image page global fx and interest rate outlook michael r. rosenberg october 2010
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Global FX and Interest Rate Outlook
Michael R. RosenbergOctober 2010
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Interest Rate Outlook
2FCW <go>
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Financial Conditions and the Monetary Policy Transmission Mechanism
Change inPolicy Rate
Change in Economic Activity
Financial Shock
Change in Financial Conditions
Real (Output) Shock
Relative Price Shock
Change in Inflation
“Monetary policy works in the first instance by affecting financial conditions, including the levels of interest rates and asset prices. Changes in financial conditions in turn influence a variety of decisions by households and firms, including choices about how much to consume, to produce, and to invest.” Federal Reserve Chairman Ben S. Bernanke, March 2, 2007
3Source: Bloomberg
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How Financial Conditions Typically Respond to Federal Reserve Policy Changes
Change inCredit Spreads
Change in Economic Activity
Change in Money-Market Rates
Change in PolicyRate
Change in Bank Lending Conditions
Change in Inflation
Change in Government Bond Yields
Change in Asset Prices
Change in Financial Conditions
4Source: Bloomberg
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Bloomberg’s Financial Conditions Index
BFCIUS index <go>Source: Bloomberg
Significantly Below Normal
Significantly Above Normal
Normal
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6
Tracking Financial Conditions –Bloomberg’s Financial Conditions Index
Bloomberg's U.S. Financial Conditions Index Components and Weights
Weight
Money Market
Ted Spread 11.1%
Commercial Paper/T-Bill Spread 11.1%
Libor-OIS Spread 11.1%
33.3%
Bond Market
Investment-Grade Corporate/Treasury Spread 6.7%
Muni/Treasury Spread 6.7%
Swaps/Treasury Spread 6.7%
High Yield/Treasury Spread 6.7%
Agency/Treasury Spread 6.7%
33.3%
Equity Market
S&P 500 Share Prices 16.7%
VIX Index 16.7%
33.3%
Total 100%
Source: Bloomberg
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Bloomberg Financial Conditions Index as a Leading Indicator of Bank Lending Conditions
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
-10.0
-8.0
-6.0
-4.0
-2.0
0.0
2.0
U.S. Bank Willingness to Lend U.S. Financial Conditions
U.S. Bank Willingness to Lend(Smoothed Index)
Financial ConditionsIndex
Bank Lending Conditions
Financial Conditions(Smoothed Index)
Source: Bloomberg
7
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Bloomberg Financial Conditions+ Index as a Leading Indicator of Real GDP Growth
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
-8.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
U.S. Real GDP (yoy %) U.S. Financial Conditions (Plus)
U.S. Real GDP Growth (yoy % chg.)(Smoothed)
Financial ConditionsIndex
Bank Lending Conditions
Financial Conditions(Smoothed Index)
Source: Bloomberg
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Monetary Policy Works by Affecting Financial Conditions, Even When the Policy Rate is Zero
Change inPolicy Rate
Change in Economic Activity
Alter Size and Composition of Central Bank’s Balance Sheet
Change in Financial Conditions
Commit to Keep Policy Rate Low for a Considerable Period
Change in Inflation Rate
Quantitative Easing Channel
Expectations Management Channel
Traditional Channel
Source: Bloomberg
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10
Federal Reserve Targeting Long-Term Rather than Short-Term Interest Rates
Change inShort-Term Policy Rate
Change in Economic Activity
Change in Financial Conditions
Change in Long-Term Interest Rate
Change in Inflation Rate
NewApproach
Traditional Channel
Source: Bloomberg
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Taylor Rule Estimates of the Fed Funds Rate –1990-2010
TAYL <go>Source: Bloomberg
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Fed Funds Rate and U.S. Core Inflation Rate
G <go>Source: Bloomberg
Core PCE Inflation
Rate
Fed Funds Rate
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U.S. Real Fed Funds Rate and the U.S. Unemployment Gap
-2
-1
0
1
2
3
4
5
6
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
-6
-5
-4
-3
-2
-1
0
1
2
Real Fed Funds Rate U.S. Unemployment Gap
Unemployment Gap
Real Fed Funds
Rate
Fed Funds Rate less PCE Inflation (%)
Source: Bloomberg
U.S. Unemployment Rate less NAIRU (%)
13
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14
CBO Projections of U.S. Output Gap
Source: Board of Governors of the Federal Reserve System and Bureau of Economic Analysis;Note: Output gap equals actual minus potential GDP.
Output GapProjections
Output Gap (%)
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15
CBO Projections of U.S. Unemployment Gap
Source: Board of Governors of the Federal Reserve System and Bureau of Economic Analysis;Note: Actual minus the Natural Rate of Unemployment.
