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UBS FX Strategy 2011 UBS FX Strategy 2011 Document Transcript

  • ab Global Equity Research Global UBS Investment Research Research Note FX Strategy - Outlook 2011 Foreign Exchange Super-volatility Summary The US dollar is likely to rally modestly overall in 2011 as markets price in the end 29 November 2010 of Fed quantitative easing, concerns continue over peripheral Eurozone economies, www.ubs.com/investmentresearch fiscal austerity impacts the UK, and Japan’s authorities remain intolerant of yen strength. However, our 2011 forecasts obscure the ‘super-volatility’ that some currencies might exhibit next year due to: (1) unusual levels of uncertainty in the Syed Mansoor Mohi-uddin world’s major economies; (2) the contrasting strength of emerging markets; and (3) Strategist the risk of policymaker error in relation to interest rates, quantitative easing and mansoor.mohi-uddin@ubs.com fiscal tightening. We therefore see EURUSD ending 2011 lower at 1.30, but its +65 64958604 range could be as wide as 1.10 to 1.50. Similarly, we see USDJPY at 85 by the end Beat Siegenthaler of 2011, but its range could be as wide as 70 to 100. Strategist beat.siegenthaler@ubs.com Top trades and themes +41 44 239 9547 Given our views on currencies in 2011, we recommend the following strategies: Brian Kim 1. Sell EURUSD on rallies as euro strength weakens peripheral Eurozone growth Associate Strategist 2. Buy USDJPY on dips as Tokyo to intervene to put a floor under USDJPY brian-a.kim@ubs.com 3. Sell GBPCHF as fiscal austerity hurts UK sentiment in H1 11 +1-203-719 8394 4. Go long Nordics in the new year after stale positions are unwound by end-2010 Geoffrey Yu 5. Sell commodity currencies on rallies as Fed quantitative easing ends by June. Strategist geoffrey.yu@ubs.com ‘Black swan’ trades +44-20 7568 0605 Next year may also feature some unforeseen events. In particular, if: 1. The US succumbs to deflation – sell USDJPY for a move to 70 Gareth Berry Analyst 2. The Eurozone agrees a fiscal transfer union – buy EURUSD for a move to 1.50 gareth.berry@ubs.com 3. Currency wars turn into trade wars – go long Swiss franc. +65-6495 8604 Amelia Bourdeau Global foreign exchange forecasts for 2011 Strategist amelia.bourdeau@ubs.com End-2011 Currency pair Current spot 1m forecast 3m forecast +1 203 719 8537 forecast Manuel Oliveri EUR USD 1.3340 1.30 1.25 1.30 Strategist USD JPY 83.70 85.0 85.0 85.0 manuel.oliveri@ubs.com +41-44-239 3339 EUR JPY 111.65 110.0 106.0 110.5 Chris Walker EUR GBP 0.8466 0.85 0.85 0.80 Strategist GBP USD 1.5750 1.53 1.47 1.63 chris.walker@ubs.com EUR CHF 1.3339 1.30 1.28 1.35 +44 20756 71311 USD CHF 1.0000 1.00 1.02 1.04 EUR SEK 9.2805 9.35 9.30 8.75 EUR NOK 8.1230 7.80 7.60 7.50 NOK SEK 1.1410 1.20 1.22 1.17 USD CAD 1.0092 1.04 1.06 1.05 AUD USD 0.9755 0.97 0.93 0.93 AUD NZD 1.2847 1.27 1.32 1.31 NZD USD 0.7595 0.76 0.70 0.71 Source: UBS estimates. Priced at market close on 25 November 2010. This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 16. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
  • FX Strategy - Outlook 2011 29 November 2010Contents page Syed Mansoor Mohi-uddin Strategist2011: Dollar a buy on dips 3 mansoor.mohi-uddin@ubs.com +65 649586042011: Euro hostage to periphery 4 Beat SiegenthalerBlack swans: US deflation 13 StrategistBlack swans: Euro fiscal union 14 beat.siegenthaler@ubs.comBlack swans: Trade wars 15 +41 44 239 9547 Brian Kim Associate Strategist brian-a.kim@ubs.com +1-203-719 8394 Geoffrey Yu Strategist geoffrey.yu@ubs.com +44-20 7568 0605 Gareth Berry Analyst gareth.berry@ubs.com +65-6495 8604 Amelia Bourdeau Strategist amelia.bourdeau@ubs.com +1 203 719 8537 Manuel Oliveri Strategist manuel.oliveri@ubs.com +41-44-239 3339 Chris Walker Strategist chris.walker@ubs.com +44 20756 71311 UBS 2
  • FX Strategy - Outlook 2011 29 November 20102011: Dollar a buy on dipsThe dollar is ending 2010 below its long-term fair value of 1.20 against the euro The dollar is our preferred G3 currencyand still historically weak against the yen, pound, Swiss franc and commodity for 2011, but we recognise tradingcurrencies. In 2011 we expect the dollar to experience a modest overall ranges are likely to be wideappreciation against the rest of the majors while trading is likely to be volatile.Chart 1: US quantitative easing is priced Chart 2: Fiscal risks are significant Fed Trsy & MBS Holdings G7 Economies 4.0 2.50 1.60 EURUSD 1.50 GDP Growth, 2011 2.00 3.0 Fiscal Tightening, 2010-2011 1.40 1.50 % Y/Y EURUSD USD Trn 2.0 1.30 1.00 1.20 1.0 0.50 1.10 Fed Starts Buying Assets 0.00 1.00 0.0 Dec-02 Mar-05 Jun-07 Sep-09 Canada France Germany Italy Japan UK USSource: UBS FX Strategy Source: UBS FX Strategy, IMFFirst, the Fed’s resumption of quantitative easing on 3 November now appearsto have been fully discounted. As Chart 1 shows, the euro rallied from below1.20 during Greece’s crisis this year to above 1.40 as the Fed announced it wasbuying an additional US$600bn of US Treasuries. But this was almost as muchas the euro’s appreciation from 1.23 to 1.51 in 2009, when the Fed’s first roundof quantitative easing – trebling its balance sheet to US$2trn – was much greater.Thus at 1.42-1.43 in early November, EURUSD had clearly overshot here. Asthe subsequent rebound in the dollar has shown, the risk now is for thegreenback to keep rising as investors focus on other issues in 2011.This has already been shown by the currency market’s reaction to Ireland’scrisis. The main message here is that the Eurozone cannot