fx market monitor - 1st quarter 2013

CURRENCIES

Currency Market Monitor 1st Quarter 2013

APRIL 6, 2013

John W. Labuszewski Sandra Ro Bluford Putnam

Managing Director Executive Director Chief Economist

Research & Product Development

312-466-7469

[email protected]


011 (44) 203-379-3789

[email protected]


212-299--2302

[email protected]

http://www.cmegroup.com

1 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP

An ongoing debate has long persisted in the global

currency or FX markets – is FX an “asset class” akin

to stocks and bonds? While practitioners and

academics may debate this point at length, perhaps

the most practical answer is – does it really matter

provided that investors may draw a return from

currency investments?

The performance of the currency or FX markets is

found in the exchange rates and cross-rates

associated with the world’s myriad currencies. The

total return associated with a currency is driven by

interest income associated with fixed income

instrument investment in the particular currency; as

well as pure price performance.

Many fundamental factors, including national

economic conditions, monetary and policies, current

and capital account flows, to name just a few,

impact the returns associated with the world’s

currencies.

This document represents a review of these factors

as they played out in the most recently completed

calendar quarter. We include consideration of the

so-called “carry trade” as well as a look at the

theory of “purchasing power parity” as it impacts FX

markets.

While we cover activity in a broad spectrum of

currencies, we focus on the currencies underlying

some of the most liquid of CME Group FX futures.

This includes the U.S. dollar (USD), Euro (EUR),

Japanese yen (JPY), British pound (GBP), Swiss

franc (CHF), Canadian dollar (CAD), Australian dollar

(AUD) and Mexican peso (MXN).

In addition, we have special interest in the

currencies of significant emerging market economies

including the Brazilian real (BRL), Russian ruble

(RUB), Indian rupee (INR) and Chinese yuan or

renminbi (CNY) – the so-called “BRIC” nations.

Finally, we highlight several CME Group FX Indexes

including a USD Index, a Carry Trade Index,

Commodity Country Index and BRIC Index.

Market Fundamentals

As a general rule, FX analysts will evaluate the

fundamental value of any particular currency by

reference to a number of national economic factors.

These factors including growth and inflation

prospects; monetary and fiscal policies; and, current

and capital account balances.

To illustrate, we include a brief discussion of the

economic situation prevailing in the United States as

of the conclusion of the most recently completed

calendar quarter. Of course, the U.S. dollar (USD)

may be just one side of any currency pair that may

be traded using CME Group FX futures.

A brief summary of economic conditions in various

nations, organized along similar lines, is included in

Appendix 1 of our document below. One may

compare and contrast these conditions as they exist

in the two countries whose currency pairing one may

be interested in to draw an appreciation of the

fundamental factors that impact currency markets.

Growth and Employment

Fourth quarter 2012 GDP was most recently

reported at a somewhat disappointing +0.4%. But

the Federal Open Market Committee (FOMC)

attributed this figure, after a rather robust advance

of +3.1% in the 3rd quarter, to “weather-related

disruptions” with an obvious nod to Superstorm

Sandy “and other transitory factors” such as

inventory drawdowns. 1

The FOMC suggested more recently on March 20th

that we are now witnessing a “return to moderate

1 Federal Reserve Press Release dated January 30, 2013.

4%

5%

6%

7%

8%

9%

10%

11%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

Q1 0

5Q

3 0

5Q

1 0

6Q

3 0

6Q

1 0

7Q

3 0

7Q

1 0

8Q

3 0

8Q

1 0

9Q

3 0

9Q

1 1

0Q

3 1

0Q

1 1

1Q

3 1

1Q

1 1

2Q

3 1

2Q

1 1

3

Unem

plo

ym

ent

Rate

Qtr

ly C

hange in G

DP

Growth and Employment

Real GDP (SA) Unemployment Rate

Source: Bureau of Economic Analysis (BEA) & Bureau of Labor Statistics (BLS)


economic growth following a pause late last year.” 2

The Fed elaborates that while “[l]abor market

conditions have shown signs of improvement in

recent months … the unemployment rate remains

elevated.” 3 Unemployment is winding down,

reported at 7.6% for March 2013. But it does

remain significantly above the Fed’s target of 6-½%.

The Fed does concede that it sees “downside risks to

the economic outlook.” Certainly these risks are

implied by the ongoing decline in labor force

participation, reported at 63.3% for March 2013.

Still, the Fed found solace in the facts that

“[h]ousehold spending and business fixed

investment advanced, and the housing sector has

2 Federal Reserve Press Release dated March 20, 2013. 3 Ibid.

strengthened further but fiscal policy has become

somewhat restrictive.” 4

Consumer confidence has been buoyed in recent

months with the Michigan Index of Consumer

Sentiment reported at 77.6 in February 2013 and up

from 75.3 in February 2012. This sentiment is

reinforced by a decline in the personal savings rate

to 2.4% in January 2013 from 6.4% in December

2012.

Further evidence of retail strength, accounting for

perhaps 70% of domestic economic growth, is found

in strong retail sales activity. The February 2013

retail sales report is the strongest figure on record,

topping numbers recorded in late 2007 before the

full weight of the subprime mortgage crisis was felt.

