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CME Group Currency Market Monitor Q4 2012


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The South Korean won and Chilean peso led gains among global currencies in carry trade performance during the fourth quarter, posting returns in excess of 4% against the U.S. dollar, CME Group analysts said in a report. Other strong performers included the Russian ruble, which returned 3.8% against the dollar, and the Colombian peso, up 3%, during the quarter, according to the latest Currency Market Monitor

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CME Group Currency Market Monitor Q4 2012

  1. 1. CURRENCIESCurrency Market Monitor4th Quarter2012JANUARY 11, 2013John W. Labuszewski Sandra Ro Bluford PutnamManaging Director Executive Director Chief EconomistResearch & Product Development Research & Product Development Research & Product Development312-466-7469 011 (44) 203-379-3789
  2. 2. An ongoing debate has long persisted in the global These factors including growth and inflationcurrency or FX markets – is FX an “asset class” akin prospects; monetary and fiscal policies; and, currentto stocks and bonds? While practitioners and and capital account balances.academics may debate this point at length, perhapsthe most practical answer is – does it really matter To illustrate, we include a brief discussion of theprovided that investors may draw a return from economic situation prevailing in the United States ascurrency investments? of the conclusion of the most recently completed calendar quarter. Of course, the U.S. dollar (USD)The performance of the currency or FX markets is may be just one side of any currency pair that mayfound in the exchange rates and cross-rates be traded using CME Group FX futures.associated with the world’s myriad currencies. Thetotal return associated with a currency is driven by A brief summary of economic conditions in variousinterest income associated with fixed income nations, organized along similar lines, is included ininstrument investment in the particular currency; as Appendix 1 of our document below. One maywell as pure price performance. compare and contrast these conditions as they exist in the two countries whose currency pairing you mayMany fundamental factors, including national be interested in to draw an appreciation of theeconomic conditions, monetary and policies, current fundamental factors that impact currency markets.and capital account flows, to name just a few,impact the returns associated with the world’s Growth and Employmentcurrencies. Market action during the 4th quarter 2012 wasThis document represents a review of these factors colored by the state of the U.S. economy. Theas they played out in the most recently completed Federal Reserve did a good job in articulating thecalendar quarter. We include consideration of the major economic issues during the quarter, so weso-called “carry trade” as well as a look at the frame the following analysis accordingly.theory of “purchasing power parity” as it impacts FXmarkets. In September 2012, the Fed announced its intentions to “increase policy accommodation byWhile we cover activity in a broad spectrum of purchasing additional agency mortgage-backedcurrencies, we focus on the currencies underlying securities at a pace of $40 billion per month … [it]some of the most liquid of CME Group FX futures. also will continue through the end of year itsThis includes the U.S. dollar (USD), Euro (EUR), program to extend the average maturity of itsJapanese yen (JPY), British pound (GBP), Swiss holdings of securities … These actions, whichfranc (CHF), Canadian dollar (CAD), Australian dollar together will increase the Committee’s holdings of(AUD) and Mexican peso (MXN). longer-term securities by about $85 billion each month … should put downward pressure on longer-In addition, we have special interest in the term interest rates … [and] … support mortgagecurrencies of significant emerging market economies markets.” 1including the Brazilian real (BRL), Russian ruble(RUB), Indian rupee (INR) and Chinese yuan or These policies seem to have exerted some positiverenminbi (CNY) – the so-called “BRIC” nations. impact as the Fed observed in December 2012 that “economic activity and employment have continuedFinally, we highlight several CME Group FX Indexes to expand at a moderate pace in recent months,including a USD Index, a Carry Trade Index, apart from weather-related disruptions. AlthoughCommodity Country Index and BRIC Index. the unemployment rate has declined somewhat since the summer, it remains elevated. HouseholdMarket Fundamentals spending has continued to advance, and the housingAs a general rule, FX analysts will evaluate thefundamental value of any particular currency by 1 Federal Reserve Press Release dated September 13,reference to a number of national economic factors. 2012.1 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
