAUD EURSEK 8.1 8.1 8.5 1 .5 1 1 .1 1 10.5 -0.89 -0.93 -0.88 EURCAD USDCLP EURUSD 13.5 13.5 13.6 13.7 14.0 14.2 -0.05 -0.18 -0.26 AUDJPY EURJP Y GB P JP Y 13.2 14.2 16.6 20.0 19.9 20.1 -1.04 -1 0 .1 -1.01 CHFJPY EURNZD EURJPY CA DJP Y GB P USD 10.9 1 .3 1 12.3 14.3 14.5 14.7 -0.83 -0.95 -1.05 GBPJPY GB PJP Y NZDUSD 14.3 14.5 15.6 18.3 18.4 18.3 -0.82 -1.00 -1 0 .1 USDCA D 12.4 12.5 13.2 14.7 14.8 14.9 -0.57 -0.69 -0.68 -1 -0.6 -0.2 0.2 0.6 1 .0 .0 -1 -0.2 0.6 1 2.2 3.0 .0 .4 USDCHF 12.9 12.9 12.8 12.6 12.9 13.0 0.08 -0.02 -0.07 USDJP Y 12.2 12.5 13.4 14.4 14.3 14.3 -0.62 -0.74 -0.87 Source: J.P. Morgan USDNOK 15.7 15.7 15.8 17.4 17.3 17.1 -0.38 -0.46 -0.59 USDSEK 15.8 15.7 15.7 18.0 17.6 17.3 -0.50 -0.54 -0.68 Front-End Vol Rankings USDA RS 5.0 8.0 15.8 10.2 15.7 26.2 -0.49 -0.80 -1 2 .1 In order of Normalized Volatility Risk Premium* USDA RS USDB RL 12.8 14.4 16.5 19.8 19.5 19.6 -0.81 -0.79 -0.77 A UDJP Y USDCLP 13.2 12.6 12.5 16.3 16.4 17.0 -0.58 -0.76 -0.98 USDSGD USDM XN 12.3 13.2 14.2 17.8 17.5 17.6 -0.70 -0.66 -0.64 EURCZK EURCZK 5.8 6.3 6.8 1 .0 1 10.2 9.3 -1.03 -1.03 -1.07 USDM XN USDJP Y Vols RICH EURHUF 10.1 1 .2 1 13.0 15.6 15.2 14.9 -0.95 -0.89 -0.58 GB P JP Y EURP LN 10.5 1 .3 1 12.3 16.8 15.9 14.9 -0.88 -0.85 -0.75 USDB RL USDRUB 12.1 12.1 12.5 14.2 15.5 18.4 -0.43 -0.67 -1.05 USDSEK USDTRY 12.7 12.8 13.6 15.5 15.8 16.8 -0.47 -0.63 -1.01 USDZA R USDZA R 14.3 14.5 15.0 20.7 20.7 20.7 -0.98 -1 0 .1 -1.41 USDNOK USDIDR 6.5 8.5 1 .9 1 16.8 17.8 19.8 -0.95 -0.96 -0.92 EURHUF EURUSD USDINR 10.5 10.9 1 .5 1 1 .5 1 12.3 13.3 -0.27 -0.38 -0.46 EURGB P Vols USDKRW 14.8 15.0 15.3 20.2 19.2 17.7 -0.46 -0.46 -0.43 USDTWD CHEAP USDP HP 8.5 8.6 9.7 10.3 1 .2 1 12.6 -0.46 -0.65 -0.74 EURCA D USDSGD 7.5 7.6 7.9 7.7 8.1 8.6 -0.09 -0.19 -0.34 EURCHF USDTWD 6.7 6.9 7.3 7.0 7.7 8.6 -0.16 -0.40 -0.60 EURNZD 0.0 0.6 1.2 1.8 2.4 3.0 *Normalized Volatility Risk Premium = 1M Implied Vol / 1M Realized Vol - 1 Source: J.P. Morgan Open Trades Entry Entry* Current P/L P/L Analyst Description Remarks date mid Units Buy 6M 25D USD/CAD strangles vs. Sell 6M 25D EUR/USD Vol spread proxy for a defensive long CAD/USD vs. CAD/EUR Sandilya 09/07/10 0.2 -0.2 -0.4 vol pts. strangles, equal USD vega on both legs correlation trade Buy 6M 25D MXN/JPY strangles vs. Sell 6M 25D EUR/JPY Vol spread proxy for a defensive long MXN/JPY vs. MXN/EUR Sandilya 23/07/10 -3.6 -1.7 1.9 vol pts. strangles, 100:140 JPY vega ratio correlation trade Buy 6M 25D AUD/USD strangles vs. Sell 6M 25D EUR/AUD Sandilya 30/07/10 -0.8 0.7 1.5 vol pts. Profit taking on realized correlation strangles, 100:120 AUD vega ratio Buy 6M 25D NZD/USD strangles vs. Sell 6M 25D EUR/NZD Sandilya 13/08/10 0.0 0.5 0.5 vol pts. Profit taking on realized correlation strangles, 100:120 NZD vega ratio Sandilya Buy GBP/USD 6M straddles 13/08/10 12.4 10.7 -1.7 vol pts. Attractive valuations on GBP vols Sandilya Sell EUR/SEK 3M 25D Risk Reversals 10/09/10 1.6 0.7 0.8 vol pts. Riskies rich vs. history,ATMs and realized skews Buy 2M AUD/USD straddes vs. Sell 2M AUD/CAD straddles, Sandilya 10/09/10 0.7 0.2 -0.5 vol pts. Relative value in gamma 100:120 AUD vega ratio Sandilya Sell EUR/JPY 1Y 25D strangles 17/09/10 16.0 16.4 -0.4 vol pts. Short yen vol theme, back-end vols rich to front Sandilya Sell USD/BRL 6M6M FVAs 24/09/10 16.6 17.2 -0.6 vol pts. Historically steep vol curve, contained vol levels Buy 6M 25D USD/CHF strangles vs. Sell 6M 25D EUR/CHF USD/CHF vols underpriced vs. EUR/CHF vols in a high dollar- Sandilya 08/10/10 1.5 0.7 -0.8 vol pts. strangles, 100:120 vega ratio based correlation environment * For delta-hedged straddles and vol products, P/L is in vol points; for directional trades, bp of notional; negative indicates a net credit at inception 13
