January 18, 2011 FX Monthly – January 2011John J. HardyConsulting FX Strategistjjh@saxobank.com+45 3977 4000 FX month(s) in review: Wild transition to the New Year The two months since our November report saw remarkable developments in FX. The post QE2 announcement environment saw a sharp reversal in some of the correlations we’ve been so used to, particularly the US dollar’s correlation with risk and even correlations across markets in general. Other key developments included a strong rise in interest rates and risk appetite into year end. Then to start the year, someone pressed the “all change” button in FX and we’ve seen a sharp reversal in many of the trends that persisted into year-end – particularly a sharp weakening in both the Swiss Franc and Australian dollar. Below are a few highlights of what has transpired since our last report. What goes up must come down? We saw a sharp rally into year-end by both the Swiss Franc and the Australian dollar, both (with some measure of 20-20 hindsight) clearly driven to some degree of fixing interest or positioning squeezes aggravated by thin liquidity in the close of the year. The strong franc was also driven by the renewed EuroZone sovereign debt pressures and the Australian dollar rally by the commodity rally that ended the year with a flourish with copper, for example, trading to new all time highs. Then, after the calendar rolled into 2011, these two currencies were the weakest of the G-10 by mid-month, with Australia suffering from a commodity sell-off and a series of flood disasters and the franc consolidating on European attempts (though somewhat feeble) to get ahead of the curve on its sovereign debt crisis. Interest rates higher. At the time of our last report in mid-November, the US treasury market had consolidated sharply from its heady gains going into the November 3 FOMC meeting – a move that was clearly (with the wonderful aid of 20-20 hindsight) a buy-the-rumor, sell-the-fact reaction to the confirmation that the Fed planned to move ahead with the QE2 policy of massive renewed bond purchases. But in December, we were faced with a treasury sell-off that looked more like a rout than a mere consolidation and this begs important questions for the USD and for major FX pairs. One the one hand, higher interest rates in the US are a fundamental support for the currency on interest rate spread comparisons, which in the past only favoured the USD when interest rates were falling because US rates were almost as low as they could theoretically go and other countries’ rates generally fell faster. On the other hand, if the higher interest rates are a reflection of bond buyers going on strike, we have an entirely different scenario – one that is far more sensitive to the credit worthiness of the various nations and their sovereign debt. The Japanese Yen could be particularly vulnerable in such a scenario. A USD/risk divergence. This is related to the point just above on interest rates. The market is a bit confused as to what to do with the USD as interest rates in the US have risen faster than for some of the other countries (at least at times – in the final days ahead of this report, some of this effect was fading). This is a USD positive. But equity markets – at least in the US and Germany and a few other countries – have marched to new highs for the cycle, which has time and time been associated with USD weakness over the last couple of years or more of the USD carry trade. We’ve been so trained to see all markets as one hyper-correlated mass that moves like a school of fish that this new divergence in the USD and risk
January 18, 2011 FX Monthly – January 2011 appetite is a signal event we must pay close attention to in coming weeks. See more on the USD and risk divergence in our Carry Trade Model article below.Themes for 2011As this is our first monthly of the New Year, we try to look at the bigger perspective and mull some of thebiggest issues that that the market will be chewing on this year:To QE or not to QE? – It is abundantly clear from the latest batch of rhetoric that even the new purpotedhawks among the voting FOMC members (Kocherlakota, Plosser, Fisher) expect for the QE2 program to run tocompletion. The degree of dissent within the FOMC is so far less than we imagined would be the case, but themore important question going forward is whether the Fed’s QE policies will end with QE2. If the economyweakens again, Bernanke and company would likely feel the itch for another round of QE, perhaps aimed atbuttressing local and state finances, but we suspect that would be a political impossibility and that the Fed’smaneuverability from here on out is extremely limited. Alternatively, if the US economy performs relativelywell, the Fed won’t find the justification for moving in the first place. We are expecting that this will eventuallysupport the USD, both because it is a sign that the Fed will be halted before it prints the greenback intooblivion (just yet. anyway). We maintain the simultaneous assumption that growth expectations elsewheremay fall relative to those for the US. These two factors, combined with at least a sideways if not falling riskappetite in the months ahead are the preconditions for a stronger dollar. Equity Markets since Fed QE2 Announcement 110 105 100 95 Shanghai Composite 90 US S&P500 MSCI Emerging Markets 85Chart: Shanghai composite vs. MXEF vs. S&P500 – Since the QE2 announcement of early November, thedivergence in equity market performance around the world and correlations across markets in general hasbeen disrupted relative to the past couple of years. Are China and the emerging markets the leading indicatorhere on risk?China and Emerging Markets/Commodities: Here we throw a few themes together, but they are allrelated. China is clearly grappling with problematic inflation levels from its property bubble and hot moneyinflows aggravated by its dirty peg to the US dollar and the implications of hyper-easy Fed monetary policy.Meanwhile, external demand is not growing at a rate sufficient to pass on strong price increases and domesticconsumers risk getting squeezed by commodity price rises and a high cost of rent from the property bubble.