live with a strongcurrency. Whenever the euro overshoots against the dollar, investors fear forgrowth. As that makes it difficult for peripheral Eurozone economies to generatesufficient taxes to service their debts, yields rise and the euro falls again.In 2011 we expect further bouts of Eurozone bond market volatility. This wouldsupport the dollar. Similarly, the dollar is also likely to benefit as Japan’sauthorities make it clear they won’t tolerate yen strength, while fiscal austerityin the UK should undermine the pound’s prospects against the greenback.One clear risk to the dollar is US fiscal policy. As Chart 2 shows, the US will US austerity a major risksuffer a sharp fiscal squeeze next year if expiring tax cuts are not renewed. Thatwould cause the Fed to keep policy super-loose for longer. In the ‘black swans’section inside, we highlight other risky scenarios for the dollar.So, while we expect the greenback to end 2011 modestly higher – our EURUSDand USDJPY forecasts are 1.30 and 85 – trading is likely to be ‘super-volatile’,with ranges as wide as 1.10 to 1.50 for EURUSD and 70 to 100 for USDJPY. UBS 3
  • FX Strategy - Outlook 2011 29 November 20102011: Euro hostage to peripheryThe euro has had a turbulent year, and its volatility is unlikely to ease in 2011. If Base scenario remains a muddling-the Eurozone crisis were to be comprehensively resolved by member states through of the Eurozone, which willagreeing to fiscal transfers and debt restructuring, then the euro could rally weigh on the eurosharply (see the section on black swans below). But a grand bargain seemshighly unlikely until there is a significant further deterioration of the debt crisisfirst. Our base case, therefore, is for the Eurozone to continue with its piece-meal approach of fighting fires one country at a time. If so, the euro will remainunder pressure as investors continue to worry about potential defaults bymember countries in the future and what that would mean for the currency union.Chart 3: 10Y bond spreads over Bunds (bps) Chart 4: Real effective exchange rate and EURUSD Greece Portugal Ireland Spain Italy REER (left) EURUSD (right) 1000 110 900 average EURUSD: 1.6 ECB starts bond 105 1.20 800 buying (10 May) 1.4 700 100 600 1.2 German push for EU 95 500 treaty change (18 Oct) 1 400 90 average REER: 97.5 300 0.8 85 200 100 80 0.6 0 75 0.4 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 1994 1996 1998 2000 2002 2004 2006 2008 2010Source: Bloomberg, UBS FX Strategy Source: BIS, Bloomberg, UBS FX StrategyThe Eurozone faces two fundamental problems, which we believe are likely topush the single currency lower during the course of 2011.First, there are serious macroeconomic imbalances within the Eurozone. This isshown clearly by diverging growth rates, and current account surpluses anddeficits between member states. This is increasingly a problem for the EuropeanCentral Bank. The ECB could raise interest rates if it set policy just for Germanyand some of the other stronger Eurozone economies. But at the same time it isunder pressure to keep rates exceptionally low for the peripheral countries now.Second, Germany is likely to continue pushing for private sector involvement inresolving Europe’s debt crises. This would keep bond markets under pressure. Inaddition, the probability of a sovereign default somewhere in the Eurozoneremains significant. By itself that should not necessarily lead to the singlecurrency area breaking up, but it would weigh heavily on the euro nevertheless.Our conclusion is that over the next few years the euro has to trade closer to its We expect the euro to weaken closer tolong-term fair value; as the above chart shows, this is around 1.20 against the its longer-term fair valuedollar. Given the economic challenges of the periphery, it would certainly makesense for the single currency to weaken. Even Germany – traditionally the onlymajor exporting nation in the world favouring a strong currency – should nothave much against a grind lower in EURUSD to our three-month target of 1.25and our end-2011 target of 1.30. UBS 4
  • FX Strategy - Outlook 2011 29 November 20102011: Yen already peakingThe yen has strengthened sharply against the dollar over the last three years of USDJPY appears to have bottomedthe credit crunch, rising from 125 in 2007 to almost record highs of 80 in after the Fed resumed quantitativeNovember 2010 as the Fed started its second round of quantitative easing. But easing in November, and is set now towith the US economy likely to recover slowly now, keeping US yields rise modestly higher in 2011supported, the risks are that yen has peaked and will begin to weaken against thedollar. We therefore think USDJPY is a buy on dips for 2011.Chart 5: Intervention, Japan Chart 6: USDJPY and two-year bond spreads Intervention, Japan Two Year Yield Spreads & USDJPY 7.5 160 USDJPY Carry Trade 7.00 160 150 5.0 Steel Tarrifs Weaken USD 2Y Spreads 140 US - JN 2Y Spreads (%Pts) Sell USD 2.5 5.00 140 130 USDJPY JPY trn USDJPY 0.0 120 3.00 120 110 -2.5 100 Buy USD 1.00 100 -5.0 Nikkei Boom 90 USDJPY G7 Warns On -7.5 JPY Volatility 80 -1.00 80 Apr-91 Apr-95 Apr-99 Apr-03 Apr-07 Sep-90 Apr-97 Nov-03 Jun-10Source: UBS FX Strategy Source: UBS FX StrategyRisk-reward favours being long USDJPY next year, for two main reasons. First,Japan’s authorities are unwilling to tolerate the yen strengthening further fromcurrent levels. In September the Ministry of Finance instructed the Bank ofJapan to intervene in the currency markets to weaken the yen, as the chart