barclays global fx quarterly fed on hold eyes on growth

8/10/2019 Barclays Global FX Quarterly Fed on Hold Eyes on Growth

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Foreign Exchange Research

September 2013

PLEASE REFER TO THE LAST PAGE FOR ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES.

Global FX QuarterlyFed on hold, eyes on growth


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Barclays | Global FX Quarterly

26 September 2013 1

CONTENTS

Top Trades ............................................................................................... 2Our top three thematic trades are short AUD/CNH, long 6m GBP/USD put spread and long

EUR/CHF. Our top two relative value trades are short ZAR, TRY against MXN, PHP and long

EUR/CZK.

Overview ................................................................................................... 3Fed on hold, eyes on growth

The Feds decision to postpone tapering delays, but does not derail our constructive USD

outlook. We expect the delays to add USD250bn to the Fed balance sheet; hence, we expect

the USD to trade sideways with a downward bias in the near term.

Theme 1: EUR and CHF ......................................................................... 8Fed does not derail EUR/USD weakness

We expect EUR/USD to range trade over the near term with downside risks, with the ECB

likely to ease liquidity conditions through a VLTRO in late Q4. Further out, diverging growth

trends and the relative monetary policy outlook still point to EUR/USD weakness.

Theme 2: EM .......................................................................................... 13Square carry shorts until tapering

For the first time since the start of the year, we recommend taking profits on our short EM

carry positions, adopting a more neutral stance. We recommend being long the RUB,

staying short the ZAR and neutral the MXN.

Theme 3: CNY, AUD and NZD ............................................................ 17Local matters

We think the PBoC will continue to use currency appreciation, albeit at a slower pace than

this year, as a rebalancing tool. Slowing growth in China, as well as a soft outlook for

domestic economies, is likely to weigh on AUD and NZD in the medium term.

Theme 4: GBP ........................................................................................ 20Fade the rally

Against the backdrop of the delay in Fed tapering, stronger UK data and a disappointing BoE

forward guidance framework have boosted GBP recently. We think the good news is largely

priced and expect underlying headwinds to re-emerge, putting downward pressure on GBP.

Theme 5: JPY .......................................................................................... 25Grind higher, against gravity

We continue to expect USD/JPY to grind higher, driven by the relative growth and monetary

policy outlooks between the US and Japan. Political uncertainty poses downside risk in the

near term yet upside risk in the longer term.

FX Views for the Year Ahead .............................................................. 28

Open Trades .......................................................................................... 33

FX Closed Trades .................................................................................. 34

FX Forecast Tables ............................................................................... 36


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26 September 2013 2

FX STRATEGY

Top trades1

Thematic trades

1. Short AUD/CNH spotChina growth is expected to remain under pressure, despite the recent bounce-back in data.

CNY appreciation will likely continue to be used as a tool for rebalancing (toward

consumption), while lower investment and growth should weigh on the AUD.

2. Long 6m GBP/USD put spread

We believe current levels offer a good opportunity to establish a medium-term view of a gradual

but persistent move lower. BoE monetary policy is set to remain loose for far longer than Fed

policy, and GBP weakness related to a rebalancing of the UK economy away from services/non-

tradable sectors toward tradable sectors is still relevant.

3. Long EUR/CHF spot

We recommend going long EUR/CHF spot on reduced fragmentation risks and significantscope for unwinds of legacy long CHF positions amid better sentiment in the euro area. A

stable EUR/USD in the near term with depreciation ahead means that we keep our long

USD/CHF position.

4. No longer underweight carry

We expect the delay in Fed tapering to provide breathing room for high-yielding EM FX and

allow some differentiation in the asset class. In our view, short EM carry is not an attractive

proposition in the near term until the likelihood of tapering increases again.

Relative value trades

1. Still Short ZAR, TRY vs MXN and PHP

A slightly more constructive global context is not enough to outweigh external funding

needs and declining activity (ZAR) and currency-mismatched balance sheets (TRY).

Structural reforms still make the MXN and PHP appealing on a relative basis, despite the

cyclical softening and dovish monetary policy for the MXN.

2. Long EUR/CZK spot

The weakness in the economy and likely downward pressure on inflation argue for central

bank intervention to weaken the crown, in our view.

1 Please refer to the Open Trades table for the specifics on these recommendations.

Jose Wynne

+1 212 412 5923

[email protected]

Aroop Chatterjee

+1 212 412 5622

[email protected]


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26 September 2013 3

OVERVIEW

Fed on hold, eyes on growth

The Feds decision to postpone tapering delays, but does not derail, our constructive

USD outlook. We expect the delays to add USD250bn to the Fed balance sheet; hence,

we expect the USD to trade sideways with a downward bias in the near term.

The EUR should trade in a range until later in Q4, when we expect to re-engage in short

EUR/USD positions. Tapering and a stronger US growth outlook, combined with ECB

LTROs, should favour a weaker EUR. Fed measures and economic recovery should be

CHF-negative. We recommend tactical long EUR/CHF positions at current levels.

We expect Chinese growth to remain under pressure, despite the recent bounce back in

data. CNY appreciation will likely continue to be used as a rebalancing tool (toward

consumption), while lower investment and growth should weigh on the AUD. We

recommend short AUD/CNH in spot.

For the first time since the start of the year, we recommend taking profits on our short

EM carry positions, adopting a more neutral stance. We recommend being long theRUB, staying short the ZAR and neutral the MXN.

Stronger UK data and disappointment in BoE forward guidance have pushed GBP up.

We think the good news is priced and expect underlying headwinds to re-emerge,

putting downward pressure on GBP. Buy a 6m GBP put spread (1.60 vs 1.55).

Data and Fed delay the USD rally

We still expect the USD to strengthen in the coming months, but recent surprises on activity

and the Feds decision to delay tapering have led us to modify our views for Q4. For the first

time in months, we think it is time to take profit on our short EM carry positions held since the

start of the year. We also think a broad-based USD rally against the major currencies, including

the EUR, will have to wait until the Fed begins to taper (in December, we expect) or until

growth trends in the US and EU re-diverge. Moreover, we see the growth rebound in China as

reassuring, though headwinds from rebalancing will likely be too much for the AUD to handle.

Thus, we recommend re-engaging in AUD shorts at current levels.

The main surprise to our short EUR/USD position was in activity data from Europe and the

Feds decision. Under our base case, we expected the US economy to grow in line with what

data have shown, with unemployment dropping faster than most anticipated on a shrinking

labor force participation rate (driven by demographic forces, such as the retirement of baby

boomers), pushing the Fed to taper in September, as most market participants believed.

The reasons for the tapering delay have yet not been made clear, but we think several factors

played a part. For instance, the housing market seems to have slowed on higher mortgage

rates and economic activity has disappointed the Feds expectations. Furthermore, taperingexerted more pressure on the belly of the UST curve than could be contained by forward

guidance alone. Most of the fiscal drag from sequestration is also likely to hit between now

and year-end, and the committee may have considered it more appropriate to wait.

Additionally, significant funding pressures in some emerging markets (ie India, Indonesia,

Turkey, South Africa and Brazil) could have increased the perception of downside risks to

global growth. Perhaps even the risk of a military strike in Syria was a factor in the decision.

We now expect the tapering program to begin in December and end in June 2014 (faster

than most expect, on falling labour force participation). Such a delay would add USD250bn

to the Fed balance sheet relative to our former expectations, part of which should end up in

Jose Wynne

+1 212 412 5923

[email protected]

Aroop Chatterjee

+1 212 412 5622

[email protected]


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26 September 2013 4

equities and part in bonds (given shrinking net UST issuance). We think European equities

and EM may attract inflows. We expect this to be priced fairly soon, if not already, but we

believe staying short EM carry is not an attractive near-term proposition until the likelihood

of tapering increases again.

Our view was also surprised by a synchronized growth recovery in the developed world

(Figure 1). Confidence manufacturing surveys, even in Europe, have been stronger than our

relatively optimistic forecasts. A synchronization of a euro area recovery with the US fuelsequities performance, but limits the scope for currency moves, supporting the EUR and

limiting a broad USD rally beyond versus EM, as we discuss in detail in Theme 1. During this

synchronized global recovery, including China, growth and sentiment surveys disappointed

in most parts of the EM world. Lackluster EM growth also exacerbated the downward

pressure in EM carry currencies while the market digested news on tapering.

