barclays global fx quarterly brief break in the usd uptrend (1)

Jose Wynne+1 212 412 [email protected]

Marvin Barth+44 (0)20 313 [email protected]

Aroop Chatterjee+1 212 412 [email protected]

Mitul Kotecha 65.6308.3093 [email protected]

Foreign Exchange ResearchMarch 2015

PLEASE SEE ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES BEGINNING ON LAST PAGE.

Global FX QuarterlyBrief break in the USD uptrend

Barclays | Global FX Quarterly

CONTENTS

Top Trades .................................................................................................... 3 Our top thematic trades are short EURUSD spot, long USDCAD spot, and long USDCNH spot. Our top relative value trades are long INRTWD and short SGDPHP.

Overview ....................................................................................................... 4 Brief break in the USD uptrend Slower US growth and softer inflation have given the Fed reasons to delay and flatten its rate hiking path. These developments have caught the USD a bit ahead of itself, but given the recent correction, we expect it to stabilize around current levels. We think the USD is likely to take a break before resuming its uptrend at a slower pace. We forecast 5% USD REER appreciation by year-end.

Theme 1: EUR ............................................................................................10 Taking depth soundings Two-way risks have increased but the two key drivers of the multi-year downtrend in the EUR remain in force. In our view, a stabilization or turn in the EUR will require a sustained and convincing pickup in real investment or an acceleration in core inflation. Neither looks likely to be on offer anytime soon.

Theme 2: JPY ..............................................................................................15 Range-bound The yen will likely remain range-bound against the USD in the year ahead amid countervailing factors. Expected USD strength into the Feds first hike may continue to exert upward pressure on USDJPY, although we have delayed our expectation of a Fed rate hike to September, which could reduce some of the upward momentum in the USD in the near term.

Theme 3: GBP ............................................................................................17 Unprecedented political uncertainty Growing political risk premium ahead of the particularly uncertain 7 May general election should put downward pressure on GBP. Beyond the election, economic outperformance relative to the euro area should see continued GBP appreciation versus the EUR. However, very low UK inflation and risks of an extended period of unchanged BoE policy are likely to temper the degree of sterling outperformance and contribute to significant GBPUSD depreciation.

Theme 4: SEK and CHF ...........................................................................20 Club sub-zero Unwanted currency strength, in anticipation of or as a result of ECB QE, has forced smaller G-10 central banks like the SNB and the Riksbank to ease policy recently, cutting rates below zero and announcing QE. We expect both central banks to keep an easing bias, at least in the short term.

Theme 5: CAD and NOK .........................................................................23 Yet to price the oil slippage Lower oil prices have weakened fundamentals and widened output gaps in oil-producing Canada and Norway. We believe the effect of lower oil will be pervasive in 2015, and we remain negative on both CAD and NOK.

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Theme 6: CNY ............................................................................................25 More flexibility, less complexity We expect China to take steps to accommodate greater CNY flexibility this year, through a combination of more volatile but modestly higher USDCNY fixings and a widening of the trading band.

Theme 7: AUD and NZD .........................................................................28 More room to fall Although both AUD and NZD have depreciated in recent months, we think there is scope for further depreciation versus USD given contrasting monetary policy stances and a firm USD. However, we do see some scope for AUDNZD to move higher, with the currency pair bottoming out around current levels.

Theme 8: EM Asia .....................................................................................32 Exploiting divergence within the pack Asian currencies have outperformed during Q1 2015 but it has not been an easy ride. Given the headwinds from expected Fed rate hikes and a strong USD, we expect Asian currencies to depreciate against the greenback to varying degrees.

Theme 9: BRL .............................................................................................36 BCB behind the curve BRL offers value, but we suggest staying on the sidelines waiting for the central bank to get ahead of the curve. High risk premia on domestic assets, along with a weaker BRL, would ordinarily make being long the currency an inviting proposition. We are not constructive, however.

Theme 10: TRY ..........................................................................................38 Less negative, but still on the sidelines TRY may find some stability in Q2 15 as the USD rally takes a breather. Although TRY provides attractive carry, we think idiosyncratic risks make it an unattractive long. We maintain our fundamentally negative view on TRY into H2 15 (Q4 15: 2.75 and Q1 16: 2.85).

Theme 11: RUB ..........................................................................................40 Weaker spot but inside USD forwards The RUB looks set for modest depreciation in 2015 on lower oil prices, persistent geopolitical risks around Ukraine and broad USD strength. Additionally, with the CBR having turned more growth-oriented amid high inflation, monetary policy support for the currency is likely to wane.

FX Views for the Year Ahead .................................................................43

Open Trades ...............................................................................................48

FX Closed Trades ......................................................................................49

FX Forecast Tables ...................................................................................52

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FX STRATEGY

Top trades

Thematic trades

1. Short EURUSD spot We now forecast that EURUSD will be below parity by year-end. Although the broad USD rally may slow in Q2, a strengthening US outlook and stable euro area interest rates (backed by a highly elastic supply of euros from the ECB) imply that short EURUSD remains the best way of expressing the long USD view.

2. Long USDCAD spot We believe the market is underpricing rate cuts by the Bank of Canada. Lower oil prices have finally begun feeding through into activity data and we expect the BoC to cut rates by 50bp over the next 3-6 months.

3. Long USDCNH spot We expect Chinas weaker growth trajectory to be consistent with further depreciation in the CNY. To avoid significant REER appreciation to an already strong currency, in the face of a strong USD, we expect the authorities to condone a move higher in USDCNY.

Relative value trades

1. Long INRTWD INR remains one our favoured currencies because of improved fundamentals and reform prospects and, unlike in the past, it appears far less susceptible to capital outflows. We find TWD to be an attractive funding currency as policymakers provide room for further weakness.

2. Short SGDPHP In our view, PHPs fall versus the USD will be more modest given its solid current account surplus, low external borrowings and relatively low foreign ownership of local assets. SGD is another attractive regional funding currency given the appetite of the MAS for currency weakness.

Aroop Chatterjee

+1 212 412 5622 [email protected]

26 March 2015 3


OVERVIEW

Brief break in the USD uptrend Slower US growth and softer inflation have given the Fed reasons to delay and

flatten its rate hiking path. These developments have caught the USD a bit ahead of itself, but given the recent correction, we expect it to stabilize around current levels. We think the USD is likely to take a break before resuming its uptrend at a slower pace. We are forecasting 5% USD REER appreciation by year-end.

Features of the liquidity facilities introduced by the ECB suggest selling EURUSD is the best way to express a long USD view, when the trend resumes. The Eonia curves insensitivity to positive European growth surprises suggests there is a highly elastic supply of euros in place, at the ECB refi rate. This implies that EURUSD volatility will come mostly from the US side. We also think that even positive growth surprises in EA could be negative for the EUR, against common wisdom, if inflation expectations rise and send real rates lower.

A USD breather is likely to benefit EM carry in the near term. Unfortunately, some of these currencies fundamentals have deteriorated and therefore we remain selective in spite of the positive global backdrop for this class. The INR remains our preferred carry long, funded out of TWD. While we expect the TRY and RUB to trade inside the forwards the risks are too substantial. BRL offers value but we are waiting for the Central Bank of Brazil to get ahead of the curve.

Sterling is likely to remain under downward pressure and see volatility ahead of the May 7 general election, but it is well priced by options in our view. Post-election volatility, however, likely is underpriced.

Stay long USDCAD and cautious on NOK as central banks need to ease beyond what is priced in. Lower oil prices are only starting to permeate through their economies.

We continue to believe the BoJ will avoid pursuing further yen weakness given the unintended contractionary consequences, and instead encourage wage policies to boost demand and inflation in the medium term. Topside volatility in yen crosses also seems too elevated, in our view.

We remain long USDCNH in spot as we believe a lower EUR, and weak domestic demand and softer inflation in China may lead authorities to mitigate the steep REER appreciation implied by an otherwise stable USDCNY. We also think Chinas fears of floating are overblown.

An enticing global backdrop for FX A remarkably desynchronized global recovery, volatile oil markets, unconventional and heterogeneous monetary stimulus, and vulnerable emerging markets continue to offer a fascinating landscape for FX markets in 2015. As if this backdrop were not attractive enough for FX investors, we think tail risks are also interesting, mildly fading on global disinflation concerns, providing a better backdrop for risky assets, and regionally mutating away from Greek exit into a more serious Chinese slowdown than we and markets may be anticipating.