  3. 3. sector has shown further signs of improvement, but tarnished by the Bureau of Labor Statistic’s Laborgrowth in business fixed investment has slowed. Force Participation Rate figure. This statisticInflation has been running somewhat below the continues to slip and is most recently reported atCommittee’s longer-run objective, apart from 63.6% in December, down two notches from 63.8%temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectationshave remained stable.” 2 Real personal consumption expenditures (PCE) have advanced remarkably since the height of the Growth and Employment subprime crisis. In fact, the November 2012 PCE 6% 11% report of $9,686.6 billion represents a new high 4% 10% Qtrly Change in GDP Unemployment Rate water mark for this statistic. But these expenditures 2% 9% have come at the expense of generally declining 0% personal savings, reported at 3.6% in October 2012. 8% -2% 7% -4% It is not entirely clear the extent to which the Fed’s -6% 6% policy with respect to mortgage financing is -8% 5% responsible, but the housing market has indeed -10% 4% shown clear signs of improvement. This is 05 05 06 06 07 07 08 08 09 09 10 10 11 11 12 12 evidenced by an upturn in housing activity with Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 building permits, housing starts and housing Seasonally Adj Real GDP Unemployment Rate completions noticeably improving. Source: Bureau of Economic Analysis (BEA) & Bureau of Labor Statistics (BLS) Building permits were reported at 899 thousandReviewing the Fed’s findings, we see that 3rd quarter units in November and up 75% from the May 20092012 GDP was last reported in December at an trough of 513 thousand units. Similarly, housingencouraging +3.1% and up from the 2nd quarter’s starts and completions were reported at 861anemic figure of +1.3%. The unemployment rate is thousand and 677 thousand units, respectively, andgenerally trending down but up-ticked to 7.8% in up 80% and 33% from their lows recorded over theDecember from November’s read of 7.7%. past several years. Personal Consumption & Savings Housing Activity $9,800 9% 2,500 $9,700 8% Personal Savings Rate $9,600 7% 2,000 PCE (Bil $) $9,500 000 Units 6% $9,400 1,500 5% $9,300 4% 1,000 $9,200 $9,100 3% 500 $9,000 2% $8,900 1% 0 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jan-04 Sep-04 May-05 Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12 Personal Consumption Expenditures Personal Savings Rate Building Permits Housing Starts Completions Source: St. Louis Federal Reserve FRED Database Source: Dept. of Housing & Urban Development (HUD)While the unemployment rate generally appears to This impetus has further been felt in housing valuesbe headed in the right direction, this optimism is where the S&P/Case-Shiller Housing Indexes have posted some nice gains over the past few months. While the October 2012 read on the Composite Index of 10 urban cities remains 29.8% below its2 Federal Reserve Press Release dated December 12, all-time peak observed in June 2006, it has 2012.2 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
  4. 4. rebounded 7.0% from its low water mark recorded U.S. Corporate Profitability 120% $1,800in April 2012. Pre-Tax Profits (Billions) 100% $1,600 Annualized Change S&P/Case-Shiller Housing Indexes 80% 320 60% $1,400 280 40% $1,200 20% 240 0% $1,000 200 -20% $800 -40% 160 -60% $600 Q1 04 Q4 04 Q3 05 Q2 06 Q1 07 Q4 07 Q3 08 Q2 09 Q1 10 Q4 10 Q3 11 Q2 12 120 80 Sep-01 Sep-06 Sep-11 Jan-00 Nov-00 Jul-02 May-03 Mar-04 Jan-05 Nov-05 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Jul-12 Annual Change Corporate Profits (Bil) Source: Department of Commerce Los Angeles San Diego San Francisco Inflation Denver Washington DC Miami Chicago Boston Las Vegas New York Comp-10 These business conditions seem to be contributing to Source: Standard & Poors the controlled inflation the Fed describes in its December report. November CPI fell to 1.8% on anWhile news on the consumer front has been upbeat, annualized basis, down from 2.2% in the previousit is not clear that the business sector has kept pace month. Much of this was driven by declining energywith the consumer sector as the Fed observed. The prices. Still, CPI ex-food & energy fell to 1.9% fromIndex of Industrial Production improved to 97.5090 2.0% on an annualized basis in November fromin November from 96.4932 in October. Still, the October.Index remains well below pre-crisis levels in excessof 100. Consumer Price Index (CPI-U SA) 6% Industrial Activity 5% 105 82% Year-on-Year Change 