January 18, 2011 FX Monthly – January 2011This margin squeeze for companies and on consumer is going to mean increasingly inferior growth rates withevery uptick in cost push inflation and every tightening of the screws on credit. In 2011, will China move moreforcefully to avert inflation risks by slowing credit markets and economic growth and overinvestment in realestate projects? It will be tough for the country to engineer a soft landing and as China goes, so goes the EMtrade. Another issue for China and many other EM countries like Korea and Brazil is the inconveniently largeinflows of capital that are making life difficult, though these problems could quickly reverse a la late 2008 ascapital flows will take flight and could aggravate a sell-off.Euro PIGS crisis – our forecasts for the Euro generally suggest that the Euro crisis will come to a head soonerrather than later in 2011. A crisis meeting will apparently be held by EU leadership in February to discuss waysin which to get ahead of the curve on the sovereign debt problem as it is widely agreed that a Spanish defaultwould be too large for the current rescue funds and EFSF to handle. There have been signs of a softeningstance from Germany on the idea of expanding EU commitments, but the efforts thus far from EU leadershiphave underwhelmed and the German politicians are fully aware of the political suicide that awaits any carteblanche approach to bailing out the periphery.One of the next key events will be the Irish election, possibly as early as late March. Ireland has no incentiveto live with its current bailout arrangement other than pride and the inertia of the EuroZone experiment andthe political opposition in Ireland is virtually guaranteed a victory. Will Ireland reschedule its debt already bymid-year or even threaten to leave the EuroZone somewhere down the line? Credit default swaps on Irishsovereign debt are trading higher and higher as the markets ponder this question – they were in the high 600’sat the time of this writing compared to sub-300 levels last summer and are sharply higher even since theEU/IMF arrangement was agreed on back in late November. (see a chart in the Forecast section for the Eurobelow).Carry Trade Model – coming unhingedThis time around, we note that the market correlations seem to be shifting more profoundly than we have seenin some time – at least the kneejerk correlation in the USD and risk appetite. Our model clearly shows that riskappetite remains very strong globally, but that the USD has failed to fall to new lows. There are a couple ofexplanations or potential predictions we can try to extract from this:The USD is no longer the ideal funding currency – this is a bit of a tough one to argue for. As long as riskappetite remains robust (which favours being long carry trades), there is plenty of evidence to argue that theUS currency is an ideal funding currency, considering that it still has a very low interest rate, that the marketexpects it to move very slowly to raise rates considering that the Fed is still in quantitative easing mode whileother banks have been raising rates for some time, and due to its lack of fiscal discipline. Still, US interestrates have jumped sufficiently higher to improve its standing in spreads versus some of the other majorcurrencies, and this has clearly been instrumental in some of the USD’s relative resilience in this market. Also,US economic fundamentals have perked up somewhat. Theoretically, if the US recovery blossoms from here,then the popularity of using the USD as a funding currency could fade and other currencies, potentially theJapanese Yen or Swiss franc could become more popular funding currencies if interest rates head higher.The stronger USD is a leading indicator on the direction of risk - When we say “stronger USD” here, wemerely mean relative to its past correlation with risk appetite, as the USD has yet to consistently rally versusthe market, though it has been relatively stable while risk appetite has gone into overdrive (at least in thedeveloped equity markets – some divergences exist elsewhere). Since the Fed’s easy money policies haveprovided the liquidity for a good portion of the rally in risk appetite since the anticipation of QE2 set in, one
January 18, 2011 FX Monthly – January 2011could argue that the anticipated withdrawal of that liquidity as June approaches means a stronger USD andlower risk appetite and the unwinding of some of the huge short USD/long risk trades out there.The weak Euro is grabbing the spotlight – this is one of the more likely explanations for the relative USDstrength and certainly explains some if not all of the greenback’s relative resilience. Flows into the Euro havedoubtless slowed from the largest potential buyers – central banks, who are likely having a hard time justifyingEuro purchases as the continent is racked with its sovereign debt convulsions. The Euro has been the onlyplausible alternative to the USD as a major reserve currency, so any Euro weakness will inevitably beexpressed to some degree as USD strength.Carry Trade Outlook – the cart leading the horse?Again, we wonder here whether the USD has become a leading indicator on risk appetite. We would suggestthat to some degree it has, as the Fed’s very loose monetary policies have been a key element in keepingglobal risk appetite at the boil - particularly in the last huge rally from late August of last year, when it becameclear that QE2 was on the way – and now that it is rather clear that the Fed plans on carrying the debtmonetization program to completion. Eventually, however, the market will move on to focus on other drivers ofglobal risk. While the USD still plays a prominent part in setting the agenda, commodity prices and interestrates will exercise increasing influence if they continue to head higher from here as risk appetite can’t possiblylike the thought of a margin squeeze and decrease in liquidity.If, on the other hand, commodity and interest rate prices fail to head higher, it is likely due to an increasingworry that China will suffer a setback and that global growth will disappoint on weak end demand. If thosethemes begin to dominate, carry trades will likely suffer steep losses, since they are generally a pro-cyclicalbarometer to begin with. There are signs that worries in China are growing, but major equity markets andmany of our risk appetite measures have failed to pick up on this consistently. This scenario is USD bullish if nosovereign debt worries come into play. The truly chaotic scenario would be risk aversion combined withsovereign debt worries, a scenario that is less USD bullish if those worries affect the assessment of the US’ability to ever pay back its debts.As for the components of the carry trade model, all of them are in relatively risk-willing territory – not a hugesurprise considering the very positive reading for the carry trade index. There are a couple of laggards, though,including a emerging market bond spreads, which are well off the lows of the recent range, and FX volatility,which has decreased somewhat, but not to the kind of extremely low levels we are seeing in equity marketvolatility indicators
January 18, 2011 FX Monthly – January 2011Saxo Bank Carry Trade Model Chart Saxo Bank Carry Trade Model 3 115 2 110 105 1 100 0 95 -1 90 -2 85 -3 80 -4 Carry Trade Index 75 USD no carry added -5 70 Chart: Saxo Bank Carry Trade Model- Longer term view. This time around, we decided to display the longer term perspective, which shows that global risk appetite, as measured by our Carry Trade Index, is still very much in risk hungry terrain. The last time it was near this high was in March-April of this year, which preceded the May 6 “flash crash” and weak equity market of the early summer. (The Sample US Carry Trade shows the carry-less performance of a basket of 7 currencies (AUD, NZD, PLN, TRY, MXN, IDR, BRL) vs. the USD and JPY.) Chart derived from data from Bloomberg.