Unemployment Gap Projections
Unemployment Gap (%)
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Fed Funds Rate Outlook – A Taylor Rule Perspective
-2
0
2
4
6
8
10
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Fed Funds Rate Taylor Rule Estimates
Fed Funds Rate (%)
Modified Taylor Rule Estimates
Fed Funds Rate
Source: Bloomberg
16
Estimates Using Fed Projected
Inflation & Unemployment
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Federal Reserve Bank of San Francisco’s Fed Funds Rate Outlook
Source: Glenn D. Rudebusch“The Fed's Exit Strategy for Monetary Policy”, FRBSF Economic Letter, June 14, 2010
17
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Fed Funds Rate and U.S. Bank’s Commercial & Industrial Loans Following the 1990-91 and 2001 Recessions
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
-25
-20
-15
-10
-5
0
5
10
15
20
25
30
Fed Funds Rate C&I Loans (y-o-y % chg.)
Fed Funds Rate (%)
C&I Loans
Fed Funds
Rate
Source: Bloomberg
18
First Rate Hikeafter 2001 Recession
First Rate Hikeafter 1990-91 Recession
Growth in C&I Loans (y-o-y %)
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-4
-2
0
2
4
6
8
10
1993 1995 1997 1999 2001 2003 2005 2007 2009
U.S. 5-Year Yields U.S. Nominal GDP Growth
U.S. Five-Year Treasury Yields and U.S. Nominal GDP Growth – 1993-2010
(%)
Source: Bloomberg
Long-term interest rates were too low relative to the level of economic activity throughout 2002-06
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Private Economist and FOMC Projections of Nominal GDP Growth
20
Forecasts of Private Sector Economists FOMC Projections2010 2011 2012 2010 2011 2012
Real GDP Growth Rate 3.1 2.9 3 3.3 3.9 4
Inflation Rate 1.6 1.6 2.4 1.1 1.4 1.4
Implied Nominal GDP Growth Rate 4.7 4.5 5.4 4.4 5.3 5.4
Source: Bloomberg ECFC Composite Analyst Forecasts; Federal Reserve Board
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Key Drivers of U.S. Bond Market Rally
21
1. Signs of renewed U.S. economic weakness
2. U.S. inflation expectations have fallen sharply
3. Downward revision in where the market see U.S. short-term interest rates heading
4. Surge in the demand for safe-haven assets in the wake of the sovereign debt crisis
5. Mutual fund portfolio flows out of equities and into bonds
6. Expected increase in Federal Reserve purchases of U.S. Treasuries as part of a new, stepped-up quantitative easing initiative
Source: Bloomberg
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ECRI Leading Economic Indicator of U.S. Economic Growth
ECRWGROW Index GP <go>
2001-02 Worldwide Recession
2007-10 Financial
Crisis/Recession
1990-92 Recession
1974-75 Recession
1980-82 Recession
Source: Bloomberg
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U.S. 10-Year Implied Breakeven Inflation Rate
23
70+ Basis-Point Decline in 10-Year Breakeven Inflation
Rate
USGGBE10 Index GP <go> Source: Bloomberg
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Expectations of Three-Month T-Bill Rates in Two-Year’s Time
24
Downward Revision in Expectations of Three-Month T-Bill Rates
in Two-Years’ Time
G0025 2Y3M Curncy GP <go>Source: Bloomberg
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2.00
2.50
3.00
3.50
4.00
4.50
5.00
5.50
2007 2008 2009 2010
0.00
1.00
2.00
3.00
4.00
5.00
6.00
10-Year Yield 3-Mo. Rate, Two Years Forward
U.S. Long-Term Interest Rates and the Projected Path of Short-Term Interest Rates
25
Expectations of Three-
Month T-Bill Rates
10-Year Treasury Yield
Source: Bloomberg
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Mutual Fund Portfolio Flows into Bond Funds Soar in 2010
Source: ICI, “Trends in Mutual Fund Investing”, July 2010.http://www.ici.org/research/stats/trends/trends_07_10
Dec. 2009
(US$ bn)
Dec. 2009
Dec. 2009
July 2010July 2010
July 2010
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Estimating the Impact of the Federal Reserve's Large-Scale Asset Purchase Program on Long-Term Interest Rates
27
Increase in Size of LSAP
Estimated Impact on
10-Year Government Bond Yield
Estimated Impact on U.S.
GDP after Eight Quarters
$1 trillion -39 basis points +1.5%
$2 trillion -78 basis points +3.0%
Source: Joseph Gagnon, "The World Needs Further Monetary Ease, Not an Early Exit", Peterson Institute for International Economics Policy Brief, December 2009.