The Fed has paused the USD rally after expressing its concerns about the greenbacks rapid strengthening, acknowledging a slower underlying growth trend, and by revising its NAIRU estimate lower. In other words, the FOMC has shifted the unemployment threshold necessary for a rates liftoff, which, together with a slower pace of job creation, should delay the beginning and flatten the path of the eventual US hiking cycle. This softer outlook for

Jose Wynne +1 212 412 5923 [email protected] Aroop Chatterjee +1 212 412 5622 [email protected]

The macro backdrop poses an enticing environment for FX markets

The Fed change of stance and the softer US outlook left the USD trading ahead of itself

26 March 2015 4


the US economy has left the recent USD strength trading ahead of itself and likely prone to consolidation around current levels during the early part of Q2. However, we look for the uptrend to resume once lower oil prices are clearly proving beneficial to global consumer spending, and hence expect the USD to catch up to our latest set of forecasts by year end, starting as soon as it becomes evident that the Fed is indeed ready to hike in September (previously expected for June).

How high can the USD go? Against this backdrop, market participants want to know whether the bulk of the USD rally now stands behind us. We acknowledge that the risk-reward in long USD positions has deteriorated, but we believe there is still substantial room for further upside in the USD as its valuation is far from stretched and cyclically the US economy is still poised to outperform.

Figure 1 shows three alternative measures of USD valuation: REER relative to its average, unit labour cost relative to US trading partners, and our measure of currency misalignment relative to the USD long run fair value (see the description of our BEER model here). While our BEER model suggests that the USD is 9.6% overvalued, equivalent to a 0.9 standard deviation move relative to fair, we anticipate that the misalignment could move into the 1.5-2.0 standard deviation range relative to fair value as the US business cycle continues to improve ahead of a sluggish world. Indeed the USD REER seems to be strongly correlated with the US output gap relative to its trading partners (Figure 2). Under all other valuation metrics, the USD seems to have even more room for appreciation, which should ease valuation concerns from the USD path in the near term, in our view.

While we think the USD has room to rally on valuation grounds, we expect a milder appreciation trend relative to what has already taken place since July 2014. Beyond our expectation of a slower US hiking path for the reasons mentioned above, we have reasons to believe that two features of this global recovery may slow the USD uptrend once it resumes, and hence we are only forecasting 5% of REER appreciation by year-end, after the 10% move observed since July 2014.

The first feature is that, this time around, the USD rally may have a more disinflationary impact on the US economy than in the past, which will impede a fast normalization of US rates. Figure 3 shows US import prices by origin since the 1990s. While the data are incomplete, it seems that US import prices were much less volatile during the 1990s and, hence, more muted to USD swings. In other words, inflation in the US was more shielded to USD fluctuations during the 1990s and was much more Asian focused. US import prices have been much more flexible since

We look for near-term consolidation of the USD, but still see it strengthening 5% in REER terms by year-end

FIGURE 1 USD, far from expensive yet

FIGURE 2 US relative output gap, closely linked to USD REER

Source: Bloomberg, Barclays Research Source: Barclays Research

Three features of this recovery suggest the USD appreciation will be more limited this time

First, the USD appreciation may be more disinflationary for the US

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the early 2000s for most countries, with the exception of those in Asia. Given our view that USD appreciation is likely to come primarily from outside Asia, mainly from a weaker EUR and EMEA FX, we suspect that we may see a more significant pass-through from a stronger USD into US inflation this time around. Thus, while the USD has room for appreciation on valuation considerations, we think the scope for steep appreciation may be more limited this time.

The second feature of this recovery that will slow the USD appreciation is that the world is likely to continue to enjoy a major source of cheap liquidity for years, as per the ECBs easing measures. We believe this feature will go a long way in keeping a big part of emerging markets well funded and, therefore, less vulnerable to Fed tightening relative to past USD rallies. For this reason, potential USD appreciation may be more subdued, contained by a more limited EM REER depreciation.

ECB liquidity features and why these matter Beyond the desynchronized recovery that we expect to keep the USD trend alive, FX markets will need to learn to trade the idiosyncratic features of the ECB liquidity facilities as the Fed prepares to withdraw USD funding globally. Just a few questions hold the key to excess returns in FX markets in the upcoming months: how fungible is the Fed versus ECB liquidity as sources of global funding? What are the differences, and why do they matter for FX markets?

We think that the liquidity facilities put in place by the ECB differ from those of the Feds in three important aspects with direct relevance for FX markets. First, the impact on global interest rates of US quantitative easing, for an equivalent size, is likely much more significant than that of the ECB. When the Fed eases, many central banks follow either via cutting overnight rates or by defending their own currencies, particularly in EM, which adds downward pressure on longer-end rates. In other words, the Fed drives the pulse of global rates much more than the ECB, maybe because global capital markets are much more integrated into the US and reliant on USD funding (the amount of USD funding taken by EM sovereigns and corporates is substantially greater than that in EUR). On the same logic, Fed easing should have a more muted impact on interest rate differentials and therefore the USD. In contrast, the recent QE easing by the BoJ had a substantial impact on onshore JPY rates, but only a more muted impact on global rates, hence, the impact on interest rate differentials and the JPY was large. We should expect the ECB QE programme to have greater impact on the EUR than similar Fed moves on the USD, although admittedly a much more muted impact than that of the BoJ on the JPY.

Second, EM FX will not melt versus the USD, as ECB funding will still be available for EM

FIGURE 3 US import prices by origin

Source: Haver Analytics

How fungible the ECB liquidity is relative to that of the Fed is something to learn about in the coming months

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TLTRO: All you can eat Second, the ECBs TLTRO has profound implications for FX markets because the programme essentially commits to an infinitely elastic supply of EUR. In contrast, when central banks set an overnight target rate, they essentially commit to fund the market at that rate only until the next monetary policy meeting. In developed markets, a positive growth or inflation surprise would then tend to appreciate the value of the currency as participants anticipate a tighter future monetary policy stance. This behaviour also manifests itself through selloffs in domestic rates, proving that the supply of liquidity is not infinitely elastic at the current overnight rate (as supply shrinks in response to a demand shock).

But given that TLTROs essentially fund the system at the refinancing rate for several years, locking in future funding costs, fluctuations in EUR demand exert virtually no pressure on the Eonia curve, and therefore on the EUR. Figures 4 and 5 show the year-to-date ranges for USD OIS and Eonia, respectively. The highest 5y Eonia rate this year has been only 9bp higher than the lowest, while the equivalent range in 5y OIS rates has been 54bp.

In other words, this feature of the ECBs liquidity provision essentially makes the supply of euro infinitely elastic at the refi rate. Because of this, positive growth or inflation surprises in the euro area (EA), or stronger inflows into equities, or any other source of demand for EUR are unlikely to lead to a stronger EUR (as supply would respond). In fact, we think positive growth surprises could actually be EUR negative if they increase inflation expectations, as nominal rates would remain unchanged while onshore real rates would likely go lower.

We think these features suggest that selling EUR will continue to be the best way to express a long USD view. In this respect, we think it should be noted that positive US growth surprises tend to coincide with higher US rates. Given that a positive US growth has positive global growth spillovers, we would also expect to see a coincidental selloff in other countries rates, albeit by a much lesser extent. But for as long as the perception of this infinite EUR supply remains in place, this is unlikely to be the same for EA rates. Hence, a positive US growth surprise is likely to have a more severe impact on interest rate differentials against the EUR than, say, the CAD or MXN or any other cross.

In other words, these features of the ECBs funding facilities make EURUSD mostly insensitive to data surprises in EA, but overly sensitive to growth or inflation surprises in the US. This is the main reason why EURUSD remains our preferred long for the USD when the

The supply of EUR is highly elastic at the refi rate; positive EUR demand shocks (portfolio inflows, EA growth surprises), should not drive the EUR higher

FIGURE 4 USD OIS curve range YTD

FIGURE 5 Eonia curve range became insensitive to positive EA growth surprises

Source: Bloomberg, Barclays Research Source: Bloomberg, Barclays Research

5y Eonia rates do not react to growth surprises anymore

Selling EUR is the best way to express a long USD view

EA growth surprises do not pose risks to our short EURUSD view

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latter resumes its uptrend. Indeed, the recent retracement in EURUSD has not been driven by the EA positive growth surprises, but has more stemmed from disappointing growth and inflation data in the US, backed by a still patient Fed. Indeed, we think more positive EA growth surprises could significantly damage the value of the EUR as they could send EA real rates even lower, as has been seen lately (Figure 6).