Furthermore, this unexpected rebound in activity in Europe has led us to push out our

forecast of further ECB easing this year from early Q4 to December. The view that the ECB

would engage in another round of VLTROs was a key ingredient in our call for a lower

EUR/USD. The ECB remains worried about the tightening of financial conditions that is

taking place as the liquidity surplus declines with LTRO money (from the past 3y LTROs)

being paid back (Figure 2). We remain enthusiastic about the idea that the central bank may

arrest the passive tightening by introducing further VLTROs at a fixed rate. In other words,

the ECB could receive fixed rates beyond the typical 3m LTRO for the first time since the

crisis, backing the recent forward guidance with a liquidity injection that would in practice

push 1y1y forward rates in Europe and EUR/USD, by extension, significantly lower.

The rebound in euro area data has removed the urgency for an immediate, large and

indiscriminate liquidity injection. Hence, it delays and mitigates our bearish EUR/USD view.

This explains why we expect EUR/USD to trade in a range over the next three months and

weaken afterward but with a lower terminal level (we have revised our 12m forecast from 1.23

to 1.27). This has become more likely with the Fed on hold and global rates stable. Had global

rates not stabilized, the ECB might have been forced to arrest tighter financial conditions with

easing measures. The weak growth trend remains a key concern for the ECB, in our view.

Finally, our lower EUR/USD call has also been challenged by the unwind of EM carry

positions. We were expecting USD, JPY and CHF to be almost the only funding currency

FIGURE 1

Synchronized rebound in global manufacturing confidence

in G4

FIGURE 2

Passive tightening to be addressed with another LTRO

(December)

Source: Barclays Research Source: Barclays Research

-5

-4

-3

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-1

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Emerging economics

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Japan

normalised

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Exc. Liq., eur bn, lhs 3bn payback

EONIA fixing, bp Exp. Eonia, bp

depo facility, bp refi rate, bp


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26 September 2013 5

beneficiaries of the EM carry unwind (see our March FX Quarterly,Opportunities emerge as

correlation falls), but were surprised by anecdotal evidence suggesting that a good portion

of these EM positions were funded in EUR. This factor pushed the EUR higher in Q3 but is

likely to be less of a factor as EM assets stabilize in the short run.

Whats next for EUR/USD?

In Theme 1 we also argue that these surprises delay but do not derail our views for EUR/USD

and the USD more broadly. On the data, we think some of the rebound will fail to be sustainedand that soon enough divergent trends in the US versus euro area will re-emerge. Figure 3

shows that imports in the euro area have sharply underperformed those from any other parts

of the world. In contrast, corporate profitability in the US is at an all-time high and investment

intentions are up, suggesting pent-up demand (Figure 4). Furthermore, gains in US house

prices show strength in household balance sheets. Last, the US fiscal deficit is beating

expectations, providing reasons for optimism on corporate investment (supporting both the

S&P 500, which is at record highs, and tighter 5y CDS on US Treasuries).

Furthermore, we believe that the Feds decision to delay tapering may generate an even

better environment for a USD rally in Q1 14. By keeping the purchase program on hold,

there may be stronger economic activity the day the Fed begins tapering and, hence, better

conditions for a broad-based USD rally, including against the EUR (as well as others in theG4). Combined with further ECB measures to address the passive tightening in late Q4 13,

this environment is likely to be a powerful combination to get EUR/USD moving lower.

Meanwhile, we expect EUR/USD to stay range-bound, with short-term upside risks toward

1.37, and grinding lower as the rebound in the cyclical data disappoint and the weak

underlying growth trend emerges.

Still short CHF

We continue to like short CHF positions. In the context of the Feds postponement of

tightening, the CHF should underperform as risk and carry trades are tactically re-established

over the quarter. USD/CHF, however, is unlikely to move higher in the near term, given its

sensitivity to moves in front-end US rates. We keep our long USD/CHF position over the

medium-term horizon, however, since EUR/USD will likely be range-bound, at best, in the near

term, followed by subsequent depreciation. For the CHF, we see a variety of reasons to remain

bearish on the currency, as discussed in Theme 1.

FIGURE 3

Eurozone domestic demand is structurally weak

FIGURE 4

US corporate profitability at record highs


70

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95100

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3mma,SA 2007=100

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Corporate profits as a % of gross value added by the corporatesector (sa)

%
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26 September 2013 6

China rebalancing to support CNY, weigh on AUD

In Theme 2, we focus on the FX implications of Chinas rebalancing. We think the recent

pickup in economic activity looks temporary. We expect economic growth to accelerate in Q3,

but we forecast a slowing into year-end and beyond. Indeed, we think the government intends

to rebalance the economy away from fixed investment and exports toward private

consumption which, although unavoidable, will be punitive for growth.

Despite the likely disappointing growth trend, we believe the government will continue to leanon currency appreciation as a rebalancing tool. We expect USDCNY to continue to fix lower

despite a stronger USD. This should continue to push CNY into stronger territory on

multilateral terms, albeit at a slower pace.

The recent improvement in Chinese growth sentiment helped AUD recover lost ground in

September, but we think downside pressure on AUD will re-emerge. The currency is still

15% and 12% expensive on a multilateral and bilateral basis, respectively. A slower China

and significantly slower investment demand should deter AUD optimism, despite the global

cyclical rebound.

Square EM carry shorts

The USD250bn of assets that the Fed is likely to purchase before revising its current policies

will prop up demand for EM assets and support carry. In Theme 3, we discuss these issuesand, although these inflows will not undo the large depreciation of many EM currencies over

the past quarter, we do expect this to provide breathing room for high-yielding EM FX.

Against a backdrop of muted risk aversion and relatively attractive valuations, we believe

markets will allow some differentiation in EM. These are our main picks:

Square underweight in the BRL and INR, stay neutral on the MXN. Mexicos structural

reforms are likely to deliver improved growth and a stronger currency, but the loss of

cyclical momentum and easier monetary policy implies balanced risks for the MXN.

Furthermore, the high carry offered by the BRL and INR seems attractive from a risk-

adjusted perspective, now that firm policy intervention is in place.

Short ZAR, long RUB, and cautious TRY and IDR. A slightly more constructive globalcontext is not enough to outweigh external funding needs and declining activity in

South Africa. Policymakers in Turkey and Indonesia will likely continue to use the

exchange rate as a policy instrument to limit liability mismatches. The RUB offers a

relatively high carry, and spot is supported by improving prospects for oil prices.

Long PLN and MYR. A recovery of global manufacturing activity would benefit Poland,

while we think funding pressures on the MYR are likely over. Leading indicators point to

a growth pickup in these economies, especially given their relatively low vulnerability to

a sudden spike in global interest rates.

Buy GBP put spreads to fade the rally

We were surprised by the stronger UK data and disappointed by the knockouts included in

the BoE forward guidance, which pushed the GBP higher. In Theme 4 we argue that the

good news is priced and that we expect underlying headwinds to re-emerge, putting

downward pressure on the GBP.

We expect BoE monetary policy to remain loose for far longer than Fed policy, which should

weigh on the currency. UK rates continue to price tighter policy than the BoE and our

economists expect. We think market pricing is inconsistent with the MPCs expectations for

the underlying growth trend and inflation outlook. The September FOMC meeting serves as

a warning to the market that central banks ultimately control policy and retain the power to

move rates where they see fit. We expect the MPC to bolster its forward guidance

framework, especially if UK economic data soften.


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26 September 2013 7

USD/JPY to grind higher

In Theme 5 we provide an update on USDJPY. We maintain our medium-term bullish view

on USD/JPY and expect it to grind higher toward 103-105 in the next 12 months. Both the

relative growth and monetary policy outlooks favour a higher USDJPY, despite the fact that

the yen is abnormally cheap. We expect the VAT hike to slow economic activity, starting in

Q2 2014, at a time when the US economy is expected to be growing 2.5%, and tapering is

well advanced (expected to end by June 2014). We expect slower activity and a marginally

more proactive BoJ to weigh on yen in a stronger USD environment.