  14. 14. Global FX Strategy FX Markets Weekly October 18, 2010 Paul Meggyesi (44-20) 7859-6714 paul.meggyesi@jpmorgan.com J.P. Morgan Securities Ltd. Trade Recommendations FX trade recommendations Trade recommendations in this section are mostly spot, for • The prospect of further QE is proving more toxic easier incorporation into the monthly Global Markets for the dollar than QE1. Outlook & Strategy (GMOS), which outlines J.P. Morgan’s flagship model portfolio across bonds, credit, equities, fx • Stay short against a broad basket of currencies to and commodities. Some directional option trades are reflect the Fed’s willingness to debase its currency. included here as alternatives to cash position, and as a complement to relative value trades discussed in FX • Similar arguments justify a broad short in GBP, Derivatives section of this publication (p. 10). especially as fiscal reality bites Current recommendations are marked to market at Friday • Closed trades: None afternoon London time. A complete inventory of closed trades is presented at the end of this section along with • New trades: None. performance statistics such as success rates and average • Existing trades: Stay short USD versus AUD, EUR, returns per trades. SEK, INR and KRW (all cash). Stay short GBP versus CHF, EUR, NOK and SEK. Hold short Chart 1: The QE2 heralded by Bernanke at his Jackson Hole speech EUR/CHF via a 1-yr at-expiry digital. is having a more adverse effect on the dollar than QE1 USD trade-weighted index set to 100 at the time of the QE announcement. For 2009 we use the March 18 announcement of Treasury purchases, for 20010 we The overarching theme for FX remains the growing divide use Ben Bernanke’s Jackson Hole speech on Aug 27 when he set out the case for between the developed world’s central banks, between the further easing. happy debasers on the one hand (the Fed and the BoE) and 104 Fed QE 'announcement' those with either an economic or philosophical objection to a more explicit pursuit of inflation. It is not necessary to 102 make a normative judgement about which central bank Mar-09 Aug-10 course is correct; merely to recognise that nominal 100 exchange rates will adjust to reflect the varying inflation 98 preferences of individual central banks. A credible commitment to inflate is a credible commitment to devalue. 96 The question for us is not whether the theme will change – 94 monetary divergence seems entrenched for a further one- 92 two quarters at least, even if the political frictions created by monetary and exchange rate policies are more -10 0 10 20 30 40 50 unpredictable – but whether QE2 is yet discounted in the Day s before/after Fed QE announcement dollar and in sterling. This is hard to answer with precision, Source: J.P. Morgan not least because the Fed has offered little if any guidance about the magnitude or timing of additional large scale asset Chart 2: USD depreciation is also more evenly spread than with QE1 FX appreciation vs USD 30 days following an ‘announcement’ of QE by the Fed. purchases. But on reasonable assumptions a $500bn asset purchase programme would depress 10-year Treasury yields to the low 2.00s, some way below their current 2.50%. On a 12 Mar-09 Aug-10 yield basis, therefore, it would seem that the dollar has 10 some way yet to decline. Another way to consider this is to compare the response of the dollar following the launch of 8 QE1 last March with its performance since August 27 when 6 Bernanke set out the case for additional stimulus (chart 1). The dollar is certainly trading as though QE2 is a reality, 4 and at 5% its trade-weighted depreciation is some 2% 2 greater than at a similar stage of QE2. Ultimately, however, QE1 led to a near 10% drop in the dollar, so on this basis 0 we doubt QE2 is yet close to being played out. Meanwhile, JPY EUR CHF NOK SEK CAD GBP NZD AUD -2 Source: J.P. Morgan 14
  15. 15. Global FX Strategy FX Markets Weekly October 18, 2010 Paul Meggyesi (44-20) 7859-6714 paul.meggyesi@jpmorgan.com J.P. Morgan Securities Ltd. Chart 3: Credibly irresponsible – the Fed yet again succeeds in Chart 4: Not all central banks are happy debasers boosting inflation expectations Monetary base (bank deposits at the central banks plus notes and coins in US 10Y breakeven inflation rate. Net change in % from the time at which the Fed circulation). Jan 2008=100 ‘announced ‘ QE. For 2009 we use the March 18 announcement of Treasury purchases, for 20010 we use Ben Bernanke’s Jackson Hole speech on Aug 27 300 BoE when he set out the case for further easing. Fed 250 0.8 