fx market monitor - 3rd quarter 2014

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2 | Currency Market Monitor 3rd Quarter 2014 | October 6, 2014 | © CME GROUP

The big story in the FX markets during the 3rd quarter 2014 was a significant rally in the value of the U.S. dollar (USD) relative to other major and emerging market currencies. This strength was driven by an improving economic outlook on a nice rebound in GDP after a weak but weather-driven 1st quarter – along with continuing growth in the labor market. This document reviews the macroeconomic factors that underlie these trends including a look at growth in various national economies, monetary policy, current and capital account flows. We further consider the impact of the so-called carry trade and purchasing power parity theory as they impact 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). We also 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). Growth and Employment The 3rd quarter of 2014 saw moderate economic growth along with decelerating improvement in the unemployment rate. International tensions continued to flare up in the Middle East and Ukraine, which led to some relatively small price spikes. Still, it could be characterized as a quiet quarter with generally low volatility on a buoyant equity market with reasonably stable rates and a moderately strong U.S. dollar. Second quarter GDP was last reported at +4.6%, representing a significant rebound from Q1-14’s weather-driven decline of 2.1%. Still, the 3rd quarter concluded on a bit of a sour note with a release as the Federal Open Market Committee (FOMC) reduced its GDP growth estimates subsequent to the September 16-17th meeting. The FOMC is now projecting GDP growth of 2.1-2.3% in 2014 and 2.6-3.0% in 2015. These figures are

downwardly revised from June projections of 2.1-2.3% and 3.0-3.2%, respectively. 1 The Sep-14 unemployment rate was reported at 5.9%, a significant downtick from the Aug-14 figure of 6.1%. Thus, the labor market is improving a bit faster than projected by the FOMC. The Committee had projected an unemployment rate of 5.9-6.0% by the end of 2014 and 5.4-5.6% by the end of 2015. These figures were revised downwards from previous estimates of 6.0-6.1% and 5.4-5.7%, respectively. 2

The FOMC acknowledged these conditions in its release following the September 16-17th meeting … “economic activity is expanding at a moderate pace.

1 “Economic Projections of Federal Reserve Board

Members and Federal Reserve Bank Presidents, September 2014,” September 17, 2014.

2 Ibid.

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Growth and Employment

Real GDP (SA) Unemployment RateSource: Bureau of Economic Analysis (BEA)

& Bureau of Labor Statistics (BLS)


On balance, labor market conditions improved somewhat further; however, the unemployment rate is little changed and a range of labor market indicators suggests that there remains significant underutilization of labor resources.” 3

This observation is underscored by a continued low labor force participation rate. While unemployment was last reported at 5.9%, only 62.7% of the population is employed. This represents the lowest rate since 1978 and has declined from the 63.2% reported a year earlier in Sep-13. The FOMC further suggests that “[h]ousehold spending appears to be rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow.” 4 Indeed, many economic indicators have recovered to eclipse their pre-financial crisis highs. This includes measures of consumer spending as well as industrial production. Real retail sales were reported at $187.2 billion in Aug-14 and +2.51% on a year-on-year (YOY) basis over the Aug-13 figure of $182.6 billion. Similarly, light vehicle sales were reported at 17.5 million units in Aug-14, representing an impressive +8.9% advance over the Aug-13 sales figure of 16.0 million units.

3 Federal Reserve Press Release dated September 17,

2014. 4 Ibid.

The Index of Industrial Production was reported at 104.1 in Aug-14 or +4.6% on a YOY basis. Capacity utilization down ticked from a high of 79.1% in Jul-14 to 78.8% in Aug-14. Still this represents an advance of 0.8% over the figure of 78.0%, as reported one year earlier in Aug-13. Thus, we strain towards the key mark of 80%, which is often considered a key inflection point above which point production bottlenecks and inflationary pressures are generally thought to emerge.

Similarly, corporate profitability has rallied to $1.84 trillion by Q2-14, representing a new all-time high and eclipsing the previous high of $1.80 trillion seen in Q3-13. This corporate success has, of course, contributed to a buoyant stock market trading near all-time highs by the end of Q3-14.