In the very near term, we think political uncertainty in the US and Japan poses downside risk

to our forecast, and as a result, we do not recommend being long USDJPY just yet. In the US,

the debt-ceiling issue (to be addressed by mid-October) and the budget for the next fiscal

year remains unresolved. In Japan, PM Abe is widely expected to go ahead with the VAT

hike as planned, but disappointments could put downward pressure on equities and USDJPY

in Q4.


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THEME: EUR AND CHF

Fed does not derail EUR/USD weakness

The main surprises to our short EUR/USD position came from euro area activity data and

the Feds decision to delay tapering. We expect EUR/USD to range trade over the near term

with downside risks as the ECB re-takes control of the short end of the yield curve and

eases liquidity conditions through a VLTRO in late Q4. Further out, diverging growth trends

and the relative monetary policy outlook still point to EUR/USD weakness. A stable

EUR/USD near-term with depreciation ahead means that we keep our long USD/CHF

position. We recommend going long EUR/CHF spot on reduced fragmentation risks and

significant scope for unwinds of legacy long CHF positions amidst better sentiment in the

euro area.

Fed action has delayed the broad USD rally, which we had expected to encompass low

yielders such as the EUR. Indeed, the bigger disappointment emerging from the September

2013 FOMC, in our view, was continued reticence in allowing the short end of the yield

curve to price in rate hikes than the decision to delay the tapering in asset purchases. So far

in H2 13, the Fed has been more successful than the ECB in controlling the short end of the

yield curve, and the relative movement in short rates has supported EUR/USD.

Although we do not expect any aggressive policy shifts by the ECB, we expect it to cap any

steepening in the rates curve and/or a decline in the liquidity surplus. As such, we see

EUR/USD stuck in a range initially (1m forecast: 1.35), potentially weakening at the 3m

horizon (3m: 1.32) as the ECB responds to the liquidity tightening with a new LTRO. We still

believe monetary policy divergence will favour the USD over the EUR in the medium term,

though the pace of depreciation is likely to be relatively slow as the US curve is allowed to

steepen only gradually. We expect the weakening trend in EUR/USD to persist (6m forecast:

1.30, 12m: 1.27), with diverging medium-term prospects implying a more aggressive ECB than

the Fed. Euro area events that pose downside risks to our forecast profile include package

renegotiations in Portugal, Greece and Cyprus, as well as added political uncertainty (Italy).

Why is EUR/USD not lower?

The resilience of the EUR is owing to a less-than-credible forward guidance (FRG)

framework, a backup in rates that has happened more rapidly than in the US (especially

Chris Walker

+44 (0) 20 3555 5863

[email protected]

Aroop Chatterjee

+1 212 412 5622

[email protected]

FIGURE 1

Correlation of 1y1yf rates in the euro area and the US

FIGURE 2

Importance of each factor (beta * standard deviation)


-60%

-40%

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0%

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Relativeequities

10Yspread

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26 September 2013 9

recently) and signs of an improved outlook in the euro area, which have led to a fresh influx

of foreign capital flows. These add to other inflows into the euro area such as from euro

area banks disposing of foreign assets, as well as investors unwinding/hedging EM risk in

the tapering-related EM asset sell-off in summer 2013.

We had argued that the imposition of forward guidance regimes should be negative for the EUR

to the extent that the frameworks are able to control front-end rates. The ECBs inability to

achieve this is striking, as Figure 1 shows, with correlations between euro area and US rates

recoupling only a month after the announcement at the July meeting. Although the euro areas

emergence from recession may have something to do with the steepening in EUR rates, the

lions share has clearly been driven by the backup in US rates (correlations are 80-90%).

The EUR has been particularly sensitive to these developments: the EURs beta to 1y rate

spreads is the strongest driver per our FFV model (Figure 2), and the movement in relative

interest rates contributes nearly two-thirds of the EURs rally since July (Figure 3). What is

striking is that other factors such as relative equity returns (which capture improved euro

area growth prospects and sentiment versus the US) have not contributed as much to the

EURs stability (about 20% of its move), even though European equities have moderately

outperformed those in the US over the past three months.

However, there is some evidence to suggest that investor flows into the euro area haspicked up recently after years of being underweight the region. Flows into Europe ex-UK

show a noticeable pickup from early July onwards. Given our overweight view on European

equities (Global Outlook,26 Sep 2013), we expect these flows to provide some additional

support for the currency.

Further, BIS data show that euro area banks continued to sell assets outside of the region into

Q1 13. Cross-border lending by euro area banks has dropped $105bn since the end of Q3 13.

The largest declines were against developed market countries, with lending into the G10 (ex-

euro area) falling about $147bn. Inasmuch as these loans are FX hedged, we would expect a

disposal of assets to generate an FX flow back into the euro area, adding to the EURs resilience.

Finally, the EUR/USD may have received additional support from the unwind of EM carry

positions. We were expecting the USD, JPY and CHF to be almost exclusively the currencybeneficiaries of the EM carry unwind (see the March 2013Global FX Quarterly), but were

surprised by the anecdotal evidence suggesting quite a bit of these EM positions were

funded in EUR.

FIGURE 3

Breakdown of EUR/USD moves using our FFV model since

July 2013

FIGURE 4

Equity mutual fund flows into each country/region, 2013

(mm, cumulative)

Source: Barclays Research Source: EPFR, Haver Analytics, Barclays Research

0

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% 3m LIBOR sprd d(3m LIBOR sprd)

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26 September 2013 10

US-EA cyclical divergence

On the cyclical outlook, we believe diverging trends in the US versus EU will re-emerge as

2014 begins. There are a variety of reasons to be positive on underlying US growth. We

expect the drag from the spending cuts/sequestration to lessen into 2014. At the same

time, the wealth effects generated from higher financial assets and housing prices should

continue to bolster consumer spending; we estimate that higher prices on financial assets

and houses will generate 1% more consumption growth in 2014, offsetting the drag from

the fiscal headwinds. On the investment side, cleaner balance sheets and improved

profitability in the corporate sector, aided by loose credit conditions, are likely to spur credit

growth and investment. In the euro area, tight credit conditions, deleveraging and banking

sector issues are likely to restrain growth. The credit crunch in the periphery has continued

(Figure 5). The upcoming asset quality review ahead of the first stage of the banking union

is a risky exercise that may increase the credit issues of the periphery, implying downside

risks to growth. With full employment in the euro area still a far-off prospect (NAIRU

estimates are about 8%, compared with a prevailing unemployment rate of north of 12%),

monetary policy in the euro area will very likely remain far looser for longer than in the US.

Over the medium term, we expect this divergence in US and euro area growth to persist and

drive the relative monetary policy outlook. For the Fed, we expect tapering to begin in

December 2013, though that is likely to have a limited effect on EUR/USD, given itssensitivity to the short end of the yield curve rather than the long end (on which QE has a

bigger effect). However, into 2014, we expect the stronger underlying trend to the US

economy to give the Fed some comfort in allowing the market to price in higher rates. And

after the September surprise from the Fed, the next policy surprise over the coming three

months may indeed arrive from the ECB.

ECB to respond

We expect the ECB to find it tough to control EUR rates beyond the front end of the money

market curve as data in the euro area improve faster than market expectations. However,

we do expect the ECB to regain control of the very front end through the unveiling of

another VLTRO program in Q4 13. This would address any liquidity pressures (ie, as the

liquidity surplus falls below EUR200bn) and prevent EONIA moving up too sharply inside the

corridor. At the September press conference, ECB President Draghi included a paragraph on

liquidity conditions for the first time, and while stating the current level of excess liquidity

(c.EUR220bn) was adequate, the ECB will act to offset any future declines that affect the

FIGURE 5

Continued signs of a credit crunch

FIGURE 6

1y1y Eonia rates to stay capped


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EONIA fixing. Additionally, it would smooth the exit from the previous LTROs, so that there

is no jump in rates after the previous ones expire, and would help (even if only on the

margin) to unlock lending to SMEs. Since we expect any new LTRO to be tailored towards

periphery SMEs, however, this may limit the scale of the liquidity injection, something

whose necessity is arguably reduced as the recovery in the euro area gains traction.