4% Industrial Production Index 80% 3% Capacity Utilization 100 78% 2% 95 76% 1% 74% 0% 90 72% -1% 70% -2% 85 68% -3% Jan-04 Aug-04 Mar-05 Oct-05 May-06 Dec-06 Feb-08 Sep-08 Apr-09 Nov-09 Jun-10 Jan-11 Aug-11 Mar-12 Oct-12 Jul-07 80 66% Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 CPI - All Urban Consumers SA CPI ex-Food & Energy SA Source: Bureau of Labor Statistics (BLS) Index of Industrial Production Capacity Utilization Source: St. Louis Federal Reserve FRED Database Monetary PolicySimilarly, capacity utilization has rebounded but While the Fed observes some improvement inremains below the pre-crisis peaks above 80.0%. economic conditions, it nonetheless “remainsThe figure was most recently reported at 78.4% in concerned that, without sufficient policyNovember and up from November’s 77.7%. accommodation, economic growth might not beCorporate profitability improved 18.6% from the 2nd strong enough to generated sustained improvementto 3rd quarters 2012 to check in at $1,752.2 billion. in labor market conditions. Furthermore, strains in3 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
  5. 5. global financial markets continue to pose significant Consideration of budget issues is, however,downside risks to the economic outlook.” 3 postponed until March.Thus, the Fed intends to continue its mortgage The fiscal cliff weighed on consumer sentiment aspurchasing programs. The Fed further hones its evidenced by the dramatic decline in the Thomsonfocus on labor markets, suggesting that if they do Reuters/University of Michigan Index of Consumernot “improve substantially, the Committee will Sentiment. The figure plummeted from 82.7 to 74.5continue its purchases of Treasury and agency between November and December 2012. Thismortgage-backed securities, and employ its other decline came despite the fact that household netpolicy tools as appropriate, until such improvement worth has been climbing nicely over the past severalis achieved in a context of price stability.” 4 quarters. Fading consumer confidence is further reflected in preliminary reports of disappointingThe Fed further intends to maintain target Fed Funds holiday retail sales. Flying in the face of theseat 0-25 basis points “at least as long as the reports, however, is generally strong automobileunemployment rate remains above 6-1/2 percent.” 5 sales.This linkage of monetary policy with a stated targetfor unemployment is quite significant. The Federal spending deficit appears to have stabilized after increasing into the neighborhood of Net Worth & Consumer Confidence $1.2-$1.4 trillion beginning in 2009. The 2012 Household Net Worth (Trillions) $70 100 deficit may be expected to fall within the same Consumer Confidence Index 95 $65 general range. Future deficits will be a function of 90 85 both economic and political considerations. $60 80 $55 75 Federal Surplus/Deficit 70 (Billions USD) $50 $400 65 $200 $45 60 55 $0 $40 50 -$200 Q4 04 Q3 05 Q2 06 Q1 07 Q4 07 Q3 08 Q2 09 Q1 10 Q4 10 Q3 11 Q2 12 -$400 -$600 Household Net Worth Consumer Confidence Index -$800 Source: U.S. Federal Reserve & FRED Database -$1,000 -$1,200Fiscal Policy -$1,400 -$1,600 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011The 2013 “fiscal cliff” provided further economicapprehension in December 2012 as executive andlegislative branches of government struggled to The federal government is, of course, aware of thereach an accord on taxes and spending cuts. By magnitude of the fiscal situation and has attemptedearly January, an agreement had passed both House to curb spending within the context of the so-calledand Senate consideration. “fiscal cliff” tax and spending negotiations. While progress has been made to forestall the expiration ofThis bill includes higher taxes on individuals the Bush administration tax cuts as of this writing,reporting $400,000+ and married couples with the spending debate has been postponed until March$450,000+ in income and increases the dividend tax 2013, as discussed above. Further drama may befrom 15% to 20% on those taxpayers. anticipated in the form of a renewed debate on the debt ceiling in coming months as well.3 Ibid.4 Ibid.5 Ibid.4 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