A buoyant stock market has, of course, contributed to a tremendous “wealth effect.” This is

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Employment Statistics

Unemployment Rate Labor Force PartcipationSource: Bureau of Labor Statistics (BLS)

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Real Retail Sales SA Light Vehicle SalesSource: U.S. Census Bureau and Dept.of Commerce

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Index of Industrial Production Capacity UtilizationSource: St. Louis Federal Reserve FRED Database


underscored by reported on household net worth which rallied to a record $81.5 trillion by Q2-14 and a cheerful University of Michigan Consumer Sentiment Index last seen at 81.2.

Still, a certain sense of glumness seems to hang over the market, driven by a skewed distribution of this wealth. The value of U.S. residential real estate owned by households was reported at $22.9 trillion as of Q2-14 but this remains 7.8% less than the pre-crisis high of $24.9 trillion as of Q4-06. Perhaps even more significantly, real household income remains well below pre-crisis highs and has generally been headed in the wrong direction.

Real, or inflation-adjusted, median household incomes were reported at $51,939 in 2013. While this is a bit of an improvement over the trough of $51,017 seen in 2012, it remains well below the

1999 peak of $56,080. More affluent Americans invested in stocks have realized significant benefits reflected in household net worth, noting that approximately 10% of households own 80% of all stocks. But these benefits do not appear to be flowing down to middle or lower class citizens, creating a widening income void between the classes. Inflation The Fed reiterates its focus on employment coupled with an inflation target, suggesting that “[w]hen the Committee decides to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.” 5 Inflation is currently running a bit below that 2% target. The Consumer Price Index (CPI-U) and core CPI ex-food and energy were both reported at an annual rate of +1.7% for Aug-14. Similarly, Personal Consumption Expenditures (PCE) were recorded at +1.6% in Aug-14 on a YOY basis while core PCE ex-food & energy checked in at +1.6%.

All of these measures fall slightly short of the Fed’s target of 2%. The Fed is projecting PCE inflation and core PCE inflation to run at 1.5-1.7% and 1.5-1.6% in 2014, respectively. Projections for 2015 are similarly modest at 1.6-1.9% for both PCE and core PCE inflation. But with capacity utilization straining

5 Ibid.

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PCE Core PCESource: Bureau of Economic Analysis (BEA)


up towards the key 80% mark, inflation could perhaps become a cause for some concern on the part of the Fed sooner than anticipated. Monetary Policy The Fed continues to wind down its QE program. The program had called for the monthly purchase of $85 billion of Treasuries, agency debt and agency mortgage backed securities (MBS), in an attempt to keep intermediate- to long-term rates at modest levels. But the Q4-13 saw the Fed begin to taper the program by $10 billion per month. Consistent with expectations, the Fed “decided to make a further measured reduction in the pace of its asset purchases. Beginning in October, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $5 billion per month rather than $10 billion per month and will add to its holdings of longer-term Treasury securities at a pace of $10 billion per month rather than $15 billion per month.” 6

Further, “[t]he Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. If incoming information broadly supports the Committee’s expectation of ongoing

6 Ibid.

improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will end its current program of asset purchases at its next meeting [scheduled for October 28-29, 2014]” 7 The conclusion of QE may presumably set the stage for possible target Fed Fund rate hikes. In the meantime, we are holding steady at 0-25 basis points as the Fed “will assess progress—both realized and expected—toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate … that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.” 8

Fiscal Policy The Fed continues to suggest that “[f]iscal policy is restraining economic growth although the extent of restraint is diminishing.” 9 Total Federal government

7 Ibid. 8 Ibid. 9 Ibid.

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Benchmark U.S. Rates

Target Fed Funds 2-Yr Treasury5-Yr Treasury 10-Yr Treasury30-Yr Treasury

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Federal Receipts vs. Expenditures(Annualized in Billions)

Fed Total Recepits Fed Total ExpendituresNet Lending/Borrowing

Source: Bureau of Economic Analysis (BEA)


expenditures (annualized and seasonally adjusted) were at $3.934 trillion in Q2-14 and up 1.9% from Q1-14’s $3.859 trillion. Total Federal receipts were last reported at $3.308 trillion in Q2-14 and up 1.3% from Q1-14’s $3.264 trillion. This results in a Q2 shortfall of $626.3 billion and a slight uptick from Q1’s $594.7 billion. Current & Capital Account Flows

The current account deficit improved to $98.506 billion in Q2-14 from Q1-14’s $102.111 billion. This represents a 20.5% decline from Q1-12’s post-financial crisis peak of $123.962 billion. It represents a far greater improvement relative to the >$200 billion deficits witnessed in the pre-crisis era of 2005-06.