aboveshows. Though that only pushed USDJPY up from 82 to 86 temporarily, Japan’sofficials subsequently made it clear they will intervene again if needs be; thishas helped put a floor under USDJPY at the key 80 level.Second, USDJPY was driven down towards 80 earlier this month as the market Yield spread widening will favourpriced in the Fed resuming quantitative easing. As the chart above shows, the USDJPY upsidespread between two-year US Treasury yields and Japanese government bondsnarrowed sharply, putting downward pressure on USDJPY. But with the Fed’seasier monetary policy now fully discounted, bond yields have begun to rise,helping push USDJPY back up as Japanese investors start buying US assets.The main risk to the dollar against the yen in 2011 is likely to come if the USeconomy succumbs to deflation. This is one of the bearish scenarios we considerin the ‘black swans’ section below. As that could result in the Federal Reservestarting a third round of quantitative easing, USDJPY would face strongdownward pressure again. If the authorities were not able to defend the 80 level,we think the currency pair could decline further to new record lows at 70.In contrast, the yen would weaken sharply more than our end-2011 forecast of85 if the Bank of Japan was to aggressively fight deflation by raising its Rinbanmonthly purchases of government bonds. That could push USDJPY back to 100,but this remains only a risk scenario rather than our base case. UBS 5
  • FX Strategy - Outlook 2011 29 November 20102011: Sterling risks mixedThe key driver for sterling in 2011 will be how the Bank of England sets Sterling risks are looking binarymonetary policy. In particular, there are both upside and downside risks toinflation, so sterling could be in for a rollercoaster ride next year.Chart 7: Weak broad money growth Chart 8: UK spending cuts set to drag GBP lower UK Broad Money Supply Growth and CPI 160 UK Nationwide Spending Index Real Effective GBP 110 6 18 Nationwide UK Spending Index GBPUSD (Real Effective Rate) 5 120 12 90 4 80 % % 3 6 Hard to sustain 70 2 these levels when 40 0 the spending index begins to fall 1 UK CPI (LHS) M4 Ex-Securitisations (RHS) 0 50 0 -6 Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09 Jul-10 May-04 May-06 May-08 May-10Source: Bloomberg, UBS calculations Source: Bloomberg, UBS calculationsUpside risks to inflation cannot be easily discounted. UK CPI currently is above The BoE’s dovish view facesthe central bank’s 1-3% target, and as part of the government’s fiscal austerity challengesprogramme the rate of VAT will rise to 20% in January. In addition, input costsare likely to remain supported next year by high commodity prices.On the other hand, fears that fiscal austerity will cause inflation to undershootthe target in two years’ time are also significant. Deep cutbacks in publicspending will act as a drag on growth as the government intends to sharplyreduce Britain’s fiscal deficit by 2% of GDP each year for the next four years.With household debt remaining at high levels and credit still scarce, the UKprivate sector may not be able to take up the baton of growth in the near term.This month the BOE raised its 2011 inflation forecast in its latest InflationReport. UK CPI inflation is expected to stay above target for most of next year.Thus the key question for UK monetary policy in 2011 is how much and howfast fiscal austerity will curb higher consumer prices. By the time of the centralbank’s next Inflation Report in February, investors and policymakers will have abetter idea of how the UK economy is being affected by the government’sspending cuts and tax rises. With one Monetary Policy Committee member,Adam Posen, already voting to resume quantitative easing, we think the risks areskewed to the downside for sterling in the first few months of 2011 as fiscalausterity starts to bite.To express this view we favour going short GBPCHF. EURGBP will remainchoppy as the Eurozone deals with its debt crises. The Swiss economy hasshown it can weather regional storms, though. The Swiss National Bank is alsolikely to consider raising interest rates well ahead of the BoE and ECB. GivenSwitzerland’s low government debt to GDP, stronger growth and the safe havenstatus of its currency, a weaker GBPCHF is likely to be one of the key themes ofearly 2011, with another test of the all-time lows of 1.51 likely. UBS 6
  • FX Strategy - Outlook 2011 29 November 20102011: Franc still in demandIn 2011 the Swiss franc will likely benefit from solid Swiss economic activity A more hawkish interest rate outlook atforcing the Swiss National Bank to become more hawkish, ongoing uncertainty home and investor risk-aversion abroadover Eurozone debt, and stricter financial regulation in the EU and elsewhere, should keep the franc supportedkeeping safe-haven assets like the franc in demandChart 9: KOF leading indicator Chart 10: EURCHF and risk index KOF Leading Indicator & CPI Y/Y EURCHF & Risk Index 3 3.5 1.8 4 2.5 EURCHF 3 2 1.7 Risk Index 3 2.5 1.5 2 1 1.6 2 1.5 0.5 1 1.5 1 0 0.5 -0.5 0 1.4 0 -1 -1.5 -0.5 KOF Leading Indicator 1.3 -1 -2 CPI Y/Y -1 -2.5 -1.5 1.2 -2 Nov-98 Nov-01 Nov-04 Nov-07 Jan-06 Nov-06 Sep-07 Jul-08 May-09 Mar-10Source: Bloomberg, UBS FX Strategy Source: Bloomberg, UBS FX StrategyLeading indicators, such as the widely followed KOF statistics, suggest A firm labour market, improvingSwitzerland’s growth outlook should improve further in 2011. UBS Economics consumption and external demand willexpects the country’s labour market to keep improving considerably