EM fear of floating The third feature of this recovery that may limit the USD rally relates to Chinas fear of floating, a concern about FX volatility versus the USD, not versus the EUR. Thus, from this perspective, the flow of EUR funding should not be completely fungible relative to USD funding. The fear of floating argument is that central banks prefer to curb the volatility of their currencies for three widely cited reasons: asset/liability mismatches, which due to funding positions in EM is related to the value of the USD in local currency terms; contractionary depreciation caused by a confidence shock on investment induced by sudden moves in the value of the USD; and credibility concerns that tend to erode public confidence, via rising inflation expectations, when USD moves push a central bank to hike rates.

This issue is particularly sensitive in China at the moment, a reason why our USDCNY forecasts are more stable than the macro backdrop would suggest. Chinas fear of floating is limiting the much-needed monetary policy easing, as authorities find it hard enough to cut rates and/or reserve requirements without adding pressures on the currency, which is already trading at the top of the band. The lack of USDCNY flexibility implies that the world faces one large USD block composed of the US and China. Given Chinas size, if its growth slows significantly, the pegging to the USD would be a drag on the value of the USD itself, much as the EA periphery limited the value of the EUR, despite Germanys stronger outlook. In other words, this time around, the US may grow without accelerating Chinas growth, and the fact the CNY is practically pegged should impose headwinds on the USD.

Top FX views and positions With this framework in mind, we explain why we still hold high conviction in staying short EURUSD in Theme 1, even as we acknowledge more two-way risks. In Theme 2 we provide an update on the yen and support our arguments for a stable yen versus even the USD. We believe this provides room for investors to consider short EURJPY positions as a serious

FIGURE 6 ECB is finally impacting EA breakevens, maintaining downward pressure on EURUSD

FIGURE 7 Largest stocks of external borrowings are in Latin America and EEMEA

Source: Barclays Research Note: These are non-fin foreign-currency borrowings from banks and through

international debt issuance as a percentage of GDP. We adjusted Chinas external borrowing to include 80% of bank borrowing from abroad following this methodology. Source: BIS, Haver Analytics, Barclays Research

The USD rally may be more limited by the CNY peg, or fear of floating, to the USD

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contender to the short EURUSD or EURGBP. The wide range of outcomes in the upcoming UK elections make us think that post-election option implied volatility may be too low for the risks, as we argue in Theme 3. We discuss our bias to be short CHF and SEK, on deflation concerns, in Theme 4. In Theme 5 we also explain that we retain a negative view on NOK and CAD, due to still underpriced oil concerns.

China seems to be struggling with its own rebalancing act, as activity is slowing more than markets expected, but monetary policy seems still too tight for the circumstances. In Theme 6, we explain why we believe fears of letting the currency weaken and adjust to a stronger USD environment may be constraining policy, and why we still see interesting optionality in staying long USDCNH in spot, even though our 12-month forecasts remain inside the forwards. This troubled outlook is likely to exert further weakening pressures on both AUD and NZD, as we discuss in Theme 7. The rest of EM Asia FX will likely see divergence from the bottom up, as the strong USD environment should not pose too much trouble for those with better idiosyncratic stories, as presented in Theme 8. Indeed, we suggest being long INRTWD and short SGDPHP, funding the good stories within Asia with regional funding currencies to avoid USD or EUR funding volatility for now.

The brief break in the USD uptrend should also present a supportive backdrop to high carry EM currencies other than INR. For these reasons we have turned less negative RUB, TRY, and BRL at current levels, as we argue in Themes 9, 10, and 11. These currencies fundamentals have deteriorated from the bottom up, however, making us retain our cautious stance. Among the three, BRL offers the most attractive opportunity given the large premia build in local currency bonds, nominal and inflation linked. We would look for a stronger message from the central bank with regard to its commitment to keep inflation expectations well anchored, however, before engaging in outright longs.

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THEME

EUR: Taking depth soundings How much lower can the EUR fall? By our soundings, a lot. Two-way risks have increased but the two key drivers of the multi-year downtrend in the EUR remain in force. In particular, as long as the ECB is committed to highly elastic provision of liquidity, the EURUSD will struggle to find its footing and risks come primarily from the US economy. In our view, a stabilization or turn in the EUR will require a sustained and convincing pickup in real investment or acceleration in core inflation that all into question the ECBs commitments. Neither appears on offer anytime soon.

After plunging 23% in 10 months, the question of how much further EURUSD can drop has moved to the fore. The question is redoubled by market expectations of sizeable foreign purchases of euro area equities and by the shift in market expectations to a slower pace of Federal Reserve policy tightening. Two-way risks almost certainly have risen and we do not expect the torrid pace of EUR depreciation to be sustained. But the two drivers of EUR weakness that we identified last summer low economic returns to capital and the European Central Banks (ECB) Odyssian commitment to lower rates for longer appear strong, suggesting to us that the EUR still has much further to fall in its multi-year downtrend. We now expect EURUSD to fall to parity by Q3 15 and to 0.95 by end Q1 16.

Two primary drivers of EUR weakness: Many have attributed EURUSDs decline to expectations of Fed policy tightening, but internal drivers of EUR weakness have been just as important, as confirmed by its significant underperformance within a trend of USD appreciation. EURUSD downside is merely the clearest manifestation of euro area weakness because the cyclical divergence is most extreme versus the US. The main internal drivers of broad-based EUR weakness, in our view, remain the two that we identified last summer: 1) persistently low expected returns to capital in the euro area due to its relatively larger output gap and its structural impediments to growth; and 2) an Odyssian commitment by the ECB to a long period of low (or negative) interest rates (see EUR: Have faith The ECB delivers, rewards believers, 27 March 2014; EUR: Extending the downside, 10 September 2014). Both forces continue to augur for a much lower EUR, despite an encouraging pick-up in euro area economic indicators and a likely slowing in the pace of Fed tightening.

Low returns to capital The euro area output gap is at its widest recorded level relative to its trading partners and is unlikely to narrow soon (Figure 1). The large utilization gap means there is little return to capital expenditure beyond modernization and needed equipment upgrades. Deviations from trend investment in the euro area and its predecessor economies have been tightly correlated with the relative output gap since at least the early 1990s as capacity constraints have driven rapid investment growth and economic slack has led to weak investment.

Exchange rates play a primary role in reallocating capital and production across economies, shifting capital from economies with excess slack to those with capacity constraints, and production in the opposite direction. The EUR REER (synthetic before 1999) has a long and persistent correlation with both detrended investment growth and the relative output gap of the euro area and its predecessor economies going back to 1980 (Figure 1). The portfolio rebalancing following the launch of the euro in 1999 is the only notable deviation. Historically, the EUR and its predecessors have bottomed only when the investment cycle has turned.

Marvin Barth

+44 20 3134 3355 [email protected]

Two-way risks for the EUR are increasing, but its downtrend still is in place

The two key drivers of EUR weakness we identified last summer low returns to capital and the ECBs Odyssian commitment to easy policy persist

The euro areas output gap relative to its trading partners remains at a historical wide, depressing returns to capital

The EUR continues to reallocate capital to economies with greater investment demand

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FIGURE 1 EUR vs relative output gap and real investment

FIGURE 2 Euro area excess capacity and real investment

Note: *Log deviation from Hodrick-Prescott trend scaled by 10 for ease of visualization. Note: Euro area relative output gap is the difference of its output gap from the trade-weighted average of its trading partners respective output gaps. Source: Haver Analytics, OECD, EcoStat, Barclays Research

Note: Gross fixed capital formation is the log difference of actual GFCF from its Hodrick-Prescott trend. Source: Haver Analytics, European Commission, Barclays Research

Yet despite the pickup in euro area activity, there is little indication that the euro area is facing capacity constraints or needs a sustained acceleration in investment. The European Commissions industrial survey shows still-high capacity (Figure 2) and that demand and financing remain the primary constraints on production, not equipment (Figure 3). With so large an output gap relative to its trading partners, this situation is unlikely to change soon. Until it does, the EUR likely will remain under broad-based pressure to depreciate as capital shifts to more constrained economies. The US economic recovery began in mid-2009, but the USD continued its nine-year downtrend for another two years, until, coincidentally, the US output gap relative to its trading partners bottomed in 2011.