The U.S. Treasury Department’s Treasury International Capital (or “TIC”) 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. U.S. vs. overseas capital flows have generally been characterized over the past decade by substantial influx of funds into U.S. Treasuries. This trend peaked in 2010, as overseas investors net purchases totaled $704 billion in U.S. Treasuries, but tailed off to $433, $417 and $43 billion in 2011, 2012 and 2013, respectively.

Foreign investors turned their attentions to the U.S. equity marketplace in 2013 as a net $522 billion flowed into stocks on the strength of a sustained bull market continuing through Q3-14.

But despite the gains realized in equities in 2014 to date, foreign investors withdrew some $0.8 billion from equities in factor of pushing $108 billion into U.S. Treasuries. This was likely driven by international tensions along with concerns over a possible correction given that U.S. equities have advanced to new all-time highs. Mutual Fund Flows The flow of equity and fixed income investments may be examined per data published by the Investment Company Institute (ICI) which tracks activity in the mutual fund industry. 10 Some $50.8 billion was invested into equity funds during 2014 through July. However, this represented a net withdrawal of $13.9 billion from U.S. equity funds and a net addition of $64.7 billion into overseas equities, despite the strong performance of the U.S. stock market and the U.S. dollar.

10 These indicators are often highly correlated with price

action as retail investors may “chase” the market by buying in response to a bull trend. Or, they may exhibit a “herd mentality” by liquidating investments in response to significant market breaks.

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Source: Bureau of Economic Analysis (BEA)

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Net US/Foreign Capital Flows (Billions USD)

US Treasuries US Gov't Agencies US CorporatesUS Stocks Foreign Bonds Foreign Stocks

Source: U.S. Treasury TIC Database


Bond funds attracted some $60.4 billion in additions in 2014 through July, despite the fact that many anticipate rising rates and declining fixed income values as the Fed winds down its QE programs and possibly considers federal fund rate hikes.

Global Economic Performance Emerging market (EM) economies grew quickly even in the wake of the subprime crisis. But growth in the EM countries is now decelerating while many analysts look for relatively modest economic upticks in the developed (DM) economies.

GDP Growth in the Euro area and the U.S. is expected to improve to +1.49% and +3.11% by 2015 from 2013’s -0.37% and 1.88%, respectively. While Japanese growth is expected to tail off a bit to +1.24 in 2015 from +1.53% in 2013, the UK is

expected to grow at a +3.03% rate in 2015 relative to 2013’s rate of +1.74%. GDP growth has slowed in many of the emerging economies but such growth has nonetheless generally surpassed that of the DMs. This will likely continue to be the case per most forecasts, albeit the gaps may narrow.

Actual & Forecast GDP Growth

2011 2012 2013 2014 (f) 2015 (f)

Developed Markets (DMs) Australia 2.59% 3.61% 2.36% 2.71% 2.58% Canada 2.53% 1.71% 2.01% 2.48% 2.45%

Euro Area 1.63% -0.60% -0.37% 1.05% 1.49% Japan -0.45% 1.45% 1.53% 1.50% 1.24%

UK 1.12% 0.28% 1.74% 3.38% 3.03% US 1.85% 2.78% 1.88% 1.66% 3.11%

Emerging Markets (EMs) Brazil 2.73% 1.03% 2.49% 1.14% 2.59% Mexico 4.04% 3.98% 1.07% 3.08% 3.62% Russia 4.29% 3.44% 1.30% 0.96% 4.36% India 7.70% 4.80% 4.70% 5.10% 6.60% China 9.3% 7.70% 7.70% 7.30% 7.60%

Source: Global FX Analyst, Goldman Sachs (July 15, 2014)

NOTE: (f) = forecast data

Trade surpluses, that have supported some EM economies notably including China, have generally contracted since the pre-financial crisis era, representing a headwind for the value of many EM currencies. On the other hand, trade deficits in the U.S. and Europe have generally declined over the same period.