January 18, 2011 FX Monthly – January 2011Central Bank Watch: Expectations shifting higher Central Bank Rate Expectations 6.00% Rate Now (17 Jan. 2011) 5.00% 1-yr. Forward Exp. 4.00% Expected Change 3.00% 2.00% 1.00% 0.00% USD EUR JPY GBP CHF AUD CAD NZD NOK SEK Chart: Central Bank expectations have certainly shifted higher since our last couple of reports, with the market beginning to price in non-trivial moves from a number of banks – even the ECB, after Trichet turned hawkish on inflation despite all of the sovereign debt woes facing the Euro Zone. G-10 CB Rates and Expectations 1600 1200 1500 1400 1000 1300 800 1200 1100 600 1000 400 900 800 200 Forward CB Expectations 1-yr. (bps - left axis) G-10 Total CB Overnight Rates (bps - right axis) 700 0 600 Chart: G-10 CB rates and rate expectations in aggregate: We’re seeing a sizable increase in expectations for the G-10 central banks in aggregate as the blue line above indicates. The market is looking for some 500 bps of rate hikes in aggregate for the year forward on top of recent hikes. Charts above derived from data from Bloomberg
January 18, 2011 FX Monthly – January 2011Saxo Bank G-10 FX ForecastsBase Case: Our basic premise that the post QE2 announcement would see a continued retrenchment in riskappetite was more or less wrong, as the adjustment higher in interest rates and the US dollar rally after theannouncement proved indecisive and as risk appetite charged higher once again (with a couple of notableexceptions – especially China, which is a critical driver of the future of global growth). China should be gettinga lot of focus now and in the months ahead, as the regime is trying to engineer a soft landing in the country’soverheating, inflation-ridden economy. China is the lynchpin of the emerging market trade, and the US dollaras well, due to carry positions and capital flows out of the US and into emerging markets. As China slows andgrapples with its economic imbalances, this could severely affect the trajectory of risk appetite as it impingesupon the major currencies. A weaker EM trade would like be USD supportive. Also USD supportive would be asignificant consolidation in risk appetite in general – something we have yet to see since last summer. Such adevelopment is overdue. The question, as always, is one of timing.Alternative Scenario(s): The alternative scenario is that we have an incipient bubble in equities andparticularly in commodities in progress and that we may have reached a point where the market boils over intoa full-blown bubble mentality of price gains feeding further price gains. In this kind of market, all attempts tofight the trend are futile and this could go on for another one week, one month, or three months. Thepersistence in the price action in US equities of late argues in favour of this view. It must be noted that theclimax and reversal off of such non-consolidating rallies is often spectacular, if not fearsome. Until theEM/Commodity/major equity markets consolidate more convincingly, the USD will have a hard time achievingany altitude and most of the alternative scenarios below for each currency discuss the potential for the existingmarket environment to persist for a time.Table: Saxo Bank G-10 FX Forecasts Currency Pair 1M 3M 12M Alternative (1-2M) EURUSD 1.3000 1.1800 1.1400 1.3400 USDJPY 85.00 89.00 100.00 80.00 EURJPY 111.00 105.00 114.00 107.00 EURGBP 0.8500 0.8000 0.7800 0.8650 GBPUSD 1.5700 1.4800 1.4600 1.5500 EURCHF 1.3000 1.3400 1.3700 1.2400 USDCHF 1.0000 1.1400 1.2000 0.9300 AUDUSD 0.9300 0.8200 0.7500 1.0200 AUDJPY 79.00 73.00 75.00 82.00 AUDNZD 1.2700 1.2600 1.2100 1.3100 NZDUSD 0.7200 0.6400 0.5800 0.7800 USDCAD 1.0200 1.1000 1.1500 0.9600 EURNOK 8.00 7.75 8.00 7.50 EURSEK 9.00 9.25 9.00 8.75
January 18, 2011 FX Monthly – January 2011 Currency Pair 1M 3M 12M Alternative (1-2M) EURPLN 4.00 4.50 4.75 3.75 USDZAR 7.00 7.50 8.00 6.75Saxo Bank G-10 FX OutlookNote that all of the charts below show the currencies versus an evenly weighted basket of the remainder of theG-10 currencies with an Index of 100 approximately 10 years before the present date. All chart content isderived from Bloomberg dataUSD – US Dollar USD 90 USD 85 200 SMA 80 75 70 65 60 In the post QE2 environment of November, the USD saw a relief bounce. Since then the USD has been largely mixed – still a relatively strong performance as we have also seen a continued surge in risk appetite, suggesting that the market is giving the rising interest rates in the US some credibility and that the use of the USD as a funding currency for carry trades is waning in popularity.Over the last couple of months, the USD’s behaviour versus other markets has changed drastically. That is atleast partially due to some signs of improvement in US data and a strong move higher in US interest rates allalong the yield curve, a move that has outpaced the moves higher in interest rates in some of the other majoreconomies, which improves the appeal of the greenback against their currencies. Among the G-3, the USD hasmore or less won out in recent weeks as the Euro is mired in yet another spasm of sovereign debt worries, andthe JPY has a hard time maintaining any measure of credibility when interest rates are on the rise.Still, strong risk appetite has been almost as much of a drag on the US currency as higher interest rates havesupported the currency’s case. (see our monthly look at our Carry Trade Model for more on this) For thegreenback to escape new multi-year lows here, we will need to continue to see an improvement in USfundamentals relative to other countries, or we will need to see a strong bout of risk aversion that sees the