And a credible commitment to lower for longer Similarly, the ECBs Odyssian commitment to low interest rates for the foreseeable future has been strengthened and, as we expected, appears to be driving an extension of EUR hedging activity among longer-term FX market participants and increased use as a funding vehicle by shorter-term participants. As we noted in June, TLTROs are a strong Odyssian commitment to low future rates as the ECB, like Odysseus strapped himself to the mast of his ship, ties itself to 0.25% rates on 400bn in contractual loan commitments for four years. Since then, the ECB has strengthened the obligation by lowering the interest rate to 0.05% and augmented it with an open-ended Odyssian commitment to buy European government bonds until inflation and inflation expectations return to mandate-consistent levels. As a result, euro interbank rates now are negative through five years, and the curve beyond is much flatter.

As we expected, the strong commitment to low rates for the foreseeable future has led to an ongoing extension of hedging maturities. Not only have EURUSD basis swap rates fallen sharply EUR lenders must discount offshore interest rates they have fallen more at longer tenors (5 and 10 years) than at shorter tenors, suggesting strong pressure from EUR lenders extending their maturities (Figure 4). Negative deposit rates further out the EONIA swaps curve have encourage banks to lend offshore further out the curve, but a large surge has come from foreign issuers of EUR-denominated notes swapping EUR proceeds into USD.

EUR IG issuance by non-euro area entities, especially non-financial issuers, has surged to its highest level since the 2005-07 credit boom (see Figure 5 and Supply Monthly: Here today, gone tomorrow, 5 February 2015). One difference with the prior boom is a significant lengthening of maturities (see Supply Monthly: Index ex-tender, 4 March 2015). But the key

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With little sign of a sustained investment boom in the euro area, the EUR will likely remain under downward pressure

Similarly, the ECBs Odyssian commitment to low rates for the foreseeable future has been strengthened and made more attractive

This has led to a further decline in the EURUSD basis, extending further out the curve

Foreign issuers are borrowing more in the euro area at longer maturities

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difference has been that the current surge is occurring alongside a dearth of euro area investment activity. The funds raised by foreign corporates are not being used for domestic investment, but for repayment of USD debt or capex in more capital-constrained economies.

Most of this debt appears to be swapped into USD, putting pressure on EURUSD basis; but not all of it. Some issuance is being used by non-euro area corporates to hedge their euro area receivables. More significantly, the downward pressure on offshore EUR rates relative to USD makes more attractive extended hedging of EUR receivables and long-lived assets through more traditional instruments like forwards and options. As we noted in September, the incentive to extend hedges is increased by a tipping point in expectations for EUR depreciation that is reinforced by its sustained resource underutilization.

The ECBs commitment is not unbreakable, however. Just as the Fed has developed mechanisms to overcome the Odyssian commitment of its large balance sheet interest on excess reserves and reverse repos the ECB can offset both its contractual TLTRO commitment and its balance sheet expansion. However, it has credibly committed to raising inflation and likely will not untie itself from that mast before that obligation is fulfilled. The ECB forecasts a return to 2% by the end of 2016, but that appears overly optimistic given recent inflation dynamics, the euro area output gap and persistent downward pressure on inflation globally. Accordingly, we see little prospect of higher euro-area interest rates for the foreseeable future and continued incentive for FX market participants to extend their hedges.

Can the EUR float on equities? Although returns to physical capital remain low, many observers have pointed to the portfolio returns likely on European equities given EUR depreciation and upward pressure on asset prices from the ECBs QE program. Euro area equities seem attractive (see the Asset Allocation chapter in the Global Outlook), but we do not expect foreign portfolio inflows into them to support the EUR. As Figure 6 shows, there is no clear relationship between net portfolio inflows into the euro area and the EUR. Indeed, the correlation is often negative. This is even more likely in the current circumstance with unusually attractive conditions for hedging portfolio purchases of euro area assets due to the highly elastic provision of liquidity by the ECB. As a result, we do not expect demand for euro area equities to offset the two key drivers of EUR weakness noted above.

FIGURE 3 Factors limiting production in euro area industry

FIGURE 4 EURUSD basis swap rates by tenor

Source: Haver Analytics, European Commission Source: Bloomberg

Sometimes swapped to USD and sometimes not as companies extend the maturities of their hedges

Without inflation pressure which is not apparent euro area rates will likely remain attractive for extended hedging

We see little prospect for portfolio inflows into euro area equities to offset the broader drivers of EUR weakness

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26 March 2015 12


Nevertheless, two-way risks have increased Although we expect significant further downside for the EUR, we also see rising two-way risks. Euro area economic activity has accelerated just as the Fed has taken some of the wind out of the USDs sails by pushing back the schedule of policy tightening. As long as the ECB continues to commit to unlimited liquidity over the medium term, however, we see this risks as tied to the USD side. We see little prospect for this to change this year.

Longer term, convincingly sustainable growth in the euro could present a more significant risk. The factors that we are watching closely are money and credit growth, both of which already may be reflecting better-than-expected success of ECB policies. Money growth has accelerated sharply and even lending growth has become significantly less negative (Figure 7), although this appears to be mostly financial lending that may reflect the hedging activity noted above (Figure 8). Perhaps most hopeful, the third TLTRO auction had an uptake more than twice as large as expected (see Larger-than-expected TLTRO3, 19 March 2015). As we highlighted in Three Questions: Quantum Evolution, 27 January 2015, the best prospects for a sustained pickup in euro area activity and inflation likely come from its credit easing

FIGURE 5 Euro area investment grade bond issuance by nonresidents

FIGURE 6 European net equity inflows and the EUR

Note: GFCF is log gross fixed capital formation deviation from its Hodrick-Prescott trend. Source: Haver Analytics, EuroStat, Dealogic, Barclays Research

Source: Haver Analytics, ECB, Barclays Research.

FIGURE 7 Euro area money and credit growth, y/y

FIGURE 8 Euro area MFI lending growth, by type, y/y

Source: Haver Analytics, ECB Source: Haver Analytics, ECB

In the near term, ECB commitments imply that risks to EURUSD come primarily from the US

But in the medium term, the success of ECB policies may present a more serious risk of EUR upsidei

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26 March 2015 13


measures like the TLTRO. A sustained pickup in both activity and inflation are precisely the ingredients we identify above as necessary for a stabilization or reversal of the EUR, but we are doubtful the signs will be convincing enough to change the EURs trend in the near term.

Yet another risk comes from valuation. The EUR is currently 9% below its fundamental long-term equilibrium value on a trade-weighted basis, on our calculations. Given the euro areas large output gap and historic cyclical divergence from its global trading partners (particularly the US) we believe even greater undervaluation is justified and likely before the EUR turns. But the case is less compelling now following the euros swift fall over the past 10 months. As a result, the pace of longer-term hedging may begin to slow and with it the pace of EUR depreciation. Already we are seeing larger retracements in the pattern of EUR depreciation as position-squaring by shorter-term FX market participants meets with less USD supply from longer-term participants.

We still think EUR trend depreciation has much further to go and is not significantly threatened in the near term. But the pace likely will slow in the year ahead and retracements on the path lower likely will increase. Accordingly, although we retain high conviction in a lower EURUSD, trading it has become more difficult.

as does the swift descent of the EUR to cheaper valuations

Thus, our high conviction in a lower EURUSD is balanced by a greater appreciation of its risks

26 March 2015 14


THEME

JPY: Contained on both sides Range-bound The yen will likely remain range-bound against the USD in the year ahead due to countervailing factors, as we argued in our last FX Mid-Quarterly Update. On the one hand expected USD strength into the Feds first hike may continue to exert upward pressure on USDJPY, although we have delayed expectations of a Fed rate hike to September, which could reduce some of the upward momentum in the USD over the near term.