Actual & Forecast Current Account Balance (as % of GDP)

2011 2012 2013 2014 (f) 2015 (f)

Developed Markets (DMs) Australia -2.76% -4.19% -3.23% -2.10% -3.22% Canada -2.75% -3.42% -3.23% -2.40% -1.76%

Euro Area 0.11% 1.46% 2.39% 2.90% 3.10% Japan 2.15% 0.99% 0.68% 0.11% 0.96%

UK -1.46% -3.83% -4.51% -4.17% -3.57% US -2.96% -2.84% -2.39% -2.58% -2.92%

Emerging Markets (EMs) Brazil -2.12% -2.41% -3.62% -3.67% -3.75% Mexico -1.07% -1.27% -2.06% -1.81% -1.47% Russia 5.56% 3.63% 1.72% 1.36% -1.28% India -3.40% -5.00% -2.60% -1.90% -2.80% China 1.90% 2.60% 2.10% 2.10% 2.10%

Source: Global FX Analyst, Goldman Sachs (July 15, 2014)

NOTE: (f) = forecast data

Forecasts suggest that the U.S. trade deficit may revert back to higher levels in coming years while

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Equity Fund Cash Flows (Billions USD)

Domestic Equities Foreign EquitiesSource: Investment Company Institute (ICI)

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Equity Funds Bond FundsSource: Investment Company Institute (ICI)


the European trade surplus expands. The Chinese surplus is expected to stabilize as a percentage of Chinese GDP – but note that Chinese GDP is expected to advance at rates in the 7% vicinity, resulting in sizable increases in the surplus measured in absolute terms. Price Performance The factors discussed above 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. 11

The CME USD Index ended Q3-14 at a value of 1,088.10 and up from Q2-14’s ending mark of 1,025.85, for an advance of 4.61%. Over the same period, EUR has turned in a spot return of -7.75% vs. USD; British pound (GPB) is at -5.22%; Japanese yen (JPY) is at -7.59%. The GBP experienced some extensive buffeting during the period leading up to the failed Scottish vote for independence. Among EM currencies are the Brazilian real (BRL) at -9.51%; Russian ruble (RUB) at -14.19%; and,

11 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.

Indian rupee (INR) at -2.54%. The Chinese yuan (CNY) managed to post an advance at +1.05%. 12 The particularly poor performance of the RUB is, of course, linked to continuing economic sanctions in the wake of the Crimean and Ukraine crisis. Total Return The “carry trade” has been one of the most popular long-term FX trading strategies over the past decade. A carry trade is deployed by borrowing in countries with low nominal interest rates to invest in countries with high nominal interest rates. Thus, one sells the “low-rate” currency and buys 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 including exchange rate fluctuation plus interest accrual. As such, carry traders implicitly discount classical exchange rate theories by assuming that the interest rate relationships may endure over extended periods of time. I.e., low-yielding currencies that are sold will not advance; or, high-yielding currencies that are purchased will not decline.

Total Currency Return = Price Movement

+ Interest As a practical matter, such relationships have been known to endure for extended periods of time. E.g., vast sums were invested in the carry trade prior to the outbreak of the subprime crisis, often by shorting the low-yielding Japanese yen (JPY) and investing in other high-yielding currencies. Appendix 2 depicts the total return associated with various currencies relative to USD in Q3-14. Among the DMs, the EUR generated a total return of -7.72% for the quarter; GBP at -5.09%; and, JPY at -7.59%.

12 The “spot return” of a currency, or the outright price

movements, is distinguished from the “total return” which includes price movements plus interest accrual.

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Long Short14.3% EUR 100% USD14.3% JPY14.3% GBP 14.3% CHF 14.3% CAD14.3% AUD14.3% CNY


To the extent that interest rates remain at near zero levels in these mature economies, the total returns are not much different than spot returns as reported above.