next year. increasingly force the SNB to becomeThus consumption will become a more important driver of domestic economic more hawkishactivity. At the same time external demand is likely to remain intact, owing tostrong orders, particularly from Asia. Under such conditions the risk ofSwitzerland’s economy succumbing to deflation should disappear, enabling theSNB to become more hawkish. As a result, UBS Economics expects the centralbank to first hike interest rates in March 2011 and raise by 100bps in total nextyear. This is an aggressive forecast as the market is only pricing in one 25bphike over the next 12 months.Global investor sentiment may also become a key driver of the franc again next Risk sentiment will once again becomeyear. Due to the SNB’s currency market interventions earlier this year, the franc a key driver of the franc in 2011was driven less by speculative positioning and more by real money flows. Hence,even during periods of improving sentiment, the franc has not been used as afunding currency this year. In 2011, however, we expect the SNB to refrain fromfurther intervention, so the franc should become more sensitive to investorsentiment once again. Investors are unlikely to invest heavily in euro-denominated assets in 2011 given concerns over the Eurozone. In contrast,Switzerland looks attractive owing to its improving growth prospects andfavourable fiscal profile. Moreover, intensifying regulatory efforts globallyshould also keep Switzerland an attractive destination for capital flows.As a result, we see EURCHF remaining heavy next year, with our three-monthtarget at 1.28 and our-end 2011 forecast at 1.35. UBS 7
  • FX Strategy - Outlook 2011 29 November 20102011: Riksbank to help kronaThroughout 2010, the Riksbank has been a model ‘normaliser’, setting an Sweden’s krona has strongexample to other central banks seeking to unwind unconventional liquidity fundamentalsmeasures from the global financial crisis and raise interest rates in an orderlyfashion. The market has rewarded this steady monetary management with astronger krona, but too much of a good thing can have disadvantages.Chart 11: Sweden’s heavy eurozone exposure Chart 12: The short EURSEK carry trade Australia, 1.4 Japan, 1.2 China, 3.1 EURSEK Deposit Rate Yields 10.5 1 Other Europe, 4.6 0.8 Other EU, 5.7 10.2 0.6 Eurozone, 37.6 Deposit Rate Spread (%) Denmark, 6.6 0.4 9.9 0.2 EURSEK 8 0 USA, 7.2 9.6 -0.2 -0.4 United Kingdom, 7.7 9.3 -0.6 EURSEK (LHS) 6m spread (RHS) -0.8 Norway, 10.1 9 -1 Others, 14.8 Jan10 Mar10 May10 Jul10 Sep10 Nov10Source: Statistics Sweden, UBS FX Strategy Source: Bloomberg, UBS FX StrategySweden’s fundamentals are unquestionably strong, but the country’s exposure to The Riksbank will continue normalisingthe Eurozone could yet limit the currency’s potential. Moreover, the krona has interest rates well ahead of theyet to make the transition from a ‘carry’ currency to a ‘safe haven’. Thus, we Eurozoneexpect krona strength against the euro to 8.75 next year to remain vulnerable torenewed bouts of investor risk aversion.Regarding Sweden’s fundamentals, the Riksgälden reported this month thatSweden will return to budget surplus next year – a rarity in the current globalbackdrop. Having ample fiscal funds may be particularly important forSweden’s growth prospects in 2011 if the Eurozone undergoes deep, structuraladjustments or worse.If Eurozone markets stabilise next year, the Riksbank will be able to continuegradually tightening monetary policy. The central bank’s current repo interestrate forecast path suggests there are a few more hikes on the way in 2011. Giventhe Eurozone is not in a position to follow until late next year at the earliest, weexpect the krona to continue attracting yield-seeking flows throughout 2011.Nevertheless, investors need to be nimble here, and should consider liquidating Our soft Eurozone view means thelong krona positions at any early sign of risk aversion, especially if it is krona will struggle for consistencyEurozone-related. In particular, the Riksbank has explicitly cited Eurozone risksas one of the reasons behind a more conservative interest rate tightening stancein Q4 10. Moreover, despite Sweden’s clear fundamental advantages,Riksgälden data shows that the share of foreign holdings of Swedish fixedincome assets continues to demonstrate violent swings. As a result, the kronalooks unlikely to be considered a safe haven anytime soon, given both Sweden’sEurozone export exposure and its lack of a commodity base. UBS 8
  • FX Strategy - Outlook 2011 29 November 20102011: Krone seeks oil boostBarring a major U-turn by Norges Bank, the Norwegian krone looks set to end So much promise, so little to show2010 as one of the weakest performers amongst the G10 currencies, despite astrong start and despite enjoying some of the strongest fundamentals around.Although the year-end sell-off in commodities has not helped the krone’s cause,we believe excess longs in the currency have taken their toll. Meanwhile, afterearly rate hikes, Norges Bank has had to temper its tightening bias as inflationhas remained subdued. Next year harbours the same challenges, but animproving global environment stands the currency in good stead for a decentrally in 2011: the only thing that is needed is a clean positioning slate first.Chart 13: Client positioning in EURNOK Chart 14: Oil production soft this year 25.0% 13.00% 20.0% 15.0% 8.00% 10.0% 5.0% 3.00%Scale Hidden 0.0% -5.0% -2.00% -10.0% Private Client Hedge Fund -15.0% -7.00% Change in Production m/m Asset Manager -20.0% EURNOK Change m/m -25.0% -12.00% Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10Source: UBS FX Strategy Source: Norwegian Petroleum DirectorateRegarding Norway’s fundamentals, headline Q3 GDP data was surprisingly A US recovery bodes well for prices ofweak as the offshore oil sector contracted. Throughout 2010 Norway has been mineral fuels – representing over 60%producing about 1.8m bbl/day of oil on average. This is below the country’s of Norway’s exportsfull-year target. Oil prices have also been stagnant for most of 2010 due toglobal growth worries, resulting in lower oil flows. This affects the krone;unsurprisingly, its ‘beta’ to changes in commodity prices is high. But withproduction normalising in Q4 10, and emerging markets and the US likely tohave a stronger outlook in 2011, Norway’s authorities can look forward to apick-up in oil-related inflows, which should boost the krone. Norges Bank’searlier decision to step up foreign currency purchases for its oil buffer fundconfirms that the authorities expect stronger oil-related inflows.Like the Swedish krona, the Norwegian krone suffers from poorer liquidity than A positioning clearout was badlyother major currencies. But Norway’s commodity base means the krone’s neededcredentials are stronger, and inflows from 2009 until mid-2010 have reflectedthis. The krone has been the ‘most owned’ currency for most of the last twoyears, according to UBS FX Flow Monitor. Clearly, this degree of positioningwas unsustainable, so the recent clearout (as shown in the chart above) meansthe krone starts 2011 without any major overhang of positions. The currencyremains attractive against the euro, given the latter’s structural debt concerns.The likely path of Norwegian interest rate hikes next year is also higher than theEurozone’s, and if underlying inflation begins to creep up, Norges Bank willundoubtedly try to cap price pressures by encouraging currency strength. UBS 9
  • FX Strategy - Outlook 2011 29 November 20102011: Commodity currenciesUncertainty over the US economic recovery has led to a divergence among the Commodity currency bloc divergenceAustralian, New Zealand and Canadian dollars in the second half of 2010. All to remainthree strengthened versus the US dollar, but, among the G10, Australia and NewZealand were the best performers, while Canada had the lowest gains. But whatabout 2011, when the US recovery is likely to be more promising and the end ofFederal Reserve quantitative easing is started to be priced in?First, we recommend being cautious on further commodity currency strengthagainst the US dollar in 2011. Improving economic fundamentals in the US andcontinued growth in China are supporting the commodity currencies for now.Furthermore, economic growth in Australia, Canada and New Zealand shouldkeep their currencies relatively attractive amongst the majors. And althoughseveral officials have voiced concern about recent currency strength, thelikelihood is that the Bank of Canada, the Reserve Bank of Australia and theReserve Bank of New Zealand may not be able to do anything about it.Nevertheless, we would be cautious here because an improving US economywill cause investors in 2011 to start pricing in the end of quantitative easing.Second, relative value opportunities should favour Canada. While we remaincautious on rallies in the Canadian dollar versus the US dollar, we expect thesame factors that will drive those pairs to provide relative value tradeopportunities against the New Zealand and Australian dollars. Despite Canadiandollar performance relative to its dollar-bloc counterparts in the second half of2010, when US concerns and investor preference for currencies more closelyassociated with Asian economic growth were major drivers, we are constructiveon Canada in 2011. With expected improvement in US economic data anddifferentiation of timing and amount of rate hikes by the dollar-bloc centralbanks, the Canadian dollar should flip the tables in 2011 and strengthen againstthe Australian and New Zealand dollars.Two drivers in particular – the US economy and central bank policy outlooks –are likely to drive relative value trade opportunities in 2011 amongst thecommodity currencies.Chart 15: Canadian longs should fare better in 2011 1.05 RBNZ initial Sept. Nov. 0.82 BoC initial rate hike rate hike FOMC FOMC QE2 0.80 1.00 AUDCAD (LS) 0.78 NZDCAD (RS) 0.76 0.95 0.74 0.72 0.90 0.70 0.85 0.68 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11Source: UBS FX Strategy UBS 10
  • FX Strategy - Outlook 2011 29 November 2010Over the second half of 2010, the Canadian dollar has underperformed its peersas investors have preferred commodity currencies more closely tied to Asiangrowth. Given the close economic ties between Canada and the US, theCanadian dollar has remained on the back foot as US data weakened and theFederal Reserve implemented a second round of quantitative easing, as shown inthe previous chart. But for 2011, the state of the US economic cycle shouldprove to be more of a help than a hindrance for the Canadian dollar.Since late 2009, the Canadian dollar has traded largely as a derivative of the USeconomic cycle, outperforming the Australian and NZ dollars when the USeconomy has been strengthening, but underperforming those currencies whenthe US economy has been softening. One way to capture this is to look at theperformance of the Canadian dollar crosses against the US ISM surveys.Specifically, we calculate a total weighted ISM for the US, applying a 17%weight to the manufacturing ISM to