We expect the market to take EUR150-250bn of new liquidity in a new long-term program

(beyond the expiry of the current 3y LTRO in February 2015). The amounts could be larger ifthe overall risk environment does not deteriorate and/or the terms are made extremely

attractive. A fixed-rate, long-dated program would likely be taken as a very dovish policy shift

by the market and help the ECB gain more traction with its FRG. Our rate strategists expect a

VLTRO announcement along the lines described above to push 1y1yf EONIAs to decline to

10-20bp (from approximately 35bp). All else equal (assuming no change to US rates and

broader risk appetite), it would imply EUR/USD could depreciate 3-4%, using the sensitivities

in our FFV model. We acknowledge this by pushing our 3m forecast down to 1.32.

Keep on the radar

After a relatively calm (in policy terms) summer, the coming quarter is likely to bring several

key policy issues back to the table. Our economists have highlighted (seeEuro Area Focus:

Busy Schedule for Finance Ministers) the large degree of uncertainty over the upcoming

asset quality review, details of which will be revealed by mid-October. While conditions for

European banks have improved significantly in the past year, it is not known how potential

capital shortages will be tackled. Policy discussions on the issue may also offer a source of

market volatility since any disagreements would delay subsequent stages of

implementation of the banking union, increasing fragmentation and worsening prevailing

financial conditions. These present downside risks to the EUR since it would invite

aggressive monetary support from the ECB.

Second, troika-programme countries are reaching important deadlines. While significant

progress has been made in Ireland (indeed, we expect the country to regain market access),

the environment for Portugal is more challenging. Negotiations on the current program are

likely to begin in November, and our economists believe that another program will be

necessary for Portugal, which is likely to reignite the PSI debate, given the hostility towards

FIGURE 7

2s10s spreads in the periphery have stabilised after periods

of stress in the past three years

FIGURE 8

Swiss banks total CHF foreign assets minus liabilities (LHS,

CHF mn) versus average Spanish and Italian deposit growth

(y/y, RHS)

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

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

-100

-50

0

50

100

150

200

250

300

350

400

Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Italy Spain EURUSD

-5

-4

-3

-2

-1

0

1

2

3

-120000

-100000

-80000

-60000

-40000

-20000

0

Dec-11 Apr-12 Aug-12 Dec-12 Apr-13

CHF A-L Spain/Italy y/y deposit growth
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13/42



further public sector debt relief in parts of northern Europe (seePortugal: More funding and

debt relief needed). Program reviews are also due to be discussed in Greece and Cyprus

over the coming quarter and could pose downside risks to EUR/USD in the near term.

Third, the risk of political uncertainty continues to linger in the euro area, most notably in

Italy. The recent decision by the Italian Senate to strip former PM Berlusconi of his

parliamentary immunity against prosecution increases the chances for his party to

withdraw support from the government, thereby threatening political stability.

For the EUR, the risk premium associated with negative tail events has slowly been priced

out, given the improvement in financial conditions and reduction in fragmentation (Figure 7).

Accordingly, the spill-over of local risk events into other bond markets and FX has been

increasingly small. Any one of the above events may increase the need for the market to

buy downside protection to the EUR (higher vol) and/or sell the EUR.

We remain medium-term bearish CHF

In a context of the Feds postponement of tightening, the CHF should underperform as risk

and carry trades are tactically re-established over the quarter. USD/CHF, however, is

unlikely to move higher in the near term, given its sensitivity to moves in front-end US rates.

We keep our long USD/CHF position, however, since, at best, EUR/USD will be rangebound

in the near term and followed by subsequent depreciation. For the CHF, we see a variety of

reasons to remain bearish.

With regards to domestic policy, while the SNB now anticipates somewhat higher inflation

in 2014, they note there are no signs of inflation risks, and the cap remains the prime policy

tool. The improvement in recent core data has been relatively sharp, but while this has

come hand in hand with a strengthening CHF, we continue to believe that the principal

drivers of the franc are external in nature.

There remains significant scope for unwinds of legacy long CHF positions, primarily those

held on deposit in the Swiss banking system. While this has started to gain traction (Figure 8),

the scale of the flows post-crisis suggests that in the absence of any major global risk

aversion (such as an escalation in the events outlined above), the steady unwind of depositsshould continue. We also view the gradual reduction in fragmentation across the

Eurosystem as a necessary condition for deposit unwinds from Switzerland, and there is

growing evidence that this is happening: with the exception of Cyprus, Eurosystem deposit

flows have moved back towards the periphery over the past 12 months (Figure 8).

Given the commitment to the floor and the scope for further unwinds of deposit flows, we

view the risks of the CHF trade as asymmetric over the medium term and recommend using

it as a funding currency. There is good reward potential in initiating long EUR/CHF (or CHF

funded selective carry) in the near term (1m). Further, we would position for this in spot FX

rather than options, since the move higher is likely to be relatively gradual and there is an

obvious location for a stop-loss (below the 1.20 floor). Accordingly, we go long EUR/CHF at

1.23050 (target: 1.2600; stop-loss: 1.1980).
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THEME: EM

Square carry shorts until tapering

We recommend taking profits on our year-to-date short EM carry strategy. We favour an

overall carry-neutral stance on EM currencies and recommend squaring our

underweight carry positions (BRL, TRY, INR, and IDR). We like long CNY, MYR, and PLN

positions ahead of the rebound in manufacturing activity. We remain long RUB, PHP,

RON, and ILS. Our preference for short ZAR and neutral MXN positions has not changed.

The quarter of a trillion USD of assets the Fed is likely to purchase before revising its current

policies should prop up demand for EM assets. These capital inflows are unlikely to fully

offset the exodus of funds from EM that has taken place this last quarter (Figure 1).

However, we do expect these investments to provide some much-needed breathing room

for EM policymakers, many of whom face challenging macro backdrops that include

funding pressures, dwindling global and domestic growth, inflationary pressures, declining

reserves, and political instability.

Against a backdrop of muted risk aversion and relatively attractive valuations (Figure 2), we

believe markets will price the different realities among EMs. We favour currencies ofeconomies likely to gain from the early signs of a synchronized resuscitation of developed

market economic activity and from Chinas apparent stabilization. Our preferred strategy is

to take profits on our short carry trades and to then combine long and short positions

within EM FX, aiming for an overall carry-neutral exposure to the asset class.

Policies and credibility: No longer short BRL and INR, still neutral on MXN

Mexicos structural reforms are still appealing and likely to deliver improved growth and a

stronger currency. However, the loss of cyclical momentum, which is likely to translate into

easier monetary policy and a worrisome erosion of the governments political capital in

Mexico, leads us to prefer a neutral stance on the peso ahead of crucial votes in Congress

regarding the energy reform.

Emerging market economies running significant current account deficits have also

experienced an upwards adjustment of their currencies carry (Figure 3). The volatility

dampening associated both with more supportive global risk tolerance and effective albeit

Koon Chow

+44 (0)20 7773 7572

[email protected]

Sebastin Brown

+1 212 412 6721

[email protected]

FIGURE 1

QEs survival will not fully reverse the outflows from EM

FIGURE 2

but it is likely to be supportive of under-valued currencies


1.0

1.2

1.4

1.6

1.8

2.0

2.22.4

2.6

2.8

3.0

3.2

-10

-8

-6

-4

-2

0

2

4

6

8

10

Sep-12 Dec-12 Mar-13 Jun-13 Aug-13

Local govt. bonds Equities UST 10yr yield, RHS

$bn %

CZK

HUF

ILS

PLN RON

RUB

ZAR

TRYBRL

CLPMXN

CNY

INR

IDR

KRW

MYR

PHP

TWD

THB

-40%

-30%

-20%

-10%

0%

10%

20%

30%

-20% -10% 0% 10% 20% 30%

BEERvaluation

REER (current level / 10y average)


15/42



not always efficient policymaking pushes the risk-adjusted carry returns of both the BRL

and the INR to levels we consider attractive. Note, however, that relative to a year ago, long-

term risk premia seem low across the major EM currencies other than the BRL (Figure 4).