But interest accruals may exert a much greater influence in less mature economies. The BRL posted a total return of -7.06% for the quarter; RUB was seen at -12.11%; INR at -0.39%; and, while the CNY checked in at +1.51%.

The CME FX Carry Index follows the performance of a basket of currencies offering relatively high rates and have historically generated favorable total returns. 13 The CME FX Carry Index closed Q3-14

13 The CME FX Carry Index represents a basket of equally

weighted positions (as of December 31, 2010) which is long a basket including the Australian dollar (AUD), Brazilian real (BRL), Mexican peso (MXN), New Zealand

at 809.65 and down 2.26% from Q2-14’s mark of 839.83. Thus, the carry trade as a strategy does not appear to have worked well at all in the post-financial crisis era. Purchasing Power Parity The purchasing power parity (PPP) theory dates to the 16th century and the School of Salamanca but was further developed in the early 20th century by economist Gustav Cassel. 14 It is based upon the assumption that exchange rates are in equilibrium when purchasing power is equivalent amongst various countries. On a granular level, PPP is based Adam Smith’s “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

Thus, if inflation as measured by an inflation index increases, the value of the currency should decline to maintain price equilibrium. Similarly, if inflation declines, the value of the currency should advance.

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 high local interest rates during the post-financial crisis era through 2010. The short components of the index were identified because of the low interest rates offered.

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

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CME FX Carry Index

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


The theory of PPP is closely related to 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. Thus, one expects that the value of a currency with a low nominal interest rate will increase into the future. Or that the value of a currency with high nominal rate will 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 are negatively correlated. Similarly, PPP suggests inflation and exchange rates are negatively correlated. As such, the IFE theory is generally consistent with the PPP theory. Putting the classic PPP theory 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 used 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 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.

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. Norwegian krone (NOK) stands out as the most over-valued currency per this analysis at +28.97%. NOK is followed by Swiss franc (CHF) at +23.48%; New Zealand dollar (NZD) at +14.86%; Icelandic krona (ISK) at +12.57%; and, the Australian dollar (AUD) at +12.43%. Under-valued currencies include Turkish lira (TRY) at -66.69%; Polish zloty (PLN) at -62.53%; South African rand (ZAR) at -61.73%; Hungarian forint (HUF) at =58.75%; and, the Russian ruble (RUB) at -55.73%. PPP numbers across all currencies have generally fallen significantly over Q3-14, noting that these figures are all measured relative to the USD. Of course, the USD exhibited notable strength during Q3. One may wish to create baskets of several currencies to buy and sell on the basis of this analysis in order to diversify risks. However, it is important to recognize that currencies might remain over- or under-valued 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. Commodity Countries Top performing currencies are often found in nations whose national income is tied heavily to commodity production. Commodity prices have sometimes seen steep advances during the past decade as seen in the rise in the value of energy, grain, livestock, precious metals and industrial metals. Price advances have frequently been fueled by demand from EM economies, although some of these trends have corrected in the past couple of years with EM deceleration and as new sources of supply have come on board. The CME FX Commodity Country Index tracks a basket of currencies from nations that rely heavily


upon the exportation of commodities and other raw materials. 15 The CME FX Commodity Country Index closed Q3-14 at 819.92 and down 7.21% from Q2-14’s 883.60. This may largely be attributed to a weak oil market, driven by new sources of supply relative to stabilizing demands in the EM countries.

Conclusion CME 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 market movements. Or, to manage the risks associated with currency holdings or international investments during turbulent times. For more information please visit our website at www.cmegroup.com/trading/fx.

15 The CME Commodity Country Index is constructed to be

effectively long Australian dollar (AUD), Brazilian real (BRL), Canadian dollar (CAD), Norwegian krone (NOK), New Zealand dollar (NZD) and South African rand (ZAR) vs. a short position in the U.S. dollar (USD). It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.