reflect its contribution to overall economicactivity, and applying the remaining 83% weight to the ISM services index.The chart below shows that as the US total-weighted ISM index improvedthrough early 2010, the AUDCAD cross declined as the Canadian dollaroutperformed. In addition, in April 2010, in a surprise move, the BoC droppedits conditional commitment to keep its policy interest rate on hold at 0.25% untilthe end of the second quarter of 2010. The sudden display of BoC hawkishnesshelped to boost the Canadian dollar at that time. However, when the USeconomy and the ISM surveys began to soften late during this summer,AUDCAD rose as the Canadian dollar lagged the Australian dollar (and indeedmost G10 currencies). This rise in AUDCAD was despite the fact that the BoCbegan its own tightening cycle in June. In recent months, however, AUDCADhas continued to rise and the Canadian dollar has underperformed as marketparticipants priced in the Federal Reserve’s resumption of quantitative easing inNovember. However, should the US total-weighted ISM and employment datacontinue to firm, we suspect the Canadian dollar will recover lost ground, andlook for the AUDCAD to move lower again.Chart 16: US total-weighted ISM and AUDCAD Chart 17: US total-weighted ISM and NZDCAD 58 CAD stronger 0.85 58 CAD stronger 0.68 Total Weighetd ISM (LS) Total Weighetd ISM (LS) AUDCAD (RS, Inverted) 0.87 NZDCAD (RS, Inverted) 0.70 56 56 0.89 0.72 54 0.91 54 0.93 0.74 52 52 0.95 0.76 50 0.97 50 0.78 0.99 48 48 0.80 1.01 AUD stronger NZD stronger 46 1.03 46 0.82 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10Source: UBS FX Strategy, Bloomberg Source: UBS FX Strategy, Bloomberg UBS 11
  • FX Strategy - Outlook 2011 29 November 2010The performance of the New Zealand dollar relative to the Canadian dollarshows similar patterns. The NZDCAD cross fell through early 2010 as USeconomic activity firmed and the BoC turned hawkish at its April meeting. ThenNZDCAD rebounded as US data softened during the summer. In addition, theRBNZ kicked off a rate-tightening cycle in June as well. But in 2011 UBS USEconomics look for stronger US activity in 2011. This should weaken theAustralian and New Zealand dollars relative to the Canadian dollar.So the US outlook will be one key driver of relative performance for thecommodity currencies in 2011. Another important factor will be central bankinterest rates. The chart below shows the AUDCAD cross and the spread ofAustralian to Canadian three-year swap rates. Clearly, the early rise in theRBA’s interest rate from 2009 has been a contributing factor to AUDCAD gains.Indeed, broadly speaking AUDCAD has moved in line with relative interest ratetrends since late last year. However, going forward we see potential for theAustralian/Canadian interest rate gap to narrow rather than widen. In 2011, UBSEconomics forecasts RBA hikes of 50bp, versus 100bp for the BoC.Chart 18: Three-year swap spread and AUDCAD Chart 19: Three-year swap spread and NZDCAD 4.00 1.05 4.00 3 year sw ap spread: NZ less Canada (LS) 0.85 NZDCAD (RS) 1.00 3.50 3.50 0.80 0.95 3.00 3.00 0.75 0.90 2.50 2.50 0.70 3 year sw ap spread: 0.85 Australia less NZ (LS) 2.00 AUDCAD (RS) 2.00 0.65 0.80 1.50 0.75 1.50 0.60 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10Source: UBS FX Strategy, Bloomberg Source: UBS FX Strategy, BloombergIn contrast, the relationship between New Zealand versus Canadian interest ratetrends and NZDCAD has not been as close over the past year. Even so, wenotice that since mid-year, NZDCAD has continued to rise even as the interestrate gap between the two countries has remained broadly steady. Moreover,UBS Economics expect interest rates in both Canada and New Zealand to riseby similar amounts in 2011. Given relatively steady interest rate differentials,there is scope for some downside in NZDCAD.Overall, should the US economy firm consistently as we move ahead, we expectthe Canadian dollar to recover lost ground against the Australian and NewZealand dollars. This view of Canadian dollar outperformance is also supportedby the interest rate outlooks. The Canadian dollar is already trading somewhat‘cheaply’ to its counterparts, considering the more positive US economic datacoming out as 2010 ends. UBS 12
  • FX Strategy - Outlook 2011 29 November 2010Black swans: US deflationEven though general economic data in the US is picking up again as 2010 ends, Could the US be facing Japan-stylethe Fed remains very concerned about the US economy falling into deflation. deflation?There are many stress-points: stagnant investment growth, ongoing declines inconsumer credit, excess capacity and weak consumer spending have allcontributed to core US inflation falling to just 0.6% y/y. As the US is recoveringfrom a banking crisis and balance sheet recession, the comparisons with Japan’sown bust over the last two decades are worrying.Chart 20: Pushing on a string? Chart 21: Deflationary US yields means weaker USDJPY Monetary Overhang 1980 - 2010 USDJPY Rate Spreads 12 145 6 Japan QE & FX 10 Japan US Intervention 5 8 130 6 4 4 115 3 % 2 % 0 100 2 -2 85 USDJPY 10Y Yield Spread -4 1 -6 70 0 -8 Jun-81 Jun-84 Jun-87 Jun-90 Jun-93 Jun-96 Jun-99 Jun-02 Jun-05 Jun-08 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10Source: Bloomberg, UBS calculations Source: Bloomberg, UBS calculationsBetween 2001 and 2006, the Bank of Japan’s balance sheet expandedaggressively as the central bank pursued quantitative easing. However, If QE doesn’t work, thethroughout this period Japan only managed a handful of