In addition, portfolio rebalancing outflows from Japan are likely to support USDJPY. Indeed, Japanese investors have accelerated their cross-border investment, led by pension funds after the GPIF announced its new benchmark portfolio in October 2014 (Figure 1). Going into the new fiscal year in April, we believe that external investment will likely continue at its recent solid pace, led by both portfolio investment and cross-border M&As.

However, it will not be a one-sided story for USDJPY by any means. Already extended valuations of the yen (yen stands 32% or 2.1 standard deviations below its long-term fair value, according to our BEER model), Japans improving current account due to lower energy prices, and recent political rhetoric against sharp yen depreciation should limit the upside in the currency pair.

Admittedly, the currency pair remains prone to a temporary sharp correction lower in reaction to deterioration in risk sentiment, as seen earlier this year due to rising uncertainties over Greek political developments. Moreover, a bout of surprise monetary policy easing by various central banks around the world has already resulted in lower cross-yen rates, resulting in an appreciation of trade-weighted JPY since the beginning of the year, despite the move higher in USDJPY (Figure 2).

More QQE to have a limited effect on JPY Inflation dynamics deteriorated further in the recent months. Core CPI (excluding fresh food decelerated to mere +0.2% y/y in February 2015 from its peak at +1.4% in June 2014. We revised our core inflation forecast further down and now expect that core CPI will turn negative around summer 2015 (Figure 3). If the actual negative reading on core inflation results in nonlinear downward adjustment on inflation expectations, it may exert greater pressure on the BoJ. Core inflation is unlikely to reach the BoJ price stability target of 2% even at the beginning of 2017, despite closing output gap by mid-2016, in our view.

FIGURE 1 Portfolio rebalancing flows accelerated since mid-2014

FIGURE 2 Yen appreciated on trade-weighted basis in early 2015

Note: Sum of external portfolio investment, foreign-currency investment funds and deposits, and external FDI. Source: Bank of Japan, JITA, Barclays Research

Source: Bank of Japan, Barclays Research

Shinichiro Kadota +81 3 4530 5038 [email protected] Yuki Sakasai

+1 212 412 5652 [email protected] Jose Wynne +1 212 412 5923 [email protected]

Core inflation dynamics deteriorated further

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26 March 2015 15


BoJ also recognized such a trend by making the third consecutive downgrading of its assessment on inflation. The March BoJ statement said that the core CPI ex-VAT effects is in the range of 0.0-0.5% after around 0.5% in February and in the range of 0.5-1.0% in January statements. BoJ also revised its outlook for core inflation to expected to be about 0 percent for the time being, down from is likely to slow for the time being. Against this backdrop, we continue to expect that the BoJ will step up its annual pace of ETF purchases to JPY5trn from the current JPY3trn at the July meeting, but its effect on the JPY should be more limited than the past expansions of QQE due to limited adjustment in terms of quantity and the muted relative effect given wave of easing globally, in our view.

Subdued inflation dynamics will keep the JPY weak Major manufacturers response to the 2015 annual spring wage negotiations (i.e., shunto) has been generally positive. Large auto and electronics companies whose earnings have improved on the back of yen weakness responded with a larger increase in base pay than last year. On the other hand, wage increases by non-manufacturing companies were relatively modest. This may be due to some adverse effect of the weak yen and limited wage pressure given increasing participation of women and the elderly in the non-manufacturing sectors. However, all-in-all, we expect this years shunto will result in a wage increase of +2.35%, further above 15-year high increase of +2.19% agreed last year.

This years shunto developments are encouraging, especially for manufacturers, and tight labor markets should continue to put upward pressure on wages (Figure 4). Yet, we note that shunto decisions affect only a small portion of the Japanese workforce and it remains to be seen if non-manufacturers and SMEs follow suit. In Japan, labor mobility is low and labor force adjustments tend to occur through participation over time rather than short-term movement. Hence, we think third arrow structural reform of Abenomics to boost labor mobility and steepen Philips curve will hold the key for longer term outlook for inflation.

Having said that, subdued core inflation dynamics suggest that the BoJ will maintain its aggressive easing policy for an extended period, keeping the yen weak in the year ahead despite its overshot valuations. We expect the USDJPY to trade in the current range at about 120 throughout 2015. The outlook for the BoJ and the yen beyond 2016 depends largely on core inflation dynamics. If there are signs of a pick up inflation dynamics it may finally allow the JPY to correct for its sharp undervaluation, but this seems a long way off at present.

Some positive developments on wage front

FIGURE 3 Inflation outlook deteriorated further

FIGURE 4 Tight labor markets to support wage growth

Source: MIC, Barclays Research Source: BoJ, MHLW, Barclays Research

Yen to stay weak in the year ahead

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26 March 2015 16


THEME

GBP: Unprecedented political uncertainty Growing political risk premium ahead of the particularly uncertain 7 May general election should place downward pressure on GBP, in our view. Near-term GBP implied volatility is appropriately elevated but we think post-election volatility is underpriced. Beyond the election, economic outperformance relative to the euro area should see continued GBP appreciation versus the EUR. However, very low UK inflation and risks of an extended period of unchanged Bank of England policy are likely to temper the degree of sterling outperformance and contribute to significant GBPUSD depreciation.

Uncertainty is the only known Growing political risk premium ahead of the 7 May general election should support high levels of currency volatility and place downward pressure on GBP, in our view. This years UK general election is probably the least predictable in a generation and, combined with a lack of a defined process for forming a government following a likely hung parliament, means GBP volatility may remain elevated well after the election a scenario that continues to be underpriced by FX markets, in our view (UK Elections Series: Pride and precedent: GBP volatility, 18 March 2015). As such, the confidence intervals around our GBP forecasts are much larger than usual. We forecast further GBPUSD depreciation to 1.42 in Q2 2015 and modest EURGBP appreciation towards 0.74 over the next one to two months as political risk premium increases. Further ahead, our expectations for economic outperformance relative to other European economies lead us to expect GBP to be the strongest of European currencies over the year ahead. However, very low inflation and risks of an extended period of unchanged Bank of England policy is likely to temper the degree of outperformance and should support significant GBPUSD depreciation. As such, we now forecast EURGBP and GBPUSD to reach 0.70 and 1.36 in Q1 2016, respectively.

Hamish Pepper

+ 44 (0)20 7773 0853 [email protected]

Election uncertainty to support currency volatility and weigh on GBP A likely hung parliament leaves a broad spectrum of policy outcomes

FIGURE 1 1-month relative GBP volatility

FIGURE 2 3-month relative GBP volatility ahead of key political events

Notes: Measures represent the average 1-month (forward or spot) volatility for GBPUSD and EURGBP divided by the average volatility for the same 1-month window in EURUSD, USDJPY, AUDUSD, and USDCAD.~ View historical spot levels and implied or realized volatility in Oasis on Barclays Live. Click here to view basket volatilities for EURGBP and GBPUSD vs EURUSD, USDJPY, AUDUSD, and USDCAD. Source: Bloomberg, Barclays Research.

Notes: Measure represents the average 3-month implied volatility for GBPUSD and EURGBP divided by the average volatility for the same 3-month volatility in EURUSD, USDJPY, AUDUSD, and USDCAD 32 trading days prior to 7 June 2001 election, 5 May 2005 election, 6 May 2010 election, 18 September 2014 Scottish Referendum and 7 May 2015 election. Average captures the average of this measure between January 2000 and 16 March 2015. View historical spot levels and implied or realized volatility in Oasis on Barclays Live. Click here to view basket volatilities for EURGBP and GBPUSD vs EURUSD, USDJPY, AUDUSD, and USDCAD. Source: Bloomberg, Barclays Research

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26 March 2015 17


Ahead of the May general election, the rise of alternative parties has eroded support for the traditionally dominant Labour and Conservative parties, making plausible an unusually wide set of outcomes. Most election projections continue to indicate a hung parliament is highly likely. Taking an average of the latest UK election forecasts from Elections Etc, Election Forecast, May 2015, and the Guardian, the Conservatives and Labour are currently projected to achieve about 280 seats each. Based on projections for other parties, neither is likely to be able to form a coalition government with less than two partners, much less secure an outright majority where 326 seats are needed. Accordingly, the resultant range of policy implications is broad, including political deadlock, EU referendum and variations around the fiscal consolidation path which is important for the pace of Bank of England (BoE) policy normalisation (for further discussion see UK 2015 general election: Unprecedented political fragmentation fuels uncertainties, 23 February 2015).