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CME FX Commodity Country Index

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


Exhibit 1: Summary of World Economic Conditions

Australia Brazil Canada

Growth, Inflation, and Fiscal

Policy

Australia’s economy is growing, but the broad-based decline in global commodity prices could

dampen growth.

Economic growth has been slow in Brazil. Once the October Presidential election has

been decided, regardless of the outcome, we expect uncertainties over future policies to diminish and real GDP growth to start to

improve incrementally in 2015.

Canada is benefiting from the continued jobs expansion in the US. A positive decision on

the Keystone pipeline could help the Canadian dollar, but political uncertainties abound. A pipeline decision, one way or the other, is

likely after the US Congressional elections in November 2014.

Monetary Policy

Monetary policy has been on hold in Australia. If commodity prices continue to fall, one can expect the central bank to consider a rate cut

if the economy weakens.

Short-term interest rates around 10% have provided some support for the currency. Rate cuts are possible in 2015 if we are correct that

uncertainties diminish after the October election.

Canada’s short-term interest rates are higher than in the US but still very low. Some

inflation pressures appear to be developing. The Bank of Canada may consider a rate rise, especially if US job growth remains robust.

Special Factors

The Australian dollar is considered a commodity currency, so the risk of

depreciation rises as energy, metals, and agriculture prices trend downwards.

Post-election, with 10% short-term rates, the Brazilian real has the potential to appreciate

against the Mexican peso or the Japanese yen, even in a strong dollar environment.

A rate rise in Canada could add support to the Canadian dollar, if it comes. A negative US decision on the Keystone pipeline, if it goes that way, would hurt the Canadian dollar.

China European Union India


Policy

Chinese real GDP may decelerate further to around 6% to 7% real GDP growth in 2015.

The economy is likely to avoid a hard landing but continues to face significant challenges.

Europe’s economies are struggling. The banking system remains under-capitalized and

not able to expand lending at a pace to support stronger growth. 2015 could see

some improvement after the ECB completes its stress tests and banks make the required

capital adjustments.

India’s elections in May brought in new leadership and enthusiasm for change. Our estimates are that real GDP growth will be in the 5% to 6% range for 2015 and that India

will take some slow steps to ease the economy’s heavy regulatory burden.

Monetary Policy

China typically uses the banking sector to increase lending activity and help keep the economy growing. There are signs that this tool for managing economic activity may not be working as well given the structural issues

and debt overhang in the banking system.

The ECB has announced plans to purchase asset-backed securities. If this program could

be coupled with some steps to ease fiscal policy, it would help. But for now, fiscal policy

remains restrictive in many countries.

Weakness in global commodity prices is likely to help reduce the inflation rate, along with

the stability of the rupee. There may be room for more rate cuts in 2015.

Special Factors

China has widened the bands for currency volatility. Nevertheless, we do not think the

demonstration in Hong Kong are likely to slow down progress to normalizes the currency and increasing capital flows between China and the

rest of the world.

With the ECB planning to purchase asset-backed securities coupled with expectations of

a rate rise in the US in 2015, the Euro has been depreciating. This trend is not likely to

reverse until after the bank stress test period.

The Indian rupee is on the mend. The

elections in May brought the possibility of meaningful economic reforms. Declining

commodity prices are helpful, too.


Exhibit 1: Summary of World Economic Conditions, cont.

Japan Mexico Russia


Policy

As consumers sought to beat Japan’s April 1st hike in its national sales tax, the January-March real GDP was exceptionally strong.

That strength was totally offset in the negative April-June quarter. And, there is another sales

tax increase coming in late 2015.

Mexico is benefiting from improved growth in the United States. Mexico has also increased its imports of relatively inexpensive natural gas through its pipeline links with Texas.

Russia’s annexation of the Crimea and further political turmoil in the Ukraine have led to costs and economic sanctions that possibly

could cause a recession. As winter approaches there are risks that Russia might curtail gas deliveries to Europe to counter the pressure

from sanctions.

Monetary Policy

The Bank of Japan is still expanding its balance sheet aggressively. Unfortunately, this effort mainly moves government bonds from banks and pensions into the central bank, but it has

not helped economic growth.