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U.S. Bond Market Rally – A Supply and Demand Perspective
Source: Bloomberg
Outstanding Stock of Publicly Held
U.S. Government Debt
U.S. Long-Term Interest Rates
Debt Level1
Debt Level2
Bs1 Bs
2
i1
i3
A
Bd1
B
C
Bd2
i2
Despite the increase in publicly held debt outstanding (from Bs
1 to Bs
2), an increase in the demand for U.S. Treasuries (from Bd
1 to Bd2)
has pushed interest rates down (from i1 to i3).
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Federal Reserve Large-Scale Asset Purchase Program – A Supply and Demand Perspective
Source: Bloomberg
U.S. Long-Term Interest Rates
Debt Level2
Debt Level1
Bs2 Bs
1
i2B
Bd1
Ai1
Fed purchases reduce the supply of publicly held debt outstanding (from Bs
1 to Bs2),
thereby pushing interest rates down (from i1 to i2).
Outstanding Stock of Publicly Held
U.S. Government Debt
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Supply and Demand for U.S. Government Debt and the Risk Premium on U.S. Debt
BDemand
Investors require higher interest rates as they are asked to add significant amounts of additional debt to their portfolios
(i3)
D1 D2 D3
BSupply1 BSupply
2 BSupply3
(i2)
(i1)
U.S. Long-Term Interest Rates
Outstanding Stock of Publicly Held
U.S. Government Debt
Source: Bloomberg
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Estimating the Interest-Rate Effects of Changes in Outstanding U.S. Government Debt
Estimated Impact on Future Long-Term
Interest Rates
For Each One Percentage Point Increase in Debt/GDP Ratio 4-5 Basis Points
25%-30% Total Increase in Debt/GDP Ratio Over Next 10 Years 100-150 Basis Points
Source: Federal Reserve Board Discussion Paper 2003-12.
31
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IMF Estimates of U.S. Treasury Bond Issuance on U.S. Long-Term Bond Yields
32
2010 2011 2012 2013 2014 2015
Projected Ex-Ante Demand (US$ bn) $8,111 $8,303 $8,551 $8,800 $9,186 $9,492Projected Supply (US$ bn) $9,683 $10,800 $11,771 $12,735 $13,767 $14,900
Excess Suppy (US$ bn) $1,573 $2,497 $3,221 $3,855 $4,581 $5,408Excess Suppy (% of GDP) 11% 16% 20% 23% 26% 29%
Estimated Yield Impact (basis points) 20-55 30-80 40-100 45-115 50-130 60-150
Source : Oya Celasun and Martin Sommer, "The Financing of U.S. Federal Budget Deficits", IMF Country Report No. 10/248, July 2010.www.imf.org/external/pubs/ft/scr/2010/cr10248.pdf
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U.S. Federal Debt Held by the Public – 1790-2035
33
Source : Congressional Budget Office, Economic and Budget Issue Brief, “Federal Debt and the Risk of a Fiscal Crisis”, July 27,2010http://www.cbo.gov/ftpdocs/116xx/doc11659/07-27_Debt_FiscalCrisis_Brief.pdf
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Median Real GDP Growth and Debt/GDP Ratios in Select Advanced Economies – 1790-2009
Source: Carmen Reinhart and Kenneth Rogoff, “Debt and Growth Revisited”, VOX, August 2010. http://www.voxeu.org/index.php?q=node/5395
Real GDP Growth (yoy %)
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Exchange Rate Outlook
35FXMI <go>
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FX Trader Performance – 1994-2010
FXTP <go>
1.6% Average Annual Return
2004-2010
6.9% Average Annual Return
1995-2003
Source: Bloomberg
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Long-Term Trends in the U.S. Dollar’s Value
USTW$ index GP <go>
8-YearDowntrend
5-YearUptrend
6-YearUptrend
7-YearDowntrend
10-YearDowntrend
2008-10 Uptrend ?