Fed QE 'announcement' 0.6 Mar-09 Aug-10 200 0.4 ECB 150 0.2 0 BoJ 100 -0.2 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 -0.4 Source: J.P. Morgan -10 0 10 20 30 40 50 the outperformance of currencies with the most orthodox, Day s before/after Fed QE announcement least inflationist central banks. Source: J.P. Morgan Trades neither the average level of dollar correlations or skew yet • Bearish USD: Stay short AUD, EUR, SEK, INR and signal a mature trend ripe for correction (see FX Derivatives KRW in cash. on page 8). Having trimmed short USD exposure last week we are Aside from the overall trend in the dollar, it is instructive to content to hold the current basket of dollar shorts going consider the cross-sectional nature of the dollar’s decline. into next weekend’s key G20 finance ministers’ meeting. As chart 2 shows, whereas QE1 was felt most keenly in Monetary policy may be the pivotal factor in the dollar’s dollar depreciation versus high-beta currencies, the dollar’s decline but the political frictions that predatory monetary decline in the early stages of QE2 has been much more and FX policies give rise to can only reinforce the general evenly distributed, with funding currencies and most negativity towards the dollar. Economically there are no notably the European currencies doing far better than they winners from a trade war but as the major international did during QE1. This does not come as a surprise to us. debtor the US is vulnerable to the financial retaliation that First time around the markets may have hoped that QE may follow a spillover from currency wars to an outright would prove a panacea for the global economy. The fact trade war. that the Fed is considering QE2 only a year and a half later As discussed above, we believe that relative central bank means that these hopes were unfounded, hence the inability credibility is playing a greater role in shaping the of the high-beta currencies to replicate their outperformance contours of dollar deprecation as we approach QE2. The of QE1. Secondly, there is a more overt inflationary optimal trade for QE1 was to sell dollars against the most motivation for QE2 than for QE1, which translates to a cyclical currencies, to benefit from expected global broader debasement in the dollar. Finally, there is far less reflation. The optimal trade for QE2 is to position for a participation in QE2 from other central banks than there more even rate of dollar deprecation. Cyclical/commodity was in QE1. Indeed, most European central banks with the currencies will still benefit from expectations of nominal singular exception of the BoE are indicating their reflation but European currencies should keep pace as preference to normalize monetary policy (the Riksbank is investors reward more the conservative central bank expected to deliver its third rate increase in two next week). practises in mainland Europe. The Riksbank meets in two QE1 could be characterized as a global effort to relate; QE2 weeks, and while a rate hike is fully discounted, such a should be seen rather as a unilateral US effort to inflate. The decision can only help reinforce the sense of division distinction matters for how one positions for dollar between the Fed and European central banks. Sweden has depreciation – QE1 heavily favoured cyclical currencies, a larger output gap than the US but unlike the Fed the QE2 is more about relative central bank credibility, hence Riksbank is sensitive to the risks from maintaining an emergency setting of policy long after the economic emergency (i.e. fear of depression) has receded. 15