The Bank of Mexico has made cuts in short-term interest rates, in part, to make sure the currency does not appreciate too rapidly to

jeopardize trade prospects.

Russia has had to raise short-term interest rates to protect the currency during the Ukraine turmoil. Political risks in Russia,

including potential takeover of foreign assets, are extremely high.

Special Factors

The Japanese yen remained quite stable from mid-2013, trading between 100 and 103 yen per US dollar, until recently when it started a move toward 108 to 110. The Bank of Japan probably wants to slow this depreciation for now and see what it does to future inflation.

Mexican inflation is well contained. Given that short-term rates are at or below inflation, however, the Mexican peso has lost some

ground in the general US dollar rally.

Over the long-term, the big issue for Russia is global oil and natural gas prices. Russia has agreed a deal to ship natural gas to China.

The Iraq turmoil has raised oil prices to Russia’s benefit. The fall in global commodity

prices, however, is a big negative for the Russian economy and currency.

Switzerland United Kingdom United States


Policy

Switzerland’s economy remains tied to the struggling nations of the European Union. This

dims their growth prospects.

The UK’s growth prospects are steadily improving. The London housing market is

booming, due to foreign buyers. The budget deficit as a percent of GDP is also declining.

The US economy is doing relatively well. Job creation is strong and the unemployment rate

has dropped just below 6%. The Federal budget deficit is likely to be balanced by FY-

2016. Core inflation, however, remains subdued and there is not much pressure on

wages.

Monetary Policy

As the EU debt crisis has morphed into a long-term banking capital adequacy problem, the

Swiss have little flexibility, and they are likely continue to keep a lid on the Swiss franc

relative to the euro.

The Bank of England may well consider raising rates now that Scotland has voted to remain part of the UK. The timing of a rate increase

might come before the May 2015 parliamentary elections.

The Yellen-led Federal Reserve is on track to end the Bernanke-Fed’s quantitative easing. The next decision, which could come soon, is

to stop the re-investment of interest and principal received on the Fed’s holdings of

Treasuries and MBS. Then, in 2015, the Fed may well abandon the near-zero federal funds

rate target.

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.

The future of the pound hinges very much on interest rate expectations, with the possibility of gains versus the euro and losses versus the

US dollar.

The debate about when/if the Fed will raise its target federal funds rate has captured the

mindset of market participants, and led to a stronger dollar, especially when the economies of Europe and Japan are struggling and their

central banks are committed to highly accommodative policies.


Appendix 2: Select Currency Performance (3rd Quarter 2014)

Currency Ticker Spot Quote (6/30/14)

Quote Convention

3-Mth Rates (9/30/14)

3rd Quarter 2014 2014 Year-to-Date Total

Return1 Spot

Return2 Interest Return3

Total Return1

Spot Return2

Interest Return3

Argentine Peso USD-ARS 8.1310 USD per 1 ARS 27.20% 7.10% -3.50% 10.98% 5.00% -22.64% 35.73% Australian Dollar AUD-USD 0.9433 AUD per 1 USD 2.86% -6.61% -7.27% 0.71% 0.14% -1.91% 2.09%

Brazilian Real USD-BRL 2.2132 USD per 1 BRL -7.06% -9.51% 2.71% 4.46% -3.47% 8.21% British Pound GBP-USD 1.7109 GBP per 1 USD 0.56% -5.09% -5.22% 0.14% -1.69% -2.08% 0.39%

Canadian Dollar USD-CAD 1.0671 USD per 1 CAD 1.13% -4.37% -4.71% 0.36% -4.24% -5.13% 0.95% Chilean Peso USD-CLP 552.45 USD per 1 CLP -6.73% -7.58% 0.92% -9.55% -12.18% 2.99%

China Renminbi USD-CNY 6.2046 USD per 1 CNY 4.20% 1.51% 1.04% 0.47% 0.01% -1.39% 1.42% Colombian Peso USD-COP 1,877.50 USD per 1 COP -6.29% -7.28% 1.07% -2.16% -4.71% 2.68%