GBP implied volatility around the election continues to be consistent with a highly unclear outcome but post-election uncertainty remains underpriced by FX markets, in our view. Updating the analysis we presented earlier this year, Figure 1 plots three measures of 1-month GBP volatility, scaled by broader G10 volatility. The dark line represents a rolling time series of the forward volatility straddling the election on 7 May; the blue line is the rolling forward volatility immediately after but not including the election, and the grey line is spot 1-month volatility. One-month forward volatility including the election continues to trade close to the levels around last years Scottish referendum. However, post-election volatility, while higher than earlier this year, remains relatively contained.

We continue to think FX represents the cleanest expression of UK election risk in asset markets. We think high GBP implied volatility and growing political risk premium should place further downward pressure on GBP as we approach Election Day. A comparison of current GBP implied volatility with relevant historical political events yields some interesting results. The UK election is about 30 trading days away. Figure 2 plots 3-month GBP relative implied volatility the same number of days prior to other key political events. The current measure is appropriately above average (GBP implied volatility tends to trade at a discount to other G10 implied volatility) and at higher levels than the Scottish referendum; but surprisingly, it is also at comparable levels to the more-certain 2010 election. Indeed, 30 trading days out from the 6 May 2010 general election, polls suggested an average Conservative lead over Labour of 5-10 percentage points. Furthermore, in the lead-up to both the 2010 election and the Scottish Referendum, GBP implied volatility was relatively slow to respond, not trading at a premium over other G10 implied volatility until the month before each event.

Post-election uncertainty remains underpriced by FX markets

Historical precedent suggests growing political risk premium should place further downward pressure on GBP

FIGURE 3 UK CPI inflation should pick up sharply at the end of this year

FIGURE 4 Significant fiscal consolidation is a key downside risk to GBP

Source: Haver Analytics, Barclays Research Source: Office for Budget Responsibility, Haver Analytics, Barclays Research

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26 March 2015 18


Relative UK economic performance remains the basis for our GBP forecasts With the election outcome highly uncertain and the most probable outcomes involving weak coalitions that are unlikely to meet ambitious fiscal consolidation plans, our forecasts remain driven by our expectations for the relative path of the UK economy. Our forecast of economic outperformance relative to other European economies leads us to expect GBP to be the strongest of European currencies over the year ahead but depreciate significantly against the broad-based strength of the USD.

The strong pace of UK economic growth remains consistent with an ongoing tightening in the labour market and an eventual pickup in inflation. We think a combination of lower oil prices and continued wage growth should support a recovery in investment and consumption growth after Q4 weakness. Indeed, BoE Governor Carney has consistently emphasised that a supply-driven fall in oil prices is unambiguously positive for the UK economy, increasing household disposable incomes and supporting wider business margins. This was reflected in the BoEs February Inflation Report which, despite sizeable downward near-term revisions, incorporated higher 2017 inflation forecasts (Figure 3). In the context of a stabilisation in euro area activity, the UKs largest trading partner, we expect robust activity and a likely re-emergence of inflation towards the end of this year to support continued GBP outperformance versus the EUR.

We continue to expect the BoE to leave its policy settings unchanged until Q4 this year but there are emerging risks that policy could remain unchanged for longer. Recent currency strength, combined with lower energy prices, will likely add further downward pressure to UK inflation, which we expect to bottom at -0.1% y/y this month. GBP appreciation of almost 20% on a trade-weighted basis since Q1 2013 has weighed heavily on already-low import prices over the past year and this is likely to persist. Indeed, the BoEs March MPC meeting minutes indicated growing concern within the MPC that recent EURGBP depreciation had the potential to prolong the period for which CPI inflation would remain below the target and exacerbate the risk that lower expectations of inflation might become more persistent.

The risks associated with the 7 May election suggest that confidence intervals around our GBP forecasts are larger than usual. Indeed, with both the Conservative and Labour parties promising substantial fiscal consolidation, a majority victory, while unlikely, may represent a particularly negative scenario for GBP. Details of Labours policies are yet to be revealed but the recent Budget confirmed the Conservative governments intention to return the headline current budget deficit of 5.6% of GDP to surplus by FY2018/19. Based on forecast changes in the cyclically adjusted primary balance, this represents aggressive fiscal tightening of 1.2% of GDP per year on average for the next five years. If this occurs, it will be the most significant period of fiscal consolidation in close to 20 years and likely holds important implications for the pace of BoE rate hikes (Figure 4).

Superior UK economic growth should support medium-term EURGBP depreciation

Robust economic activity should support GBP

But downside GBP risks include low inflation

and fiscal consolidation

26 March 2015 19


THEME

SEK and CHF: Club sub-zero Unwanted currency strength, in anticipation, or as a result of ECB QE, has forced smaller G-10 central banks like the SNB and the Riksbank to ease policy recently, cutting rates below zero and announcing QE. We expect both central banks to keep an easing bias, at least in the short term. We expect negative interest rates and SNB FX interventions to maintain EURCHF stability. We forecast EURCHF to appreciate to 1.08 in Q2 before depreciating to 1.05 by Q1 2016. On the other hand, we expect moderate EURSEK appreciation in H1 2015 and expect the cross to reach 9.50 by Q2 2015. From there on, we think the SEK may reach a turning point as fundamentals strengthen and inflation stabilizes further. We expect EURSEK to depreciate to 8.90 by Q1 2016.

CHF: SNB welcomes CHF weakness In the short term, we expect the SNB to preserve its easing bias, with negative interest rates providing a meaningful disincentive to hold large CHF deposits. Negative rates and the downside risks to inflation and growth from an overvalued CHF imply significant CHF depreciation in effective exchange rate terms, in our view. Further out, we think that the SNB may allow some EURCHF depreciation under our baseline of a multi-year EUR downtrend. We now expect EURCHF to appreciate to 1.08 in Q2 before depreciating to 1.05 by Q1 2016.

Since the SNB abandoned the EURCHF floor, the CHF has retraced about 50% of the roughly 20% REER appreciation, driven primarily by broad-based EUR weakness. Nonetheless, the CHF remains more than 20%overvalued according to our BEER model and remains at the heart of the SNBs decision process. Indeed, the SNB has repeatedly stated that the CHF remains an important policy target and that it may continue to intervene in FX markets if necessary. We model the SNBs reaction function using a simple forward-looking Taylor rule that includes inflation, output and exchange rate deviations from target. We use the SNBs forecasts and an inflation target of 1% in our calculations. We use OECD estimates for the Swiss output gap and our BEER misevaluation for the exchange rate deviation.

Nikolaos Sgouropoulos

+44 (0)20 3555 1578 [email protected]

Negative rates still a meaningful disincentive to hold large CHF deposits

The CHF remains an important policy tool for the SNB besides negative rates, which are expected to persist

FIGURE 1 Forward-looking Taylor rule implies negative rates for the rest of the year

FIGURE 2 KOF indicator suggests downside risks to economic activity in coming quarters

Source: SNB, Haver Analytics, Barclays Research Source: Haver Analytics, Barclays Research

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Our model fits history adequately and forecasts negative rates throughout 2015 (Figure 1). Moreover, further CHF depreciation would help improve a rather grim economic outlook. Consumer prices dropped further into negative territory in February, whereas the effect of the latest CHF appreciation has yet to be fully reflected in the inflation data. The recent sharp drop in the KOF leading indicator for growth poses downside risks to GDP in the forthcoming quarters (Figure 2).

The exchange rate remains the most important intermediate policy target for the SNB. The market has been speculating that the current EURCHF target range is 1.05-1.10. We would caution making such conclusions, however. The expansion in the ECBs asset purchase program implies that the SNB may not be solely focused on the EURCHF exchange rate despite the euro areas importance as its largest trading partner. If the EUR weakens further owing partly to ECB QE (also against USD), we would expect the SNB to accommodate some further appreciation against the EUR, before intervening in FX markets again.

SEK Recommend buying, but not just yet A highly pro-active Riksbank with a strong easing bias is likely to keep SEK under pressure in the short term. The recent shift towards targeting a weaker SEK suggests that the risks for further easing, in the form of further negative rates and/or expansions in the existing QE program, remain high for now. Nonetheless, once inflation stabilises, we think strong fundamentals will help support the SEK against other European currencies like the EUR and the NOK. Furthermore, SEK undervaluation of about 16% suggests room for a medium-term correction higher, in our view. We expect EURSEK to appreciate to 9.50 in Q2 but see a likely turning point towards the second half of the year as positive fundamentals support the SEK.