  16. 16. Global FX Strategy FX Markets Weekly October 18, 2010 Paul Meggyesi (44-20) 7859-6714 paul.meggyesi@jpmorgan.com J.P. Morgan Securities Ltd. Meanwhile, the ECB may not be tightening official result of which the BoE is starting to play a little fast and policy in the same way as the Riksbank but excess loose with its credibility. To get the UK price level back liquidity in the eurosystem continues to decline, which on track, consistent with a 2% inflation target, the BoE translates to a de facto tightening in money market would need to target annual deflation of -1% for the next conditions (chart 4). De facto and de jeure tightening five years. Next week the focus will fall squarely on the constitute a bullish backdrop for EUR and SEK. government’s long-awaited announcement of its detailed medium-term spending plans on Wednesday. The In addition to the general dollar-trend, INR has been a government has to find some £80bn over five years to beneficiary of IPO-related inflows from foreign investors. match its budget commitments, a tall-orders that risks In our estimation probably slightly less than half of the further undermining economic confidence as the populace flow has been done so far (2-3 billion USD), so we will digest the personal implications (non-protected budgets look to run this position for another week before covering will need to be slashed by some 25% in real terms over as the unsuccessful IPO bidders will be refunded this period). eventually and part of the inflow into INR will be reversed. ⎯ Stay long EUR/GBP. Bought Oct 1 at 0.8680, Chart 5: As the Fed moves to ease, the ECB presides over a de-facto marked at 0.7%. tightening in money market conditions ⎯ Stay short GBP/CHF. Sold Sept 24 at 1.5479. 1.0 First ECB 1Y repo EUR 1M EONIA Current mark 1.0%. 0.9 USD 1M OIS ⎯ Stay short GBP/NOK. Sold Sept 24 at 9.3081; 0.8 ECB repo drain marked at 1.0%. 0.7 0.6 ⎯ Stay short GBP/SEK. Opened Sept 10. Current 0.5 mark 6.3%. Cut stop to 10.66. 0.4 Chart 6: BoEs credibility as an inflation-targeter is on weak ground 0.3 GDP deflator, Q1 200=100. 0.2 UK 130 0.1 US 0.0 120 May -09 Aug-09 Nov -09 Feb-10 May -10 Aug-10 EUR Source: J.P. Morgan 110 ⎯ Stay long EUR/USD. Bought Oct 1 at 1.3720, Price lev el consistent w ith 2% inflation target 100 marked at 2.6%. Raise stop to 1.3450. Japan ⎯ Stay short USD/SEK. Sold Oct 1 at 6.7100, marked 90 at 2.4%. 80 ⎯ Stay long AUD/USD. Bought Sept 17 at 0.9385. Current mark 6.0%. Raise stop to 0.9750. 00Q1 02Q1 04Q1 06Q1 08Q1 10Q1 ⎯ Stay short USD/KRW. Sold Oct 1 at 1130, marked Source: J.P. Morgan at 1.7%. ⎯ Hold short USD/INR. Sold June 18, marked at • Stay short EUR/CHF via options +4.8% Cut stop to 44.60. The tactical outlook for EUR/CHF is neutral/moderately • Stay short GBP vs EUR, CHF, NOK and SEK. higher as the ECB effectively tightens policy and the SNB tries to justify still near-zero rates for an economy Sterling remains overshadowed by the dominant focus on with no output gap. The SNB can maintain this policy the dollar. Nonetheless, as a candidate for additional pretence for a while but ultimately it risks being surprised quantitative easing of its own, GBP remains vulnerable once more by an economy that refuses to follow its against the harder currencies of mainland Europe. Unlike bearish script. the Fed, the BoE lacks any inflation pretext for additional easing. Indeed, the UK has suffered a singularly bad ⎯ Hold a 1-yr 1.250 at-expiry digital in EUR/CHF. inflation performance over the past decade (chart 6), as a Bought on June 8 for 13%. Currently 15.2% 16
  17. 17. Global FX Strategy FX Markets Weekly October 18, 2010 Paul Meggyesi (44-20) 7859-6714 paul.meggyesi@jpmorgan.com J.P. Morgan Securities Ltd. Table 1.Current FX spot recommendations and P&L Active trades are marked to market on Friday afternoon London time. Long Short Entry Entry Current Stop Comments date level level loss P&L since entry, % EUR USD 01/10/10 1.37 1.41 1.35 2.6% hold SEK USD 01/10/10 6.71 6.55 6.93 2.4% hold AUD USD 17/09/10 0.9385 0.9950 0.9750 6.0% stop raised KRW USD 01/10/10 1130.0 1111.5 1158.0 1.7% hold INR USD 18/06/10 46.17 44.06 44.60 4.8% stop lowered CHF GBP 24/09/10 1.55 1.53 1.59 1.0% hold EUR GBP 01/10/10 0.868 0.874 0.858 0.7% hold SEK GBP 10/09/10 11.19 10.53 10.66 6.3% stop lowered NOK GBP 24/09/10 9.31 9.22 9.33 1.0% stop lowered Table 2. Current FX derivatives (directional/non-RV) recommendations and P&L Active trades are marked to market on Friday afternoon London time. Description Entry Expiry Days to Spot Entry Current P&L since Comments date date expiry reference offer entry Buy a 1Y EUR/CHF 1.2500 at-expiry digital put 08/06/10 08/06/11 236 1.3438 13.0% 15.2% 2.2% hold 17