In Brazil, the aggressive USD60bn intervention is likely to keep BRL volatility contained.

While we still expect a weaker BRL for structural reasons, the real could remain rangebound

in the short run. In the absence of large price movements, we recommend investors not

hedge their exposure to the BRL given the currencys 8% 3m FX-implied yield.

Similarly, the RBIs credibility has improved. Furthermore, its recent decision to hike the

official repo rate while lowering the MSF to provide liquidity leads us to believe that

controlling inflation might not have excessive costs in terms of growth. Likely reforms to the

local bond market and the implementation of measures to encourage capital repatriation

suggest a more neutral INR stance is warranted to avoid missing the 12% yield implied by

3-month forwards.

When sentiment is not enough: Cautious TRY and IDR and stay short ZAR

Despite the temporary rehabilitation of some high-yielding currencies, we believe there

are structural weaknesses in the countries that have experienced credit-driven economic

growth over the past five years (Figure 5). And while an intervention of USD60bn can

temporarily blur the structural weaknesses of Brazils economy and their effect on the BRL,

there is no such shield for the IDR and the TRY. Policymakers in Turkey and Indonesia will

continue to use the exchange rate as a policy instrument as currency-mismatched balance

sheets in the government and private sector turn any sell-off into an extremely costly event.

Thus, while we remain neutral, we recommend selling TRY and IDR on rallies.

A slightly more constructive global context is not supportive enough to expect anything

other than further depreciation of the ZAR. The ZARs well-known structural woes, external

funding needs, and declining activity, along with increasing inflationary pressures, shape

our very pessimistic view on the ZAR.

Upcoming elections in Indonesia, Turkey, and South Africa during 2014 are yet another

reason to be cautious about exposure to these currencies. To highlight the differencebetween EM economies facing structural bottlenecks and those pushing for structural

improvements, as well as the effect of these diverging paths on the value of their currencies,

we reiterate our recommendation of being long a basket of MXN and PHP funded by a short

position in a basket of TRY and ZAR.

FIGURE 3

Attractive risk-adjusted carry of some CA-deficit currencies

FIGURE 4

but long-term real premia is low, except in Brazil*

Source: Barclays Research Note: * EM real yields US real yields EM CDS spreads. Source: Barclays Research

0.0

2.0

4.0

6.0

8.0

10.0

12.0

INR

BRL

TRY

RUB

CLP

ZAR

IDR

RON

MXN

HUF

CNY

PLN

MYR

KRW

THB

ILS

SGD

CZK

%

Last

3m FX implied yields (last, 25 percentile and 75percentile over last 1y)

-150-100

-500

50100150

200250300350

Brazi

l

Po

lan

d

Thailan

d

Turkey

Mexico

Korea

Israe

lSA

FX 10y real premium FX 10y real premium, 1y ago

Bp


16/42



Beneficiaries of a synchronized recovery: Long CNY, MYR, and PLN

While a timid yet globally-synchronized rebound of manufacturing is not enough for the

ZAR, we believe its effects on the Chinese, Malaysian, and Polish economies could be

significant. Leading indicators point to a growth pickup in these economies, which should

lead an appreciation of their currencies, especially given these economies relatively low

vulnerability to a sudden spike of global interest rates.

To express our views on the CNY, we recommend being short AUD/CNH spot (ref. 5.72,target: 5.40, stop: 5.88). In addition to Malaysias improving growth outlook, we think the

MYR has sold off excessively over the past two months and recommend selling SGD/MYR

1m NDF (1m fwd ref. 2.5680, target: 2.50, stop: 2.60). Finally, we reiterate our

recommendation to remain long PLN/short EUR.

Idiosyncratic longs: RUB, ILS, PHP, and RON

The relatively low vulnerability of these currencies to external funding pressures and

favourable growth outlooks allow us to capitalize on supportive idiosyncratic factors across

these countries (Figure 6).

The RUB offers a relatively high carry, and the spot is supported by improving prospects for

oil prices. We recommend a long RUB position funded by a basket of EUR and USD.

From a more structural standpoint, we still like the PHP and think that after the recent sell-

off, it offers significant room for appreciation due to its reforms. We look for a rebound of the

PHP and like selling the USD/PHP 1m NDF (1m fwd ref. 43.26, target: 42.50, stop: 43.65).

The RON is also attractive due ongoing reforms in Romania and its exposure to rebounding

activity in Europe, so we recommend being short EUR/RON. Finally, we like the ILS because

policymakers in Israel have given up on depreciating the shekel and only hope for managed

appreciation, so we also recommend a long ILS position funded in EUR.

FIGURE 5

Credit-driven growth economies face currency pressures

FIGURE 6

Who can survive higher global interest rates?

Source: Haver Analytics, Barclays Research Source: Barclays Research

Turkey

Russia

S. Africa

Poland

Hungary

Romania

Ukraine

NigeriaGhana

Serbia

India

KoreaTaiwan

Indonesia

PhilippinesThailand

Malaysia

Brazil

MexicoChile

Peru

ColombiaVenezuela

-30

-20

-10

0

10

20

30

-15 -5 5 15 25Changeinbankingsystem's

LTDratio

Change in domestic credit since 2007 (% GDP)

0

20

40

60

80

100

120

140

HUF

PLN

TRY

CLP

ZAR

THB

RUB

IDR

MXN

MYR

PHP

COP

BRL

Externaldebt % GDP

Government Private sector

HUF, PLN, TRY:Cannot affordsustaineddepreciation


17/42



THEME: CNY, AUD, NZD

Local matters

Recent stronger-than-expected China data have overcome hard landing concerns,

supporting CNY outperformance relative to its regional peers. Although we expect a

weaker growth trajectory in 2014, we think the PBoC will continue to use currency

appreciation, albeit at a slower pace than this year, as a rebalancing tool. For the AUD,

weak domestic data and the RBAs aversion to currency strength are likely to cap gains

in the near term, offsetting a further pickup in Chinese activity and potential USD

weakness into year-end. In 2014, slowing China growth, a stronger USD and ongoing

weak Australian domestic activity will see AUD/USD depreciate to 0.83 in 12 months.

China hard landing fears subside; rebalancing-led slowdown in 2014

Recent economic data for China have confounded expectations of a hard landing that were

ubiquitous three months ago. Market sentiment gauged by the Shanghai composite index

and copper prices has been recovering gradually from its late-June trough at the height of

the interbank liquidity squeeze (Figure 1). The PBoCs hawkish stance and the perceived

willingness of the new government to avoid policy stimulus while deleveraging theeconomy fuelled the worst hard-landing fears for China since 2011.

The trigger for a turn in market sentiment was hard economic data and began with the official

manufacturing PMI unexpectedly moving into expansionary territory in July. More recently, the

acceleration in industrial production growth to 10.1% y/y in July-August, from 9.1% in Q2,

was significant, signalling an improvement in Q2s 7.5% y/y growth rate to 7.7% in Q3. As

such, we recently fine-tuned our 2013 growth forecast to 7.6% from 7.5%. However, the

recent pickup in economic activity reflects the traditional drivers of Chinese GDP growth and is

being led by infrastructure investment, similar to the temporary rebound in Q4 12.

While we expect economic growth to accelerate in Q3, we forecast a slowing into year-end

and recently lowered our 2014 GDP growth forecast to 7.1% y/y from 7.4%, as rebalancing

increasingly takes hold (seeChina: The new norm No pain, no gain,18 September 2013).