Source: Bloomberg
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The Dollar and the Euro-U.S. Two-Year Yield Spread
U.S. and Euro-area
two-year bond yields
reflect expectations
of Fed and ECB
policy rates for the
next two years
1.10
1.20
1.30
1.40
1.50
1.60
1.70
2006 2007 2008 2009 2010
-200
-150
-100
-50
0
50
100
150
200
250
US$/Euro Exchange Rate Euro-U.S. 2-Yr. Yield Spread
(US$/Euro) Euro-U.S. 2-Year Yield Spread (basis points)
Source: Bloomberg
38
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Key Drivers of U.S. Bond Market Rally
39
1. Signs of renewed U.S. economic weakness
2. U.S. inflation expectations have fallen sharply
3. Downward revision in where the market see U.S. short-term interest rates heading
4. Surge in the demand for safe-haven assets in the wake of the sovereign debt crisis
5. Mutual fund portfolio flows out of equities and into bonds
6. Expected increase in Federal Reserve purchases of U.S. Treasuries as part of a new, stepped-up quantitative easing initiative
Source: Bloomberg
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The U.S. Dollar’s 2010 PPP Undervaluation
40
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The Dollar’s PPP Over/Under-valuation vs. the Euro – 1990-2010
41
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A Stylized Model of the Dollar’s Long-Term Cycles
From undervalued to fair valued to overvalued and back again
Time
US$ Value
Maximum Overvaluation
Maximum Overvaluation
Maximum Undervaluation
Maximum Undervaluation
Maximum Undervaluation
5+ Years 5+ Years 5+ Years 5+ Years5+ Years
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European Debt Crisis – Greece Credit Default Swap (CDS) Rate
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Key Determinants of the Long-Term Trend in the U.S. Dollar’s Value
44
Valuation
Carry
Risk Premia
Momentum
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3x3 Passively Managed G-10 Carry-Trade Basket
Three-Month Euro-Deposit Rate (%)
Source: Bloomberg; as of October 5, 2010
45
G-10 Short-Term Interest Rates
Long the 3 Highest Yielders
Short the 3 Lowest Yielders
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Long-Term Profitability & Drawdowns of a 3x3 G-10 Carry Trade Basket
FXFB <go> Source: Bloomberg
1992ERM Crisis
1998Unwind of the
Yen Carry Trade
2005-06Unwind
2007-08Financial
Crisis
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3x3 Passively Managed Emerging-Market Carry-Trade Basket
Three-Month Euro-Deposit or NDF Rate (%)
Source: Bloomberg; as of April 13, 2010
47
EM Short-Term Interest Rates
Long the 3 Highest Yielders
Short the 3 Lowest Yielders
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Long-Term Profitability & Drawdowns of a 3x3 EM Carry Trade Basket
FXFB <go> Source: Bloomberg
2005-06Unwind
2007-08Financial
Crisis
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Fundamental Drivers of Long-Run Carry-Trade Performance
Time
Cumulative Carry-Return Performance
Wide Short-Term Spreads Attract Capital Inflows
(1)
Trend Decline in Inflation Expectations
Trend Decline in Currency Risk Premium
(2)
(3)
(4)
t0 t1 t2 t3 t4
Gradual Rise in Real Long-Run Equilibrium Exchange-Rate
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Explaining the Persistence of Positive Excess Returns on Carry-Trade Strategies
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High-yield currencies are more sensitive to changes in market volatility and asset-price trends. (High-yield currencies behave similar to high-beta stocks.) Because they entail greater systematic risk, they command higher expected returns.
High-yield currencies are subject to periodic crash risk. Excess returns represent the compensation for taking on that crash risk.
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The Response of High-Yield and Low-Yield Currencies to Changes in Market Volatility
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Excess Return
Market Volatility
Low Yielders
Level of Volatility Required to Insure
that Uncovered Interest Rate Parity
Holds
High Yielders
Vol1
Average Level of Market Volatility
Low Yielders Avg. Return
High Yielders Avg. Return Excess
Return of High Yielders
over Low Yielders
Vol2
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The Negative Skew in the Distribution of G-10 3x3 Carry-Trade Monthly Excess Returns
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0
10
20
30
40
50
60
-12% -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% 12%
Monthly Excess Return
Number of Months
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The Negative Skew in the Distribution of EM 3x3 Carry-Trade Monthly Excess Returns
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0
5
10
15
20
25
-14% -12% -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% 12% 14%
Monthly Excess Return
Number of Months
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Active Management of Carry Trades
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Volatility filters
Valuation yardsticks (such as PPP and FEER)
Moving-average crossover trading rules
Filters/Yardsticks/Strategies for Determining Whether a Carry-Trade Position Should be Opened or Closed
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Actively Managing a Carry-Trade Portfolio with a Moving-Average Crossover Trading Rule
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Time
Cumulative Excess Return Index
Long-Run Moving Average
Short-Run Moving Average
Open all Positions Open all PositionsClose (or Reverse) all Positions)
Crossover --Close All Positions
Crossover --Open All Positions
Long LongFlat (or Short)
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Excess Returns of an Actively Managed G-10 Carry-Trade Portfolio for the Past Four Years
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Excess Returns of an Actively Managed EM Carry-Trade Portfolio for the Past Four Years
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Long-Term Valuation Yardsticks for Carry Trades
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Purchasing Power Parity
Long-Run Uncovered Interest-Rate Parity (LRUIRP)
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A$ PPP Over/Undervaluation – 1989-2010
PPP <go> Source: Bloomberg
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NZ$ PPP Over/Undervaluation – 1989-2010
PPP <go> Source: Bloomberg
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Long-Run Excess Returns on a Long-A$/Short-US$ Position–1989-2010
FXCT <go> Source: Bloomberg
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Long-Run Excess Returns on a Long-NZ$/Short-US$ Position–1989-2010
FXCT <go> Source: Bloomberg