4 Ibid.

63%

64%

65%

66%

67%

4%

5%

6%

7%

8%

9%

10%

11%

Jan-0

2

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

1

Jan-1

2

Jan-1

3

Labor

Forc

e P

art

icip

ation

Unem

plo

ym

ent

Rate

Employment Statistics

Unemployment Rate Labor Force Partcipation

Source: Bureau of Labor Statistics (BLS)

55

60

65

70

75

80

85

90

95

100

1%

2%

3%

4%

5%

6%

7%

8%

9%

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Jan-1

3

Consum

er

Confidence

Pers

onal Savin

gs R

ate

Personal Savings & Sentiment

Personal Savings Rate Consumer Sentiment Index

Source: FRED Database

1.20

1.25

1.30

1.35

1.40

1.45

1.50

$150

$155

$160

$165

$170

$175

$180

$185

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Jan-1

3

Invento

ry:S

ale

s R

atio

Reta

il S

ale

s (

Bil $

)

Retail Sector Activity

Real Retail Sales & Food Services SATotal Business Inventory:Sales Ratio

Source: U.S. Census Bureau

0

500

1,000

1,500

2,000

2,500

Jan-0

4

Sep-0

4

May-0

5

Jan-0

6

Sep-0

6

May-0

7

Jan-0

8

Sep-0

8

May-0

9

Jan-1

0

Sep-1

0

May-1

1

Jan-1

2

Sep-1

2

000 U

nits

Housing Activity

Building Permits Housing Starts Completions

Source: Dept. of Housing & Urban Development (HUD)


March housing activity figures were generally quite

upbeat with building permits rising to 946 thousand

units and housing starts up to 917 thousand units

and the highest levels recorded since 2008.

Further signs of growing momentum may be found

in housing values. The S&P/Case-Shiller Composite

Index of 10 U.S. cities was reported for January

2013 as 8.4% above the trough recorded in March

2013 but still 29.9% below the all-time peak from

June 2006.

This consumer optimism spilled over into the

industrial sector as the Index of Industrial

Production was recorded for February 2013 at its

highest level since April 2008. Similarly, capacity

utilization rose to 78.3% in February 2013. Still,

these figures fall a bit short of the peaks observed in

late 2007 and early 2008 just prior to the onset of

the subprime crisis.

Industrial growth was further reflected in strong

corporate profitability. Third quarter 2012 corporate

profits were recorded at $1.74 trillion. This is an

advance of 17.9% over the 2nd quarter 2012 figure

and the highest observed performance yet to be

recorded.

Inflation

The Fed observed that “[i]nflation has been running

somewhat below the Committee’s longer-run

objective, apart from temporary variations that

largely reflect fluctuations in energy prices. Longer-

term inflation expectations have remained stable …

[t]he Committee also anticipates that inflation over

80

120

160

200

240

280

320

Jan-0

0

Nov-0

0

Sep-0

1

Jul-

02

May-0

3

Mar-

04

Jan-0

5

Nov-0

5

Sep-0

6

Jul-

07

May-0

8

Mar-

09

Jan-1

0

Nov-1

0

Sep-1

1

Jul-

12

S&P/Case-Shiller Housing Indexes

Los Angeles San Diego San Francisco

Denver Washington DC Miami

Chicago Boston Las Vegas

New York Comp-10

Source: Standard & Poor's

66%

68%

70%

72%

74%

76%

78%

80%

82%

80

85

90

95

100

105

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Jan-1

3

Capacity U

tilization

Industr

ial Pro

duction I

ndex

Industrial Sector Activity

Index of Industrial Production Capacity Utilization

Source: St. Louis Federal Reserve FRED Database

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

Q1 0

4

Q4 0

4

Q3 0

5

Q2 0

6

Q1 0

7

Q4 0

7

Q3 0

8

Q2 0

9

Q1 1

0

Q4 1

0

Q3 1

1

Q2 1

2

Pre

-Tax P

rofits

(Billions)

Annualized C

hange

U.S. Corporate Profitability

Annual Change Corporate Profits (Bil)

Source: Department of Commerce

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

Jan-0

4

Aug-0

4

Mar-

05

Oct-

05

May-0

6

Dec-0

6

Jul-

07

Feb-0

8

Sep-0

8

Apr-

09

Nov-0

9

Jun-1

0

Jan-1

1

Aug-1

1

Mar-

12

Oct-

12

Year-

on-Y

ear

Change

Consumer Price Index (CPI)

CPI - All Urban Consumers SACPI ex-Food & Energy SA

Source: Bureau of Labor Statistics (BLS)


the medium term will run at or below its 2 percent

objective.” 5

Indeed, both CPI and CPI ex-food and energy prices

were recorded, on a seasonally adjusted (SA) basis,

at 2.0% in February 2013 and precisely equal to the

Fed’s stated objective.