positive annualised CPI Fed has a problemprints. This is a classic ‘pushing on a string scenario’, which the US hasthankfully not faced until now, owing to more resilient consumption. Forexample, during the US savings and loan crisis in the late 1980s, financialinstitutions bore the brunt of balance sheet adjustment, rather than the consumer.The more recent financial crisis of 2007-09, however, has hit US consumershard, Structurally, the US economy is now perhaps far closer to Japan,compared to previous cycles. If growth expectations falter again, either due toexternal shocks or excessive fiscal contraction, deflation is possible.In that case, the obvious response would be ‘more quantitative easing’. Interest If deflation spreads, the Fed willrate yield differentials would move further against the US, punishing the dollar. respond, causing a dollar routUSDJPY could fall below the key 80 level, and if Japan’s authorities fail to holdthe line, a move in the pair to 70 is conceivable.Moreover, that may not be the end of the story. In his famous “helicopter Ben”speech in 2002, Fed Chairman Bernanke warned that in addition to quantitativeeasing, the central bank has the authority to buy foreign government debt. Thisis the ‘nuclear option’; if Bernanke drops even the slightest hint that this is beingconsidered, there will be a dollar rout, leading to substantial currency and tradetensions in the global economy. UBS 13
  • FX Strategy - Outlook 2011 29 November 2010Black swans: Euro fiscal unionAfter Greece’s crisis in the summer of 2010, the euro was able to rally because The ECB may start to detach itsof consistent upside surprises in economic data, as shown in the chart below. In monetary policy stance from liquidityparticular Germany’s economy has been performing strongly, sparking talk provision to the banking systemsabout a boom even while peripheral countries face multi-year recessions. ECBPresident Trichet has hinted that one way for the ECB to solve this dilemmamay be to detach liquidity provision to the banking systems from its monetarypolicy stance. This could allow the ECB to raise interest rates without exitingunconventional measures first. The ECB’s desire to raise interest rates alsohelped the euro recover to highs above 1.42 against the US dollar in Novemberbefore Ireland’s crisis struck.Chart 22: UBS growth surprise index Chart 23: ECB peripheral bond purchases 110 US Eurozone Cumulative (right) Weekly (left) 18 70 100 16 60 90 14 50 12 80 10 40 70 8 30 60 6 20 4 50 10 2 40 0 0 2005 2006 2007 2008 2009 2010 May Jun Jul Aug Sep Oct NovSource: UBS Economics, UBS FX Strategy Source: Bloomberg, UBS FX StrategySince then, of course, the euro has tumbled again as the Eurozone’s peripheral Solving the sovereign debt crisis forbond markets have entered renewed turmoil. But if the European Union was good would be the other big surpriseable to ‘solve’ the debt crisis, the euro would likely experience a major rally that could push the euro highertowards 1.50 against the US dollar next year.The question, of course, is what such a solution would look like. We seeessentially two routes. First, the Eurozone could implement a fiscal union,whereby transfers from the wealthier countries would permanently bail out theperipheral countries. This would certainly be feasible given that in aggregate theEurozone public finance position is reasonably solid. What would be crucial,however, is the level of political will, particularly in the largest creditor nation –Germany.If Germany were to balk at bailing out fiscally challenged countries, as would A fiscal union would be one way toseem likely, then the second comprehensive solution would be debt ‘save’ the euro, the other being orderlyrestructurings. If done in an orderly way, this would not, in our view, debt restructuringsautomatically mean the end of the Eurozone. Particularly with a sovereign debtrestructuring mechanism in place, this route may be painful in the short term butcould eventually enable the euro to emerge stronger. Not an easy task to be sure,but if successful the euro could become a more viable reserve alternative to thedollar. UBS 14
  • FX Strategy - Outlook 2011 29 November 2010Black swans: Trade wars‘Currency wars’ – deliberate attempts to weaken exchange rates through direct The Swiss franc seems well placed toforeign exchange intervention, or indirectly through loosening domestic benefit if currency wars turn into trademonetary policy or imposing capital controls – have the potential to turn into wars‘trade wars’ if countries start imposing tariffs on imports.Chart 24: Foreign exchange reserves Chart 25: Swiss, German and Eurozone growth Foreign Exchange Reserves Real GDP Growth Singapore 8.0 8.0 India Eurozone Growth Brazil Swiss Growth HK 4.0 4.0 Switzerland Korea %Y/Y %Y/Y 0.0 0.0 Taiwan Russia Chi German Growth Saudi -4.0 -4.0 Japan China -8.0 -8.0 0.00 0.50 1.00 1.50 2.00 2.50 3.00 Mar-92 Jun-95 Sep-98 Dec-01 Mar-05 Jun-08 USD TrillionsSource: UBS FX Strategy Source: UBS FX StrategyThis would increase risk aversion to the benefit of the safe-haven dollar, yen andSwiss franc. But since the US economy is dependent on capital inflows tofinance its current account deficit at prevailing exchange rates, and Japan’seconomy is heavily dependent on exports for growth, the Swiss franc may bebetter placed than the US or Japanese currencies if the global economy were hitby the ‘black swan’ of widespread protectionism.Like Japan, Switzerland has ample foreign exchange reserves to defend itscurrency, following the