Loose monetary policy will likely keep the SEK under pressure in H1 2015. Citing a strong SEK, particularly against the EUR, the Riksbank decided to make its monetary policy even more expansionary in March to support the recent upturn in inflation. Indeed, the Riksbank re-iterated that it was too early to call a bottom in inflation, despite its recent stabilization, highlighting that a stronger currency continues to pose downside risks to the inflation outlook. On this basis, we remain sceptical about sustained SEK appreciation in the near term and see limited scope for a significant shift in the Riksbanks reaction function, which will likely remain sensitive to economic and political developments in the euro area. We think risks of further repo rate cuts and/or greater expansion on the Riskbanks QE program remain high, but we continue to assign a low probability to FX interventions.

CHF depreciation to help alleviate downward pressures to inflation

The SNB is likely to allow some CHF appreciation vis--vis the EUR as the single currency depreciates further

Recent focus on SEK strength likely keeping the Riksbank on an easing bias

Too early to call for stabilization in inflation, keeping us skeptical about sustained SEK appreciation in the near term

FIGURE 3 Swedens relative output gap to turn positive in 2015

FIGURE 4 as savings decline and consumption is boosted

Source: OECD, Haver Analytics, Barclays Research Source: Riksbank, Haver Analytics, Barclays Research

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26 March 2015 21


We believe that accommodative monetary policy, a weaker SEK, lower oil prices, and the incipient euro area recovery will provide a supportive environment for growth and inflation. In the context of significant SEK undervaluation of about 16% according to our BEER model and our expectations for further EUR depreciation, we expect the Riksbank to tolerate some SEK strength once further signs of stabilizing inflation are realized.

We expect the SEKs depreciation trend to turn around during Q3-Q4 of this year, by which time both our and the Riksbanks estimates suggest further stabilization in inflation and improving economic growth. Using OECD estimates and our BEER weights, we calculate a measure of Swedens output gap relative to its trading partners (Figure 3). According to our estimates, Swedens relative output gap is expected to turn positive by the end of 2015, in line with the Riksbanks estimates of increasing consumption growth driven by a reduction in the rate of savings (Figure 4).

We expect a turning point in the SEK towards the end of year as the currency trades in line with positive economic fundamentals

26 March 2015 22


THEME

CAD and NOK: Yet to price the oil slippage Lower oil prices have weakened fundamentals and widened output gaps in oil- producing Canada and Norway. We believe the effect of lower oil will be pervasive in 2015, and we remain negative on both CAD and NOK. The prospect of rate cuts in Canada, which we believe the market is underpricing, suggests that the CAD is a more reliable short. Further downside in NOK likely will have to wait until the Norges Bank is more comfortable with domestic financial stability issues.

Underpriced BoC rate cuts increase CAD downside We continue to think that the market is significantly underpricing the risks of additional stimulus from the Bank of Canada. After falling by 10% on a NEER basis between mid-2014 and January 2015, the CAD NEER has been in a tight range and USDCAD has largely been responding to broad USD movements. USDCADs sharp rise in recent months has mirrored moves in the relative rate expectations for the US versus Canada (Figure 1). We expect the divergence in Fed/BoC monetary policy to intensify in the months ahead.

We think the BoC has yet to respond to the economic effects of the nearly 60% decline in oil prices (Western Canada Select) since September 2014. Lower oil prices will reduce investment and weigh on consumption as aggregate income and wealth fall on the negative terms-of-trade shock. Our hypothesis that oil prices may remain volatile is an additional negative for investment in a Canada where production tends to be capital intensive (see Oil Special Report: The Volatility Hypothesis, 12 March 2015). Furthermore, we think that the recent decline in CAD and the BoCs January rate cut will not be enough to offset these negative growth dynamics.

Without additional monetary easing, BoC projections suggest growth could undershoot its baseline by 1.4pp over the next two years. However, its official growth forecasts are only 0.2pp lower over the same period. We see this as indicating its intention to cut rates to offset the disappointment. We estimate that at least 50bp of cuts will be needed over the next 3-6 months, significantly more than priced (Figure 2). As such, the movement in relative output gaps between the US and Canada is likely to become more supportive for USDCAD. Our Q4 15 and Q1 16 forecasts are 1.32 and 1.36, respectively,

Aroop Chatterjee

+1 212 412 5622 [email protected] Nikolaos Sgouropoulos +44 (0)20 3555 1578 [email protected]

FIGURE 1 Fed-BoC policy divergence has been crucial for USDCAD

FIGURE 2 Barclays forecasts for the Fed and BoC expect this to intensify, pushing USDCAD higher

Source: Bloomberg, Barclays Research Source: Bloomberg, Barclays Research

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

0.90

0.95

1.00

1.05

1.10

1.15

1.20

1.25

1.30

Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15

USDCAD Curncy US-CA 1y1yf nominal (RHS)

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

0.8%

0.9%

1.0%

Q1 15 Q2 15 Q3 15 Q4 15 Q1 16

Policy rates

USD FF futures CAD OISFed: Barclays forecast BoC: Barclays forecast

26 March 2015 23


We think the recent retracement in rate cut expectations in Canada and rate hike expectations in the US is an opportunity to buy USDCAD. We remain long USDCAD spot (FX Focus: CAD: Downside ahead, 25 February 2015).

NOK is a lower conviction short now Our expectation of rising oil imbalances in the near term, coupled with likely lower-for-longer oil prices, imply more NOK downside, in our view. Despite the lack of proactive central bank policy in March, we maintain our view that further easing will eventually materialise. Although we still like long USDNOK spot positions and see upside risk for EURNOK, the NOK has become a lower-conviction short in the near term as financial stability concerns delay easing.

We expect the NOK to remain an underperformer in 2015 given our expectations of material demand-supply oil imbalances in the short term, lower-for-longer oil prices further out and elevated oil price volatility weighs on energy investment. In this environment, we think the Norges Bank will likely keep a strong easing bias and cut by at least 50bp in 2015.

Norwegian output growth is expected to slow and was revised lower by both Norway Statistics in its Outlook Survey and the Norges Bank at its 19 March meeting. At the same time, the sharp decline in oil prices implies that activity in the petroleum industry is declining more rapidly than previously envisioned (Figure 3). Employment growth is expected to slacken; as a result, the Norges Bank has revised the path of the policy rate significantly lower and signalled rate cuts as soon as lower oil prices start to materially affect the data, which we expect as early as Q2 2015 (Figure 4). Any further easing will likely be against a backdrop of elevated concerns about financial stability linked to the Norwegian housing market, with the central banks reaction function likely, in our view, to start weighting expected capacity underutilization more heavily than concerns about an overheating housing market.

The main risk scenario for the economy and the NOK, however, is a prolonged period of low oil prices, materially exposing the economys structural reliance on the oil sector. Under this scenario, we see scope for looser monetary policy initially, though incremental rate cuts would likely exhibit diminishing efficacy. During the global financial crisis, when oil prices last plunged, the Norges Bank cut rates by 4.5pp in nine months. But the level of rates was markedly higher then and the economic outlook materially gloomier, allowing for more aggressive monetary policy adjustments. With the Norges Bank now significantly nearer its lower bound, room for large manoeuvres may be limited, though we still think monetary policy easing will be the first line of defence. Under the scenario of lower-for-longer oil prices, we see more reason for a weaker NOK to provide some protection for local-currency exports.

FIGURE 3 Lower oil prices weighing on confidence and investment

FIGURE 4 signaling potential rate cuts

Source: Norges Bank, Barclays Research Source: Norges Bank, Haver Analytics, Barclays Research

-20.00

-15.00

-10.00

-5.00

0.00

5.00

10.00

-4

-2

0

2

4

6

8

10

Apr-09 Oct-10 Apr-12 Oct-13 Apr-15

IndexExpected growth (%)

Oil Aggregated Consumer confidence (RHS)

-1.00

-0.80

-0.60

-0.40

-0.20

0.00

0.20

0.40

Sep-

15

Dec

-15

Mar

-16

Jun-

16

Sep-

16

Dec

-16

Mar

-17

Jun-

17

Sep-

17

Dec

-17

Demand CostsInterest rates abroad Exchange rateChange in rate

26 March 2015 24


THEME

CNY: More flexibility, less complexity We expect China to take steps to accommodate greater CNY flexibility this year, through a combination of more volatile but modestly higher USDCNY fixings and a widening of the trading band. We think this reflects Chinas recognition of the increasing costs associated with limiting the exchange rates ability to respond to changes in external and domestic economic conditions. We maintain our year-end 2015 forecast of USDCNY at 6.40.