Monetary Policy

The Fed suggests that “a highly accommodative

stance of monetary policy will remain appropriate for

a considerable time after the asset purchase

program ends and the economic recovery

strengthens … [thus, it is maintaining] … the target

range for the federal funds rate at 0 to ¼ percent

and currently anticipates that this exceptionally low

range … will be appropriate at least as long as the

unemployment rate remains above 6-½ percent,

inflation between one and two years ahead is

projected to be no more than a half percentage

point above the Committee’s 2 percent longer-run

goal, and longer-term inflation expectations continue

to be well anchored.” 6

While Fed policy on the very shortest end of the

curve remains fixed, they nonetheless “decided to

continue purchasing additional agency mortgage-

based securities at a pace of $40 billion per month

and longer-term Treasury securities at a pace of $45

billion per month … Taken together, these actions

should maintain downward pressure on longer-term

5 Ibid. 6 Ibid.

interest rates, support mortgage markets, and help

to make broader financial conditions more

accommodative.” 7

Fiscal Policy

The Fed comments that “fiscal policy has become

somewhat restrictive.” 8 Certainly this restrictive

stance is reflected in a decline the Federal deficit for

2012 of $10.1 trillion. While this is a considerable

figure and far in excess of all previous deficits prior

to the onset of the subprime crisis, it nonetheless

represents some improvement over the deficits of

2009, 2010 and 2011.

Still, the budget battle in Washington is not over as

the gap between the Democratic and Republican

fiscal visions are far apart. This battle may reach

crisis proportions around May 19th when the next

debt limit crisis is projected to come to a head.

Entitlement spending, income and estate taxes and

the size of government remain controversial issues.

Current & Capital Account Flows

Just as incremental progress is achieved with

respect to the Federal spending deficit, we also see

some improvement with respect to the U.S. current

account or trade deficit. The 4th quarter 2012 deficit

was reported at $100.4 billion. While not altogether

cheerful, it represents a significant improvement on

the $133.8 billion deficit from the 1st quarter 2012

7 Ibid. 8 Ibid.

0%

1%

2%

3%

4%

5%

6%

7%

Jan-0

1

Jan-0

2

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

1

Jan-1

2

Jan-1

3

Benchmark U.S. Rates

Target Fed Funds 2-Yr Treasury

5-Yr Treasury 10-Yr Treasury

30-Yr Treasury

-$1,600

-$1,400

-$1,200

-$1,000

-$800

-$600

-$400

-$200

$0

$200

$400

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Federal Surplus/Deficit(Billions USD)

Source: Office of Management and Budget (OMB)


and is running at roughly half of the pre-crisis

deficits which peaked in 2006.

Another interesting source of flow of funds data may

be found in the U.S. Treasury Department’s

Treasury International Capital (or “TIC”) database.

This database tracks flows into and out of the U.S.

The data is broken into foreign stocks, foreign

bonds, U.S. stocks, U.S. corporate bonds, U.S.

government agencies and U.S. Treasuries.

Capital flowing out of the U.S. by domestic or

foreign investors was rather negligible during the

entirety of 2012. Some $105.2 billion, on a net

basis, flowed into the U.S. equity markets from

overseas in 2012. But the major story was the

continued inflow of funds into the U.S. Treasury

markets as overseas investors bought some $391.6

billion of Treasuries, on a net basis, in 2012.

Still, this represents a significant decline from the

$703.7 billion flowing into Treasuries in 2010.

Clearly, U.S. Treasuries continue to be regarded as a

“safe haven” investment that is highly valued by

foreign investors, despite generally low yields.

In any event, the weight of these structural U.S.

fiscal and trade deficits appears likely to exert

influence on the future course of the USD for many

years to come

European Sovereign Debt Crisis

In addition to developments specific to the U.S.

economy, the currency markets continue to be

colored by a number of fundamental news events

including the ongoing European sovereign debt

crisis. The 1st quarter was heavily colored by

developments in Italy, Cyprus and on the

unemployment front.

Deadlock surrounding Italy’s elections held on

February 24-25th elevated concerns that it would not

hold firm on economic austerity measures.

President Giorgio Napolitano continues attempts to

facilitate negotiations aimed at forming a new

government.

Meanwhile, Cyprus concluded an accord to impose

losses on uninsured depositors in the Bank of Cyprus

and Cyprus Popular in return for some €10 billion in

bailout funds from the IMF, ECB and EU. These

loans carry a 2.5% rate over 22 years.

Finally, Eurostat reported record 12.0%

unemployment in the 17-nation Eurozone bloc by

-$250

-$200

-$150

-$100

-$50

$0

Q1 0

4

Q3 0

4

Q1 0

5

Q3 0

5

Q1 0

6

Q3 0

6

Q1 0

7

Q3 0

7

Q1 0

8

Q3 0

8

Q1 0

9

Q3 0

9

Q1 1

0

Q3 1

0

Q1 1

1

Q3 1

1

Q1 1

2

Q3 1

2

U.S. Current Account Deficit(Billions USD)

Source: Bureau of Economic Analysis (BEA)

-$800

-$300

$200

$700

$1,200

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Net US/Foreign Capital Flows (Billions USD)

US Treasuries US Gov't Agencies US Corporates

US Stocks Foreign Bonds Foreign Stocks

Source: U.S. Treasury TIC Database

1.10

1.20

1.30

1.40

1.50

1.60

1.70

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

Nov-1

2

EUR/USD Exchange Rate


Feb-13. This rate is up from 10.9% in Feb-12 and

includes some 19.1 million unemployed persons.