January 18, 2011 FX Monthly – January 2011market unwind still very large outstanding USD shorts. In the past, our outlook has favoured USD strengththrough risk aversion, but the merciless charge of the bulls has made that proposition appear hopeless for thetime being. Going forward, however, we wonder how long the market can continue to bid commodities andequities higher simultaneously, especially in an environment of rising interest rates. At some point, thepressure of a rise in commodity prices will be felt in margins and in end demand – particularly in the emergingmarket trades – many of which are funded in part with short USD positions.OutlookWe assume the economic trajectory for the US will look better than that of the G-3 and perhaps better thanmany other countries as well after the Obama administration primed the pump even further with the extensionof jobless benefits and the payroll tax exemption, not to mention the extension of the Bush tax cuts that wouldotherwise have expired. By the same token, those latter measures make us worry about the longer termprospects for the USD when the federal government has failed to show the least whiff of the kind of austeritywe are seeing Europe attempt (although this is happening at the local and state level in the US by necessity inmany instances). This has us adjusting our USD forecasts for the longer term a bit lower than they werepreviously.Ahead of 2011, we speculated that the Fed would find more dissent within its ranks than it saw previously withthe yearly shuffle in voting member composition. But so far, the rhetoric from two of the expected hawks is farmore cooperative than we imagined, with even Plosser saying that he was all for keeping QE2 on scheduleeven though he is not sure that it will help. So the only apparent forces keeping the Fed from moving again tokeep the liquidity gravy train rolling will be the new Congress just convened on Capitol Hill and positiveeconomic data. Even without major dissent within the Fed, we suspect the political environment will keep theFed more sidelined than the market is counting on, even if the US economy proves weaker than currentlyexpected.The other major force acting on the USD is the direction of risk appetite – which has only been up, up, up sincelast summer. Our assumption is that a more two-way market for risk develops soon at minimum as the marketis getting ahead of itself with interest rates on the rise and margins getting squeezed.Next FOMC Meeting: January 26Alternative scenario: the USD makes a serious attempt at its lows for the cycle amid an attempt by themarket to get back on the rally train as the risk bulls and growth Pollyannas talk up global growth prospects
January 18, 2011 FX Monthly – January 2011EUR – Euro EUR 130 125 120 115 110 EUR 105 200 SMA 100 The Euro dropped to the lowest level vs. a basket of the rest of the G-10 since 2002 before rallying strongly in the wake of a couple of “successful” sovereign debt auctions from Portugal and Spain. Has the market priced in too much pain in the short term for the single currency?The Euro weakened anew in recent weeks on “Take Three” of the PIGS debt crisis as we have progressed fromGreece to Ireland and now Portugal, which is in the throes of rumors on whether it will also require a bailoutsooner rather than later. While the situation in Euroland looks dire and sovereign debt spreads and default riskmeasures are at close to their widest ever, there are a few rays of light for the Euro in mid-January. After verylittle progress from EU leadership on addressing the issues back in December, we have a few signs thatGermany’s stance on the idea of expanding the rescue facility is softening. We also have the odd couple ofChina and Japan willing to sink funds into the Titanic of PIGS sovereign debt. This will not end well furtherdown the road (as we discuss below), but the question, considering where Euro is trading in some of thecrosses (particularly EUR/commodity currencies, EUR/SEK, etc.) is how much pain is already priced in andwhether we might have enough positive news in the short term to at least put a floor under the Euro for awhile. Indeed, in the final days of our preparation of this report, the Euro was sharply stronger across theboard. Another round of broad Euro weakness may have to wait another couple of months, depending on thenews flow.While growth is struggling in Europe at the periphery as austerity measures bite on the need to confront thepublic debt situation, the growth in Germany continues to astound – to such a degree that further upsidesurprise from current activity levels and survey readings will be hard to come by from here on out.
January 18, 2011 FX Monthly – January 2011 Ireland Debt Spreads vs. CDS Prices 8 Ireland/Germany 10-year 700 7 spread 600 6 Ireland CDS Price 500 5 400 4 3 300 2 200 1 100 0 0 An intriguing divergence: while German-Irish debt spreads appear somewhat under control in mid-January as the ECB and possibly China and Japan prop up the debt “market” for Irish debt, the fear in the CDS market is clearly that the risk of an Irish default remains on the rise. CDS prices may be a better measure of Euro sovereign debt stress than interest rate spreads.OutlookWe continue to expect that the longer term solution for Europe to its sovereign debt challenges – whether it’s amassive increase in bailout funds combined with new ECB easing, or we see PIGS countries themselvesthrowing up their hands and demanding a restructuring of their debt – will mean either easier monetaryconditions in Europe relative to the US or chaos – effectively a lose/lose situation for the Euro regardless of thepath taken. Outside the EURUSD cross, we also expect EURGBP to fall in coming months for the same reason.But against the more pro-risk currencies, we wonder if most of the downside potential for the short to mediumterm is fully priced in. Only a really chaotic scenario for the Euro combined with an extension of this very long-toothed rally in risk appetite would justify a further stretching of valuations in crosses like EUR/AUD, EUR/NZD,EUR/SEK and possibly even EUR/CHF.While the EU leadership may manage to move ahead with a new and bigger bailout package in the weeks tocome (which could give the Euro some very temporary relief), we have to ponder the concrete risk from a Irishelection (possibly as early as late March) and its potential to produce a new government and political processthat aims at throwing the yoke of the Euro and the impossible burden of public debt (much of it bad debtsunwisely transferred from the private sector topped off now with high interest-bearing EU/IMF bailout-relateddebt). If the Irish move to default, it is quite possible that the other PIGS countries – and perhaps even Italy –eventually begin to look at Ireland with envy and consider the wisdom of a EuroZone exit themselves.Next ECB Meeting: March 3Alternative scenario: With the involvement of China and Japan in propping up public debt markets acrossEurope, the bearish bets on the Euro and its debt are squeezed mercilessly and EUR rallies strongly across theboard in the shorter term.