Swiss National Bank’s efforts last year and this year tocurb the strength of the Swiss franc through buying foreign currency, as shownin the chart above.Like Japan, Switzerland is also a significant net exporter. So if the world Domestic demand a good safety buffereconomy were to fall prey to trade wars, the Swiss economy would be hurt bydeclining exports. But unlike Japan, Switzerland’s economy is less dependent ontrade for growth. As the right-hand chart above shows, Swiss GDP growth, likeGerman growth, has been strong in 2010, easily outpacing the Eurozone. This isbecause Switzerland’s domestic economy has not suffered excessively from thecredit crunch, as local banks have continued to lend. Thus, in the event ofwidespread protectionism disrupting global trade, Switzerland may still be ableto rely upon domestic demand to help keep its economy afloat.In contrast, Japan’s heavily reliance on exports suggests Tokyo would be muchquicker to respond to serious trade frictions by resorting to intervention toweaken the Japanese yen. That would reduce the yen’s safe-haven appeal.Similarly, for the world’s other main safe-haven currency – the US dollar –concerns that foreign central banks could stop buying US Treasuries if the USwere to impose trade tariffs would reduce the appeal of the greenback. UBS 15
  • FX Strategy - Outlook 2011 29 November 2010 Statement of RiskForecasting earnings and corporate financial behaviour is difficult because it isaffected by a wide range of economic, financial, accounting and regulatorytrends, as well as changes in tax policy. Analyst CertificationEach research analyst primarily responsible for the content of this researchreport, in whole or in part, certifies that with respect to each security or issuerthat the analyst covered in this report: (1) all of the views expressed accuratelyreflect his or her personal views about those securities or issuers; and (2) no partof his or her compensation was, is, or will be, directly or indirectly, related tothe specific recommendations or views expressed by that research analyst in theresearch report. UBS 16
  • FX Strategy - Outlook 2011 29 November 2010Required DisclosuresThis report has been prepared by UBS Limited, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliatesare referred to herein as UBS.For information on the ways in which UBS manages conflicts and maintains independence of its research product;historical performance information; and certain additional disclosures concerning UBS research recommendations,please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance isnot a reliable indicator of future results. Additional information will be made available upon request.UBS Investment Research: Global Equity Rating Allocations 1 2 UBS 12-Month Rating Rating Category Coverage IB Services Buy Buy 51% 37% Neutral Hold/Neutral 40% 33% Sell Sell 9% 22% 3 4 UBS Short-Term Rating Rating Category Coverage IB Services Buy Buy less than 1% 20% Sell Sell less than 1% 0%1:Percentage of companies under coverage globally within the 12-month rating category.2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided withinthe past 12 months.3:Percentage of companies under coverage globally within the Short-Term rating category.4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were providedwithin the past 12 months.Source: UBS. Rating allocations are as of 30 September 2010.UBS Investment Research: Global Equity Rating Definitions UBS 12-Month Rating Definition Buy FSR is > 6% above the MRA. Neutral FSR is between -6% and 6% of the MRA. Sell FSR is > 6% below the MRA. UBS Short-Term Rating Definition Buy: Stock price expected to rise within three months from the time the rating was assigned Buy because of a specific catalyst or event. Sell: Stock price expected to fall within three months from the time the rating was assigned Sell because of a specific catalyst or event. UBS 17
  • FX Strategy - Outlook 2011 29 November 2010KEY DEFINITIONS Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not aforecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stocks price target and/or rating aresubject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect anychange in the fundamental view or investment case.Equity Price Targets have an investment horizon of 12 months.EXCEPTIONS AND SPECIAL CASESUK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management,performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell:Negative on factors such as structure, management, performance record, discount.Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment ReviewCommittee (IRC). Factors considered by the IRC include the stocks volatility and the credit spread of the respective companysdebt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating.When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece.Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are notregistered/qualified as research analysts with the NASD and NYSE and therefore are not subject to the restrictions contained inthe NASD and NYSE rules on communications with a subject company, public appearances, and trading securities held by aresearch analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any,follows.UBS AG: Syed Mansoor Mohi-uddin; Beat Siegenthaler; Manuel Oliveri. UBS Securities LLC: Brian Kim; Amelia Bourdeau.UBS Limited: Geoffrey Yu; Chris Walker. UBS Securities Pte. Ltd.: Gareth Berry.Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report. UBS 18
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