The highest rates were recorded in Greece (26.4%);

Spain (26.3%); Portugal (17.5); Ireland (14.2%);

and, Cyprus (14.0%). The lowest unemployment

rates were recorded in Austria (4.8%); Germany

(5.4%); Luxembourg (5.5%); and, the Netherlands

(6.2%).

These ongoing uncertainties in the Eurozone

weighed heavily on the value of the Euro currency

which declined below $1.30/Euro.

Emerging Economy Performance

Emerging market economies including those in the

so-called BRIC nations of Brazil, Russia, India and

China, have played the most prominent role in

global economic expansion in recent years.

However, this growth has slowed in recent years

from its previous arduous pace.

BRIC Nation GDP Growth

2009 2010 2011 2012

Brazil -0.33% +7.53% +2.73% +0.87%

Russia -7.80% +4.03% +4.34% +1.96%

India +6.40% +9.80% +7.30% +5.10%

China +9.20% +10.40% +9.30% +7.80%

NOTES

2012 figures based on early indications and subject to further revisions.

These slow-downs have been driven, in some cases,

by policies aimed at slowing down inflation and the

possibility of asset bubbles. Note that the four BRIC

nations experienced (estimated) inflation of 5.4%,

5.12%, 9.5% and 2.6%, respectively, in 2012. Still,

growth is generally expected to re-accelerate in the

emerging markets moving forward.

Policy-Driven JPY Movement

One of the more dramatic stories in the FX markets

surrounds the movement in the Japanese yen (JPY).

A stellar performer a couple of years ago, the JPY

has reversed downward some 24% since its peak in

October 2011.

This decline may be attributed to pressure applied

on the Bank of Japan (BOJ) to adopt a more

expansionary monetary policy and to address the

ongoing threat of deflation. As such, the BOJ

adopted its own version of quantitative easing (QE)

and has increased its target for inflation to 2%. This

has prompted large scale capital outflows from

Japan.

Price Performance

These factors exert an obvious impact upon the

price performance of the U.S. dollar vis-à-vis other

world currencies. In order to monitor this price

impact, CME Group has developed the “CME USD

Index” as one in a family of similarly constructed FX

Indexes. 9

9 The CME USD Index represents a basket of equally

weighted positions (as of December 31, 2010) of the USD vs. the Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar (AUD) and Chinese yuan (CNY). It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.

75

80

85

90

95

100

105

110

115

120

125

130

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

Nov-1

2

USD/JPY Exchange Rate

900

950

1,000

1,050

1,100

1,150

1,200

1,250

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

Nov-1

2

CME USD Index

Long Short16.7% EUR 100% USD16.7% JPY16.7% GBP 16.7% CHF 16.7% CAD16.7% CNY


The CME USD Index generally advanced during the

1st quarter 2013 on signs of a consumer-driven

economic recovery in the U.S. along with increased

tensions in Europe and tepid conditions in emerging

economies. Thus, investors have been moving

funds into USD-denominated investments. Thus,

our USD Index remains rallied from 992.19 to

1,027.16 during the 1st quarter 2012.

Total Return

One of the most popular long-term FX trading

strategies over the past decade is known simply as

the “carry trade.” This practice simply suggests

that one might exploit “cost of carry” by borrowing

in countries with low nominal interest rates to invest

in countries with high nominal interest rates. Thus,

one might sell the “low-rate” currency and buy the

“high-rate” currency.

Carry trade � Sell low-rate currency &

buy high-rate currency

By so doing, one hopes to capitalize on discrepant

interest rates, and by implication, divergent

investment opportunities, in the two countries. This

strategy further recognizes that total currency return

consists of 2 components, specifically, exchange rate

or price movement plus the accrual of interest.

Total Currency

Return =

Price Movement +

Interest

The implicit assumption is that these interest rate

relationships will endure. As such, carry traders

implicitly discount classical exchange rate theories

by assuming that the interest rate relationships may

endure over extended periods of time. This

suggests that low-yielding currencies that are sold

will not advance; and, that high-yielding currencies

that are purchased will not decline.

Historically, such relationships have been known to

endure for extended periods of time, reinforcing

interest in the carry trade. In particular, vast sums

of money totaling in the trillions of U.S. dollars were

invested in the carry trade, specifically by shorting

the Japanese yen (JPY) and investing in other

currencies including the Icelandic krona (ISK).

Appendix 2 below depicts the total return associated

with various currencies, relative to the U.S. dollar,

during the most recently completed calendar

quarter. Note the Mexican peso (MXN) led the pack

with a quarterly return of +5.20%; followed by the

Icelandic krona (+4.92%); Argentine peso

(+4.65%); and, Indian rupee (+3.65%).

The Japanese yen continued its downward skid

during the 1st quarter 2013, posting a total return of

-7.90%). Other currencies turning in a weak

performance during the quarter included the South

African rand (-7.67%); British pound (-6.39%); and,

the South Korean won (-3.67%).

Because the carry trade has become such an

important and widely followed transaction in the

global FX markets, CME Group has developed the

CME FX Carry Index.