January 18, 2011 FX Monthly – January 2011JPY – Japanese Yen JPY 120 110 100 90 JPY 80 200 SMA 70 The JPY is on a road to nowhere, which is actually a fairly strong performance, considering the degree to which interest rates have risen in the US and elsewhere and the strong continued rise in risk appetite (mostly concentrated in the US, we must note). The direction in interest rates may dominate the JPY outlook going forward.US interest rates rose sharply in late November and into December, but have since range traded – and inUSDJPY this has resulted in a solid bounce off a throwback sell-off toward the 80 level. Elsewhere, the JPY haslargely been a passive participant in the currency market and hardly cut a profile as the market has failed tofind any strong new Japanese theme.The economic outlook for Japan is not particularly encouraging, with deflation still in full swing while highercommodity prices and a still fairly strong currency are crimping Japanese profits. With China on a policywarpath aimed at breaking the back of the inflation threat and the property bubble, the outlook for Japan andits export economy aren’t particularly encouraging. Unlike the US Fed, which may find itself facing increasingheadwinds on further action from an irate Congress in the coming year, the Bank of Japan would be happy tothrow another log on the QE fire after already having practiced a round of unsterilized currency interventionand other easing measures. The political environment in Japan is also so shaky that at some point, if theeconomy dips again, we can’t rule out more drastic measures. Meanwhile, the debt continues to accumulate onan already world-beating debt load with no credible program for bringing public sector revenues in line withcosts. When do we get the wake-up call? Credit default swaps on Japanese public debt are rising in price, butnot to a sufficient degree to show up on the market’s radar screen. Watch for this possible eventuality by theend of this year.OutlookJapan’s debt is a time bomb with an unknown trigger date – a date that will move closer if interest ratescontinue to rise from here and that will be delayed if interest rates fall again. Higher rates even bring the riskof a disorderly decline in the JPY under the right circumstances as loss of confidence can be a sudden thing, aswe experienced back in the fall of 2008. In the longer term perspective, the government has soaked up asmuch of the country’s domestic savings as it can and new debt will have to be printed into existence or funded
January 18, 2011 FX Monthly – January 2011from beyond Japan’s borders. This does not add up to a bullish scenario for the country’s currency. Anystrength in the currency will likely be relatively fleeting, even if we can’t rule out one more sizable surge in theJPY if we see a government bond rally sometime this year as the world goes into risk aversion mode andpossibly unwinds some of its bets on emerging markets. The repatriation trade could provide a temporaryresuscitation of the JPY before it heads weaker.Next BoJ Meeting: January 25Alternative scenario: Bonds make a strong stand while risk appetite shows signs of rolling over into a majorconsolidation. This kind of scenario could see the JPY make one more dash to the strong side and USDJPYheaded below its all-time low in 1995 of 79.95.GBP – British Pound GBP 100 GBP 95 200 SMA 90 85 80 75 70 After dipping yet again to an all time low heading into 2011, sterling has since risen very sharply, driven by a combination of tighter liquidity conditions perhaps as well as a “good thing it’s not the EuroZone” mentality. Has the currency finally put in a real low for the cycle?The pound was sharply weaker heading into year-end for no particular apparent reason, but has sincerebounded. A couple of possible reasons included far tighter liquidity conditions for the currency relative torecent moves elsewhere as 2-year interest rates have increased more sharply than for any other currency inrecent months. Some of that has to go down to the apparent tightening in bank credit. As well, the renewedwoes in the EuroZone meant that the pound found strength in the important EURGBP pair. Finally, many of thenew austerity measures are set to take effect this year, and the market is perhaps rewarding the currency forthe government’s fiscal probity. The latter is an important feature missing in the US picture.On the negative side, the ugly trade balance numbers keep getting uglier and mean that the UK will have tofind a way to attract capital flows to offset such a large trade deficit. After the implosion of the UK financialservices sector and so many of the nation’s banks, will the country ever be able to rebuild what it once had?These are important questions for the longer haul, as is the question of whether the paradox of savings means
January 18, 2011 FX Monthly – January 2011that austerity measures end up meaning a shortfall in tax revenue and fail to improve the country’s fiscalimbalances. Also pulling to the negative side are signs that consumers are increasingly negative on the futureand that housing faces gathering declines. GBPUSD vs. CDS Spread 10 1.65 0 1.6 -10 1.55 -20 1.5 -30 CDS Spread 1.45 -40 GBPUSD -50 1.4 Charting GBPUSD versus the spread of the UK vs. the US CDS prices shows us an interesting divergence of late – a divergence explained in part by interest rate spreads widening as well in favour of the UK. The 2-year swap spread favors GBP by almost 90 basis points – the most since January of 2009. Which development wins out?OutlookOur assumption is that the pound will continue to trade more or less in correlation with the USD due to thesimilar themes the two currencies face (twin deficits, post bubble banking sector, lower interest rates andrelatively active central banks). The currency may find a tailwind this year due to its very cheap valuation andas the EuroZone must work its way through a sovereign debt crisis. The highest volatility may be seen incrosses like GBP/AUD and GBP/NZD if the commodities rally comes undone at some point during the year. Ifrisk aversion strikes especially hard, however, the pound will have a hard time keeping up with the US dollar.The currency is entering an important period as the world waits and watches to see how deeply austeritymeasures, tighter control of bank credit, and a rise in the VAT affect the country’s growth and markets.Considering where the currency is coming from, it is tough to find a downside scenario unless the wild globalbullishness continues unabated or the sovereign debt theme becomes applied more generally.Next BoE Meeting: March 10Alternative scenario: Wild bullishness keeps up a head of steam, which sees the market looking elsewherefor better yield.