The cost of restricting greater USDCNY flexibility is rising We believe China has the capacity to maintain exchange rate stability. Even if selling pressures on the CNY were to intensify, Chinas large FX reserve holdings (of around USD3.8trn) should allow the authorities to engage in FX intervention for a prolonged period to limit the CNYs decline. However, as we discussed in CNY: Deflation, downturn and the deepening monetary dilemma, 12 February 2015, recent developments increasingly point to a reduced need for China to maintain a strong currency, especially on a trade-weighted basis:

First, inflation in China is less of a concern, in our view, while deflation risks have risen. Pre-emptive moves to allow for greater flexibility in the USDCNY to help dampen the CNY REERs appreciation would be desirable, in our view, as studies have shown that the exchange rate has a significant impact on inflation in China.

Second, CNY overvaluation is getting more extreme, with USDCNY remaining relatively stable while trade partner currencies fall sharply versus the USD. Our BEER model estimates that the CNY is around 20% overvalued, making it one of the most expensive currency globally.

Third, FX intervention to limit CNY depreciation pressure would dampen the effectiveness of liquidity-easing efforts. Economic activity at the start of this year was weaker than expected (our China Economists have downgraded their 2015 GDP forecast to 6.8% from 7.0%) and monetary easing efforts are not helping to lower market interest rates. However, FX intervention to limit CNY weakness (ie, selling USD)

Mitul Kotecha

+65 6308 3093 [email protected] Dennis Tan +65 6308 3065 [email protected] Recent developments increasingly point to the reduced need for China to maintain a strong currency

FIGURE 1 CNY REER has appreciated sharply, up more than 17% since July 2014

FIGURE 2 USDCNY has pulled away from the top of the band

Source: Barclays Research, Bloomberg Source: Barclays Research, Bloomberg

35

40

45

50

55

60

65

70

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

CNY REER

CNY REER (rolling 10-yr average)

Index

+17.3%

5.95

6.00

6.05

6.10

6.15

6.20

6.25

6.30

6.35

6.40

Jan-14 Jul-14 Jan-15

USDCNH Upper band

USDCNY fix Lower band

26 March 2015 25


is having the effect of tightening domestic CNY liquidity. The PBoC does have room to cut the reserve requirement ratio (RRR) rate to offset the liquidity impact of FX intervention, as the current RRR level of 19.5% is high by historical standards the ratio was as low as 6% in 2002. However, a further drain of liquidity may not be appropriate if a step-up in monetary easing is needed to counter a sharper growth slowdown and to bring down elevated funding costs.

Fourth, the global recovery remains uneven and desynchronized, with the US being the sole engine of growth. While Chinas exports are so far performing better than other EM Asian economies, the recent sharp CNY REER appreciation might have a dampening effect on Chinese exports to countries apart from the US.

The government does not seem overly concerned about capital outflows Chinas capital outflows are accelerating. The monthly trade surplus has risen to a record high this year, but we view the surge in FX deposits as a sign that Chinese corporates are keeping their export proceeds in USD, possibly in anticipation of greater CNY adjustments ahead (see CNY: Unprecedented surge in FX deposits, 6 March 2015). Commentators have often cited hot money outflows as a factor preventing China from allowing greater currency weakness. However, recent comments by the PBoC governor Zhou Xiaochuan and PBoC adviser Yi Gang at the National Peoples Congress (NPC) seem to suggest that the government is not overly concerned about the increase in capital outflows and CNY volatility.

China has typically refrained from making policy adjustments when selling pressures on the CNY are heaviest. However, the recent softening in the USD post-FOMC and the pullback in USDCNY from levels near the top band may present an opportunity for Chinese policy makers to make changes should USDCNY long liquidation extend further. USDCNY has moved sharply away from the top of the band (Figure 2), while the spread between USDCNH and USDCNY has narrowed (Figure 3), suggesting less bearishness in the offshore market relative to onshore. USDCNY fixings have also been moved lower as the authorities appear to be dampening expectations that they would like to engineer a weaker currency. This, in our view, could provide a suitable backdrop for a band widening as the risk that USDCNY moves to the top of the wider band has receded.

Capital outflows are accelerating but official comments suggest that the PBoC is not overly concerned

FIGURE 3 USDCNH USDCNY spread narrows, suggesting bearishness in the offshore yuan market is easing

FIGURE 4 Hot money' outflows are persisting, but official comments suggest the government is not overly concerned

.Source: Haver Analytics, Barclays Research Note: *Net FX purchases of financial institutions less the sum of the sum of the trade balance, net FDI flows and portfolio flows. Source: Bloomberg, Barclays Research

Recent pullback in USDCNY from close to the top of the band could present an opportunity to make policy changes

-400

-300

-200

-100

0

100

200

300

400

Jan-13 Jul-13 Jan-14 Jul-14 Jan-15

Spread between USDCNH - USDCNY spot spread (5-day avg)

No of pips

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-100

-80

-60

-40

-20

0

20

40

60

80

100

Estimated 'hot money' inflows*

3M chg in CNY vs. USD (RHS)

USD bn

26 March 2015 26


We believe a move to adjust currency settings should not be seen as a sign of capitulation on the part of China under the pressures of slowing economic growth and growing capital outflows. Instead, against the backdrop of an intensifying currency frictions externally and growing growth headwinds domestically, we think China may be recognising the increasing costs associated with limiting the ability of the exchange rate to respond to changes in external and domestic economic conditions. Refinements to the existing framework to allow for greater flexibility and to allow a greater role of market forces in determining the value of the CNY is a step in the right direction, in our view. We maintain our year-end 2015 forecast for USDCNY of 6.40. We also tighten the stop-loss on our long USDCNH recommendation initiated on 24 September 2014 (see CNY: No longer a one-way trade in Global FX Quarterly: ECB says EURs, 24 September 2014) to our entry level of 6.1414 from 6.0450 previously.

China appears to recognise the increasing costs associated with limiting the exchange rates ability to respond to changes in external and domestic economic conditions

26 March 2015 27


THEME

AUD and NZD: More room to fall Although both AUD and NZD have depreciated in recent months, we think there is scope for further depreciation versus USD given contrasting monetary policy stances and a firm USD. However, we do see some scope for AUDNZD to move higher, with the currency pair bottoming out around current levels.

Closer to fair value? AUD has declined steadily since September 2014, dropping around 20% versus the USD. It has also fallen sharply against the NZD, dropping around 8% since the end of October 2014. A number of factors have weighed on the AUD, including the RBAs active encouragement of a weaker FX trajectory, narrowing yield differentials and declining commodity prices, all against the background of a strong USD. Moreover, the decline in AUD continues to track the deterioration in Australias terms of trade, with little sign yet that the worsening in the terms of trade is close to ending.

Nonetheless, the drop in AUD has helped to reduce some of the currencys overvaluation. Indeed, the AUD REER deviation with its long-term (20 year) average has now declined to around 2.6%, while the RBAs own fair value model estimates also put the currency at around 2% expensive earlier in Q1 (our own version of the same model shows that the AUD is 4% expensive in Q1 to date). However, our BEER model estimate suggests that the AUD is around 14% overvalued, implying scope for further depreciation on this measure.

Given the sharp depreciation in the AUD in recent months, the RBA no longer argues that the exchange rate is significantly overvalued relative to fundamentals; instead, it has reframed its criticism of the high exchange rate, with Assistant Governor Kent arguing that the exchange rate remains relatively high given the state of our overall economy. This suggests to us that the RBA would be comfortable if the AUD were to overshoot fair value. We think this implies that a potential move to around 0.70 cents would not fuel any discomfort from the RBA. Indeed, our revised forecast now looks for a drop to cl

barclays global fx quarterly brief break in the usd uptrend (1)

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