This novel index is designed to follow the

performance of a basket of currencies that offer

relatively high interest rates and have, at least on

an historical basis, generated favorable total returns. 10 The CME FX Carry Index closed the 1st quarter at

10 The CME FX Carry Index represents a basket of equally

weighted positions (as of December 31, 2010) which is effectively long a basket including the Australian dollar (AUD), Brazilian real (BRL), Mexican peso (MXN), New Zealand dollar (NZD), South African rand (ZAR) and Turkish lira (TRY) vs. short positions in the USD and EUR. It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010. The long components of the CME FX Carry Index were selected in light of the high local interest rates that prevailed in those countries during the post-financial crisis era through 2010. The

-8%

-6%

-4%

-2%

0%

2%

4%

6%

USD-JPYUSD-ZARGBP-USDUSD-KRWUSD-CHFEUR-USDUSD-TWDUSD-COPUSD-CADUSD-RUBUSD-TRY

USDAUD-USDUSD-CNYNZD-USDUSD-BRLUSD-CLPUSD-INRUSD-ARSUSD-ISK

USD-MXN

Carry Return (Q1 2013)


934.15 and up 1.3% from its 4th quarter value of

922.27.

Purchasing Power Parity

The theory of purchasing power parity (PPP) dates to

the 16th century and the School of Salamanca but

was further developed in the early 20th century by

economist Gustav Cassel. 11 The theory is based

upon the assumption that exchange rates are in

equilibrium when purchasing power is equivalent in

the two countries.

On a granular level, PPP is based on the “law of one

price” or the notion that identical products should be

priced at the same level in different national markets

adjusted for exchange rates. Typically, this law is

qualified by the absence of significant trade barriers

or other artificial constraints on commerce.

But the theory of PPP expands the application of the

law of one price from any single good or product to

generalized prices in any particular economy as

measured by inflation indexes, e.g., Consumer Price

Index (CPI) or Producer Price Index (PPI). The

implication of this theory is that inflation rates and

exchange rates should exhibit negative correlation.

If inflation

increases �

Currency value

should decline

If inflation

decreases �

Currency value

should advance

short components of the index were identified because of the low interest rates offered.

11 See Cassel, Gustav, “Abnormal Deviations in International Exchanges” (December 1918).

Thus, if inflation as measured by an inflation index

increases, the value of the currency should generally

decline to maintain price equilibrium. Similarly, if

inflation declines, the value of the currency should

advance.

The theory of PPP is closely related to another

classic theory that addresses exchange rate values

known as the International Fisher Effect (IFE). This

theory suggests that the disparity between nominal

interest rates in two countries drive the future path

of exchange rates.

Per this theory, one might expect that the value of a

currency with a low nominal interest rate might

increase into the future. Or that the value of a

currency with high nominal rate might decline.

IFE further assumes that real interest rates (i.e., the

risk-free interest rate less inflation) should generally

be equal across countries. This implies that nominal

interest rates and inflation are positively correlated.

If inflation

increases �

Rates

increase �

Currency value

should decline

If inflation

decreases �

Rates

decrease �

Currency value

should advance

The IFE suggests interest rates and exchange

negatively correlated. Similarly, PPP suggests

inflation and exchange rates negatively correlated.

As such, the IFE theory is generally consistent with

the PPP theory.

Putting the classic theory of purchasing power parity

into practice requires a measurement of inflation in

order to calculate the proportion by which any

particular currency is (theoretically) over- or under-

valued relative to the norm. There are three popular

methodologies that have been referenced in this

regard.

• OECD - The Organization for Economic Co-

operation and Development (OECD) provides data

that is useful in this regard by comparing price

changes in a representative basket of goods in

various countries.

• Bloomberg - Bloomberg offers an analytical tool

that is grounded in a very long-term assessment

of inflation, as measured by either CPI or PPI in

700

750

800

850

900

950

1,000

1,050

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

Nov-1

2

CME FX Carry Index

Long Short16.7% BRL 50% USD16.7% AUD 50% EUR16.7% ZAR 16.7% NZD16.7% TRY16.7% MXN


various countries extending from January 1982

through June 2000.

• Big Mac - Finally, the Economist’s “Big Mac PPP”

methodology compares the price of a (almost)

universally available product with verifiable pricing

in the form of the McDonald’s Big Mac hamburger

in various countries.

Actually, all three methodologies may readily be

referenced on Bloomberg quotation devices.

Appendix 3 below provides data from all three

methods. Further, we have taken the average of

the three assessments (where available) for a

variety of national currencies and rank-ordered the

set from most over-valued to most under-valued.

Note that the most over-valued currency, per our

methodology, remains the Norwegian krone (NOK)

at +39.83% relative to the USD. Other highly

valued currencies include the Swiss franc (CHF) at

29.84; the Brazilian real (BRL) at +29.66%; the

Australian dollar (AUD) at +27.27%; and, the

Swedish krona (SEK) at +23.13%.

Under-valued currencies, per our analysis, include

the South African rand (ZAR) down at -55.60%; the

Polish zloty (PLN) at -53.71%; the Hong Kong dollar

(HKD) at -49.95%; and, the Hungarian forint (HUF)

at -49.00%.

One might recommend creating “baskets” of several

currencies to buy and sell on the basis of this

analysis in order to diversify risks to a certain

extent. However, it is important to recognize that

currencies might remain in apparent states of over-

or under-valuation for extended periods of time. In

fact, the carry trade as discussed above, takes a

completely opposite approach to the classic PPP

theory by buying high-rate currencies and shorting

low-rate currencies.