The Third Plenary Session of the 18th Central Committee in November will represent a

major marker on how the government intends to rebalance the economy away from fixed

Nick Verdi

+65 6308 3093

[email protected]

Hamish Pepper

+65 6308 2220

[email protected]

Jian Chang

+852 2903 2654

[email protected]

FIGURE 1

Measures of China sentiment have improved recently

FIGURE 2

Real GDP growth has tended to slow post-rebalancing

during past episodes

Source: Bloomberg, Barclays Research Note: *China data are for the period since 2009. Source: WDI, Barclays Research

Hard landing concerns have

receded, with economic

momentum likely to have

improved further in Q3

6300

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8800

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1,900

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2,100

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Jan-13 Mar-13 May-13 Jul-13 Sep-13

USD/MTIndex Shanghai composite (index)

Copper (USD/tonne, RHS)

25 July - China

announces ministimuluspackage

1 Aug - Upside PMI surprisebegins period of better China data

Japan

(1990)

Korea

(1996)

China

(2009)

Avg. ann. GDP growth 4.6 8.8 10.3

Cum. chg. in fixed capitalformation (%GDP)

2.8 10.2 13.4

Cum. chg. in consumption

(%GDP)-5.1 -8.0 -7.7

Avg. ann. GDP growth 1.1 2.9 9.1*

Cum. chg. in fixed capital

formation (%GDP)-3.5 -6.1 3.1*

Cum. chg. in consumption

(%GDP)4.6 2.3 2.2*

10y pre-rebalancing

10y post-

rebalancing
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18/42



investment and exports towards private consumption. Some of the fundamental challenges

facing the Chinese economy industrial sector overcapacity, a latent property bubble,

financial risks and lower potential growth remain unaddressed. However, it is becoming

increasingly clear that the government is willing to tolerate slower growth to address these

issues. Indeed, on 3 September, President Xi said, We would rather bring down the growth

rate to a certain extent in order to solve the fundamental problems hindering our economic

development in the long run.

Chinas rebalancing process is underway, but is in the early stages. Although consumptions

share of GDP has increased, it has not yet led to a meaningful decrease in investment.

Historical parallels including Japan and Korea which faced rebalancing, albeit as a result of

financial crises support our view that GDP growth slows next year and beyond (Figure 2;

see alsoFX Mid-quarter Update: How does China matter for FX,15 August 2013). However,

if the economy slows more sharply than we expect in 2014, the authorities willingness to

provide further stimulus at the expense of rebalancing will be tested. An important lesson this

year is the governments efforts to support the economy whenever hard landing fears

intensified, suggesting that USD/CNY volatility will remain subdued.

For now, the upside surprise in Chinas growth momentum has seen a decline in portfolio

outflows, to about USD32bn in July and August, respectively, from USD48bn in June. In

addition, a pickup in PBoC FX purchases in August suggests CNY appreciation pressures are

building (Figure 3). Reflecting this, in the recent EM FX sell-off, USD/CNY has remained

stable, appreciating almost 4% since 1 May 2013 on a nominal effective exchange rate basis

and outperforming its EM counterparts (Figure 4).

Market sentiment on China will likely continue to be supported through November, in

response to the improving economic momentum that we expect to be reflected in the Q3

data. That suggests USD/CNY will trend lower in the coming weeks. After that, we expect

USD/CNY to continue to move lower as the Chinese authorities use a stronger currency as a

rebalancing tool. However, 2014 will be framed by a stronger USD environment, in our view,

suggesting that the pace of CNY will slow. Furthermore, the CNY has appreciated

significantly this year and on a real effective basis is more than two standard deviations

above its 2010-13 average.

The rebalancing experience in

Japan and Korea points to

slower GDP growth

Portfolio outflows have slowed

FIGURE 3

Recent portfolio outflows are likely to turn around on

improving economic data

FIGURE 4

CNY outperformed its EM counterparts in the recent selloff

Source: CEIC, Barclays Research Source: Barclays Live

-80

-60

-40

-20

0

20

40

60

80

100

120

Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13

USD bn

Estimated portfolio capital inflow

Change in PBoC FX purchase

88

93

98

103

108

May-13 Jun-13 Jul-13 Aug-13 Sep-13

NEERIndex

CNY

EM Asia (ex China and India)

EEMEA

LatAm
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19/42



AUD: Conflicting forces give way to weakness in 2014

An improving China growth outlook has seen AUD/USD rally 5.2% through September,

following a 14% decline during May-August. But in the context of a stronger USD and a fairly

weak outlook for Australian domestic activity, we maintain our view of AUD/USD depreciation

over the coming year. We forecast GDP growth will decline to 2.1% y/y in 2014 from 2.5% this

year. While there are concerns about strong growth in housing finance recently, consumer

spending remains subdued, and last years pickup in non-mining investment has been

unwound. As such, growth in overall bank lending remains low. The labour market also

remains weak, and the unemployment rate has continued to move higher in recent months. In

addition, recent declines in Australian exports to China are concerning (Figure 5), and our

forecasts for Australias commodity prices are fairly mixed (Figure 6). RBA forecasts imply an 8-

10% drop in Australias terms of trade over the next year or so. However, net exports are likely

to provide a partial offset to weaker growth, as previous mining sector investment comes online

(allowing a pickup in mining exports) and mining-related capital imports decline.

Consistent with a weak domestic economic outlook, the RBAs low tolerance for a stronger

currency is an AUD negative, in our view. Concerns about a rapidly recovering housing market

indicate that the central bank is keen to achieve looser financial conditions through a weaker

exchange rate, rather than adding to the 225bp reduction in the cash rate already administered

during this cycle. The RBA would also welcome further AUD weakness to help the economyrebalance away from resources investment toward other sources of demand, noting in the

minutes of its 3 September policy meeting: Some further decline in the exchange rate would

be helpful in achieving such an outcome. However, if the AUD appreciates further, thereby

tightening monetary conditions, we think the likelihood of a rate cut increases, as the central

bank would likely become increasingly concerned about the downside risks to the non-mining

sector. This factor will limit AUD gains from here, in our view.

The effect of a weak domestic outlook and the RBAs aversion to a stronger currency is

likely to be mostly offset by a pickup in Chinese economic activity and some USD weakness

in the context of Fed tapering being off the agenda until December. This combination will

see AUD/USD broadly flat at a one-month horizon, in our view.

However, we expect this sell-off to become more pronounced towards the end of this year

and through 2014, driven by a stronger USD environment, continued weakness in

Australian economic conditions and slowing Chinese economic activity. We continue to

AUD domestic concerns and

slower China growth point to

AUD/USD downside

The RBA is uncomfortable

with AUD strength

FIGURE 5

Chinese imports from Australia have declined recently

FIGURE 6

A mixed outlook for Australias commodity prices

Source: Bloomberg, Barclays Research Note: Percentage in parentheses refer to commodity weight in the Reserve Bank

of Australias commodity price index. Source: Bloomberg, Barclays Research

60

70

80

90

100

110

120

10

13

16

19

22

25

28

Jan-10 Jan-11 Jan-12 Jan-13

Chinese imports from Australia, 3m rolling USD bn

RBA commodity price index (USD, RHS)

-15%

-10%

-5%

0%

5%

10%

Gold (8%) Crude oil (6%) Copper (5%) Aluminium(5%)

Q2 Q3f

Q4f 2014f


20/42



think the AUD, as a high-yielding G10 currency, remains vulnerable to rising US interest

rates. Moreover, our analysis suggests the AUD is the most vulnerable to a China growth

surprise, encapsulating commodity and high-beta currency characteristics (see FX Mid-

quarter Update: How does China matter for FX, 15 August 2013). Combined with still-

significant overvaluation (AUD/USD is 12% overvalued based on our Behavioural

Equilibrium Exchange Rate model), we believe these factors will ultimately weigh on the

AUD; thus, we maintain our forecast for AUD/USD to reach 0.83 in 12 months.

Relative domestic factors to lead AUD/NZD lower

Further near-term improvement in Chinese economic activity bodes well for the NZD, in the

context of strong domestic growth and elevated terms of trade. AUD/NZD has declined

about 9% year to date, and we expect this to continue as economic outlooks and

commodity prices diverge further. The RBNZ expects increased consumption and the

reconstruction of Canterbury to drive GDP growth to 3.5% y/y in mid-2014, significantly

higher than our forecast for Australian GDP growth of 2.1% y/y in 2014. A pickup in export

demand from an improving global economy is also likely to contribute to economic activity.

Despite the recent strength in the NZD, export revenues are currently being protected by

high NZ commodity prices, which have increased almost 20% this year in world terms,

while Australias commodity prices are flat year to date.

However, market expectations for RBNZ rate hikes (of about 75bp over next 12 months) are

likely overdone in the context of inflation outcomes below the lower end of the RBNZs

1-3% inflation-targeting band and the recent announcement of macro-prudential measures

to cool the housing market. We do not expect the RBNZ to hike rates until Q2 14, in line

with RBNZ forecasts.

Slowing Australian and Chinese economic growth in 2014, which together take almost 40%

of New Zealands exports, is likely to weigh on the NZD further ahead, in the context of

broad-based USD strength. As such we forecast NZD/USD to reach 75 cents in 12 months.

We do not think a rebalancing of Chinese economic activity away from investment towards

consumption will be an important driver of AUD/NZD. Despite New Zealands large

proportion of agricultural commodity exports relative to Australia, which suggests NewZealand should benefit to a greater degree from the rebalancing of Chinese growth, we

recently found that the import content of investment and consumption goods in China is

not as large or dissimilar as markets tend to believe (see FX Mid-quarter Update: How does

China matter for FX,15 August 2013).

Trade recommendation: short AUD/CNH

Short AUD/CNH spot (ref. 5.72, target: 5.40, stop: 5.88). Further AUD/USD appreciation is

unlikely, given weak domestic economic activity and the RBAs low tolerance for further

currency strength. However, we acknowledge the possibility of USD weakness in the

coming weeks as markets play out Septembers no taper Fed decision. As such, we prefer

to express AUD weakness versus CNH (a proxy for CNY spot), with improving Chinese

growth driving portfolio inflows near term, and CNH appreciation aiding economicrebalancing further out.

AUD/NZD downside in

prospect on relative

domestic outlooks

However, slowing Australian

and Chinese GDP growth

will likely weigh on NZD/USD

in 2014
https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181


21/42



THEME: GBP

Fade the rally

Against the backdrop of the delay in Fed tapering, stronger UK data and a disappointing

BoE forward guidance framework have boosted GBP recently. We think the good news is

largely priced and expect underlying headwinds to re-emerge, putting downward

pressure on GBP. BoE monetary policy is set to remain loose for far longer than Fed

policy, and GBP weakness related to a rebalancing of the UK economy away from

services/non-tradable sectors toward tradable sectors is as relevant today as in the

post-crisis period. We recommend buying a 6m GBP/USD put spread (1.60 (ATM) vs

1.55) to express our view of a gradual but persistent move lower.

Upside surprises for GBP in Q3

Circumstances were conducive to GBP strength in Q3, during which the currency was

second only to the NZD in terms of performance. Economic data in the UK consistently

surprised to the upside during much of Q3, with the market caught being too bearish on the

economic prospects (Figure 1). The UK recovery has been relatively broad-based, with

survey data suggesting a continuation of the improvements into Q4. The better news

implied that stretched GBP short positioning had to be covered (Figure 2).

Some of the bearishness toward GBP heading in to Q3 related to the announcement of the

MPCs forward guidance framework a tool for keeping interest rates low in a cyclical

recovery by focusing the market on the long-term issues of economic slack and structural

rebalancing. Yet reaction to the unveiling of the BoEs forward guidance suggests the MPC

may struggle to contain market enthusiasm about better cyclical data. The correlated GBP

appreciation and selloff in short rates (Figure 2) suggest that the market viewed the forward

guidance framework as quite soft, and the inclusion of relatively ambiguous knockouts (since

dubbed thresholds) has raised questions about the BoEs commitment to the framework.

Finally, GBP was expected to depreciate versus the USD as the Fed finally moved to endasset purchases and, more important, allowed the market to price in more aggressive rate

hikes at the short end of the curve. Indeed, the Feds message of low for longer rates at

the September FOMC was yet another disappointment for short-GBP positions and, in our

view, more important than the decision to delay the tapering in asset purchases.

Aroop Chatterjee

+1 212 412 5622

[email protected]

Chris Walker

+44 (0) 20 3555 5863

[email protected]

FIGURE 1

UK data have consistently surprised the market during Q3

FIGURE 2

Combined with steepening UK rates, this has put pressure on

bearish GBP positions

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

-5

-4

-3

-2

-1

0

12

3

4

-0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

0.20

0.25


DSI

UK DSI (LHS) GBP NEER

%

-15

-10

-5

0

5

10

15

20

25

-0.40

-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30


%

GBP net long (% open interest, LHS) UK 3m2y slope

bp


22/42



Reasons to be bearish GBP in the medium term

BoE monetary policy is set to remain loose for far longer than Fed policy, continuing to

weigh on the currency. UK rates continue to price tighter policy than the BoE and our

economists expect. Short sterling futures currently price the first hike around March

2015, more than 12 months before our economists expect action (August 2016). While

this premium in the curve may be partly justified by the improvements in cyclical data, it

is not in line with levels the MPC sees as consistent with the longer-term outlooks for

growth and inflation. The September FOMC meeting serves as a warning to the market

that central banks ultimately control policy and retain the power to move rates where

they see fit. We expect the MPC to bolster its forward guidance framework, especially if

UK economic data soften.

We do not expect much follow-through in USD weakness against low-yielding currencies

like GBP from the September FOMC since the Feds low-for-longer message effectively

arrests the move in the short end of the yield curve instead of pushing it lower. The

underlying cyclical trend is still very positive in the US with consumption remaining strong,

investment picking up and labour market resilient. We expect the market to revisit the issue

of rate hikes once tapering is underway, leading to the long-awaited broad USD rally.

We expect GBP, like the EUR, to be stuck in a range in the near term as recent sources ofsupport are set to hold firm. Our 1m and 3m forecasts are 1.59 and 1.57; further out, we see

a gradual depreciation in the currency to 1.55 and 1.53 in 6m and 12m, respectively.

The longer-term divergence between the UK and the US is even more telling. The output

gap in the UK is only expected to narrow very slowly versus the US (Figure 3). Weak

productivity levels and an economy that has to rebalance away from services towards

tradable sectors will keep growth slower than trend, which is something that UK monetary

policy will have to accommodate by being dovish.

Is dovish monetary policy crucial for GBP weakness?

Although GBPs depreciation of more than 22% on a nominal effective exchange rate basis

since its peak in 2007 has coincided with aggressive monetary policy by the BoE, we do not

think monetary policy has been the sole driver of currency weakness. If monetary policy is

credible, long-term inflation expectations should be stable since central bank easing would

largely be endogenous ie, in response to deterioration in the real economy. As long as

prices adjust, any currency weakness in the short run would be temporary. However, when

long-term inflation expectations have risen and the currency has remained persistently

FIGURE 3

Output gaps in the US and UK

FIGURE 4

GBP/USD spot vs the level implied by monetary policy

expectations (RNFV)

Source: IMF WEO, Barclays Research Source: Haver Analytics, Barclays Research

-8

-6

-4

-2

0

2

4

6

2007 2009 2011 2013 2015 2017

% potentialGDP

US UK

1.10

1.30

1.50

1.70

1.90

2.10

2.30

Jun-05 Jun-07 Jun-09 Jun-11 Jun-13

GBPUSD spot GBPUSD RNFV


23/42



weak, it is possible that central bank easing was largely viewed as exogenous (see

Broadbent (2011) for a discussion of this). But can we pin down a fair value level for

GBP/USD that is consistent with the movement in inflation expectations?

In a risk-neutral world, with financial market equilibrium and purchasing power parity

holding over the long term, nominal GBP/USD should be such that an investor is indifferent

between investing in a long-term (10y) zero-coupon inflation linked bond in the UK (currency

unhedged) or in the US. We follow the work of Clarida (2012) to determine this so-calledrisk-neutral fair value (RNFV) level for the currency the one that is largely determined by

relative long-term inflation expectations and interest rates (ie, monetary policy) Assuming UK

and US interest rates and inflation expectations in the US are constant, an increase in UK

inflation expectations would drive down real yields and imply a lower RNFV for GBP/USD.

Figure 4 shows the GBP/USD RNFV over time. It is clear that most of the decline in

GBP/USD in the early post-crisis years was not driven by monetary policy considerations.

The portion that is unexplained by monetary policy shifts could relate to: fundamentals that

affect the real value of the currency; or currency risk premia. We find that about 20% of the

changes in the deviation of spot from the RNFV (since the crisis) can be explained by

fundamentals that drive value of the currency over the medium term 2

We find that monetary policy has actually been a bigger driver of GBP/USD since the

beginning of 2013, with the GBP/USD RNFV declining as expectations of a more activist BoE

versus the Fed have grown and the backup in US real interest rates has far outstripped

those in the UK. The gap driven by fundamentals/risk premium has declined to the extent

that GBP/USD is not trading above its RNFV, implying either better fundamentals or lower

risk premium. The latter is not likely given the still-elevated levels of government debt and

disproportionately large financial sector compared with the size of the economy. What have

the developments been on fundamentals?

. The remainder are

driven by pure risk premia shifts ie, political/fiscal/financial risks.

Rebalancing: Another reason for a weaker GBP

The importance of services, especially finance (contributing 92% of the 4.7% average

growth in GVA from 2000-09), has left the economy susceptible to financial sector shocks.

2 These are relative productivity, terms of trade, net foreign assets and relative government consumption as specifiedin our BEER model please see Currency valuation from a macro perspective, June 2011, for more details.

FIGURE 5

GVA for financial services, goods production and

construction (% total)

FIGURE 6

GVA breakdown by sector in 2012 (% total)

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

0

2

46

8

10

12

14

16

18

20

03 04 05 06 07 08 09 10 11 12

Finance and Insurance

Total Goods Production

Construction

Total Goods Production

Construction

Distribution, Leisure

ICT

Finance and Insurance

Real Estate

Professional & supportservicesGovernment services

Other


24/42



Because these events coincided with a weak public sector balance sheet, the scope for

countercyclical fiscal policy was reduced. Healthy job creation without public sector

assistance requires the economy to rebalance away from finance into other sectors,

including tradable. The recent strength in GBP is, we think, an impediment to a much-

needed reallocation of resources.

The rebalancing process has not gone very far. For one, the UKs current account position

has remained roughly the same as it was pre-crisis. Digging deeper into the productiondata, we find that total goods production (manufacturing and mining) has been in steady

decline since before the crisis. Despite the significant GBP depreciation following the crisis,

the goods production sectors share of total gross value added (GVA) has remained broadly

flat (Figure 5). The financial and insurance services share of GVA peaked in 2009 at 10%

and has since fallen by roughly 3pp. A 3pp GVA shift away from finance and insurance can

be seen on the margin as rebalancing, but is, at best, minor, in our view. In 2012, total

production of goods still contributes a relatively minor amount of UK output relative to the

dominant service sector (Figure 6).

What about forward-looking indicators? If the rebalancing process were proceeding well, we

would expect equity markets to price in higher value added/profitability in the tradable sector

versus the non-tradable sector. We gauge this by looking at the performance of the UK equity

market at the sectoral level3

We ran regressions of the returns on the different sector quintile baskets on the level of the

currency (versus the RNFV) in the previous period, controlling for the currency return and

broad equity market return. Figure 8 shows that a higher level of GBP leads to

outperformance of the non-tradable sector baskets (T5 and T4) versus the tradable baskets

. We characterise the various sectors on the basis of their relative

sensitivity to GBP movements (we regress weekly sector returns on the broad market and the

GBP NEER, using data from 2004-07; see the Appendix, Figure 9) and construct equal-

weighted quintile baskets. These baskets, based on the tradability of the sector, are shown in

Figure 7, with T5 the least tradable basket and T1 the most tradable. The significant

underperformance of T1 briefly in 2011 and, more recently, since 2012 is striking.

3 We use sectoral data of the FTSE 350 index. We exclude sectors that are composed of fewer than three differentcompanies to avoid capturing stock-specific drivers. We exclude the financial sectors to minimize the importance ofthe financial crisis and its aftermath.

FIGURE 7

Cumulative price returns of equity sector baskets on the

basis of tradability (Jan 2009=100)

FIGURE 8

Regression of equity sector baskets on the basis of

tradability on market variables

d (GBP) d (FTSE) GBP (t-1) Const

T5 0.12 0.71*** 2.62 0.22

T4 -0.13 0.75*** 0.90 0.20

T2 -0.29*** 0.83*** 0.14 0.24

T1 -0.24* 1.32*** -0.89 -0.36

T5-T1 0.36** -0.61*** 3.51 0.57

Note: We regress weekly sector returns on the broad market and the GBP NEER,

using data from 2004-07 and construct equally weighted quintile baskets based

on the estimated coefficients on GBP. T5 and T1 represent non-tradable and

tradable sectors, respectively. Source: Bloomberg, Barclays Research

Note: We regress weekly returns of the different basket returns on GBP and FTSE

returns, as well as the GBP level versus the RNFV, in the past week.

*** significant at the 1% level; ** significant at the 5% level; * significant at the

10% level. Source: Barclays Research

50

100

150

200

250

300

350

Feb-09 Jan-10 Dec-10 Nov-11 Sep-12 Aug-13

Index

T5 T4 T2 T1


25/42



(T1 and T2). Its effect on the difference in performance between the extreme baskets (T5

and T1) has the right sign but the effect is not statistically significant. There appears to be

limited evidence that the low level of GBP has helped differentiate the performance of the

tradable versus the non-tradable sector.

There are structural reasons that may explain why the tradable sectors have not performed

as well over the medium term. These issues relate to wider questions of competitiveness

(which has been on a persistent decline), the nature of goods/services exported (price-insensitive) and the high import content of exported goods (ie, a weaker GBP increases

import costs). This suggests that in order to achieve any successful rebalancing, GBP will

have to remain weaker for far longer.

Where do we go from here?

We believe current GBP levels are attractive for establishing a medium-term short. On the

one hand, we have argued that BoE monetary policy will remain loose for far longer than the

Fed, continuing to weigh on the currency. On the other, the real factors for GBP weakness

related to rebalancing the UK economy away from services/non-tradable sectors toward

tradable ones are as relevant today as they were in the post-crisis period.

We favour establishing medium-term downside positions in GBP/USD via a 6m put spread

with strikes at 1.60 and 1.55 at a cost of 1.05% of notional. Over the next three months, Fed

and BoE policy are unlikely to shift markedly. However, we expect the market to price in more

aggressive Fed rate hikes once tapering is announced (in December, we expect). UK economic

data have been unusually strong recently (as suggested by our data surprise index), and there

are signs that the market has become too optimistic about the UK outlook. A retrenchment of

market expectations for the UK would add further weight to the currency. Finally, the medium-

term structural negative from the rebalancing remains very much in place.

Appendix

FIGURE 9

Sensitivity of FTSE 350 sectors to changes in GBP NEER from 2004 to 2007 (we exclude financial services from our baskets

given their specific role in the crisis)

Source: Barclays Research

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

IndustrialMetals

Oil&Gas

Construction

Mining

Investment(Fins)

Industrialeng

FoodProduction

Software

Banks

Engineering

Beverages

TechHardware

FinancialServices

ElectronicEquip

Pharmaceuticals

Non-lifeInsurance

Leisure

SupportServices

Aerospace

Media

HouseholdGoods

Chemicals

Investment(Realest)

Telecommunications

Gas

Oilequipment

Generalretail

Foodconsumption

T1 T2 T3 T4 T5


26/42



THEME: JPY

Grind higher, against gravity

Despite a surprise from the Fed, we continue to expect USD/JPY to grind higher, driven

by the relative growth and monetary policy outlooks between the US and Japan. The

pace of appreciation is likely modest given the Feds gradualism to policy normalization

and the stretched valuation of JPY. Political uncertainty poses downside risk in the near

term yet upside risk in the longer term.

The Fed on hold, but effect expected to be limited

The Fed surprised the market by not announcing tapering this month. We do not expect it

to have much effect beyond the near term, however, given that the market is already pricing

in Feds renewed

barclays global fx quarterly fed on hold eyes on growth

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