January 18, 2011 FX Monthly – January 2011CHF – Swiss Franc CHF 140 CHF 135 200 SMA 130 125 120 115 The Swiss Franc saw a spectacular spike into year-end with the renewal of the EuroZone PIGS and EURCHF selling as well as USDCHF selling, possibly on the fiscal profligacy of the new stimulus measures from the Obama administration. But the franc has started the year on a very weak footing – perhaps due to excessive valuation and higher interest rates elsewhere moving against the franc’s favour?The Swiss franc outperformed until the beginning of the year, when it went from profound strength to profoundweakness. Some of the move lower was in the days before this report, when the Euro was also surging, as theCHF seems to trade as a kind of anti-Euro, trading exceptionally weak when the Euro is strong and vice versa.That “Anti-Euro” trade seems to be the main theme going for the franc, though we wonder if some measure ofits weakness in the beginning of the year may be on the realization that it yields virtually nothing and interestrates and commodity prices have been heading higher, giving it the appearance of a tempting fundingcurrency. Also, at some point, a currency’s strength becomes an economy’s weakness, particularly an economythat is highly reliant on exports.OutlookThe highs may be in now for the Swiss franc versus the broader market. While another round of the Euro crisiscould potentially see the EURCHF pair to new lows, we have technical signs of trend exhaustion in the crosseslike USDCHF and GBPCHF, which may have now put in significant lows. For EURCHF, the move back higher (acouple of days before this report was published) through 1.2765 is promising for those looking for a reversal,though eventually the pair needs to work north of the 200-day moving average (currently around 1.3475) as astronger indication that the franc’s strength is fading against the single currency as well.The Swiss government has expressed profound concern about the level of the currency’s strength, thoughrecent history suggests there is little the government can do about it as the market has overwhelmed previousattempts by the SNB to manage the currency. Rather, the natural forces of the market may be the only thingthat can see the franc weaker in the months ahead. It’s behaviour certainly seems to suggest that it is far from
January 18, 2011 FX Monthly – January 2011being the safe haven currency of yore – we suspect that any potential for risk aversion will do little to help thecurrency in coming cycles.Next SNB Meeting: March 17Alternate scenario: EURCHF collapses back towards the lows on renewed PIGS sovereign debt worries andCHF heads to a new high versus the G-10.AUD – Australian Dollar AUD 145 AUD 135 200 SMA 125 115 105 95 The Aussie outdid itself with a new all-time peak right at year-end. But with the transition to the New Year, the currency is struggling from a batch of weak data and a flooding disaster. Has the miracle currency had its last hurrah?AUD defied gravity yet again, riding the enthusiasm for precious metals and other industrial commodities andrisk appetite into year-end. The currency touched a new multi-decade high against the USD and the EUR. Agood portion of the strength has faded since the beginning of the year, however, as commodity marketperformance has turned patchy, but also as a number of Australian economic activity surveys (the AiG surveysfor Manufacturing, Services and Construction) suggest a strongly slowing non-mining economy. Finally, after astring of very positive employment reports, the December employment report showed virtually no payrollgrowth.The catastrophic Queensland floods are a one-off development that risk warping data both ways in comingmonths (to the downside due to interruptions and then possibly some measure of upside activity down theroad on rebuilding). The worst damage besides the immediate human and residential costs are that key miningareas for coal and iron ore have been affected. This could even have implications for Chinese growth if coalprices spike further as the country is a huge consumer of these Australian imports.On the housing front, which is one of the country’s main vulnerabilities (outside of potential for commodityprice drops), activity remains sluggish with very high, but stagnating prices, a classic sign of a peaking market.The RBA has been removing accommodation for 15 months now and may nudge the rate to 5.00% at itsFebruary meeting.
January 18, 2011 FX Monthly – January 2011OutlookAfter the ramp up into year-end and subsequent drop (the most significant drop in the Aussie since lastsummer), it appears we have a significant area of resistance for the currency. We can buttress this argumentwith clear evidence that yield expectations for Australia are beginning to underperform a majority of other G-10 currencies.Going forward, there are two main threats to the Australian economy: a correction in commodity prices, whichis inevitably a question of Chinese demand, and the threat of an unwinding in the Australia housing bubble,which by itself could see the country’s banks in sufficiently dire straits to require the RBA to change course(and if the RBA does not change course, it could be because of high inflation elsewhere, making the threat oneof sharply inferior growth). Either way, the currency is still priced for perfection, and only a sharp renewal incommodity prices and risk appetite would see the AUD making another ascent to the strong levels at which itclosed 2010. (We argue elsewhere in this publication that at some point not terribly far from where we are nowin energy prices in particular, a rally in both commodities and risk appetite are incompatible on the implicationsfor margins from cost-push inflation).In China, authorities are concerned about recent inflation rates and are cracking down on credit and bankreserve requirements, both to cool inflation and the risks of a housing bubble (too late, actually, but zero costof carry on Chinese apartments and local officials neck deep in a personal financial interest in keeping thebubble alive will make the price discovery mechanism very tricky indeed). The Chinese regime is alsoconcerned with keeping their economy growing strongly at all costs and shifting growth over to the consumer,which it will be hard pressed to do with consumers handing over an increasing percentage of their earnings tofood and rent. Australia trades like a China derivative in many ways.Next RBA Meeting: February 1Alternative scenario: The goldilocks scenario for Aussie continues and it has another go at its highs asnatural resource prices arch higher again.