Impact of Commodities

As a general rule, the nations whose currencies have

remained top performers over the past decade may

be identified as those whose national income is tied

heavily to commodity production.

Commodity prices have advanced rather sharply

over the past decade as seen in the rise in the value

of energy, grain, livestock, precious metals and

industrial metals. These price advances have largely

been driven by emerging market demand in nations

including China and India.

CME Group has developed the CME FX Commodity

Country Index to follow the performance of a basket

of currencies from nations that rely heavily upon the

exportation of commodities and other raw materials.

To the extent that commodities have been in great

demand over much of the past decade, these

currencies have, on a historical basis, generated

favorable total returns. 12

The 1st quarter 2012 saw modest advances in

energy prices with mixed grain prices but gold

declined approximately $50 on growing economic

12 The CME Commodity Country Index is constructed to be

effectively long AUD, BRL, CAD, Norwegian krone (NOK), NZD and ZAR vs. a short position in USD. It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.

$200

$400

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

$0

$20

$40

$60

$80

$100

$120

$140

$160

Jan-0

7

Aug-0

7

Mar-

08

Oct-

08

May-0

9

Dec-0

9

Jul-

10

Feb-1

1

Sep-1

1

Apr-

12

Nov-1

2

Gold

($ p

er

troy o

z)

Cru

de O

il (

$ p

er

Bbl

Crude Oil & Gold

Crude Oil Gold

Source: Bloomberg

650

700

750

800

850

900

950

1,000

1,050

1,100

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

Nov-1

2

CME FX Commodity Country Index

Long Short16.7% AUD 100% USD16.7% BRL 16.7% CAD 16.7% NOK16.7% NZD16.7% ZAR


optimism. Thus, the CME FX Commodity Country

Index declined 2.0% from 953.60 to 934.32 over

the course of the 1st quarter 2012. This decline

might be more aptly attributed to USD strength on

modest economic momentum more so than any

movements in commodity values.

CME Group has further developed the CME FX BRIC

Index to follow the performance of select “emerging

market” economies and their national currencies,

namely the Brazilian real (BRL), Russian ruble

(RUB), Indian rupee (INR) and Chinese yuan (CNY),

that have created much of the demand for

commodities in the world today. 13

The CME FX BRIC Index ended the 1st quarter at

921.56 and essentially unchanged from the 4th

quarter value of 920.65.

Conclusion

CME Group offers a broad array of currency futures

and option contracts covering a wide range of

currency pairings (where one side is the U.S. dollar)

and cross-rate pairings (which do not involve the

U.S. dollar).

These products provide facile and liquid vehicles

with which one may express a view on prospective

13 The CME BRIC Index is constructed of equal weightings

of long Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese yuan (CNY) vs. a short position in the USD. Like other CME FX indexes discussed above, the BRIC Index was equally weighted and calibrated to equal an arbitrary 1,000.00 as of December 31, 2010.

market movements. Or, to manage the risks

associated with currency holdings or international

investments during turbulent times.

800

850

900

950

1,000

1,050

1,100

1,150

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

Nov-1

2

CME FX BRIC Index

Long Short25% BRL 100% USD25% RUB 25% INR 25% CNY


Appendix 1: Summary of World Economic Conditions

Australia Brazil Canada

Growth,

Inflation

& Fiscal

Policy

China avoided a hard-landing but China risk still weighs on the Australian economy.

Economic growth slowed in 2011, and remained sluggishness in 2012. Lower rates and fiscal stimulus provided in the past year are likely to see their impact in higher real

GDP growth rates in 2013.

Canada’s is benefiting from the continued jobs expansion in the US economy. Domestically,

the oil sector has some challenges.

Monetary

Policy

Short-term interest rates were lowered in 2012 to cushion economic growth without fear

of inflation pressures accelerating. Further rate declines in 2013 are unlikely unless significant currency strength emerges.

The short-term SELIC rate was brought down in 2012 narrowing the premium over the

prevailing inflation rate. Further rate reductions may occur in 2013 if the central bank decides to lean against the wind of

potential currency appreciation.

Canada’ rate policy is on hold. There are no inflation pressures. The former Governor of

the Bank of Canada has been exported to the UK to run the Bank of England.

Special

Factors

The Australian dollar was once a favorite for the long-side of the carry trade versus the

Japanese yen. With Japan adopting a “weaken the yen” approach to policy, the

Australian dollar may again receive inflows from this source.

The major factor impacting the Brazilian real in 2013 is likely to revolve around the zero

interest rate policies of the US, UK, Europe, and Japan, as currency traders expand their

risk appetites for higher rate currencies.

Rate differentials with the US are too small to support the Canadian dollar, even if markets

shift to risk-on trading.

China European Union India

Growth,

Inflation

& Fiscal

Policy

Economic growth in 2012 decelerated faster than many had projected or hoped. With new

leadership and a brighter global outlook for 2013, China’s real GDP growth is likely to

stabilize in the 6% to 7% range.

The fiscal austerity related to the sovereign debt crisis will continue to be a major drag on

economies within the EU in 2013. Europe faces rising unemployment and the possibility of another year of negative real GDP growth.