Euro EUR-USD 1.3692 EUR per 1 USD 0.03% -7.72% -7.75% 0.03% -7.95% -8.09% 0.15% Icelandic Krona USD-ISK 112.86 USD per 1 ISK 5.85% -5.25% -6.64% 1.50% -0.43% -4.72% 4.50% Indian Rupee USD-INR 60.0435 USD per 1 INR 8.63% -0.39% -2.54% 2.21% 6.97% 0.07% 6.90% Japanese Yen USD-JPY 101.33 USD per 100 JPY -0.09% -7.59% -7.59% 0.00% -3.92% -3.96% 0.04% Mexico Peso USD-MXN 12.9682 USD per 1 MXN 3.29% -2.78% -3.43% 0.68% -0.81% -2.92% 2.18%

New Zealand Dollar NZD-USD 0.8758 NZD per 1 USD 3.89% -9.98% -10.85% 0.97% -2.47% -4.94% 2.61% Russian Ruble USD-RUB 33.9783 USD per 1 RUB 9.66% -12.11% -14.19% 2.42% -11.44% -17.00% 6.69%

South Africa Rand USD-ZAR 10.6387 USD per 1 ZAR 6.40% -4.18% -5.74% 1.66% -3.06% -7.02% 4.26% South Korean Won USD-KRW 1,011.95 USD per 1 KRW -3.66% -4.11% 0.47% 1.06% -0.51% 1.58%

Swiss Franc USD-CHF 0.8868 USD per 1 CHF -0.05% -7.15% -7.15% 0.00% -6.52% -6.51% -0.01% Taiwanese Dollar USD-TWD 29.870 USD per 1 TWN 0.88% -1.55% -1.76% 0.21% -1.41% -2.03% 0.64%

Turkish Lira USD-TRY 2.1185 USD per 1 TRY 10.00% -4.78% -7.01% 2.40% 1.69% -5.71% 7.85% United States Dollar USD 1.0000 USD 0.28% 0.07% 0.07% 0.19% 0.19%

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 9/30/14)

% Over/Under Valued

Currency ISO Code Average OECD Bloomberg

(CPI) Bloomberg

(PPI) Big Mac

Norwegian Krone NOK 25.04% 28.97% 3.79% 42.36% Swiss Franc CHF 23.48% 31.28% 17.88% 2.07% 42.67%

New Zealand Dollar NZD 14.86% 11.98% 26.06% 33.37% -11.98% Icelandic Krona ISK 12.57% 12.57% Australian Dollar AUD 12.43% 24.28% 22.79% 18.17% -15.53%

Danish Krone DKK 11.86% 23.81% 11.34% 9.66% 2.64% Canadian Dollar CAD 5.53% 9.49% 6.08% 4.29% 2.25% British Pound GBP 2.65% 11.27% 14.70% -4.94% -10.43%

Euro EUR 2.41% -1.93% 10.01% 4.44% -2.89% Swedish Krona SEK 1.74% 17.27% -18.44% -13.36% 21.47% Brazilian Real BRL -3.72% -3.72%

Colombian Peso COP -14.06% -14.06% Singapore Dollar SGD -22.10% -22.10%

Japanese Yen JPY -23.63% -6.00% -23.47% -22.10% -42.95% South Korean Won KRW -23.72% -23.34% -24.09%

Chilean Peso CLP -31.78% -31.78% Czech Koruna CZK -32.44% -32.44%

Chinese Renminbi CNY -41.95% -41.95% Thai Baht THB -42.11% -42.11%

Phillipines Peso PHP -47.26% -47.26% Argentina Peso ARS -50.06% -50.06%

Indonesian Rupiah IDR -51.27% -51.27% Hong Kong Dollar HKD -51.98% -51.98% Malaysian Ringgit MYR -53.32% -53.32%

Mexican Peso MXN -54.31% -67.94% -40.67% Russian Ruble RUB -55.73% -55.73%

Hungarian Forint HUF -58.75% -91.58% -25.91% South African Rand ZAR -61.73% -61.73%

Polish Zloty PLN -62.53% -81.43% -43.63% Turkish Lira TRY -66.69% -107.44% -25.94%

Notes

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


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fx market monitor - 3rd quarter 2014

Economy & Finance

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