  6. 6. Current & Capital Accounts In addition to monitoring current account activity, we may likewise study capital account flows. TheIn addition to the troublesome fiscal deficit, the U.S. U.S. Treasury Department’s Treasury Internationalfaces a significant trade deficit as reflected in the Capital (or “TIC”) database represents a readycurrent account balance. While the trade deficit source of information. This database tracks flowsdiminished in the immediate wake of the subprime into and out of the U.S. The data is broken intocrisis, it is growing once again although it has not foreign stocks, foreign bonds, U.S. stocks, U.S.yet breached pre-crisis levels. Still, the deficit corporate bonds, U.S. government agencies andstrains upwards to 4.0% of GDP in 2011 and the U.S. Treasuries.highest amongst all G10 nations. Foreign investors acquired some $432.6 billion in U.S. Current Account Deficit U.S. Treasuries, on a net basis during the first 10 (Billions USD) $0 months of 2012. Clearly USD-denominated investments, specifically in the form of U.S. -$50 Treasuries continue to be regarded as a “safe haven” investment despite the unusually low yields -$100 currently prevailing in the marketplace. While the 2012 inflows are unlikely to match the 2009 or 2010 -$150 investments of $538.4 and $703.7 billion, -$200 respectively, the number is substantial and supportive of the Treasury market. -$250 04 04 05 05 06 06 07 07 08 08 09 09 10 10 11 11 12 12 European Sovereign Debt Crisis Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 In addition to developments specific to the U.S. Source: Bureau of Economic Analysis (BEA) economy, the currency markets continue to be colored by a number of fundamental news eventsSome improvements in these figures seem to be including the ongoing European sovereign debtdeveloping as the trade deficit decreased to $107.5 crisis.billion in the 3rd quarter from $133.6 billion in thefirst quarter. The decrease in the current account Euro/US Dollar Exchange Ratedeficit may be attributed to a declining deficit on 1.50goods and an increase in the surplus on income. 1.45 Net US/Foreign Capital Flows 1.40 (Billions USD) $1,200 1.35 $700 1.30 1.25 $200 1.20 Sep-11 Sep-12 Jan-11 Mar-11 May-11 Jul-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Nov-12 -$300 -$800 German Chancellor Angela Merkel warned in an Thru 10/12 2003 2004 2005 2006 2007 2008 2009 2010 2011 address to usher in the new year that “the crisis is US Treasuries US Govt Agencies US Corporates far from over” and that a final resolution of the US Stocks Foreign Bonds Foreign Stocks issues will require “a lot of patience.” But she Source: U.S. Treasury TIC Database further indicated that “the reforms that we’ve introduced are beginning to have an impact.”5 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
  7. 7. Germany has, of course, taken on the bulk of the growth in the so-called emerging markets such asburden in funding the European Stability Mechanism China seems to be abating in recent months. Thus,as a standing bailout fund. That move, along with investors have become increasingly willing to movethe European Central Bank’s plan to purchase funds out of USD-denominated investments.soveriegn debt securities – a European quantitativeeasing program if you will – has gone far to stabilize Thus, our USD Index remains is hovering just belowthe region and bolster the value of the Euro during 1,000 or its (arbitrarily established) value as ofthe latter half of 2012. December 31, 2010 and near the bottom of the range established from 2007 through the conclusionThis is in evidence when one considers that the of the 1st quarter 2011. This long-term USDGreek stock market turned in the top performance of weakness may largely be attributed to the weight ofall Eurozone nations in 2012. The ATHEX index of the dual U.S. fiscal and trade deficits as discussedGreek equities closed out the year +33%, above.surpassing the +29% performance of the Germanbelwether DAX Index in 2012. Still, the ATHEX Total Returnremains well above its peak of few years ago. One of the most popular long-term FX tradingPrice Performance strategies over the past decade is known simply as the “carry trade.” This practice simply suggestsThese factors exert an obvious impact upon the that one might exploit “cost of carry” by borrowingprice performance of the U.S. dollar vis-à-vis other in countries with low nominal interest rates to investworld currencies. In order to monitor this price in countries with high nominal interest rates. Thus,impact, CME Group has developed the “CME USD one might sell the “low-rate” currency and buy theIndex” as one in a family of similarly constructed FX “high-rate” currency.Indexes. 6 Sell low-rate currency & Carry trade CME USD Index buy high-rate currency 1,250 Long Short 16.7% EUR 100% USD 1,200 16.7% JPY 16.7% GBP By so doing, one hopes to capitalize on discrepant 16.7% CHF 16.7% CAD interest rates, and by implication, divergent 1,150 16.7% CNY investment opportunities, in the two countries. This 1,100 strategy further recognizes that total currency return consists of 2 components, specifically, exchange rate 1,050 or price movement plus the accrual of interest. 