Like China and Brazil, India saw a rapid deceleration of economic growth in 2012. India has taken a number of steps in the

direction of policy reform, especially regarding foreign investment, that should work to help

the economy regain its balance in 2013.

Monetary

Policy

Expanded bank lending and a push toward more rapid development of financial

institutions is likely. This may include more debt issuance by the Government to fund

health care and pollution reforms.

ECB rate policy is on hold after the fall-out from the messy bail-out of Cyprus. The ECB

will continue to provide bank’s with liquidity as needed.

The monetary authorities have less scope to lower short-term rates than other emerging

market countries, because of elevated inflation. Nevertheless, rate cuts are possible in 2013, especially if the currency takes a turn

toward appreciation and inflation declines a bit.

Special

Factors

An end to economic deceleration portends a more balanced supply and demand for the RMB, and this may allow for a faster pace toward normalizing the currency in 2013.

Elections in Germany in September may add significant political volatility to the path of the

euro. Chancellor Merkel is not popular enough to win an outright majority and new

collation partners may constrain her power to act.

India has shown some signs of becoming friendlier toward foreign investment. This is likely to help the rupee to appreciate along

with other high-rate currencies in response to the very low rates from the US, UK, Europe,

and Japan.


Appendix 1: Summary of World Economic Conditions, cont.

Japan Mexico Russia

Growth,

Inflation

& Fiscal

Policy

Japan’s new Prime Minister is totally focused on expansionary policies to raise both the real GDP growth rate and to ignite some inflation

pressures.

With brighter prospects for economic growth in the US economy and with the worst of the

fiscal cliff being avoided, Mexico should benefit from increased trade with its partner to the

north.

Elevated crude oil prices are benefitting Russia’s economy, but an aging population and a difficult

environment for foreign investment suggest slower economic growth in the years to come.

Monetary

Policy

The Bank of Japan has a new leader and his first act has been to expand purchases of

Japanese Government Bonds.

Currency strength in 2012 may have the lagged effect of helping to reduce inflation

pressures in 2013. The central bank may be able to make further modest reductions in

short-term interest rates.

Russia has accumulated a large quantity of foreign reserves giving the authorities some firepower to counter any ruble weakness, if they so choose,

during periods of oil market weakness.

Special

Factors

The Bank of Japan’s new commitment to quantitative easing is likely to support a

weaker yen. A 2% inflation target by the BoJ would suggest a 110-120 yen/dollar rate.

Mexico’s currency has emerged as one of the favorites for the long-side of the carry trade, funded by zero-rate short-term US dollars.

Russia’s energy supply dominance of Europe may be challenged by alternative supplies. The ruble

may be the casualty.

Switzerland United Kingdom United States

Growth,

Inflation

& Fiscal

Policy

Switzerland is not immune to the ramifications of the long-term debt problems facing the European Union. Economic growth will be

constrained for another year.

The UK’s fiscal austerity has constrained economic growth. As we start to look toward

future elections, even well down the road, fiscal policy may get a little less restrictive.

US economic growth in 2013 faces some increased fiscal austerity. We see just enough economic growth to keep the unemployment rate on a

declining path.

Monetary

Policy

As the EU debt crisis has morphed into a long-term problem, the Swiss have little flexibility and are likely continue to keep a lid on the

Swiss franc relative to the euro.

The Bank of England, now led by a Canadian, is likely keep rates very low and focus its

efforts on financial supervision.

The Federal Reserve may end its asset purchase programs in 2013 or early 2014. Even with a

declining unemployment rate, the Fed is unlikely to consider abandoning its zero federal funds rate policy until it sees some inflation pressure, and

there is none.

Special

Factors

The post-2008 financial crisis has led to increased regulation of financial institutions all

over the world. On net, this increased regulation poses additional challenges for the

traditional model of Swiss secrecy and the overall role of Switzerland in the world’s

financial system.

Tensions between the UK and the European Union are only likely to intensify. Any push by the EU to impose financial transaction taxes will only worsen tensions. UK politics may lead to a non-binding referendum on EU

membership around 2015.

The US dollar is not a strong currency. The US dollar is exhibiting strength against the pound, euro, and yen because they are all even weaker currencies with even bigger long-run problems.


Appendix 2: Select Currency Performance (1st Quarter 2013)

Currency Ticker Spot Quote

(3/29/13) Quote

Convention 3-Mth Rates

(3/29/13)

1st Quarter 2013 2013 Year-to-Date

Total

Return1

Spot

Return2

Interest

Return3

Total

Return1

Spot

Return2

Interest

Return3

Argentine Peso USD-ARS 5.1231 USD per 1 ARS 18.25% 4.65% -4.02% 8.95% 4.65% -4.02% 8.95%

Australian Dollar AUD-USD 1.0419 AUD per 1 USD 2.95% 1.00% 0.23% 0.69% 1.00% 0.23% 0.69%

Brazilian Real USD-BRL 2.0200 USD per 1 BRL 2.69% 1.47% 1.12% 2.69% 1.47% 1.12%

British Pound GBP-USD 1.5198 GBP per 1 USD 0.47% -6.39% -6.50% 0.04% -6.39% -6.50% 0.04%

Canadian Dollar USD-CAD 1.0174 USD per 1 CAD 1.11% -2.22% -2.49% 0.20% -2.22% -2.49% 0.20%

Chilean Peso USD-CLP 472.15 USD per 1 CLP 2.82% 1.49% 1.23% 2.82% 1.49% 1.23%

China Renminbi USD-CNY 6.2102 USD per 1 CNY 3.55% 1.42% 0.33% 1.02% 1.42% 0.33% 1.02%

Colombian Peso USD-COP 1,825.00 USD per 1 COP -2.35% -3.18% 0.79% -2.35% -3.18% 0.79%

Euro EUR-USD 1.2819 EUR per 1 USD 0.11% -2.80% -2.83% -0.04% -2.80% -2.83% -0.04%

Icelandic Krona USD-ISK 128.07 USD per 1 ISK 5.90% 4.92% 3.53% 1.26% 4.92% 3.53% 1.26%

Indian Rupee USD-INR 54.2800 USD per 1 INR 8.25% 3.56% 1.32% 2.14% 3.56% 1.32% 2.14%

Japanese Yen USD-JPY 94.2202 USD per 100 JPY 0.09% -7.90% -7.93% -0.04% -7.90% -7.93% -0.04%

Mexico Peso USD-MXN 12.3312 USD per 1 MXN 4.34% 5.20% 4.23% 0.85% 5.20% 4.23% 0.85%

New Zealand Dollar NZD-USD 0.8371 NZD per 1 USD 2.65% 1.71% 1.01% 0.62% 1.71% 1.01% 0.62%

Russian Ruble USD-RUB 31.0564 USD per 1 RUB 7.40% -0.03% -1.71% 1.64% -0.03% -1.71% 1.64%

South Africa Rand USD-ZAR 9.2362 USD per 1 ZAR 5.07% -7.67% -8.26% 0.57% -7.67% -8.26% 0.57%

South Korean Won USD-KRW 1,111.35 USD per 1 KRW 2.54% -3.67% -4.22% 0.51% -3.67% -4.22% 0.51%

Swiss Franc USD-CHF 0.9492 USD per 1 CHF 0.00% -3.57% -3.56% -0.08% -3.57% -3.56% -0.08%

Taiwanese Dollar USD-TWD 29.033 USD per 1 TWN 0.85% -2.45% -2.66% 0.14% -2.45% -2.66% 0.14%

Turkish Lira USD-TRY 1.8103 USD per 1 TRY 6.38% 0.07% -1.47% 0.01% 0.07% -1.47% 0.01%

United States Dollar USD 1.0000 USD 0.28% 0.07% 0.00% 0.07% 0.07% 0.00% 0.07%

Notes

(1) Return from price movement and interest (2) Return from currency price movement vs. USD as “base currency”

(3) Return from interest at prevailing 3-month rates or implied NDF rate

Source: Bloomberg


Appendix 3: Purchasing Power Parity (“PPP”) Analysis (as of 3/29/13)

% Over/Under Valued

Currency Ticker Average OECD Bloomberg

(CPI)

Bloomberg

(PPI) Big Mac

Norwegian Krone NOK 39.83% 36.86% 11.59% 71.03%

Swiss Franc CHF 29.84% 33.52% 20.31% 6.46% 59.06%

Brazilian Real BRL 29.66% 29.66%

Australian Dollar AUD 27.27% 37.09% 33.24% 27.42% 11.34%

Swedish Krona SEK 23.13% 26.50% -4.72% -2.78% 73.52%

New Zealand Dollar NZD 21.89% 21.88% 30.47% 36.35% -1.14%

Danish Krone DKK 17.57% 26.25% 14.17% 15.26% 14.61%

Canadian Dollar CAD 14.02% 16.91% 14.76% 4.11% 20.31%

Icelandic Krona ISK 13.23% 13.23%

Euro EUR 8.94% 3.50% 13.14% 11.24% 7.88%

Colombian Peso COP 7.88% 7.88%

British Pound GBP 0.59% 3.52% 8.10% -2.01% -7.26%

Chilean Peso CLP -4.86% -4.86%

Japanese Yen JPY -5.87% 10.28% -7.06% -3.54% -23.16%

Argentina Peso ARS -15.58% -15.58%

Singapore Dollar SGD -17.50% -17.50%

Czech Koruna CZK -18.52% -18.52%

Turkish Lira TRY -29.54% -66.38% 7.30%

South Korean Won KRW -30.95% -36.56% -25.33%

Thai Baht THB -31.47% -31.47%

Phillipines Peso PHP -33.51% -33.51%

Indonesian Rupiah IDR -34.98% -34.98%

Mexican Peso MXN -39.88% -47.90% -31.85%

Chinese Renminbi CNY -41.02% -41.02%

Malaysian Ringgit MYR -41.87% -41.87%

Russian Ruble RUB -45.90% -45.90%

Hungarian Forint HUF -49.00% -79.55% -18.44%

Hong Kong Dollar HKD -49.95% -49.95%

Polish Zloty PLN -53.71% -71.83% -35.58%

South African Rand ZAR -55.60% -55.60%

Notes

Please note that data regarding all countries is not generally available.

Source: Bloomberg


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