January 18, 2011 FX Monthly – January 2011CAD – Canadian Dollar CAD 120 CAD 115 200 SMA 110 105 100 95 The broad comeback in CAD faltered somewhat just ahead of this report, perhaps as the rally in the US dollar also failed to follow through by mid January. The currency may keep its weak correlation with the USD, outperforming other commodity currencies when the USD is strong and underperforming when the USD is weak.The fundamental position of the Canadian currency looks rather strong, with its strong mix of commodities(energy in particular) in an environment of strong commodity price increases and with the much touted“world’s most solid banks”. These qualities as well as the improvement in some of the US data has seen thecurrency tracking generally higher for the last few months versus the broader market, though it has seen a bitof a swoon by mid January on the spike in European currencies after the January ECB meeting. Against theUSD, the currency was able to take out the parity level and USDCAD remained below that psychologicalthreshold for a number of days ahead of this report. An additional factor in favour of the currency includes thepro-business plan to ratchet corporate tax rates lower in coming years, already starting this process with adrop in corporate tax rates to 16.5% this year from 18%. Compare that to 35% in the US.While most factors look positive for Canada and its currency if current conditions continue, particularly if crudeoil prices can rally and stay above 100 dollars per barrel, we are concerned about a number of factors that maysee the currency lower versus the USD and other currencies in coming months. Eventually, the commodity rallywill become self-correcting on the destruction of demand from higher prices (and we are particularly concernedabout China’s potential for a rough ride in coming months as authorities there try to engineer a soft landing).In addition, while the Canadian government has been very prudent since its fiscal crisis of the 90’s and itspublic debt loads are very modest by US and other standards, the private sector in Canada is the world’s mostleveraged, as a housing bubble has taken house prices into extremely unaffordable territory and private debtloads are very heavy from housing and other types of consumer credit. Any bump in the road on real estateprices and suddenly the “world’s most solid banks” will appear far less sturdy. It is remarkable that the housingmarket is already showing signs of topping out and correcting despite Canadian interest rates having only beenhiked to 1.00% . On the downside of a housing bubble, this also shows how little easing the BoC will have towork with compared to the US, where the Fed was able to drop rates 500 basis points to ease the pain. (In the
January 18, 2011 FX Monthly – January 2011day head of this reports publication, the government announced important new measures aimed at reducingmortgage credit and we are reminded that the CMHC is much like the US’ Fannie Mae, meaning that pricedeclines on the order of those in the US after its housing bubble could suddenly make the entire country’sbalance sheet look completely different in a year’s time).OutlookPreviously, we expected that the Canadian dollar would be unlikely to trade as a particularly high beta currencyon the expectation that it would tend to follow the lead of the US dollar. But the extreme swings in the Euroand a sudden reassessment of Canadian fundamentals in light of the continued strength in risk appetite andcommodity prices has seen plenty of volatility and USDCAD has headed below parity again.We would still expect that the Canadian dollar has more middle-of-the pack potential going forward: it’sovervaluation versus the market is less stark than that for Australia (AUDCAD shorts are an interesting idea onthis theme and have shown a lot of traction over the last month) and its exposure to China is far less direct,but an eventual correction in the bubble-like commodities markets (an eventual expectation) would weighheavily on the currency, as would the threat of an unwind of the country’s housing bubble. The market isexpecting more than 80 basis points of tightening from the Bank of Canada – so if conditions fail to continue toimprove to the degree expected, USDCAD’s stay below parity could prove a short one.Next BoC Meeting: March 1Alternative scenario: Oil goes to 110 dollars a barrel and the market believes that this won’t lead to any riskof a slowdown as CAD rallies sharply across the board.NZD – New Zealand Dollar NZD 140 NZD 200 SMA 130 120 110 100 NZD has pulled higher once again versus the broader market on still buoyant expectations for RBNZ rates and the commodities (particularly food commodities) rally has helped boost the currency. But should we really be closing in on an all time high for the currency considering the potential risks out there?
January 18, 2011 FX Monthly – January 2011The kiwi had a roller coaster ride since our November report – weaker for a time perhaps on the New Zealanddrought and a muted view on the potential for the RBNZ to hike going forward, but then stronger ascommodity prices – and particularly milk prices - have rebounded strongly and risk appetite has maintained astrong head of steam in to mid January. AUDNZD flows may have also heavily influenced the currency’s overalllevel, as a strong new high in that pair in December above 1.35 was roundly rejected as Australia hit a fewspeed bumps to start the year.The domestic economy is not performing particularly strongly, but the market may not be focusing much onthe basic growth data as it is on commodity prices – particularly for foodstuffs, which have risen to highenough levels to trigger riots in some food insecure countries like Tunisia and Jordan. This may mean that thecurrency is becoming a bit one-dimensional in its behaviour and may correlate with food commodity pricesgoing forward – for better or worse. Elsewhere in the economy, house prices are in a persistent, if slowlygrinding, downtrend, and could continue to weigh on growth, as will the currency’s strength.OutlookNZD and AUD look overvalued, but both will require a more persistent correction in risk and perhaps on top ofthat, signs of a real slowdown in China before any lasting sell-off can develop. In the kiwi’s case, a slowdown inkey food commodity prices will also be a necessary component of a further search for lower valuation. Westated back in mid-November that “the NZD may act as a kind of lower beta version of the Aussie – the one G-10 currency it is likely to appreciate against if risk appetite/competitive devaluation trades beat a hasty retreatdue to the Aussie’s poster child status in this market” Since then, the NZD weakened a bit against the Aussieinto December, but then came storming back due to problems special to Australia, but also possibly because ofthe increased focus on food prices, which are so important in New Zealand’s export mix. From here on out,NZD may continue to outperform the Aussie for the same reason. Elsewhere, the currency is overvalued andmay be set for a fall once food prices hopefully revert back to the mean.On the interest rate front, the RBNZ is clearly uncomfortable with the strong currency and complained stronglyabout it strength preventing a “rebalancing” of the economy back toward stronger exports. As long as thecurrency continues to see the kind of strength we have seen lately, the bank is unlikely to change its tunemuch on a cautious approach to further rate rises, and if rate expectations head lower (regardless of thecurrency level), that would likely only be on fears of slower economic growth generally, usually a kiwi-negative.Next RBNZ Meeting: January 26Alternative scenario: Food prices continue to ratchet higher and equity markets arch to new highs, takingNZD to a marginal new high versus the rest of the G-10 currencies.
January 18, 2011 FX Monthly – January 2011NOK – Norwegian Krone NOK 120 115 110 105 NOK 100 200 SMA 95 The Norwegian krone greeted its new central bank chief (who took office at the first of the year) with its weakest levels since late 2008, but the currency has since rallied on the strength in crude oil prices and renewed projections that the Norges Bank leadership may move again to raise rates.The Norwegian krone finally bottomed out around the time of our last report and has been generally strongersince then. The persistent rise in oil prices back to 90 dollars per barrel has been the critical factor in thatrenewed strength, as well as perhaps a focus on its solidity relative to the fragility of other Europeansovereigns at the EuroZone periphery. Important as well, interest rate expectations from Norges Bank havemoved from a near complete lack of expectations for the last several months to now looking for slightly morethan 50 basis points of tightening in the coming 12 months. The expectation is that strength in the economyand the continued risk of overheating in the housing market will mean that Norges Bank may raise ratesdespite EURNOK trading close to its lowest levels of the last five years (in the past NB chief Olsen has statedthat the currency’s strength or weakness would be instrumental in setting interest rate policy. Watch the nextNorges Bank meeting for any follow up on that rhetoric or lack thereof.)OutlookNow that the Norwegian krone has rebounded from levels we considered undervalued the last time around, ouroutlook is a bit more neutral. We are still generally positive on the currency as the only significant downsidescenario for the krone is a market in which risk appetite and commodity prices are collapsing in an absence ofsovereign debt worries. Such a scenario will be difficult to come by in this world of enormous debt public debtburdens. On the upside potential, we have to consider what happens if oil goes to well over 100 dollars perbarrel.Perhaps the most interesting scenario for NOK is an investment environment in which the market worries aboutsovereign credit ratings again, in which case NOK has few peers. At the extreme, an out-and-out globalsovereign debt crisis could mean that JPY and NOK become the two poles of the G-10 universe - NOK on thestrong side and JPY on the weak.
January 18, 2011 FX Monthly – January 2011We reiterate our view that long NOK versus the most overvalued corners of the market – particularly Aussie,but possibly also NZD and SEK, could be an interesting way to trade relative valuation. We mentioned this ideatwo months ago and the NOK was weaker still against these currencies into December but now seems to haveturned the corner – quite significantly in the case of AUDNOK. NOK still looks relatively attractively valuedversus the pro-risk currencies almost regardless of whether things turn out well or poorly down the road.Next Norges Bank Meeting: January 26Alternative scenario: oil accelerates to well over 100 dollars per barrel and the market starts to heavilyfavour any currency with a positive correlation with energy prices.SEK – Swedish Krona SEK 110 105 100 95 SEK 200 SMA 90 The krona was back on the up-and-up with a steady stream of robust data, a central bank that continues to hike rates, and on renewed Euro woes. As well, the krona’s general positive correlation with risk appetite has seen the currency remain relatively strong while major global equity markets have been very strong. But is it reaching the top of its potential against the rest of the major currencies?After a period of consolidation against the broader market late last year, the krona regained its legs and hasrallied back towards its 2010 highs against the rest of the G-10 currencies. Against the very weak Euro, thecurrency touched its strongest level in almost 10 years. The country is in a remarkably strong position relativeto the weaker countries of the EuroZone periphery and almost has the fundamentals of booming Germany, butwith better demographics and lower debt levels. Also, the Riksbank is looking to continue its hiking ways dueto the strength in the economy and in housing prices in particular.OutlookEverything looks great for the Swedish krona at present, but this is more or less fully priced into the currencynow that it has rallied back to the top of the longer term range – particularly in light of its valuation against theEuro, which is at longer term highs. Down the road, the risk of a weaker European economy has to rate as oneof the larger risks to continued strength in the currency due to potential implications for the exports.
January 18, 2011 FX Monthly – January 2011Eventually, as well, the country will need to confront its housing bubble, though the question is how muchmore accommodation (or alternative policies aimed at clamping down on credit related to real estatepurchases) will need to be removed before this really bites into home prices. Another potential overhang is theselling of the country’s currency by the Swedish National Debt Office, which acquired billions of SEK in an effortto smooth the currency’s decline during the 2008-09 crisis. The currency will likely find a more permanent toparound the time the Euro finds a bottom and/or when risk appetite goes at least sideways and stops itsseemingly ever-upward spiral.Next Riksbank Meeting: February 15.Alternative scenario: if Europe manages to stave off sovereign debt worries for another quarter or two andequity markets fail to blink, the currency could post new highs versus the rest of the G-10 currencies beforefading again.
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