1,000 Total Currency Price Movement + 950 = Return Interest 900 Sep-08 Dec-09 Oct-10 Aug-11 Jan-07 Jun-07 Nov-07 Apr-08 Feb-09 Jul-09 May-10 Mar-11 Jan-12 Jun-12 Nov-12 The implicit assumption is that these interest rate relationships will endure. As such, carry traders implicitly discount classical exchange rate theories by assuming that the interest rate relationships mayThe CME USD Index generally declined during the 4th endure over extended periods of time. Thisquarter 2012 as European sovereign debt fears were suggests that low-yielding currencies that are soldquelled. Further, concerns about decelerating will not advance; and, that high-yielding currencies that are purchased will not decline.6 The CME USD Index represents a basket of equally weighted positions (as of December 31, 2010) of the Historically, such relationships have been known to USD vs. the Euro (EUR), Japanese yen (JPY), British endure for extended periods of time, reinforcing pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), interest in the carry trade. In particular, vast sums Australian dollar (AUD) and Chinese yuan (CNY). It is (arbitrarily) established at a value of 1,000.00 as of of money totaling in the trillions of U.S. dollars were December 31, 2010. invested in the carry trade, specifically by shorting6 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
  8. 8. the Japanese yen (JPY) and investing in other CME FX Carry Index 1,050currencies including the Icelandic krona (ISK). 1,000Appendix 2 below depicts the total return associated 950with various currencies, relative to the U.S. dollar,during the most recently completed calendar 900quarter. Note the South Korean won (KRW) led the 850 Long Short 16.7% BRL 50% USDpack with a quarterly return of +4.99%. The KRW 16.7% AUD 50% EUR 800 16.7% ZARwas followed by the Chilean peso (CLP) at +4.40%; 16.7% NZD 16.7% TRYthe Russian ruble (RUB) at +3.84%; and, the 750 16.7% MXNColombian peso (COP) at +3.04%. 700 Sep-08 Dec-09 Jan-07 Jun-07 Nov-07 Apr-08 Feb-09 Jul-09 May-10 Oct-10 Mar-11 Aug-11 Jan-12 Jun-12 Nov-12 Carry Return (Q4 2012) USD-KRW USD-CLP USD-RUB USD-COP Purchasing Power Parity USD-CHF EUR-USD USD-TRY The theory of purchasing power parity (PPP) dates to USD-ARS USD-CNY the 16th century and the School of Salamanca but USD-TWD AUD-USD was further developed in the early 20th century by USD-MXN GBP-USD economist Gustav Cassel. 8 The theory is based NZD-USD upon the assumption that exchange rates are in USD-BRL USD equilibrium when purchasing power is equivalent in USD-CAD USD-ZAR the two countries. USD-ISK USD-INR USD-JPY On a granular level, PPP is based on the “law of one -12% -10% -8% -6% -4% -2% 0% 2% 4% 6% price” or the notion that identical products should be priced at the same level in different national markets adjusted for exchange rates. Typically, this law isThe Japanese yen was a major loser during the 4th qualified by the absence of significant trade barriersquarter 2012 as its value reversed sharply or other artificial constraints on commerce.downward vs. the USD and other major currencieswith a total return of –10.11%. Other currencies But the theory of PPP expands the application of theturning in a weak performance during the quarter law of one price from any single good or product toincluded the Indian rupee (-1.77%), the Icelandic generalized prices in any particular economy askrona (-1.61%) and the South African rand (- measured by inflation indexes, e.g., Consumer Price1.21%). Index (CPI) or Producer Price Index (PPI). The implication of this theory is that inflation rates andBecause the carry trade has become such an exchange rates should exhibit negative correlation.important and widely followed transaction in theglobal FX markets, CME Group has developed theCME FX Carry Index. This novel index is designed tofollow the performance of a basket of currencies thatoffer relatively high interest rates and have, at leaston an historical basis, generated favorable totalreturns. 7 Turkish lira (TRY) vs. short positions in the USD and EUR. It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010. The long components of the CME FX Carry Index were selected in light of the high local interest rates that prevailed in those countries7 The CME FX Carry Index represents a basket of equally during the post-financial crisis era through 2010. The weighted positions (as of December 31, 2010) which is short components of the index were identified because of effectively long a basket including the Australian dollar the low interest rates offered. 8 (AUD), Brazilian real (BRL), Mexican peso (MXN), New See Cassel, Gustav, “Abnormal Deviations in Zealand dollar (NZD), South African rand (ZAR) and International Exchanges” (December 1918).7 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP