Global FX Strategy | Economic Bubble | Euro

Global FX Strategy

November 24, 2009

Global FX Strategy 2010
John NormandAC
(44-20) 7325-5222 john.normand@jpmorgan.com

Paul Meggyesi
(44-20) 7859-6714 paul.meggyesi@jpmorgan.com

Ken Landon
(1-212) 834-2391 kenneth.landon@jpmorgan.com

Tohru Sasaki
(81-3) 6736-7717 tohru.sasaki@jpmorgan.com

Gabriel de Kock
(1-212) 834-4254 gabriel.s.de.kock@jpmorgan.com

Arindam Sandilya
(1-212) 834-2304 arindam.x.sandilya@jpmorgan.com

Niall O’Connor
(1-212) 834-5108 niall.oconnor@jpmorgan.com

Contents

Global FX Outlook 2010 Five global macro themes and top trades Global FX Carry Trade Monitor FX alpha strategies in 2010 Post-mortem: 2009 forecasts and trades FX Derivatives Long-term Technicals JPY EUR GBP CHF SEK Commodity currencies Risk scenarios & hedging strategies Event risk calendar for 2010 J.P. Morgan Forecasts FX vs Forwards & Consensus Global Growth and Inflation Global Central Bank Rates

3 11 12 14 16 18 24 34 40 46 52 57 62 68 76 78 80 81

Rates, Credit, Equities & Commodities 79

www.morganmarkets.com/GlobalFXStrategy

J.P. Morgan Securities Ltd.

The certifying analyst is indicated by an AC. See page 83 for analyst certification and important legal and regulatory disclosures.

Global FX Strategy Global FX Strategy 2010 November 24, 2009 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd.

• Global FX Outlook 2010: New year, new lows (John Normand) The dollar will turn in 2010, but not before marking new lows versus the euro (1.62), Swiss franc (0.91) and possibly the yen (82). This move is more than a carry trade, given broad weakness in the balance of payments. • Five global macro themes and top trades (Paul Meggyesi, John Normand) The dollar will undershoot (worst-of basket on CHF, AUD, JPY); recover is discounted but exit strategies are mispriced (GBP/CHF, AUD/NZD); the end of inflation targeting? (NZD/NOK); a CNY revaluation’s impact on G-10 FX is overstated (EUR/JPY); and long-term valuation gaps to close in 2010 (EUR/SEK). • FX Derivatives: A macro model for vol and strategy implications (Arindam Sandilya, Talis Bauer) A macro model for implied volatility suggests that VXY (3-mo implieds) should range between 10% and 14% in 2010, with spike risk more likely in Q3/Q4. Focus on vol carry for trading returns. • Long-term Technicals: Major transition ahead (Niall O’Connor,Thomas Anthonj) The dollar will undergo a major consolidation phase over the next two months before resuming its bear trend. • Yen: What would push USD/JPY to all-time lows? (Tohru Sasaki, Junya Tanase, Yoonyi Kim) USD/JPY can decline to 82 this year before rebounding. Even that level would not prompt BoJ intervention. • Euro: Few obstacles to new highs (Paul Meggyesi) The euro’s drivers are less idiosyncratic than other currencies, but it will still rise in an environment of broad dollar weakness. Most counterarguments – export impact, China revaluation, euro break-up – are overstated. • Sterling: Funding currency or investment vehicle? (Paul Meggyesi) Sterling’s undervaluation limits the scope for further weakness, but it is premature to expect a rebound. The trinity of deleveraging in the household, banking and public sectors remains a powerful obstacle. • Swiss franc: Franc to rally as SNB steps off the brake (Paul Meggyesi) Like the yen, the franc is transforming into a pro-cyclical currency in this post-crisis world of low global yields. The currency will rally in 2010 as the SNB end its intervention (EUR/CHF to 1.46, USD/CHF to 0.91.) • Swedish krona: The myth of krona undervaluaton (Kamal Sharma) The krona is not as undervalued as most think, but it can still rally 7% in 2010. • Commodity currencies: Where's the gold? (Gabriel de Kock, Matthew Franklin-Lyons) NOK and AUD will lead the advance in 2010, driven by valuations and policy tightening. NOK is the valuation champ, while AUD benefits from Asian growth. Policy disappointment and valuations hobble CAD and NZD. • Risk scenarios and hedging strategies (Ken Landon) An inflation surprise, a US funding crisis and US mid-term elections are three to hedge. • FX Alpha Strategies in 2010 (John Normand, Matthew Franklin-Lyons) Carry should deliver roughly 8% returns as volatility ranges but central banks tighten. Forward Carry returns will moderate from 2009’s 10%. Simple price momentum will struggle in Q3/Q4 when the dollar turns. • Global FX Carry Trade Monitor (Yoonyi Kim) The carry trade has returned as it always does post-recession, but it is half as large as it seems. Currency managers, global macro funds, CTAs and Japanese retail have moderate exposure. US and European have little. • Post-mortem on 2009 forecasts and trade recommendations (John Normand, Kamal Sharma) Forecasts were correct on direction but too conservative on magnitude. 60% of trades were profitable. • FX Forecasts EUR/USD targets raised to 1.62 by Q2 and 1.50 by Q4. USD/JPY should reach 82 by Q2 before rebounding to 89 at year-end. EUR/GBP should peak at 0.94 and AUD/USD at 1.02.
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Global FX Strategy Global FX Strategy 2010 November 24, 2009 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd.

Global FX Outlook 2010: New year, new lows
• The dollar will end this decade with its worst performance since the 1970s. 2010 will mark a turning point, but not before the dollar approaches new lows versus the euro (1.62), the Swiss franc (0.91) and possibly the yen (82). Fed policy is partly to blame, since extreme rate environments have driven the dollar’s largest over/undershoots of the past three decades. Even though recovery is discounted and the dollar slightly cheap, cash stockpiles are enormous for this rate environment. Another $300bn in drawdown could occur, with the dollar still the chief casualty. This move is more than a carry trade, however. Other components of the US capital account are weak too (M&A/FDI, equity portfolio flows). The dollar is not yet in bubble trouble. Currency markets do not meet the usual criteria for bubbles – extreme valuation, momentum and leverage. Q1-Q2 also lacks the trigger for a reversal, namely a major downside shock to growth or upside shock to rates. If the Bank of Japan’s exit from QE in 2006 is any guide, this apparent stability could change in Q3 2010 as the Fed initiates its exit strategy. This policy shift should be worth a 5-10% dollar rally in H2. Until then, implied volatility should range between 10% and 14% (basis VXY for 3-mo implied), with spikes more likely in Q3 – Q4. Alpha strategies: This vol environment implies returns of 8% on carry, which is less than 2009 but still decent. Forward Carry returns will moderate from 2009’s 10%. Simple price momentum will struggle in Q3/Q4 when the dollar turns. Risks to the view: Corporates fail to spend; USD decline turns volatile, prompting intervention; China revalues +10%; inflation resurfaces; US midterm elections impose fiscal discipline. Five global macro themes and top trades: USD will undershoot (worst-of basket on CHF, AUD, JPY); recovery is discounted but exit strategies are mispriced (GBP/CHF, AUD/NZD); the end of inflation targeting? (NZD/NOK); a CNY revaluation’s impact on G-10 FX is overstated (EUR/JPY); and long-term valuation gaps to close (EUR/SEK).

At its current pace of decline, the dollar will end this decade down 12% trade-weighted, its worst performance since Bretton Woods collapsed in the 1970s. As cold comfort, at least the 2009 bear market has been comparatively mild. The dollar has fallen only 5% trade-weighted this year and against 75% of currencies globally, compared to proper routs in the early 1970s, late 1980s and early 2000s when the dollar fell at least 8% and sometimes versus all currencies (chart 1).
Chart 1: Ranking USD bear markets: annual change in tradeweighted USD vs percentage of currencies against which USD rose
Based on annual spot movements of G-10 and emerging market currencies vs USD
100% % of currencies against which USD depreciated, lhs 75% change in USD trade-weighted, rhs 15% 5% 50% -5% 25% -15% -25% 71 74 77 80 83 86 89 92 95 98 01 04 07
Source: J.P. Morgan

25%

0%

Naturally some think that the new year brings an inflection point, particularly since the dollar has become slightly cheap (4% trade-weighted on J.P.Morgan’s fair value model1). The dollar will turn in 2010, but not before nearing all-time lows trade-weighted and surpassing old lows versus the euro, Swiss franc and possibly the yen. The Fed’s rate stance drives part of this move, but reducing the dollar to a carry trade ignores much of the story. The US’s capital account leaks on several sides (direct investment, portfolio equity) such that Fed policy may not drive a sustained reversal unless the FOMC proves uncharacteristically aggressive – or disruptive – with its exit strategy. We extend the trough in USD weakness from Q1 2010 to Q2 and move targets to 1.62 on EUR/USD, 82 on USD/JPY, 0.91 on USD/CHF and 1.02 on AUD/USD. GBP/USD will benefit from EUR/USD’s rise (peak at 1.74 in June), but underperform due to EUR/GBP rally to 0.94. These projections are more bearish than the USD lows we published this summer when we expected EUR/USD to peak at 1.50 and USD/JPY to trough at 89, but three issues have arisen since then. The Fed is proving more
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J.P.Morgan’s fair value framework is detailed in A new fair-value model for G-10 currencies, de Kock, September 6, 2008 and updated quarterly in World Financial Markets.
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Global FX Strategy Global FX Strategy 2010 November 24, 2009 John Normand (44-20) 7325-5222 john.normand@jpmorgan.com J.P. Morgan Securities Ltd.

comfortable with a zero rate environment than almost every other G-10 or emerging market central bank but the Bank of England; cash positions (domestic and cross-border) remain too high for the 2010 interest rate environment; and reserve diversification has accelerated to a record pace. Although the structural arguments for a dollar collapse (even crisis) are less credible than the alarmists claim, cyclical dynamics are powerful enough to drive this overshoot of fair value, much like the late 1980s and in 2007/early 2008. Since this move will occur within a low-inflation expansion, implied volatility should range between 10% and 14% (basis J.P.Morgan’s VXY2 for 3-mo implied vol). Spike risk centers on late Q2/early Q3 when the Fed begins implementing policy to reduce extraordinary liquidity, such as altering the FOMC statement or undertaking repo operations, even though rates are on hold until 2011. The Bank of Japan’s experience in 2006 highlights that exits from quantitative easing inject considerable uncertainty, even when rate hikes are small or distant. This volatility environment implies that alpha strategies such as carry will perform worse than in 2009 (predicted returns of 7% in 2010 vs 20% in 2009) but still benefit from the rise in cash rates in the current high-yielders. Forward carry (trading on rate momentum) also should perform worse in 2010(returns of 10%) but still gain. Price momentum will struggle in H2 when the dollar turns again. The 2010 Outlook details these issues in six sections: • global FX outlook outlining the case for a dollar overshoot, five global investment themes and the five most compelling strategic trades; measures of the global FX carry trade based on public and proprietary data; a macro model for implied volatility and projections for 2010 based on growth surprises, central bank surprises and investor leverage. long-term technical outlook for G-10 and emerging markets currencies; research notes on the major currencies and recommended strategic (12-month) trades/hedges; and hedging strategies for three tail risks over the next year–inflation surprise, a US funding crisis and US mid-term elections.

bubble-like, carry trade. This statement is a half-truth. Shorts in low-yield currencies have revived as they always do post-recession, but exposure has climbed to only half its pre- Lehman size when measured across the range of investor-types such as dedicated currency managers, global macro hedge funds, CTAs, Japanese retail and US retail (see Global FX Carry Trade Tracker on pages 12-13).3 Balance of payments data on short-term capital flows (US T-bills, deposits and commercial paper) also suggests that dollar selling this year has been substantial but has not fully unwound crisis-related dollar buying. As markets turned in Q2, the US posted $90bn of net short-term capital outflows, an amount equivalent to a quarter of the $360bn of inflows from January 2008 to March 2009 as the credit crisis
Chart 2: Short-term capital flows: Most USD buying from the credit crisis has not been reversed
Net short-term capital flows (T-bills, CDs and commercial paper) on a quarterly basis and as a four quarter rolling sum
400 300 200 100 0 -100 -200 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: J.P. Morgan, BEA

four quarter rolling sum

quarterly flow 226

-91

Chart 3: Foreign direct investment: Stronger US corporate profits have revived net FDI outflows

• •

S&P500 corporate profits growth year-on-year versus US net FDI flows. FDI shown as four quarter rolling sum. Dotted line shows J.P.Morgan projections based on JPM earnings forecasts and the historical relationship between profits and net FDI. 200 -40%
150 100 50 0 -50 -100 -150 -200 90 93 net FDI flows, $bn, 4 quarter sum, lhs Corporate profits growth, % oya, rhs 96 99 02 05 08 -30% -20% -10% 0% 10% 20% 30% 40%

• • •

The bearish case: it’s more than carry Judging from market patter over the past several months, the dollar’s decline simply reflects a burgeoning, even

Source: J.P. Morgan

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See Introducing J.P.Morgan’s VXYTM & EM-VXYTM, Normand and Sandilya, December 2006.

Several weekly and daily indicators for tracking the carry trade’s size and ownership are detailed in Keeping up with the Watanabes: Who drives the carry trade post-crisis?, Normand, May 15, 2009.

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unfolded (chart 2). This figure controls for the valuation effect on reserve from a weaker dollar.P. even though flows are positive.normand@jpmorgan. USD cheap but cash piles enormous The 2010 outlook is more challenging for two reasons: recovery is mostly discounted. since changes to growth expectations have been positively correlated with stock prices and negatively correlated with the dollar this decade (charts 6 and 7). 1. equities and short-term USD deposits. ECB and Ministry of Finance 3 EUR20bn USD9bn 2 1 0 JPY0. Forecasts for other economies have risen significantly too and now stand at 1. Australia ($20bn) and UK ($10bn) One hopeful spot is net equity inflows. bills and Agencies plus TIC-reported holdings of corporate bonds. 3-month moving average basis Global reserves calculated as sum for 15 emerging markets with reserves greater than $50bn. Australia.4 The difference suggests reserve diversification. per the IMF’s COFER estimates. $bn. Foreign official purchases is sum of weekly Fed custody holdings of Treasuries. In theory a further dollar decline should require another few quarters of upside growth surprises. Sept 18. the pipeline of pending cross-border M&A deals (announced but not completed) now stands at $40bn for the US compared to net inflows for the Euro area ($60bn). Federal Reserve and national central banks Foreign official purchases of US securities Monthly reserve accumulation in EM 5 . Since little has changed since 2001 – except that the US current account deficit has dropped by half – dollar bearish during a recovery was the obvious view (see Postmortem on 2009 forecasts and trade recommendations on page 16). This development is cyclical: US corporates become more acquisitive internationally as profit growth improves. Morgan Securities Ltd. Hence the negative correlation between equity movement and the dollar: the US attracts less global capital than other countries.Morgan. up significantly from the 0. 5% for Emerging Asia and 3.3trn -1 -2 -3 Euro area US Japan Chart 5: Global reserve accumulation vs foreign official purchases of US securities. FX Markets Weekly. If this story sounds familiar.3bn per month). Unlike the drain in equity capital that accompanied much of the 2002-2007 expansion.P. 2010 dilemma: recovery discounted. Net official purchases of US securities run at roughly $50bn per month. Expensive. 4 The greater challenge in 2009 was pegging the timing and strength of the recovery. 2009 John Normand (44-20) 7325-5222 john. but judging from other cash indicators which correlate well with balance of payments data (see chart 8 on page 6). We assume that central banks hold a roughly 25% allocation to euros.4% for Japan. For example net FDI flows. Norway and Switzerland).P. or less dollar-positive than headline figures suggest. are deteriorating again. plus G-10 central banks which intervene (Japan. 2009). US Treasury (TIC). Central banks remain significant buyers of dollars but there is mounting circumstantial evidence that they are hedging their bets.8% over the next four quarters. Chart 4: The US’s net equity flows are weaker than Euro area’s but stronger than Japan Net equity inflows. which is high relative to the US’s trade deficit (roughly $30bn per month) but low compared to the nearly $100bn of forex reserves that emerging market central banks have been accruing monthly since June due to intervention (chart 5). More recent data are unavailable.5% for Latin America.5% expected six months ago. the US is now attracting equity portfolio flows on a net basis. but only a third of the €20bn ($30bn) per month which the Euro area gathers. 150 gap between reserve accumlation and US purchases is near record wide 100 50 0 -50 -100 00 01 02 03 04 05 06 07 08 09 10 Source: J. and this recovery is proving no different from previous ones (chart 3). 3-month moving average 40 30 20 10 0 -10 -20 -30 -40 06 07 08 09 10 Source: J.2% for the Euro area. The average investor expects US growth of 2. Similar capital account strains appeared after the 2001 recession when the dollar was cyclically weak due to low rates and structurally weak due to the current account’s size and its financing mix. it should. Other components of the US capital account are outright negative. Indeed.Morgan. which now runs at a record pace (see Reserve diversification is back.com J. but foreign buying is less dollar-bullish than it appears. which have been negative for most of the past decade. Net purchases are high outright ($9bn per month) and relative to Japan (¥300bn or $3. and the dollar is already slightly cheap. low-yield assets of debtor countries should typically fall in that environment either through carry trades or the hedging of long-term capital inflows.Global FX Strategy Global FX Strategy 2010 November 24. it is unlikely that more than half of 2008’s inflows have been reversed.

US investor repatriation of non-US investments and foreign demand for dollars as flight to liquidity.00 -2% 2 R = 0. 600 500 400 300 200 100 0 -100 -200 01 02 03 04 05 06 07 08 09 10 Source: J. The two cash measures converged during the crisis.36x + 0.01 2 R = 0.6% -0. BEA.0. this asset is not cash.com J.2% 0.normand@jpmorgan. During a recovery.4% -0. Short-term capital inflows should rise if central banks are buying US assets for reserve accumulation.5% on USD trade-weighted monthly change in USD trade-wtd Monthly change in consensus forecasts on US growth vs monthly returns on USD. Note that the figures are not additive. The domestic series represents US household balances in retail money market funds.6% -0. comprising T-bills. Short-term capital inflows totalled $360bn from 2008 Q1 through 2009 Q1 while US household cash holdings rose by roughly $250bn over the same period.8% -0.Morgan Chart 7: …and -2.P.Morgan. Chart 8 plots the two concepts of cash relevant for the dollar – one crossborder and one domestic.P. 5% 4% 3% 2% 1% 0% -1% y = -2.2% -1. The cross-border series tracks US net short-term capital flows from the balance of payments.4% monthly change in consensus US growth forecast Source: J. since Chart 6: Each percentage point increase in the consensus view on US growth generates a 10% move in stocks… Monthly change in consensus forecasts on US growth vs monthly returns on the S&P500.Global FX Strategy Global FX Strategy 2010 November 24. Consensus projections based on monthly Blue Chip survey monthly change in S&P500 y = 11. the only disagreement centres on whether this process is natural and positive.0% -0. if investors buy dollars during a rising rate environment or if investors accumulate dollars during a financial crisis due to short-covering or flight to liquidity. or engineered and sinister. demand deposits or checkable deposits.2% -1.Morgan’s projections are more bullish than the consensus.4% monthly change in consensus US growth forecast Source: J.P. as if the move is inexorable but also irrational. and (2) can benign asset reflation become a destabilising bubble. 6 .2% 0.4% 0. they are more bearish than the historical norm. Many investors characterise the switch more cynically as the wall of money. the bar for dollar depreciation isn’t so high that it requires a growth upgrade. Morgan Securities Ltd.0% -1.5 In practice. while central banks purchased short-term USD assets as part of their intervention policy. cumulative figures since January 1999 (starting point chosen by data availability). Federal Reserve short-term capital flows (US balance of payments) US household cash 5 The first year of recovery brings growth twice the pace of the decline.2% 0. By now the market impact of excess liquidity is well accepted. US money market and demand deposit data from Federal Reserve.P. That move could occur next year because consensus forecasts are still low relative to the growth economies typically achieve in the first year of a recovery. certificates of deposit and commercial paper (same series as chart 2 on page 4). So while J.Morgan Chart 8: Cross-border and domestic cash holdings of dollar still look too high relative to the rate environment USD billion.54 10% 5% 0% -5% -10% -15% -0. 2009 John Normand (44-20) 7325-5222 john.0% 0.P. The flow continues as long as the growth and policy environment are stable.79x . Short-term capital flow data from US balance of payments data. And the move is rational because investors tend to seek assets offering the highest risk-adjusted return. but not if they worsen.26 -3% -4% -1.8% -0. reflecting the domestic switch from stocks and credit into US cash. The reason is evidence of a still-sizable cash overweight. Central bankers call the move from cash to financial assets a “transmission mechanism” or “asset reflation” that stimulates growth through lower borrowing costs and positive wealth effects. The two series ran counter to one another after the 2001 recession because recovery pushed funds from money markets into stocks (particularly international ones) and credit. The critical issues for 2010 are (1) what is the appropriate cash allocation. It is neither.0% -0. nor a low-yield currency of a debtor country.2% 0. implying that the US should be expanding by at least 6% in 2010.

normand@jpmorgan. lhs 1900 6% Fed funds rate lagged 1yr. (US retail has purchased $160bn of bonds. debt-toGDP levels and inflation – suggests that the dollar is only 3% cheap in trade-weighted terms (chart 11). cash balances should fall well below pre-Lehman levels. This is the fastest pace of cash liquidations post-recession in the past forty years (chart 9). Their duration is quite December 2008 but is still cheap since current spreads (750bp) overcompensate for the 4% default rate like this year. US household cash has fallen by $250bn this year. high-yield credit has rallied 1100bp from its wides in .6. But Lehman is the wrong anchor. and since the funds rate is 200bp lower than it was in September 2008. with zero marking the last month of NBER-dated recessions.P. 7 The same argument applies to credit and equities: markets are not expensive because they have experienced an unprecedented rally from their lows. Short-term cyclicals drive this move. Only $90 was liquidated in Q2. Deviations around fair value occur in every asset market. but official investors recycle some of these flows into US T-bills and deposits as part of their intervention practices. other checking accounts and money market funds indexed to 100 at t=0 (end of recession).P.Morgan Chart 10: US household cash tracks Fed funds with a lag US household cash calculated as sum of retail money market funds. Valuation must be judged relative to a market’s long-term drivers. In FX they resurface each decade. The path of cross-border short-term capital flows is harder to predict because they do not track the funds rate nor US vs rest-of-the-world spreads tightly. the real exchange rate will trend rather than mean-revert.Morgan aggregate valuation reflects offsets from an expensive euro (+6%) and yen (+10%) versus cheap sterling (-14%) and fairly-valued commodity currencies. If the historical beta between cash balances and money market rates holds. quarterly variables – current account. and more than reverses the cash hoarding which Lehman’s bankruptcy inspired.com J. since the dollar’s long-term drivers have not worsened materially. $bn. mostly to fund bond purchases. As a baseline we assume that the full amount which entered post-Lehman ($360bn) will be unwound. higher-yielding government bond markets (particularly emerging markets) or pure currency allocations (ETFs) obviously would be USD negative. 2009 John Normand (44-20) 7325-5222 john. another $300bn could flow into asset markets over the next year (chart 10).P. Q3 data are not yet available but the correlation between US household cash and balance of payments flows (chart 8) suggests that the process has another two quarters and tens of billions left to run. 110 average of 1980-2001 recessions 105 current 100 95 90 85 -12 -9 -6 -3 0 3 6 9 12 Source: J. Equities are fairly valued despite a 65% rally from their March lows. since 2009 delivered earnings of $62 on an end-recession P/E of 16. some of the household cash increase probably reflected repatriation of foreign equity investments. rhs 1800 5% 1700 4% 1600 3% 1500 2% 1400 1300 1200 00 01 02 03 04 05 06 07 08 09 10 1% 0% Source: J. Our long-term fair value model based on some of the standard. Y-axis shows US retail holdings of demand deposits. This 6 Chart 9: US retail cash positions have dropped this year more rapidly than after any recession of the past three decades x-axis shows number of months before and after the recession ends. Calibrating an undershoot Projecting how far the dollar could fall in this environment requires calibrating an undershoot. net investment income.Global FX Strategy Global FX Strategy 2010 November 24.5 implies an S&P target of 1010. Flows into US stocks would be dollar-neutral. For example. but those into international equities. but balances are still too high for a zero-rate environment. even though it has fallen 15 % trade weighted since March. Purchasing power parity approaches suggest that the dollar is much cheaper (7% below its long-term average) but pure price-based approaches to valuing currencies are flawed for reasons which are well-known: if an economy’s structure evolves over time. $65bn of credit but sold $21bn of equities year-to-date). Nine months into the dollar’s decline. Current series assume the 2008-09 recession ended Jun 2009. cash liquidations are very advanced relative to their pre-Lehman levels. This disconnect reflects the offsetting sources of dollar demand in a low-rate environment: private investors sell USD to fund non-US investments. Because household cash balances track money market rates with a lag. Morgan Securities Ltd. demand deposits and other checkable deposits (USD bn) plotted against Fed funds rate lagged one year. 7% 2000 US household cash.

Norges Bank). Rate hikes should wait in 2010. Indeed. QE exit. But with two central banks having tightened in 2009 (RBA.P. In the mid-1980s the dollar’s overvaluation reached 20% due to record interest rates under Volcker and record fiscal deficits under Reagan. the dollar’s current yield deficit versus the rest of the world (1% as a weighted average) has closed from the -3% extreme of late 2008. The extension of that move to 12% cheapness in 2008 occurred alongside unilateral Fed easing. In 2004 the dollar undershot fair value by some 5% as the funds rate hit 1%. 1. True. Ahead of its first interest rate hike in mid-2006. but emerging market intervention and subsequent reserve diversification shifts more of the adjustment to G-10 currencies. the dollar’s undervaluation reached 7% following the three–year easing cycle which accompanied Plaza Accord intervention. Although the BoJ had been explicit in stating that QE would 8 end when Japan emerged from deflation – a notable contrast to the Fed and Bank of England’s vagueness – the liquidity withdrawal nonetheless sparked a 9% drop in USD/JPY and a 2 point rise in implied volatility in 2006 Q2 as short yen positions were covered (chart 13 and 14). This environment could produce an overshoot as large as the typical ones. then normalisation should drive a reversal. the rate deficit will widen over the next year. 2010 looks like a year of unfinished business as the dollar contends with the lagged effects of an extreme rate environment. By the usual cover story test – a trend reverses once it becomes a cover . variable and they sometime bear no link the US business cycle.Global FX Strategy Global FX Strategy 2010 November 24. That normalisation could come in late Q2/early Q3 as the Fed begins to exit from exceptionally low levels of policy through some combination of FOMC statement changes and repo operations to reduce excess reserves.99 on USD/CAD (see full forecast profile on page 71).Morgan actual fair value Chart 12: USD deviations from fair value have corresponded to policy extremes of very tight or very loose Fed policy vs the rest of the world USD deviations from fair value (positive indicates overvaluation) versus spread between Fed funds rate and policy rates in the rest of the G-10 (weighted average). but that patience does not guarantee tranquil markets or a trend dollar decline through end-2010.62 on EUR/USD. Chart 11: USD real effective exchange rate: Actual vs predicted Predicted value based on J. and therefore short. others to follow in 2010 (most emerging markets) and some to simply turn more hawkish (ECB). albeit brief. and new lows on the dollar will motivate G-3 intervention. For simplicity we assume G-10 currencies will appreciate roughly 8% by Q2 to 1. some 7% weaker than current levels. the Fed’s exit is unlikely to be entirely graceful.P. The resulting rise in volatility against a backdrop of much larger dollar shorts could easily drive the dollar some 5-10% higher in Q3 and Q4. Each is a misconception. which delivered a dollar 10% cheap to fair value in trade-weighted terms. 1.74 on GBP/USD. Morgan Securities Ltd.normand@jpmorgan.com J. 82 for USD/JPY. USD reversal in Q3: The Fed’s graceless exit from QE may mirror the Bank of Japan’s in 2006 If extreme rate environments drive overshoots around fair value. 25% 8% USD deviation from fair value model 15% 5% -5% -15% -25% 80 84 88 92 96 00 04 08 Source: J. 160 150 140 130 120 110 100 90 80 84 88 92 96 00 04 08 Source: J. Given the historical experience.P. In 2001 the dollar’s overvaluation reached 10% as a lagged response to the US rate advantage that persisted until that year. We address each in turn.Morgan estimates as outlined in A new fair-value model for G-10 currencies. 2008. 2009 John Normand (44-20) 7325-5222 john. But they do share one commonality: overshoots tend to occur as a lagged response to an extreme policy environment (chart 12).Morgan 6% Fed funds spread to G-10 cash rates. 1. but the analogy to dollarfunded carry by the time the Fed begins to withdraw liquidity next year should be obvious.02 on AUD/USD and 0. the experience of Japan set the precedent for a messy. the Bank of Japan began reducing commercial banks’ target for current account balances (excess reserves) from a record ¥35trillion. lagged 1 year 4% 2% 0% -2% -4% -6% -8% Three misconceptions about the dollar Dollar bulls will counter that an undershoot is unlikely due to three constraints: most investors are extremely bearish. Those moves reversed within three months. currency markets are experiencing an unsustainable bubble which will soon be punctured. In the late 1980s. de Kock. September 6.P. Despite the best efforts at transparency and signaling. Everyone is bearish and therefore short. Normally such a move should be spread equally across the US’s major trading partners.

the only consensus bearish USD call comes against Emerging Asia (chart 15). in fact. 0. . there is little evidence that views are so extreme or positions so short that they should impede the current bear trend. Loeys. Our view on 7 Chart 13: The end of Japanese QE in Q1 2006 prompted a spike in USD/JPY volatility… Commercial banks current account balances with Bank of Japan versus USD/JPY 3-mo implied vol 13% 35 BoJ reduces reserve balance 12% targets 30 25 20 15 10 5 0 01 02 03 04 05 06 07 bank reserves. story in the popular press – the dollar’s decline should have ended this fall. The label has been applied to almost every asset market this year except housing. Bloomberg See Are alternatives the next bubble?.15% undervaluation (charts 11 and 12). G-3 central banks would intervene at new lows for the dollar. since equities. rhs Jun-05 Nov-05 Apr-06 Sep-06 104 100 Chart 15: Consensus expectations for currency movements versus USD over the next 12 months %. Morgan Chart 14: …and a liquidation of yen-funded carry IMM net speculative positions in JPY vs USD/JPY spot 50 BoJ reduces reserve balance targets 0 -50 -100 -150 -200 Jan-05 Source: J. impossible. 3. Even amongst the emerging market currencies.88 on AUD/USD and 1. requires the Treasury. internet stocks in the late 1990s. lhs USD/JPY spot. the currencies look like most other asset markets – heady but hardly bubble-like. housing in the 2000s). the dollar flunks all sections. Morgan. But despite the bearish dollar patter.normand@jpmorgan.com J. Many marketsexhibit tremendous price rises. Being non-consensus in this instance is no great shame. credit. By Q2 2009 this scratch test could yield a different judgment. This conservatism usually corresponds to positions. 12% 9% 6% 3% 0% -3% -6% -9% JPY KRW CHF CNY BRL SEK NOK GBP CAD EUR AUD NZD TWD MXN TRY IDR INR ZAR 9 Source: J. 7 Applying this scratch test to currencies. thou contract. Bank of Japan and ECB. As noted earlier. rhs 11% 10% 9% 8% 7% 6% 5% Source: J. September 2006. Thus we can only distinguish bubbles from more ordinary bull markets ex post. but far from the extremes of 10% . RBA). of course. extraordinary momentum and high leverage. however. Consensus expectations are. Identifying asset bubbles ex ante is. the dollar is cheap. which is why many of the indicators tracked on pages 13-14 (Global FX Carry Trade Monitor) continue to evidence modest carry – and by extension short USD – exposure. 98 on USD/JPY. lhs USD/JPY 3-mo implied vol. some commodities and most high-yield currencies have posted unprecedented gains since March. 1. 2.06 on USD/CAD. Currencies are in bubble trouble. however: extreme valuation. positive (negative) indicates that the consensus expects foreign currency to appreciate (depreciate) versus the dollar by end-2010.64 on GBP/USD. JPY trillion. Morgan Securities Ltd. Short dollar/long carry positions have risen quickly but only to about half their preLehman levels (see Global FX Carry Trade Monitor on page 14). are far from the -10%to -15% annual moves which have marked turning points in the past (chart 17). with end-2010 forecasts of 1. but for now. Morgan 124 120 116 112 108 IMM positions in JPY.Global FX Strategy Global FX Strategy 2010 November 24. dollar-bullish.P.P. Related to the fear of excessive USD bearishness and USD shorts is the characterisation that currency markets are experiencing a speculative bubble.P. Intervention is standard practice for many emerging markets central banks and some G-10 banks (SNB.45 on EUR/USD.P. The intervention which drives the USD trend. since the average forecaster has been too conservative in anticipating USD weakness. even when they correctly predicted the dollar decline (chart 16). Markets that crashed shared three characteristics. measured as rolling 12month returns. And price momentum. but the only ones which earn the label of a bubble are those which crashed (Japanese real estate in the last 1980s. 2009 John Normand (44-20) 7325-5222 john.

The dollar’s decline becomes volatile. A significant upturn in inflation.P. See Risk scenarios on page 70 for the most efficient hedging strategy. Morgan G-10 FX EM FX 1 qtr ahead 2 qtrs ahead 1 yr ahead 2 yrs ahead Chart 17: Bubble test for excess momentum: USD’s move this year has not been excessive by historical measure Annual returns on trade-weighted dollar and 2-sigma bands 30% 20% 10% 0% -10% average plus 2 sigmas average minus 2 sigmas -20% 70 75 80 85 90 95 00 05 Source: J. 3. 2009 John Normand (44-20) 7325-5222 john. Corporates fail to spend bumper profits.com J. since a stronger yuan would reduce China’s buying of nonUSD assets as part of its reserve diversification. but not before the dollar posts a sizable H1 fall. 12% 10% 8% 6% 4% 2% 0% Current qtr Source: J.58 by December 2010). will avoid setting policy next year with asset prices in mind because few markets exhibit extreme overvaluation. See EUR: Few obstacles to new highs on page 38. Politics is rarely a consistent G-10 FX influence. China surprises with a +10% one-off revaluation of the yuan. Morgan importance. Coming at a time when expectations of Fed tightening are building. We suspect that such a policy move would be a low-probability event given China’s skepticism about the global recovery and its lack of meaningful inflation. Even the most hawkish central banks. A divided USD government after mid-term elections.9% in the US and 1% in Europe.Global FX Strategy Global FX Strategy 2010 November 24.normand@jpmorgan. while the long-standing anxieties around fiscal policy and exit strategies raise questions about how much inflation expectations can or should decline. Whether inflation rises gradually (a low-volatility event) or abruptly (a high-volatility event) drives the feedback to currencies as the CPI trend evolves. Only a significant. The dollar would appreciate as carry/cyclical trades are unwound. such as Fed hikes. 5. See Risk scenarios for the most efficient hedging strategy. Japan also faces considerable domestic opposition to further USD accumulation. intervention during this dollar decline is the same as our view during the dollar’s 2008 rise: G-3 central banks will not intervene in currency markets unless FX moves raise volatility and drive other asset markets lower.P. where error is calculated as difference between actual rate and forecast r ate over horizons of one quarter to two years.step-wise appreciation (10% or more) would impact EUR/USD. or a more meaningful shift to asset price targeting in the G-3 central banks that control global liquidity. leading to a growth slowdown in early 2010. however. however. but to only 1. We continue to expect the yuan to appreciate next year (forecast: USD/CNY at 6. The dollar would rise versus the high-yield currencies and commodity currencies given the increase in volatility. The consensus expect global inflation to turn higher in 2010. Eventually such a move could prompt G-3 intervention. but when fiscal policy is a central issue. this electoral outcome could aid the dollar’s rebound late in the year. 2. Many smaller central banks already have cited asset price inflation as motivations for recent tightening. We are not worried about premature tightening. See Risk scenario 3 . The immediate reaction would be a lower euro. . and the ECB has always expressed more concern about excess liquidity than the Fed. Where are we wrong? The most significant risks to the bearish view are the following: 1. Dollar weakness and resulting commodity price strength render that projection a moving target. The dollar would probably fall versus the euro and Swiss franc since the underlying cause of the move is a US sovereign risk issue.P. US mid-term elections in November could result in a divided Congress. but that baseline move is too modest and gradual to impact the euro. possibly due to a US financing issue next year. which may then result in more conservative fiscal policy in 2011. as discussed in JPY: Can it reach new all-time lows? on page 34. 4. Morgan Securities Ltd. The rationale is simple: G-3 policymakers know that intervention’s impact is fleeting without a sea change in monetary policy. Their comfort level may change in 2011 if price trends continue at the 2009 pace. A positive (negative) value indicates that the consensus underestimated (overestimated) foreign currency strength vs USD. elections assume greater 10 Chart 16: Forecast errors: the consensus has been too conservative in forecasting USD weakness this decade Consensus error on G-10 and emerging market FX forecasts vs USD.

 Buy 6-mo 0. RKO 1. 140bp by the RBA. Five global macro themes and top trades Our short-term trade recommendations are outlined and marked to market each Friday in FX Markets Weekly. Global recovery is discounted but country exit strategies are mispriced.30 AUD call/NZD put. this trade is premature. 1.5 notional. We focus fresh USD shorts in one of the few currencies to be undervalued vs.  Buy a 6-mo USD put/worst-of basket call where the basket comprises CHF. On average we have held cash trades for three weeks and option trades for two months (see Table 1 in Postmortem: 2009 forecasts and trade recommendations on page 16).9762. weak long-term capital flows. AUD and JPY. It seems unlikely that the RBNZ would tighten more than the RBA given Bollard’s commitment to keeping rates on hold through mid-year. Morgan Securities Ltd. Valuation gaps will close in the next year Several currencies are misaligned on our fair value model. A CNY reval’s impact on G-10 FX is overstated As discussed in the euro section (page 40).7%. The consensus has marked up its growth forecasts considerably over the past six months (page 7) and we have little quibble with current estimates. Low rates.21 (35 delta). 2.50%. OIS curves imply almost 175bp of tightening by the RBNZ over the next year. The more significant mispricing.Global FX Strategy Global FX Strategy 2010 November 24. consistent with the view that SEK’s undervaluation is smaller than presumed but still worth capturing (see SEK: The myth of krona undervaluation on page 57). Cost 0.  Buy a 12-month EUR put/SEK ratio call spread in 1x1.  Buy a 6-mo 1. We therefore sell EUR/SEK through a ratio put spread. so accordingly the tenor is longer (6-12months) than the types of trades we typically recommend in FX Markets Weekly. 2009 Paul Meggyesi (44-20) 7859-6714 John Normand (44-20) 7325-5222 J. 11 . The broad USD trend will dominate currency-specific factors. concerns exit strategies.60-1. whilst the NZ Treasury is cognisant of the dangers of continued over-reliance on anti-cyclical monetary policy. NOK (-9%) and SEK (-5%).90/3.9426 and 85. We expect EUR/JPY to remain rangebound as a result. the dollar is headed for another undershoot of fair value. 0. Norway by contrast is the only major country where unemployment is below its long-term average. but since valuation gaps rarely close without a cyclical or policy trigger. The end of inflation targeting? Although central bank mandates are not officially under review. but we hold these elsewhere.  Buy a 6-mo 1. leaving the Norges Bank relatively free to normalise policy in pursuit of medium-term price stability. The obvious mean reversion trade would be to purchase GBP/JPY.45 RKI on the lower strike. And the lack of term premium in the Swiss curve is unusual for a country which suffered relatively little damage from the Great Recession. we believe that the impact of CNY revaluation expectations on EUR and JPY is overstated and that the broad dollar trend will dominate these and other idiosyncratic factors. 60bp by the BoE and 25bp from the SNB. even if it is already slightly cheap.) Selling USD/NOK or EUR/NOK are candidates. 4. Strikes are 0.83% vs.35%.5 notional. 5.3%. BoE tightening in the next year is at odds with a central bank still concerned enough about the recovery to leave open the possibility of further QE asset purchases.  Buy a 6-mo 123-142 EUR/JPY range binary for 23. especially amongst the group of former funding currencies (CHF and JPY) whose inverse correlation to risk markets has/will break down. New Zealand’s Labour Party has already withdrawn its support for inflation targeting.41. (Sterling’s re-rating requires Bank of England tightening.68%. As detailed in the Outlook (pages 3-10). Cost 1. The dollar will undershoot. 3. Cost 0.8900 USD/CHF one-touch for 16.36% for the cheapest vanilla.88%. Cost 0. in our view. USD (CHF) and in a worst-of basket to benefit from de-correlation savings.60 NZD put/NOK ratio call spread in 1x1.50 GBP put/CHF call spread with a 1. high cash levels and EM intervention policy will drive this move in Q1/Q2. Cost 1. with the most overvalued being JPY (+12%). 2. AUD (+6%) and EUR (+5%). leaving USD as the pre-eminent funding currency. and the most undervalued being GBP (-15%).P. This section focuses instead on five global macro issues which we expect to define 2010. with decent odds of a sharp reversal only later in the year.  Buy a 6-mo 3. they are certainly under legislators’ microscope.

Japanese margin traders have been building JPY shorts since August. 12 . This year’s peak is 80% of the pre-Lehman high of ¥24. ranked in the order of total asset as of Nov 17th 09 25 70 80 20 90 100 110 120 10 Chart 2: Japanese retail — aggregate retail margin shorts in JPY ¥trn. Issuance in Latin America doubled from last year. which is roughly 80% of the record 2008 issuance of $27bn.P.1trn) marked in September is roughly 57% of the pre-Lehman peak of ¥7.1trn reached in Aug 2007. Bloomberg Source: J. JPY trn 15 Market cap of top 100 ITs.8trn is slightly less than the year-to-date high of ¥19. Morgan. As of November 19. GBP. NZD. Morgan • Japanese retail margin shorts in JPY against USD. Current JPY shorts at ¥3.3bn in Oct and £8. AUD bn local currency. and AUD recorded new historical peak in the later half of 2009. market capitalization of 100 largest investment trusts excluding funds investing in equities. GBP. Morgan. USD/JPY longs and GBP/JPY longs each reached a historical peak at $27.P. • Total issuance in FX structured notes globally reached $21bn in 2009. positive indicates long in local currency/short in JPY 30 25 20 15 10 5 0 -5 -10 -15 08 08 08 09 09 09 USD GBP AUD • Despite fluctuations between long and short positions this year.19 at A$16. The current level of ¥18.Global FX Strategy Global FX Strategy 2010 November 24.2trn reached in August 2008. Morgan. JPY trn. TFE • Japanese retail exposure to foreign currencies via investment trusts has been rising since January at a moderate but consistent pace.P. region is where the note was issued Asia ex Japan 25 20 15 10 5 0 Latin America North America Europe 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: J. GBP and AUD on Tokyo Financial Exchange. Chart 3: Japanese retail — margin shorts in JPY vs USD. North America and Asia ex Japan this year stands at 36%.4trn reached in late October.3bn.6bn whilst issuance elsewhere declined sharply. reaching a record high at $7. eclipsing the previous record in July.P.kim@jpmorgan. lhs JPY trade-w td index . EUR.0trn (Nov 19) is 74% of the year-to-date peak.x.5bn in September.8bn and £3. Chart 4: Global retail — issuance of FX-linked structured notes $bn. TFE Source: J. positive indicates shorts in JPY ¥8 ¥6 ¥4 ¥2 ¥0 -¥2 06 06 07 08 08 09 Aggregate JPY shorts in Japanese margin accounts. equivalent to 18% and 38% of their historical highs. longs in USD and GBP stands at $4. 2009 Yoonyi Kim (81-3) 6736-7729 yoonyi. Japanese retail measured by positions in USD. 76% and 69% of their respective peaks reached in 2008 for Europe and Asia exJapan and in 2007 for North America. Issuance in Europe. The year to date peak in JPY shorts (¥4. while AUD/JPY longs marked a new record peak most recently on Nov.com JPMorgan Chase Bank NA Global FX Carry Trade Monitor Chart 1: Japanese retail — market capitalisation of 100 largest FXdenominated Its ¥trn.7bn. inv erted rhs 06 07 08 09 10 Source: J.

CAD.kim@jpmorgan.5 -1. Currency managers and global macro hedge funds — Beta with emerging markets carry strategies Source: J. GBP. USD short positions reached a year to date peak at $3.0 1. CME Source: J. Barclay BTOP Index and Parker Blacktree Index used for currency managers.5 1.7bn in October. • US retail exposure to foreign currencies via ETFs enjoyed a moderate but consistent up-trend since the equity market rally in March. NZD. Barclay BTOP Index and Parker Blacktree Index used for currency managers.3. $ bn. Prior to the Lehman shock.5 2. Positive value indicates longs in foreign currency.P.5 -2.0 -1.2 to 0.0 0.5 0. which is 70% of the pre-Lehman peak in August 08 at $5.5. shorts in USD 5 4 3 2 Chart 6: US retail — market capitalization of US-listed FX ETFs 75 80 85 90 95 100 10 -$20 -$30 -$40 00 02 04 06 08 10 1 0 06 07 Market cap of US-listed FX ETFs.5 while those of currency managers peaked at 1.5 1. 13 .P.0 -0.0 -0.1bn.com JPMorgan Chase Bank NA Chart 5: CTAs — aggregate IMM shorts in USD $ bn as the sum of net speculative positions on the IMM in AUD.0bn. 2. JPY.0 0. CTAs continue to hold a large stake in USD carry trade.1 for currency managers. While the current level of USD shorts has fallen to $18bn or 15% off from the recent peak. $bn.Global FX Strategy Global FX Strategy 2010 November 24.3 to 0. rhs 08 09 Source: J. hedge funds betas peaked at 2. a short in dollars HFR used for global macro hedge funds. Morgan • Currency manager and macro hedge fund exposure to G-10 carry. which is equivalent to 60% of the preLehman peak at $36bn in Nov 07.0 05 06 07 08 09 Currency managers Global macro hedge funds Chart 8. • Betas for currency managers and macro funds with respect to emerging markets carry baskets has alone been rising steadily but is well off the 2007-2008 peaks. has trended higher throughout the year. But with betas of 0.5 0.5 -1. lhs $bn. $20 $10 $0 -$10 Aggregate USD shorts on IMM. EUR.P. a short in dollars HFR used for global macro hedge funds. Morgan. Morgan. lhs USD trade-w td index . as proxied by their return beta with a carry basket.4 are well below the pre-Lehman peaks of 1. roughly 15% down from the recent peak. exposure appears to be a fraction of the highs reached in 2007-2008.0 05 06 07 08 09 Currency managers Global macro hedge funds Positive beta implies a long in carry. Chart 7: Currency managers and global macro hedge funds — beta with G-10 carry strategies Positive beta implies a long in carry.8 for global macro funds and 1.0 1. 2009 Yoonyi Kim (81-3) 6736-7729 yoonyi. 2.P.x. Bloomberg • Since turning flat in May. inv erted. CTAs have been rebuilding USD shorts with aggregate IMM position rising to year to date peak at $22bn in October. CHF and MXN. Morgan Source: J. Current betas of 0. Most recent data shows the current position at $3.

then carry returns could reach 8%. The strategy would only deliver above-average returns if central banks surprise meaningfully next year.4% because rate signals often contradicted medium-term price momentum.5% on emerging markets (table 1). We assume that implied volatility will range between 10% and 14% in 2010 (see FX Derivatives section on page 19). Normand. thus causing rate spreads to trend for several months. JPMorgan Chase Bank NA FX alpha strategies in 2010 After the carry trade’s appalling performance in 2008. Any move in rate spreads in the dollar’s favour around mid-year would neutralise bearish dollar signals from medium-term price momentum and thus induce the model to take profits on dollar shorts. which is higher than average but lower than this year’s returns. is preferred in such an environment. we suspect returns to both strategies will be average in 2010. interest rate markets will deliver less powerful signals in 2010 since a major repricing has already occurred – this year’s shift in frontend rates to imply more aggressive tightening in most countries relative to the US. returned 10%. (See next page for descriptions of J. Forward carry. Carry performs best when volatility is declining but policy rates increasing. Econometric models for predicting the returns to forward carry and price momentum are less robust. The performance and signals from each models are reported weekly in the FX Alpha Strategies section of FX Markets Weekly. But these models are vulnerable in the second half of the year because price signals alone will not warn of an impending dollar turn in H2 as the Fed begins withdrawing excess liquidity and volatility rises. It lost only 0. 14 . Price momentum tends to perform best in periods of declining interest rates. January 2009). thus raising the running yield. 2009 John Normand (44-20) 7325-5222 Matthew Franklin-Lyons (1-212) 834-4565 J. The Forward Momentum Overlay model. Normand and Sandilya. which until mid-year was still recommending to buy dollars because of the currencies strong performance in late 2008. delivering higher absolute and risk-adjusted performance than many industry composites (table 1).P. which uses short-term interest rate expectations to confirm price signals. performed relatively better.Morgan research has explored the issue of forecasting returns from various alpha strategies. which trades currencies based on momentum in interest rate spreads. thereby boosting the rate advantage of highyielders. which we call Forward Momentum Overlay because it uses the shortterm rate signal from Forward Carry to confirm price momentum. The average carry on G-10 and emerging markets baskets will rise by about 150bp due to monetary tightening.P. An alternative to simple price momentum. losing 10% year-to-date.Global FX Strategy Global FX Strategy 2010 November 24. since excess returns tend be regime-dependent (see Currency manager returns. Forward Carry tends to perform best when central bank cycles are unsynchronised. roughly equivalent to last year’s performance of 12%. If historical betas hold. More qualitatively. August 2006 and FX in a world with less leverage and more regulation. most model-driven strategies staged a comeback in 2009. For forward carry.P. We expected as much: mediumterm price momentum models almost always underperform at turning points because the lookback period used to generate signals places too much weight on a mature trend. which limits the upside on carry relative to 2009’s unprecedented decline in volatility. which is unlikely in the current inflation environment. trading styles and Fed cycles. Simple price momentum should perform better in early 2010 than in 2009 since lookback periods now incorporate a bearish dollar trend. Standard carry strategies delivered returns of 20% on a G-10 basket and 9. Morgan Securities Ltd. probably because such an environment drives long-term bear markets for the dollar..) Simple price momentum performed the worst this year. Previous J.Morgan’s rule-based strategies.

03 -0.8% 1.22 -0.62 -3.86 0.00 0.07 0. Forward Carry buys the currency in whose favor rate expectations have moved over the past month.38 -0.5% 5.08 4.6 0.2% 12.14 1. Expectations are based on 1mo rates 3mos forward.8% 0.0 0.0% 7.01 0.02 0.7% 1.3 0.07 -0.0 -0.01 0. 15 .6% 0. so combines standard carry and Forward Carry concepts.0 -0.20 -0.5% 0.09 -0.3% 4.04 -0.6% 2.00 -0. Alpha strategies Manager performance Forward Carry (rate G-10 carry EM carry spread momentum) 2009 YTD Avg annual return Std dev IR Beta with respect to Equity vol (VIX) Rate vol (MOVE) FX vol (VXY) UST 2-yr 2004 .4% 3.05 0.00 -3.08 -0. currency managers and global macro hedge funds.00 -0.04 -0.3 10.7 9.4% 1.44 0.01 0.05 0.00 -0.03 4.2009 Betas are calculated between monthly returns on strategies/manager composites and the level of volatility/interest rates.37 -2. Thus it combines the standard price momentum framework with Forward Carry.9% 1.3% 1.7% 2.06 Strategy descriptions G-10 and Emerging Markets Carry strategies select four currencies with highest ratio of carry (1 mo rate differential) to volatility (annualized spot vol over past 30 days).7% 0.00 0.00 -0.9 0.4% 7.6% 0.02 0.5 -0.05 0.4% 2.0% 4.0 Price momentum Forward Momentum Overlay (price momentum plus Forward Carry) HFR global Barclay Currency Barclay Group Parker macro hedge Traders Index BTOP FX Blacktree CMI funds -10.01 -0.2% -0.01 -0.1% 1.4% 16.15 -0.5 -0.00 3.09 0.02 -0.01 0.5% 7.00 0.35 2.0% -0.08 -1.01 0.0% 7.26 4.11 -0.4 -0.3 9.02 -0.04 0.8% 0.01 -0.41 0.18 -0.7 0.03 -0.09 0. 1999 .11 0.34 -0.0% 0.13 -0.6 0.9 0. Forward Momentum Overlay only buys currencies which have appreciated in spot terms and are experiencing rising rate expectations relative to another currency. All strategies are described in Alternatives to Standard Carry and Momentum in FX (Normand and Ghia.14 2.42 -0.8% 1.4% 5.4% 10.01 0.8% 0.07 2.7 -0. August 8.03 -0.5% 15.00 -0.00 0.1 0.02 -0.9% 6.01 0.1% 2.P..09 NA NA NA NA NA NA NA NA NA NA NA NA NA NA 8.4% 4.1 -0.2008 (10 years) Avg annual return Std dev IR Beta with respect to Equity vol (VIX) Rate vol (MOVE) FX vol (VXY) UST 2-yr -0.00 0.01 0.06 3.7 -0.01 -0.6 10.6 7. Morgan Securities Ltd.8% 1.00 0.51 0.4% 11.0% 1.7% 1.1% 1.01 0.72 20. Forward Carry Overlay only buys high yield currencies if rate expectations are also moving in that currency’s favor.2% 0.00 0.7% 1.Global FX Strategy Global FX Strategy 2010 November 24.01 0.21 0.00 -0.06 -0.09 -0.61 -0. JPMorgan Chase Bank NA Table 1: Performance of rule-based FX alpha strategies.04 -0.0 0.2% 0.5% -0.02 0.6 5.0% 11.02 0.2008 (5 years) Avg annual return Std dev IR Beta with respect to Equity vol (VIX) Rate vol (MOVE) FX vol (VXY) UST 2-yr 1999 .01 0.01 0.03 -0.0% 0.42 0.00 -0.04 5. 2008).4% 1.01 -0.42 -0.9% 10.17 0.15 2.7% 0.00 -0.05 0.9 -0. 2009 John Normand (44-20) 7325-5222 Matthew Franklin-Lyons (1-212) 834-4565 J.02 7.01 0.00 0.05 0.

our projections trailed actual AUD/USD moves by an average of 22%. As with our forecasts for EUR/USD. Our forecast profile for USD/JPY assumed that the dollar would weaken in the first half of the year before recovering modestly towards the end of 2009.71 0.33 1.30 1. our forecast was much closer to the mark than the consensus (JPM 90.P. our forecasts had looked for a 27% appreciation in AUD/USD which compares favorably to the 31% actual appreciation.65 0. Post-mortem: 2009 forecasts and trade recommendations This time last year we expected deleveraging to push the dollar higher versus all currencies but the yen in Q1 2009.60 0. rallying over 12% from Q2 to Q4 (chart 1).Morgan and consensus forecasts in January 2009 Spot on Jan 1. From Q2 onwards.30 1.35 1. 2009 John Normand (44-20) 7325-5222 Kamal Sharma (44-20) 7777-1729 J.35 at the start of the year.35 90 90 90 88 92 99 85 94 96 85 96 90 90 97 89 0.35 1.91 Chart 1: JP Morgan forecasts for EUR/USD versus consensus 1.69 0. equivalent to the consensus forecast. In the event.40 Q3 09 1. Table 1: J. Morgan Securities Ltd.88 0.Morgan forecast for dollar weakness was broader and more aggressive than the average forecast. forecasting only a 4% appreciation over the same period. The consensus forecast was flat around 1. EUR/USD ended Q1 at 1. This view was shared partially by the consensus.81 0.71 0. from Q1 to Q4 we had correctly forecasted the degree of the AUD/USD recovery.28 by end Q1 from 1.25 01 Jan 09 Source: JP Morgan JPM Consensus Actual Q1 09 Q2 09 Q3 09 Q4 09 Chart 2: JP Morgan forecasts for USD/JPY versus consensus 100 98 96 94 92 90 88 86 84 82 01 Jan 09 Source: JP Morgan JPM Consensus Actual Q1 09 Q2 09 Q3 09 Q4 09 16 .P. By year-end.64 0.70 0.37 1. 2009 EUR/USD JPM Consensus Actual USD/JPY JPM Consensus Actual AUD/USD JPM Consensus Actual Source: JP Morgan Forecasts for Q1 09 1. We were wrong in Q1 as USD/JPY rallied following a collapse in Japanese growth and the country’s trade surplus.66 0.46 Q4 09 1. From end Q1 to Q4 2009.33 1.33 1.33 Q2 09 1. we projected a much stronger recovery – and therefore dollar sell-off – than the consensus.28 1.35 1.33.40 1. This compares to an average miss of 24% by the consensus. expecting continuous USD/JPY appreciation through Q4.32 1. following by dollar weakness as the recovery unfolded.33. The consensus was much more bullish. We expected EUR/USD to fall to 1. Given the lower starting point of our forecast by end Q1. The euro well exceeded both. however.48 1.71 0. however. even though we pegged the turning point correctly. The consensus lagged well behind. so forecast 7% EUR/USD appreciation through year-end.P.68 0.45 1.Global FX Strategy Global FX Strategy 2010 November 24. we overestimated the Q1 decline and the Q2 recovery in commodity currencies. although J. consensus 97).35 1.65 0.50 1. we expected 7% appreciation in Q2 but AUD/ USD rallied by over 16%. However. For example with AUD/USD.76 0.

1% 75 13 77% 0. 2009 John Normand (44-20) 7325-5222 Kamal Sharma (44-20) 7777-1729 J. Success rates were high (63%) and average returns per trade decent (0. Chart 1: 2008-2009 performance summary: Average returns per trade Cash Non-digital Digital RV (non-digital) Technical -5% Source: J. Relative value derivatives recommendations In 2009.6% 0. The average return was 0.6%) for non-digitals.1% 0. our trades have delivered a 61% success rate over 2008-2009.6% 54 23 39% -3. Technical trade recommendations In 2009. unweighted) Average holding period (days) 44 55% 0. whilst weighted average returns were 1. Macro trade recommendations This year we recommended fewer cash trades (59) than in 2008 (85).6% Chart 2: 2008-2009 Performance summary: Success rate by type of trade Cash Non-digital Digital RV (non-digital) Technical 55% 43% 0% Source: J.5% 56 19 63% 0. The number of recommendations more than doubled to 28. Nonetheless.2% 9 131 47% 0.Global FX Strategy Global FX Strategy 2010 November 24. Trade Recommendations portfolio Cash # of trades Success rate Average return per trade (%.2% in 2008. Nonetheless. Trade recommendations are detailed each Friday in FX Markets Weekly and are classified as macro directional trades (cash and options).6% -3.0% 0.0% 63% 59% 0% 44% 20% 68% 77% 63% 2009 2008 0. whilst the success rate was marginally lower at 68% (from 77% in 2008). III.P. our success rate improved by over 10% to 55%. FX Derivatives portfolio (relative value) Non-digital # of trades Success rate Average return per trade (%. Morgan Table 1. In 2009 we issued more derivatives trades than in 2008:19 non-digitals (vs 3 in 2008) and 18 digitals (vs 5 in 2008).P. the average return on each trade was close to flat versus +0. Performance statistics 2008 – 2009 2009 YTD I. our relative value recommendations focused on non-digitals. unweighted) Average holding period (days) Derivatives (digital) # of trades Success rate Average return per trade (%. unweighted) Average holding period (days) II. Technical Strategy portfolio # of trades Success rate Average return per trade (%.1%.1% 9 NA NA NA NA 3 33% 8% 33 3 33% 8% 33 28 68% 0.0% 31 144 61% 1.6% over the same period.6% 1.P.6% 26 2008 2008-2009 weighted avg Source: J.0% 18 85 59% 2.0% 9 87 43% 0. derivatives relative value and technical trades. Morgan 2009 2008 -0.2% -4% -3% -2% -1% 0% 1% 2% 3% 20% 40% 60% 80% 100% 17 .6% 66 22 55% 0 58 59 63% 1. unweighted) Average holding period (days) Derivatives (non-digital) # of trades Success rate Average return per trade (bp. but not for digitals (success rate of 44% and average loss of 3.5% -3. The average return per trade was 1% compared to 2% in 2008.0% 0. unweighted) Average holding period (days) III. unweighted) Average holding period (days) Digital # of trades Success rate Average return per trade (%. we recommended half the number of technical trades as we had done in 2008. However. at 44. In weighted terms. at 63% compared to 59% in 2008. II.5%).P.6% 57 3 0% -0. Morgan 2.5% lower than in 2008 at 0. I. Morgan Securities Ltd. our success rate was higher.5% 56 5 20% -3.6% 53 41 71% 0 68 18 44% -3.

as measured by leverage.P.7 -100 754 1. Index 140 120 100 80 60 40 Jan-09 Source: J. FX (VXY G7) and commodities (gold and copper). The decline in volatility across asset classes in 2009 was nothing short of dramatic. and assume no transaction costs. and many of our RV trade recommendations benefited indirectly from the reduced uncertainty in the macro environment. Own long-dated EUR and CHF vols as portfolio hedges. 2009 Arindam Sandilya (1-212) 834-2304 Talis Bauer (44-20) 7777-5276 JPMorgan Chase Bank NA FX Derivatives: A macro model for volatility and strategy implications • The unexpectedly strong economic recovery in 2009 sponsored a dramatic decline in volatility across asset classes and proved our forecasts too cautious. We envision growth surprises to be fairly muted in 2010 as the recovery matures. Chart 1.7 -80 162 -138 0. but some shocks in monetary policy could lie in store towards the latter half of the year as exit from QE and the trajectory of the Fed hiking cycle assume centrestage. indexed to 100 as of 01Jan-09.2 -67 554 1. and our underestimation of the post-QE 18 bp USD 100 80 60 40 20 0 -20 -40 -60 -80 -100 Jan-09 Source: J.P. but the depth of the latest recession compared to those in the recent past and the pace of the rebound that followed rendered such historical calculus irrelevant. Focus on vol carry – for instance the premium (discount) of forward vols to spot vols – as a more reliable generator of trading returns. As it turned out. with upside risks in H2. Our economic forecasts lead us to believe that VXY should stay within a 10-14 range in 2010.5 -70 230 0.3 -70 439 1. . We were admittedly in the cautious camp as far as vol forecasts went. We conceptualize volatility at a fundamental level as the product of the supply of macroeconomic surprises and the vulnerability of markets to such surprises. Our model linking currency volatility to leverage and surprise factors finds current VXY levels close to fair value. most market participants would have settled for a 2009 that offered little more than a modicum of stability. Options are re-struck at the start of the month. we outline our framework for analyzing currency volatility and draw some conclusions on the likely trajectory of vol next year.7 -26 400 0.7 -43 432 0. expecting a 3-4 vol decline in the VXY from the unsustainable early 2009 highs based on usual normalization dynamics around recessions. and sponsored a decline in volatility across asset classes that was nothing short of dramatic (chart 1). the strength of the economic recovery caught a very cashoverweight market by surprise. Lower vol is however a favorable environment for relative value trading styles. (bp USD) Ann. Morgan S&P US 3M10Y Copper US 3M2Y Gold VXY G7 • • Mar-09 May -09 Jul-09 Sep-09 Nov -09 • Chart 2. and G10 FX was no exception 3M ATM implied volatilities in equities (S&P 500). Morgan bp USD 500 400 300 200 100 Weekly short gamma P/L(LHS) Cumulativ e short gamma P/L(RHS) Mar-09 Jun-09 Aug-09 Nov -09 0 -100 euphoria cost us full-blown participation in the gamma selling fest that followed (chart 2). with the basket composition mimicking that of JPMorgan’s VXY G7 index. 2009 was a stellar year for gamma selling Short gamma returns calculated as the P/L from selling a basket of 3M delta hedged ATM straddles.Global FX Strategy Global FX Strategy 2010 November 24.2 -59 -0. Currency relevant leverage resides in two pockets – the overhang of dollar shorts among investors. Such multiple vega annual declines in financial market volatility have not been the norm in postrecession years over the past two decades.0 -30 376 0. and the massive build up of public sector debt. US interest rates (2Y and 10Y tails).3 -41 -79 • 5% Tail Loss* -73 -83 -214 -234 -46 -115 -112 -229 -190 • Back from the brink After the annus horribilis that was 2008. Return IR Max Loss* * Weekly stats AUD EUR GBP NZD CAD CHF JPY NOK SEK Basket 506 0. In the sections that follow. Lack of any real directional momentum in vols is likely to reduce the efficacy of gamma trading strategies.

and unanticipated policy actions by the government. In this framework.5 Dec-10 Source: J. Morgan. 2009 Arindam Sandilya (1-212) 834-2304 Talis Bauer (44-20) 7777-5276 JPMorgan Chase Bank NA Volatility = Surprise X Leverage Previous JPMorgan research has conceptualized volatility at a fundamental level as the product of the supply of surprises and the vulnerability of markets to these surprises (see Volatility. Growth surprises in the US are highly correlated to the business cycle…. we focus on the macroeconomic forces of the “surprise production function” to project changes in the supply of these surprises.5 0.0 Dec-90 Dec-94 Dec-98 Dec-02 F'cast Dec-06 % Grow th YoY change in US Unemploy ment % Surprise 4. our economists remain upbeat on growth forecasts and anticipate US labor markets to stabilize by the end of the year.5 0. Exit from the current recession assumed to be Jun’09.. This approach aims to link views on volatility to the macroeconomic reading of financial markets.8 -1. …. Currency managers and global macro hedge funds have increased their holdings of pro-cyclical FX post-QE. but positions are still only half the size of those at the height of 2007 frenzy Rolling 30-day betas from regressing daily returns for i) a composite of 25 dedicated currency funds compiled by JPMorgan and ii) HFR global macro hedge funds on returns from JPMorgan’s IncomeFX and IncomeEM carry baskets. Entering into the second year of recovery. 0. Loeys and Panigirtzoglou. Given the linkages of the rest of the world to the business cycle in the US.8 0. October 2005).0 2.4 0. Larger the surprise and more levered the market.5 -1.0 1. 2.0 0.3 1. Leverage and Returns.0 -0. we rely on Blue Chip consensus forecasts instead in chart 3. The magnitude of this variability also depends on the degree of wrong-footedness of the market in absorbing these revisions – in other words leverage.2% 4 3 3 2 1 0 -1 -1 -2 Oct-09 Chart 5.P. Shaded areas represent NBER recessions. Morgan. these US-based measures are likely a good proxy for economic surprises even for world markets.Global FX Strategy Global FX Strategy 2010 November 24.2 0.5 3. The outlook for FX vol next year therefore rests on two key questions: • • Where can currency-relevant surprises spring from? Where does leverage reside in the system? Chart 3.5 2. In the absence of a liquid real time market for growth expectations however. the greater should be the resulting volatility. Ideally. Broadly speaking.5 1. The sample period includes three recessions – 1991.0 -0.3 0. Along the lines of Loeys et al. Bloomberg Currency Managers Global Macro Hedge Funds S i 3 Fed announces QE 19 . and is different from the dominant time-series approaches to forecasting volatility that is best represented by the GARCH class of models. both surprise functions exhibit reasonable correlation to the business cycle.8 3.1 0. Morgan Chart 4. using standard deviation of monthly changes in 2-yr treasury yields. Exit from the current recession assumed to be Jun’09 bp 60 50 40 30 20 10 Jun-91 Feb-95 Oct-98 Jun-02 Feb-06 Source: J.as are monetary policy surprises Monetary Policy Surprise YoY change in US Unemploy ment % Surprises – where from? One can think of surprises as the supply of market relevant exogenous events or news.5 0. with the unemployment rate falling from 10.6 0. 2001 and the current one – which seem to define the peaks in growth and monetary policy surprises. Charts 3 and 4 depict these surprise production functions for US growth and monetary policy by looking at the impact of monthly flow of information on market expectations over the coming year.P.0 Feb-05 Jan-06 Jan-07 Dec-07 Nov -08 Nov -09 Source: J.P. leading to variability in its price. one would like to record surprises in real time as we do for monetary policy expectations in chart 4. either in the form of unexpected developments in macroeconomic variables such as growth or inflation. shocks or surprises in the form of news or unexpected events prompt revisions in expectations of cashflows from an asset. Shaded areas represent NBER recessions. Growth surprises defined as the rolling 12M standard deviation of monthly changes in the 1-year ahead consensus expectations for US growth. Blue Chip Indicators Monetary policy surprises defined as the rolling 12M standard deviation of monthly changes in 2Y US swap rates.

2009 Arindam Sandilya (1-212) 834-2304 Talis Bauer (44-20) 7777-5276 JPMorgan Chase Bank NA currently to 9. and sharply improved their liquidity ratios (chart 7). Bloomberg -4 -6 Dec-13 20 . with the turning point coinciding with the Fed’s QE announcement in March. After extensive deleveraging throughout 2008 and most of this year.3% in the US. Neither Japanese retail nor CTAs have enthusiastically sold JPY and CHF in 2009. Leverage – where is it? Leverage within the investor community in FX carry trades – defined here as outright positions in high-yield currencies held by dedicated currency managers. allowing savings rates to rise (3. dollar shorts represent the most substantial position overhang facing currency markets in 2010. not very far from the ¥560bn where they began the year. TFE. CME IMM JPY and CHF positions 2 0 -2 -4 -6 JPY retail positions Apr-08 Feb-09 -8 Nov -09 Chart 7. a modest decline in fixed investment. net yen retail positions currently stand at ¥870 billion.6% in the UK). the trajectory of eventual Fed hikes.P.P. Balance sheets have also taken a more conservative turn as firms have shifted out of short-term financing to longer term debt. Japan and UK % % Budget Balance/ 100 4 Debt/GDP Ratio GDP Ratio 80 2 0 60 -2 40 20 Dec-90 Aug-95 Mar-00 Oct-04 May -09 Source: J. the financing gap for US corporates— the gap between internal funds and that needed to finance fixed investment and inventories—had turned to a financing surplus by 2Q09 (chart 7). Judging from the historical relationships in charts 3 and 4. Consumers in the US and UK have cut spending sharply this year. Morgan 40% 35% 30% 25% 20% 15% Dec-93 Nov -97 Sep-01 Aug-05 Jun-09 Chart 8. Morgan. As chart 6 shows. CTAs have been net buyers of JPY and CHF for almost the entire year based on IMM net speculative positions. as well as the room for such surprises to play catch up with business cycle indicators even at current levels. CTAs or Japanese retail – has increased in 2009 judging from the upturn in their return betas with our carry strategy indices (chart 5). and represent the most significant position overhang facing currency markets in 2010 Retail holdings based on total retail positions on the Tokyo Financial Exchange $ billion ¥ trillion 20 4 IMM USD positions 10 0 -10 -20 -30 -40 Jan-06 Oct-06 Jul-07 Source: J. and this surplus is likely to expand again this quarter given the forecast of strong profit growth. Not surprisingly. much of the move was funded in dollars rather than in traditional low yielders such as yen or Swiss francs.P. but is incomplete in the UK. USD shorts have funded the bulk of the recovery trade. the USD has picked up the funding slack. Morgan. this suggests that the supply of growth shocks next year is likely to be muted. instead. Instead.Global FX Strategy Global FX Strategy 2010 November 24. and reduced but still sizable inventory liquidation. EU. global macro hedge funds. we estimate that a large part of corporate and household retrenchment is already Chart 6. where the size of the balance sheet repair has been small relative to the outstanding debt stock. While still only half the size of holdings in mid-2007. but developments on the monetary policy front could surprise markets given the uncertainty around the timing of exit from QE.8% by YE 2010. Net-net. The process should stabilize around the turn of the year in the US. a far cry from the $30bn short in the heydays of the carry boom. with net outstanding IMM shorts at $18 bn (chart 6). Corporate balance sheets are not a source of leverage Financing gap defined as capital spending less internal funds for non-financial corporates in the US Long-term debt as a 4% 50% Financing share of total credit gap 3% 45% 2% 1% 0% -1% -2% -3% Feb-90 Source: J. 5. Neither Japanese retail nor other leveraged investors such as CTAs have displayed their pre-crisis penchant for selling JPY and CHF. Public sectors have geared up massively even as the private sector has retrenched over the past two years Average debt /GDP and budget balance/GDP ratios across US. Corporates and households look fairly tame from a gearing standpoint.

00 p-v alue 0. As private sectors retrenched violently over the past two years. ignoring the fiscal leverage buildup altogether– largely because public sector leverage measures are too low frequency compared to other inputs. public sector leverage has balooned across the developed world (chart 8). foreign central banks remain committed to reserve accumulation and deflation remains the reality for next year. with US and UK being the biggest culprits.14 0. Our expectations for modest US unemployment in 2010 lead us to a forecast for nearly unchanged VXY levels by next year All variables as defined in Chart 9.4 Monetary Policy Surprise (bp) 42 ment (%) Unemp.08 Grow th 0.00 Inv estor Lev erage 0.93 Monetary Policy Surprises vs. However an inflation scare could be a game changer as financing costs rise and rollover risks come to the forefront. Unemployment Coefficient t-stat Intercept YoY Unemploy ment Forecasts Umeploy - 0.42 t-stat 2.P. business cycle relationship depicted in charts 3 and 4 to predict the extent of macro-surprises in store next year. it is possible to run vol projections using our base case growth and policy forecasts.01 0. and save in a few pockets.25 p-v alue 0.8 (b) the measure of investor leverage is not a currency specific metric like those outlined in chart 5. VXY looks fair to modestly rich to model fair value.08 35.14 0. Unemployment Coefficient t-stat p-v alue Intercept YoY Unemploy ment 0.2 0. have intuitive signs and the adjusted R2 is more than acceptable in the context of econometric models in academic literature that attempt to capture the macroeconomic/financial market volatility link.06 + 0. At current levels. public sectors have of course done the opposite.63 3. involving first quantifying the surprises vs.9 21. and too slow moving to be a signficant explanatory variable in a G7 context.Global FX Strategy Global FX Strategy 2010 November 24.00 0. As a result.56 8.11 35.42*Inv estor Lev erage +/.16 4.8 Source: J. The monetary policy surprise forecast assumes that the 18 bp current dislocation from levels justified by unemployment figures will correct over the course of 2010. and then plugging in those surprise readings into the vol model described in chart 8. Note that the leverage variable used in the model suffers from two handicaps: (a) it measures only investor leverage. 2010 should begin to see an upturn in the leverage cycle. Investor leverage taken to be the average beta of CSFB Tremont hedge fund index on JPMorgan’s IncomeFX and IncomeEM carry baskets Coefficient Intercept Monetary Policy Surprise Grow th Surprsise Inv estor Lev erage 25 VXY Actual 2. All variables are statistically significant.P. once again necessitated by the lack of a longer history of currency manager return data. but rather the broad beta of the entire universe of hedge funds (proxied by the CSFB Tremont Hedge Fund return index) to FX carry. Table 1 tells the story in a nutshell: our economic forecasts translate into muted growth surprises next year and some pickup in 21 8 Unlike in an EM setting where external vulnerability has been well documented to be key factor in past crises . Morgan VXY 12.UK) and governments virtually everywhere supplemented these efforts through looser fiscal policy. A Macro Model for FX Volatility Chart 8 presents a regression model linking the VXY to the surprise and leverage factors discussed earlier. Morgan Table 1.16*Monetary Policy Surprise + 20 4. Central banks resorted to unconventional measures such as quantitative easing (US. but the deviation is insignificant given the standard error around the estimate. Financing this massive government debt is not a problem as long as weak loan demand maintains the commercial bank bid for government paper.01 0. 2009 Arindam Sandilya (1-212) 834-2304 Talis Bauer (44-20) 7777-5276 JPMorgan Chase Bank NA behind us.00 0. Growth Surprises vs.00 VXY Model = 2.9 21. Broad money supply growth and inflation expectations therefore merit close tracking to gauge the risks of such an event unfolding. (%) Surprise (%) 9.3 signficant in the context of the current environment and likely biases model fair value estimates lower. Monetary policy surprises as defined in Chart 4.2 YoY -0.1 Std. VXY current looks about fair given the investor leverage stock and the supply of surprises Growth surprises as defined in Chart 3.60 6.00 0. Error Bands Adj R 2 = 51% 15 10 5 Jul-96 Mar-99 Nov -01 Jun-04 Feb-07 Sep-09 Source: J.06 0. The latter is less of an issue since it only forces the regression coefficient of the leverage variable to capture spillover effects from other asset markets – not in itself terrible given the one-factor nature of most portfolios at present – but the omission of public sector leverage is Chart 9.63*Grow th Surprise + 3. With rates at or close to zero. This is a two stage process. With these model parameters.36 2.

thin supply and sensitivity to a disorderly dollar decline make long-dated vols attractive portfolio hedges for 2010. it is clear that lower ρS. we do not view a deluge of long-end vol supply to the street as likely given the market’s memory of the havoc that the past two years wrought. Morgan EUR/USD USD/CHF Tenor (Y) 3 5 6 8 10 . Chart 10. making short FVA a likely source of alpha for currency option portfolios. error tolerance of 2 vol pts – in other words roughly a 10 – 14 vol range for the vol index. Outright short gamma returns computed as the P/L from selling a basket of 3M delta hedged ATM straddles.rate diff leads to higher σF. Such decorrelation between FX and rates is positive for longdated vols as it increases the volatility of forwards. makes long-dated EUR and CHF vols attractive to own as portfolio hedges Vols (%) 14 13 12 11 10 9 8 1 Source: J. v ol pts. the twin themes of earning positive vol carry and lack of back-end vol supply dovetail nicely to suggest value in owning long-dated (10-year) EUR/USD and USD/CHF vols. and together with an unchanged leverage factor point towards a VXY forecast for YE 2010 at 12. but not unreasonable that the sizeable correction in vol levels from late 2008 highs is already behind us. Our analysis of strategy returns in various vol regimes shows that the lack of vol momentum tends to act as drag on these trading styles. In addition. bonds and currency). The combination of positive slide. A typical example of earning carry in vol space is to be short (long) forward volatility on steeply upward sloping (inverted) vol curves – investors stand to pocket the premium (discount) of forward vols to spot implied vols if vol curves remain unchanged over the trade horizon. Morgan Chart 11. Granted that the long/short gamma trading scheme used as proxy for relative value vol trading returns is too simplistic for style analysis. Long/short relative value returns computed as the P/L from buying 3M delta hedged ATM straddles in the two best long gamma currency pairs among the G10 majors and selling3M delta hedged ATM straddles in the two best short gamma candidates.P. If we are correct on the VXY. one can write the variance equation as: σF2 = σS2 + σrate diff2T2– 2 σS σrate diff T ρS.Global FX Strategy Global FX Strategy 2010 November 24. and assume no transaction costs. From the equation. and that large vol moves are unlikely from levels that are not far from long-term averages (15-year average close to 11). Finally. rendering stable vol environments unfriendly towards gamma trading (Chart 10).rate diff. vol carry trades likely stand to perform resaonbly well. but that RV tends to underperform short gamma in vol sell-offs and outperform in vol rallies – probably holds. No doubt this is a bland outcome given that VXY is currently trading close to those levels.3. this likely means that vol curves are likely to retain their upward sloping shape next year. EUR and CHF are the two currencies that are most responsive to a dollar crisis scenario (see Risk From the standard forward – spot relationship: F = S *exp (-rate diff)*T. but the broad conclusion from the chart – that gamma trading strategies irrespective of flavor tend to yield low absolute returns when vol is rangebound. as the lack of vol momentum acts as a drag on usual trading styles Average yearly P/L from outright short gamma and long/short gamma strategies contingent on the magnitude of the YoY change in VXY. with sizeable +/.1 std. Positive slide at the back-end of vol curves. further out in tenor the forward. Good gamma sells (buys) defined as those that rank high (low) on a composite metric given by rolling 1-yr z-score of 3M implied vol * 3M implied vol / realized vol ratio. “beta” vol trading strategies like outright short-gamma will have a hard time delivering the stellar returns that they did this year. Coupled with anchored front-end vols. coupled with likely lack of vol supply. the tail risk scenario mentioned above is likely to involve a decoupling of the dollar and US rates as foreign holdings of US assets are liquidated en masse (stocks. and even more market-neutral trading styles are likely to find 2010 challenging. Options are re-struck at the start of the month. higher the impact9. and while some of this is doubtless attributable to portfolio protection driven demand for long-dated dollar calls that is likely to reverse next year. Short-dated volatility strategies are likely to find 2010 challenging. 20 15 10 5 0 -5 -10 -15 -20 <-10 -10 to -6 -6 to -2 -2 to 2 2 to 6 6 to 10 >10 Short gamma Relativ e Value Source: J.P. 22 9 Scenarios section) and long-dated vols in both slide positively along inverted vol curves. 2009 Arindam Sandilya (1-212) 834-2304 Talis Bauer (44-20) 7777-5276 JPMorgan Chase Bank NA monetary policy surprises. the presence of the T term in the equation means that longer tenor vols benefit more than shorter-dated vols from higher rate vol and a de-correlation between spot and rates. Also. Vol curves in G10 are currently close to historic highs in steepness. with the basket composition mimicking that of JPMorgan’s VXY G7 index. However if vol levels do not shift radically.

with an average P/L of 1.6. both proved profitable. all of which are profitable. in our long GBP/USD 3M vol versus short USD/JPY 3M vol trade. as has our short gold vol versus long silver vol trade.1 27 63% 10 3 67% -0. yet the trade lost money as spot drifted from strike in both currencies.5 Vol points 1. Performance statistics 2008 – 2009 2008-09 2009 YTD Vanilla Options # of trades Success rate Av erage return per trade (bp. 2009 Arindam Sandilya (1-212) 834-2304 Talis Bauer (44-20) 7777-5276 JPMorgan Chase Bank NA Post-mortem: 2009 FX Derivatives Trade Recommendations Trade performance in 2009 resulted in a lower hit rate than in 2008 as well as a lower average trade P/L (table 1). making transaction costs less prohibitive for relative value positions. Morgan 23 .P. realized volatility outperformed our implied entry level.5 2. announcement of quantitative easing proved problematic for delta-hedged straddles (as opposed to a flat gamma product such as a volatility swap).6 N/A N/A N/A *Vol products include volatility swaps and Forward Volatility Agreements (FVAs) Chart 1: 2008-2009 Performance summary: Success rate by type of trade (average P/L) Vanilla Options 2009** 2009 2008 0 10 20 30 bp 40 50 60 2009** 2009 -1.e. unw eighted) Source: J. versus only 9 bp and -0.Global FX Strategy Global FX Strategy 2010 November 24.6 3 33% 0. Table 1. and this resulted in sizable losses.0 2.e. Our tactical entry into cross-asset trades. respectively.3 points for vol products. when we include the positions initiated in 2008 but held until 2009 (all of these trades were initiated pre-Lehman). although the number of trades increased. The two vol swaps that have been closed out have both ended up being profitable.0 -0.5 ** Does not include trades initiated in 2008 (all of which were prior to mid-September 2008 i. Positions that were initiated in 2008 and unwound in 2009 suffered as the correlations that made the trades attractive at the time broke down. If we exclude these P/Ls from our 2009 summary. which is still open. For instance. We have a slightly better hit rate on our vol product trades (which include FVAs and vol swaps) but with an average of -0. we have been able to successfully make use of vol swaps. enabling us to cleanly monetize implied-realized vol mispricings. the jump in USD/JPY at the time of the announcement proved particularly problematic for a position being delta-hedged on only a daily basis. unw eighted) Vol Products* # of trades Success rate Av erage return per trade (v ol pts.5 0. We currently have three vol swap positions still open. However. counting only those trades initiated and unwound in 2009. Nonetheless.3 vol points.5 -1. The jump risk around an event such as the collapse of Lehman or the U. pre-Lehman) Source: J. i. unw eighted) Digital # of trades Success rate Av erage return per trade (%.0 Vol Products 1. short FX vol versus long SPX vol.0 0. our average P/L is 25 bp for vanillas (chart 1) and 1. As liquidity returned to the options market in the second half of 2009. The number of trades rose as liquidity conditions began to improve in the latter half of 2009..P. Morgan 2008 13 77% 60 N/A N/A N/A 3 33% 8% w eighted av g 40 68% 26 3 67% -0. vol products have made up only 10% of our total portfolio. we end the year with a hit rate above 63% and an average of over 10bp on our vanilla trades.S.6 points per trade.

Scandinavian currencies face stronger setbacks in 2010 but the uptrends are incomplete.4250 zone which should continue to hold if new cycle highs can develop. but not without an initial consolidation phase as short-term risk factors increase. we sense the USD will be vulnerable to a more sustained correction particularly given the completion of long term Elliott patterns.5165 and 1. As such. patterns in CAD/MXN and USD/MXN confirm the bullish MXN view. if not break the 2008 USD low.45/1. Also. GBP has the potential to outperform within G10 by the end of 2010. This should allow for EUR/USD to push into the 1. the current trends are struggling to extend through a number of important USD supports/targets. the key question for 2010 is whether there is any hope for a USD rebound. In that regard.00.9800 with deeper targets near 1. A focus on levels and equities In line with the oversold setup. as well as the more entrenched oversold setup. AUD/USD should seek a retest. the medium term setup suggests EUR/USD can seek the 1. while an overbought or oversold extreme is usually a condition for a potential 24 . The highlight of this setup is the consolidation below the critical 1.4% retracement from the 2008 cycle low. await better location to buy AUD/USD. MXN is in position to play catch up. the Dollar Index faces an important test at the 75/74. Trade strategy: Sell EUR/MXN. 2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA. J. EUR/USD sees important support in the 1.63 zone. we will be more inclined to look for opportunities to establish long USD positions at that time. Cross JPY presents a more intriguing setup given the potential to extend medium term trends. retracement. Chart 1: Dollar Index– Weekly Chart – Momentum indicators suggest a deep oversold setup. USD/MXN.98/1. Also.Global FX Strategy Global FX Strategy 2010 November 24. USD/KRW and USD/INR at better levels.60 area. also look to sell EUR/AUD. Morgan Securities Ltd. We see a mixed setup for JPY given the range bias over multiple timeframes. New USD lows should complete the final leg down for the bear trend leading to a more sustained USD recovery later in 2010.4% retracement from the 2008 cycle high. this short term correction should eventually lead to new lows. • • Major transition ahead As 2009 draws to a close and the broad-based USD bear trend continues to develop. We still see a growing risk that a corrective phase can develop into year-end and during Q1. Long-term Technical Strategy: Major transition ahead • The USD bear trend is expected to continue into 2010.50/1. By most technical measures the USD is deeply oversold and due for a correction (chart 1). The ability to sustain through these important USD supports should be a difficult task for the short term view. it does not guarantee a sustained shift in trend. EUR/MXN is vulnerable to a deeper correction. CAD seems to be at or close to an exhaustion point.60/1. implying an underperformance in 2010.P. For the medium term view. CZK expected to lag. if not break of the 2008 high near . but the overall trend remains intact • • • • • • • • From this point. EUR/CAD and GBP/CAD. with a recovery and more formal basing process developing later in 2010. EM currencies maintain the medium term bullish bias and should continue to outperform in 2010.30 support zone which also represents the 76.5300 resistance areas for EUR/USD which includes the 76. but we are also aware that an extension through these levels would imply a greater risk that prices should eventually test. The bullish setup for CE-3 remains intact led by PLN and HUF.00. if not higher while the Dollar Index targets 73/71 and AUD/USD extends to . but it will likely be a short term development as the current technical setup does not yet support a sustainable USD recovery. Still. we see potential for the USD to retest if not break the 2008 cycle lows. However. while the Dollar Index targets the 73/71 zone.

With correlations between risky assets and currencies still at a high level and expected to continue into the 1H 2010.00 zone for the Dollar Index. Given the overbought setup. Importantly. Chart 2: S&P500 Index . Note that this indicator has been an effective tool in confirming the broad trends as seen during the USD bull trend in 2008. With that in mind. Violations would suggest a more important USD low is in place and a deeper corrective phase underway.8700/.45/1.8300/. In that regard. Michael Krauss and Jason Hunter who cover the Chart 3: EUR/USD– Daily Chart – The Elliott wave count suggests a short term corrective phase before new highs. Similar 25 . The quality of any retracement will be telling. J. For now. while EUR/USD can retrace to the 1. or stages a deeper reversal. it also implies that the overall trend is incomplete. short term bias suggests a pause. Chart 4: Dollar Index .8600 area. these levels will likely define where we are wrong on our view for new USD lows. we see the range view as the likely scenario. current signal remains bearish.Weekly Chart –Moving average signals have defined medium term trends. As this setup usually precedes a corrective process. we sense the USD can transition into a consolidation phase during Q1 to alleviate part of the oversold condition. a consolidation phase for the equity markets should position the USD for a Q1 corrective phase. Similarly. but not broken. 2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA. these levels should be a maximum for this corrective phase and lead to a return to the underlying trend.8200 zone.P. We see a similar story from an Elliott wave perspective (chart 3). we still point to the bearish USD setup for many of our medium term trend indicators. we do see some potential short term negative risks for equities as most indicators point to a trend that is stretched. S&P500 Index suggest the market is losing upward momentum against these key levels.Daily Chart – Approaching key resistance in the 1110/1135 zone.4230 zone. as well as the cyclical decline from the 2006 peak. if not the . The USD likely completed a third wave decline from the March highs and typically suggests an oversold extreme which points to a consolidation phase (fourth wave). AUD/USD has potential to pull back into the .Global FX Strategy Global FX Strategy 2010 November 24. With regards to the medium term view. Our Fixed Income technical analysts. Morgan Securities Ltd. In that regard. the short term risks suggest the S&P Index should struggle against the key 1110/1135 resistance zone (chart 2). our chief market strategist Jan Loeys points out that equities historically consolidate for several weeks during this stage of an economic recovery. as it should help define whether the USD shifts into a range. Moreover. Encouraging signs apparent that the battered British Pound has discounted most of its bad news but medium-term risks persist Since the British Pound hit an all-time low around the yearturn 2008/2009 it showed a remarkable recovery particularly against USD and JPY where 5-wave structures up have formed against the long-term downtrend. our moving average system which has been bearish the USD since June remains intact (chart 4). The outcome would suggest a correction back to the 78/80. Moreover.

129.33 in GBP/JPY. Concerning the main question though whether we might have seen a long-term turnaround at 0. Allowing a bit of Only the decisive break below the equivalent 76.0362 (int.9803 Chart 6: EUR/GBP .4 % (1. Morgan Securities Ltd.6629 in GBP/CAD or 1. 2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA. 76. would deliver the final evidence that a long-term trend reversal has taken place at 0. J.07 up to the 1.0004.4339) of the preceding 5wave advance.8249 a resumption of the uptrend can not be excluded yet. 38.Weekly Chart –Above key-support at 0.7332 in GBP/USD and/or on a trend line break (currently at 1. Given this almost textbook structure the following and still ongoing decline is perceived to be a countertrend B-wave decline only which usually retraces 76.9803 or whether the long-term up-trend is still intact the market is giving a clear answer in providing two major T-junctions which are at 0.4 %) would finally challenge the bigger T-junction at 1. The defense of the former would support a triangle consolidation whereas a decline to 0. As part of this bottoming process the market might well trade a range between 1.4 %) over the coming months as shown in the chart picture below before the strong C-wave rally up is expected to materialize.P.8639 and at 0.0004 (76.Global FX Strategy Global FX Strategy 2010 November 24.1127/64 (previous top/int.e. This could well dominate the first half of 2010 before a stronger recovery (wave C or Wave 3) can be expected again. A story of relative underperformance within G10 could be forming in CAD where shown setups favor a much broader setback The best example in this context is probably USD/CAD where the market displays a 5-wave structured rally (wave A) from the 0.1.4 % retracement’s (i. 76.8249 1 or A 1.3063 top in March this year. 1.8249 though 26 . 0.4 %) and at 0. The only outstanding market in terms of displayed structures is EUR/GBP as the GBP recovery from the alltime high at 0.9059 low in Nov.8249 in EUR/GBP with respective stops opposite these barriers to bet on a potential resumption of the bull-trend. A break above daily trend line resistance at 1.4339 in GBP/USD. Chart 5: GBP/USD– Weekly Chart –Looking constructive long-term.4339 2 or B In terms of monetizing these described scenarios we suggest being a GBP seller towards 1. In terms of shape and extent that does not make a difference as both scenarios would look for a 3-step decline which retraces roughly 76. but medium-term a stronger setback is still looming.e.8249 (38.4 % retracements (i.9803 can only be described as complex.5833 in GBP/CHF) would resume the GBP bear-trend in favor of new all-time lows.8249 and the defense of it would potentially form the C-leg down of a doublezigzag 4th wave consolidation.0004 handle (B-wave). The short-to medium-term picture though (1st half of 2010) looks critical as the market is still missing a stronger countertrend 3-step decline which is either going to form the so-called B-wave down within a broader A-B-C upconsolidation or a 2nd wave low in case a new up-trend is unfolding.6080) to bet on a mediumterm B/2nd wave decline or towards the key-supports at 0. A decisive break below 0.2 %) and 1. That said there is a very good chance that the market is forming a 2nd higher base in the 1. Once in the trade GBP would of course offer a perfect risk-reward to reverse existing short positions towards the previously described 76.4339 in GBP/USD) with a rather wide stop there under to finally bet on what is assumed to constitute the GBP out performance in the 2nd half of 2010. towards 1.4 % of the preceding Wave A.8639 0.8639 (int. pictures are displayed in GBP/CHF and in GBP/CAD which gives further support to the idea that we are at least going to see more of the same in form of a bigger C-wave up in the 2nd half of 2010.7332 1.0785 would in this context indicate a test of the upper range boundary whereas a break below 1.8639 and at 0.2 % on higher scale). In both scenarios we’d be missing the final 5th wave up with new price extremes in the parity region.

So as long as 1.9763 1. 76. slippage and as the 76. Chart 7: USD/CAD .4 %) is not taken out thee door for a stronger up-swing into 1.5036 in USD/NOK.0004 the odds are in favor of a strong CAD setback.6872 or 1.Weekly Chart – Above 1. there is a risk of forming the right shoulder of a potential inverted H & S pattern towards 1.Weekly Chart –Market sitting on Key-support from where a broader consolidation is expected to unfold.6629 is not broken decisively the odds remain in favor of a stronger recovery up to 1. 61.e.6489 in USD/SEK.-support at 1.6629 (int. 5.9038 (int.. Scandis are risking broader setbacks in 2010 whereas NOK is expected to under perform SEK. 5.9697/1.2 % on higher scales).0210 in EUR/SEK). In case the market fails to come anywhere close it would be worth going with the break above daily trend line resistance in USD/CAD (currently at 1. Short-to medium term though.07 low at 0. A deeper investigation unveiled the key-T-junctions to distinguish between the two scenarios in form of internal 38.Weekly Chart –Above 1.4 % retracement’s (i. 8. Such a break would eliminate this whole scenario in favor of a re-test of the Nov.4465 in Chart 9: USD/NOK .9303 1.0004 The structures in EUR/CAD are comparably a lot less exciting but as long as minor Fib.5414 (int.9303 in USD/NOK) and trend line resistance at 10.0785).6629 the odds are in favor of a stronger recovery in the course of 2010 6.9038 5.6629 EUR/SEK.8 % retracement (i. Remaining below these resistance levels the long-term trends are assumed to be still intact whereas decisive breaks above the just-mentioned resistance barriers would end the dominance of the Scandis in favor of a much broader depreciation.2270 in EUR/NOK ) or in form of a 61. 10.Global FX Strategy Global FX Strategy 2010 November 24.8/76. After a strong 2009.8654 (76. B 1.4 %/old top) and maybe even up to 1. 2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA. Another market which supports the idea of a stronger CAD setback within 2010 is GBP/CAD where the dynamics of the latest rebound suggest that a much broader recovery has already been started.2 %) and most likely towards the big T-junction at 1. J.e. Chart 8: GBP/CAD .6629 in GBP/CAD whereas stops should be place at least 3 full points below in order to allow some overshooting. 76. 27 . Morgan Securities Ltd.0004 in USD/CAD and at 1. 38.9059. Having had an incredible run throughout the whole of 2009 NOK and SEK have both reached key-resistance levels in form of 76. That said these markets face an increased risk of at least running into a stronger rebound if not into a countertrend rally of much larger scale.2 % retracement’s (i.P.4% retracement’s which are at 1.5904 in EUR/NOK.9697/1. 8.6960/72 (int. 7.4 %).2476 in USD/SEK.9763 (38. 6.1936 5.e.9711 (pivot).4 % on big scale) remains wide open.5036 1.4 % is more a target zone than a strict support a decisive break of the latter would only be indicated on a break below 0. The ideal risk-rewards to bet on a stronger CAD setback throughout 2010 would of course be given around the 76.

5300 print would eliminate this risk in favor of an extended 3rd wave rally into the 1. 38.2 % retracement levels (i.2476 we’d have to be prepared for a new down-trend (C-wave) unfolding with a potential price target of 1.5036 in USD/NOK and at 10.9303 as shown in chart 9 would call for a much broader up-consolidation but as long as the last Tjunction at 6. Provided the higher Fib’s are not taken out at least one new price extreme (wave 5) towards the 2008 lows can be expected.7646 to 1.5164 the risk of a stronger setback persists 1.Weekly Chart –Up-trend seen intact but below 1.Weekly Chart –Market sitting on Key-support from where a broader consolidation is expected to unfold.Global FX Strategy Global FX Strategy 2010 November 24.5164 (76.4232 (int.-support at 8. Chart 10: USD/SEK . These levels would offer a perfect risk-reward to bet on the missing 5th leg down towards the 2007 low at 1.2270 in EUR/NOK. it probably offers the best risk-reward to not try to catch the anyway choppy up-swing but to buy NOK or SEK at the key 38.2476 and 7.1640.6489 Assuming that the long-term up-trends for NOK and SEK are still intact as long as the decisive Fib’s are not taken out.1936 in USD/NOK. J. countertrend rally (B-wave) within an even broader A-B-C down consolidation.2 % on two different scales) could unfold.7888 handle (int.5164 1.1936 is not taken out we are missing the final evidence of an even broader countertrend rally unfolding what would imply that the original up-trend in Scandis is still missing one leg after the initially expected setback to complete the whole cycle.5126 in USD/SEK) with respective stops above. Chart 12: EUR/AUD .4 %) in the way which could prove to be tricky. The defense of the latter is absolutely crucial in order to avoid the risk of having only performed a huge 3-step 28 1.4232 7. Morgan Securities Ltd. 7.6241/1.5926 and 1. In terms of cycles though this market is also trading very close to key-support between 1. at 5. A break above 5. Chart 11: EUR/USD .e. A 1. G10 in brief: EUR Apart from the 3 key-themes just described one of the main questions left is of course what’s going to happen in EUR/USD? Fundamentals support an extension within the overall USD bear trend but from a technical perspective there is one key-barrier at 1. 38.Weekly Chart –Market sitting on Key-support from where a broader consolidation is expected to unfold. A .2 %) which can be seen as the key-T-junction on bigger scale. say by a 1.5477.6326 handle where a long-term topping pattern is expected to be formed.5126 7.7646 More or less the reverse picture is unfolding when we look at EUR/AUD where the EUR has been under tremendous pressure throughout 2009. 2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA. 6. 5. the market is running the risk of a setback into key-support at 1.5300 print.7888 1.5793 (old low/weekly trend line) from where an internal 4th wave recovery into the 1. To dissolve the risk of a major rebound in favor of a resumption of the still prevailing trends it would on the other hand require decisive breaks below key-Fib.0711 (trend line) in EUR/SEK. As long as it is not broken decisively.P. If such a break would occur though.9303 and 6.

In that regard. Moreover.7430) in line with the loss of upward momentum and the Chart 15: NZD/USD . .00. However. still viewed within the context of the medium term advance. The . the sustained rally in commodities and in particular precious metals contributed to the favorable setup highlighted by the breakout and acceleration to new all-time highs for Gold.6445 . NZD NZD follows AUD in the standings for best performer for 2009. if not lower.8265 closer test of 1. Below these levels though. this uptrend violated a previous month’s low just once during that timeframe. J.5309 in EUR/CHF and/or Fib. 2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA.Daily Chart –The failure below the October high points to the short term corrective phase and underperformance. if not break of the 2008 high. While the trends are still intact. A clear indication that CHF is due for a stronger setback would clearly be given once trend line resistance at 1. Still. the downside remains open and could be extended first before CHF is due for a stronger consolidation. CHF A rather mixed picture is on the other hand given in most of the CHF crosses but with a general consensus that the strong appreciation of the Swiss Franc we have observed through 2008 and 2009 is still due for further consolidation in 2010. The struggles to sustain above the next line of key targets/resistance levels (76. this bias is still viewed within the context of the medium term uptrend. it demonstrates the strength of the overall trend. While a simplistic explanation of the price action. Morgan Securities Ltd. Despite the medium term bullish setup. Note that our basic moving average system which is used to define the medium term trend maintains the current Buy signal from late-March.9850 with some risk for a Chart 14: Gold – Monthly Log Chart – Still trending higher following the breakout while demonstrating a potential five-wave pattern from the 1970 low. we still sense the short term framework can allow for a consolidation phase into year-end and into the early-part of 2010. This is in line with the loss of upward momentum and the approach of macro targets closer to the 2008 highs.Global FX Strategy Global FX Strategy 2010 November 24.7082 29 .4% retracement at . straight break below 1.5793 would reversely delay the expected recovery and challenge 1.5477 immediately. be looking for a setup to establish long positions for the extension.8500 area.Weekly Chart –Short term corrective phase should ultimately lead to a test. we see potential for the rally to retest of the 2008 cycle highs near . AUD AUD has been the best performer in G-10 this year as the bullish cyclical shift and steady improvement in risk sentiment led to a one-way advance from the February/ March lows. Moreover.-resistance at 1.0380 in USD/CHF would be taken out. In turn. Note that a November close at current levels Chart 13: AUD/USD .8568 would confirm an unprecedented ten consecutive higher monthly closes for AUD/USD. the medium term setup calls for new highs and we will . our short term view for the USD opens the window for a corrective phase.8860 support zone will be key as breaks would suggest a deeper pullback is possible into the . . our medium term trend filters continue to point to further upside.P.

if not through the important 1. we sense a catch up trade will be seen in 2010. With the potential to correct lower we see good support in the 76/74 zone. we note that the 127 support area should continue to hold to maintain the potential upside bias for new highs and a Cwave into the 145 zone.7000 is important for this view and will likely define whether a deeper pullback can develop into the . For the short term setup. cross JPY does appear vulnerable to a short term consolidation phase particularly as a number of pairs have struggled to extend through the next line of important resistance levels highlighted by the important 139 resistance zone for EUR/JPY. as the short term risks grow.15 support zone which includes the lows from December 2008 and January 2009. AUD/JPY fell short of the key 86/88 resistance zone.50/83.00 EM: the bullish case is intact While we see risk that a consolidation can develop particularly against the USD during the early-part of 2010.30 resistance zone and recent range highs will imply whether a deeper retracement back to the 94.8200 zone. while the action in the USD may be more two-sided. Prices are expected to base here for the next leg up into the 92/95 area.6600 area (38.50/93. J. Chart 17: EUR/JPY .2% retracement from March and July breakout zone) would question whether prices can extend to new highs.14 127. In turn. Still. However.85 and 97. we see medium term targets in the .Daily Chart – The range below the 139. 30 . we continue to view the AprilNovember range as a consolidation phase before the medium term downtrend that began in March resumes.8000/. For the Latams. 139. However. there is still little evidence of a reversal at this point. As such. as well as the 2007 peak. JPY The technical case for JPY shows several cross currents raising the risk that JPY will be more range-bound into 2010 particularly against the USD. Alternately. Morgan Securities Ltd.30 medium term range highs. support at 127. critical test at 87. we sense the upward path will be more of a grind given the patterns in the crosses. Also. The patterns and trends that have developed over the past year now seem mature and suggest a growing risk of a bullish shift not only against the USD but also on the crosses. this range may persist particularly 87.14 area suggests a bullish bias/C-wave.30 resistance levels.00 and then the 84.Global FX Strategy Global FX Strategy 2010 November 24. a key focus will be on MXN.P. As the currency has lagged the performance of other Latams for most of 2009. For USD/MXN. one of our favorite trades is bullish AUD/NZD as we sense the cross can retest.50/93. Moreover.00 is critical. Similar to the USD trends.Daily Chart – Expected to be range-bound in 2010. the broad EM trends remain intact and are expected to continue into the new year. Similarly. we see several compelling developments for the crosses which suggest the bullish case for EM can persist in 2010.6700 area and ideal basing zone for continuation of the medium term rally phase. recent failure below the October high are consistent with the setup for a short term correction. the overall trends remain intact and we sense additional upside will likely develop beyond any corrective phase that may develop in Q1.50 trendlines (April 2009 and 2007).15 support and 92. basing patterns are developing in the likes of EUR/NZD and GBP/NZD following the bullish reversals in October. much of the medium term technical view will depend on the important 87. Support near . a violation of the key . In that regard. As we recognize the extended trend that has developed from the 2009 high. As such. The concern for NZD is the relative weakness that has developed over the past month which points to a potential underperformance bias into 2010.15 extension can develop towards deeper targets located near 86. the action in the JPY crosses has the potential to be a more interesting trade for next year. 2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA. the 92.50 ideal basing zone. Breaks here should define whether an Chart 16: USD/JPY . while we see potential for NZD/USD to resume the bull trend beyond this short term corrective phase. Also.

We maintain an overall bullish bias for BRL. Still. J. while also suggesting the diagonal ending pattern from the 2008 low is likely complete.8470 area suggests a bullish bias/C-wave. or sustained reversal we note that the short term trends appear mature particularly given the decline from the July high. Still.65/11. Importantly. we sense any corrective phase is likely to retain a range bias before the outperformance resumes. Also. While we 31 . As we monitor the action in the ADXY Index.8% retracement from the 20008 cycle highs.00 area.75 levels deeper into 2010. if not lower. as a number of medium-term targets have been met amid a deep. A key focus for 2010 will be KRW and INR.50/11. oversold framework. We also see this development in the individual USD pairs. This is where we would expect price to base for another run at the highs.00 zone and quite possibly to the 16. given our view for CAD underperformance into next year. if not new highs. The short term view is consistent with this setup given the potential double top near 20. Chart 17: USD/MXN . but like most markets a short term consolidation is likely due.80 support zone should allow for an extension into the 12. Importantly. Our long standing bullish view on Asia FX remains intact. we note the advance from the 2009 lows is entering important resistance/target zone in the 110. In turn. as well as the 2008 cycle low is mature and now appears vulnerable to a reversal. a break of the critical 12.Daily Chart – Short term setup can allow for a corrective phase against the 1120/1100 support area. we will be looking for a better setup and location to establish short term positions as we sense the overall trend is incomplete.75 zone. we are closely monitoring the 12.8470 12. we see deeper targets in the 1050/1000 zone. the medium term advance is over. we see a similar pattern for CAD/MXN as the trends are mature and vulnerable to a deeper correction. While there is still little evidence of a base. We see risk of a retracement back to the 18. Again. if not larger consolidation below the recent highs.Daily Chart – The range below the 13. support at 12. Moreover. We also note that BRL/MXN appears vulnerable to a corrective phase as well. 2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA.75 area which includes the 61. but the cross does appear primed for a MXN catch up trade which could take prices back to the 6.00. As such. In turn. Chart 18: USD/KRW . given the potential for some retracement in risk during the early part of this year. the 13.77 is critical.29 support zone is necessary to confirm the short term retracement phase. 13.80/13.17/20 support zone would suggest an increased risk that a corrective phase is underway. but medium term trend points lower. any extended retracement from current levels will be viewed as an opportunity to re-establish BRL long positions for the next leg down.85 area should continue to act as key resistance and maintain the downside bias. Morgan Securities Ltd. we do not sense just yet that 1120 For USD/KRW. but do sense that a short term corrective phase is likely to develop particularly as both USD/BRL and EUR/BRL are holding important support levels amid a deep oversold setup. beyond a short term corrective phase.85/6.20/18.P.60/15.Global FX Strategy Global FX Strategy 2010 November 24. the steady decline during 2009 has led to a test of medium term support in the 1165/1145 zone. The medium term bearish setup remains compelling for USD/INR in 2010 as the broad topping pattern continues to develop. we sense that sustained downside from current levels will be a tall order. this head and shoulders pattern points to additional INR strength next year beyond any short term corrective phase that may form in early-2010.05 support level as breaks would confirm a deeper retracement into the 11. we sense this short term corrective phase will ultimately lead to renewed outperformance. but a break of the 7. However. This view seems consistent with the pattern from the July low which seems close to completing a five-wave advance..77/12. Still.34/7.30 levels. A break of the 19.77 The rally in EUR/MXN from the April low.

In that regard. stop at 20.Global FX Strategy Global FX Strategy 2010 November 24. 16. The case for a deeper decline into the 42.80/3. This suggests the downtrend has potential to test medium term targets starting in the 44.6032 14. EUR/HUF has the potential to stage another push lower for this decline from the 2009 high which seems consistent with the broad.Weekly Chart – Head and shoulders topping pattern argues for continued downside into 2010. the decline from the 2009 high has failed to make the case for a sustained break of the critical 25. we are monitoring for some consolidation during the early-part of 2010 particularly as a number of key retracement levels have held including those for EUR/PLN and EUR/HUF. The setup in CZK is less favorable and there is a growing risk for underperformance on the crosses.10/43. Chart 20: EUR/PLN . In that regard. • Given the latest failure at upper triangle resistance (20. We see targets in the 255/247 area. The latter implies that the market has been performing a 5th wave impulse since which is already looking pretty stretched.7410 • EUR/MXN shows an impressive uptrend since the 1980’s whereas the 7.4% retracement) can also be made. Morgan Securities Ltd. we see potential for EUR/PLN to extend this decline into the key 3.50/75 support zone has thus far failed to elicit a trending bias.30 Chart 21: EUR/MXN .8% retracement from the 2007 cycle low and equal swing target from the March peak.00 area (76. note the breakdown below the important 46. 32 .86 support/target zone as the next leg of the downtrend develops. Similarly. head and shoulders pattern from late-2008.1457) and the very dynamic sell-off there after we see strong evidence given that a major top is already in place.50. the pattern and the corrective nature of the price action from the recent lows argue for a continuation of the decline from March. And this setup is in line with the bullish action from the 2009 cycle lows.56 bottom in 2001 looks like the 4th wave low of bigger scale. We note the recent outperformance in the likes of PLN and HUF point to a renewed trending bias.Weekly Chart –An upward sloping converging triangle signals the end of a multi-year up-cycle In CEEMEA a primary focus will be on CE-3. However. Chart 19: USD/INR .Daily Chart – A series of lower highs and lows suggests another leg down into 2010. Again. Trade Recommendation • Strategy: Sell EUR/MXN at market. the overall bullish action is expected to continue led by PLN.70 & 15. target 16.00 support area.P.65 zone which include the 61. J. like the broad risk view. 2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA. • But what really caught our attention is the upward sloping converging triangle which has formed over the last year and regularly constitutes a major topping pattern.

2009 Niall O’Connor (212) 834-5108 Thomas Anthonj (44-207) 742-7850 JPMorgan Chase Bank NA. Finally.6030 (last bottom) and potentially even to 15. we will monitor for opportunities in AUD/CAD for a continuation of the medium term rally phase. as the broad trends continue to point lower. short positions in CAD/MXN will ultimately make sense for a deeper correction of the rally from the 2008 low. Downside Potential: A broad down-consolidation towards at least 16. Similarly.74 (int.1457 as this could trigger another extension higher. we sense EUR/CAD and GBP/CAD will present excellent risk/reward buying opportunities beyond a short term corrective phase. Morgan Securities Ltd.2 %/old bottom) Risk: A recovery exceeding triangle resistance at 20. we will be monitoring for a better setup and location to reestablish short USD positions for the next leg of the bear trend.Global FX Strategy Global FX Strategy 2010 November 24.80 support. 33 . Moreover. short term corrections in USD/KRW and USD/INR should present a setup to enter short positions for the next leg down of the EM outperformance trends.77/12. J. we will be looking for a setup to establish short positions in EUR/AUD for that final leg down to new lows. Watch list As the expected short term corrective phase takes hold. Also. Similarly. we will look for opportunities to set short positions in USD/MXN for a breakdown of the medium term range below 12.P. in line with our view for CAD to struggle. Our primary focus will be on AUD/USD for final 5th wave up within the prevailing trend. As we expect MXN to outperform. 38.30/14.

we expect USD/JPY to decline to 82 by mid-next year while keeping an eye on further risk of USD/JPY testing the record low at 79. may raise Japan’s weight once the yen and Japan’s long-term yields start rising. The yen is still not so strong As many people clearly remember the sharp yen appreciation after the Lehman shock on September 2008 (JPY’s NEER estimated by J. as the market will start pricing in the normalization of the Fed’s monetary policy. who are extremely underweight yen. however. With regards to the yen. (4) JPY purchases stemming from Japan’s Homeland Investment Act (HIA) and (5) the Fed’s low-forlong policy. Upward pressure on Japan’s long-term yields may rise given concerns over Japanese fiscal condition. the recovery trade got back on track and JPY started declining against the majors. Foreign central banks. JPY declined to a historical low level on June 2007 and after then. For example. Therefore. If our view is correct. Examining relative performances in the G-10 currencies since early March. Since then. the recent level of JPY seems to be perceived as strong by majority of the people. 2009.Morgan 2000=100 av erage since 1970 (86.P. we can find a pattern of both JPY and USD weakening whilst JPY-cross rates generally trading higher when investors’ risk appetites improve. We expect USD/JPY to decline to 82 by mid-next year and see risk of USD/JPY testing the historical low marked in April 1995. (3) JPY purchases by foreign central banks. (2) foreign purchases of Japanese stocks. however. The yen’s current level is neutral from the perspective of purchasing power parity (PPP). sharply rose to slightly above the long-term . as concerns over the systemic risk of global financial system began to recede and investors across the world started to observe global economic recovery underway. Chart 1: Yen real effective exchange rate 130 120 110 100 90 80 70 60 Jan-70 Jan-76 Jan-82 Jan-88 Jan-94 Jan-00 Jan-06 Source: J. USD/JPY will extend its downside with the combination of “weak dollar and strong yen” in 1H 2010. reached our target of 90. Japan’s Homeland Investment Act (HIA) and foreign purchases of Japanese stocks are other possible factors supporting JPY. Risk factors to our bullish view on JPY include dehedging of foreign bond investments by Japanese institutional investors and re-acceleration in Japanese foreign investments. This move would accelerate repatriation flows and strengthen the yen. it was mainly due to USD weakness and JPY remained weaker in general than we had anticipated with EUR/JPY still trading around higher than our previous target of 123. USD/JPY 34 We expect USD weakness to persist into until mid-2010. we expect to see a modest rebound in USD/JPY. Morgan. we believe such recognition is not necessarily correct. where JPY NEER marked the recent peak) and USD/JPY is trading well below 100. Trade: Buy a 6-mo 123-142 EUR/JPY range binary to position for an equal USD decline within the G-3 pairs.75 marked in April 1995. however.Global FX Strategy Global FX Strategy 2010 November 24. MoF intervention is unlikely. Meanwhile. which was one business day before Lehman Brothers filed for Chapter 11.21. heading into 2H10. 12. set at the beginning of the year. equity markets across the world traded on a weak tone between the beginning of the year and early March in 2009 while the yen traded firmly over the period. and Jan. In 2010 several factors conspire to push USD/JPY lower in Q1 and Q2. excluding USD. we expect the currency to strengthen given the following upside factors including (1) a possible rise in Japan’s long-term yields. partly due to Japanese corporates’ public offerings. However. We believe that yen-selling intervention by Japanese MoF would still be highly unlikely even if USD/JPY breaks the historical low.P.4) • • • • • • • Upside risk to JPY to heighten in 2010 As markets dragged on the aftermath of global deleveraging.Morgan rose 31% between Sep. 2008. 2009 Tohru Sasaki (81-3) 6736-7717 Junya Tanase (81-3) 6736-7718 Yoonyi Kim (81-3) 6736-7729 JPMorgan Chase Bank NA Research Note JPY: What would push USD/JPY to all-time lows? • Since March 2009 the yen has declined against all major currencies but the dollar as the recovery trade gained traction. Even at that level.P. if we see REER estimated by J.

increases in JGB issuances have not necessarily led to any rises in Japanese long-term yields. When JGB yields start going higher with amounting concerns on financing difficulties for public debt.75 yen (1 dollar = 57 yen) from the perspective of the PPP. as more than 90% of JGB outstanding is held by domestic players 35 . The main reason behind the long-term upward trend in JPY is the prolonged deflation in Japan. Morgan expects Japanese public debt to rise to about 200% of GDP in 2010 and to reach 300% in 2019 without any hike in consumer tax rate. (2) strong home bias amongst Japanese investors and (3) well contained domestic inflation expectations.4 dollar =79. Japan’s headline consumer price index has stayed close to flat between 1995 and now. due to (1) ample domestic savings. the current level of JPY is still not considered strong. these moves should be perceived as a normalization process of “JPY-weakness bubble”. At least from the perspective of the PPP. relative inflation is not the only factor driving the FX trend. what should happen in the FX markets? It seems typical to take any rise in JGB yields stemming from fiscal concerns as JPY-negative. upward pressure on JGB yields should elevate. JPY REER is now trading around slightly below the long-term average level (chart 1). It means that even if USD/JPY hits 79. however. Therefore. Therefore. in the longrun. particularly in the short to medium term. Under such condition.P. Possible rise in Japan’s long-term yields We expect Japanese fiscal condition to deteriorate further. even if USD/JPY declines by 10% from the current level and reaches the historical low marked in 1995. Chart 2 shows the change in CPI since January 1990 in the major countries and changes in FX rates for these countries over the same period. The chart suggests that. Indeed. 1. our fair-value model. JPY’s REER suggests that the level seen in 1995 certainly represented a “super strong” yen.Morgan NZD NOK SEK CAD CHF JPY Grow th rate of CPI since Jan. JPY should still be considered much weaker than in 1995 when USD/JPY was at 79. In other words. as we expect Japan’s demographic change to result in lower household saving rate and it’s unlikely that saving rate in corporate sector will rise significantly. 2009 Tohru Sasaki (81-3) 6736-7717 Junya Tanase (81-3) 6736-7718 Yoonyi Kim (81-3) 6736-7729 JPMorgan Chase Bank NA average. however. 1 dollar=79. the currency for lower inflation country should appreciate against the currency for higher inflation country. The most important factor in explaining the divergence in the extent of JPY strength between 1995 and now. Obviously. So far. relative growth rate in inflation is the dominant factor for the strength of currencies. JGB issuance amount for FY2009 is expected to exceed ¥50 trillion (11% of GDP). in particular. while the headline CPI in the US has risen by 40% over the period.P. currencies for higher inflation countries tend to weaken and vice versa.Global FX Strategy Global FX Strategy 2010 November 24. in line with the PPP theory.75 yen in 1995 is now equivalent to 1. J. into account on top of inflation level. This idea is called as the “Purchasing Power Parity (PPP)”. If concerns over this scenario heighten further. However. these factors are likely to change over time. Regarding (1).75 now. However. As the current level of the yen is close to neutral in the context of PPP. JPY movements after the Lehman shock should not be seen as a process of the yen overvaluation. However. We do not expect such condition will materialize over the next year (we expect Japanese current account balance to turn deficit in 2014). Needless to say. suggests that the current level in JPY is overvalued by more than 10%. is the difference in inflation trend between the US and Japan. If exchange rates move towards the direction which offset the divergence in purchasing power between two countries. Chart 2: Inflation and currency performance in the major countries % 80 60 40 20 0 USD AUD GBP EUR Source: J. government debt and current account etc. central banks’ monetary policy aims to achieve stable inflation rate to realize stable value of currency. these factors have had little impact on the long-term trend in exchange rate. it should rather be seen as a corrective move of the extremely weak JPY to a more neutral level. Meanwhile. JPY’s REER should not match the 1995’s high (JPY REER needs to rise by about 40% to match the historical high). However. upside risks and downside risks to JPY look more balanced. Japan at one point will fall into a situation where the government cannot finance its deficit by domestic savings only and will be forced to depend on foreign money to finance the deficit.75. We have heard some arguments that exchange rate should reflect the power of each country and downward trend in population in Japan suggests a long-term JPY weakness. which takes the terms of trade. we believe that factors listed below will lead to a strong JPY in 2010. JGB yields will need to rise to attract foreign investors those who seek for higher risk premium. Under such condition. 1990 currency mov ement against JPY % -60 -50 -40 -30 -20 -10 0 Factors suggesting JPY strength in 2010 The theory of purchasing power parity takes very long time to realize and is not useful in forecasting FX moves within 1-2 years. However.

Japanese Homeland Investment Act (HIA) J. relevant flows could be JPY-supportive. If the main reasons behind the underweighted JPY lie in extremely low level in JGB yields and continuous JPY weakness until mid-2007.50% by the end-2010. For Japanese institutional investors (for lifers in particular). public offering by domestic financial institutions and corporates should accelerate in coming quarters.8 trillion of JPY purchases by foreign central banks.45 since 1986) than between USD/JPY and US-Japan 10year spread (-0. JPY accounts for only 3% of foreign reserves held by global central banks. Therefore. Japan as a country is the world’s largest net creditor.08 over the same period). selling pressure on JPY due to JGB selling should be limited. Against our view.P. we believe that an impact of higher JGB yields on JPY should be positive.P. If this increases to 6%. 4. Foreign purchase of Japanese stocks Although foreign investors aggressively bought Japanese stocks between 2004 and 2007. if JGB yields start rising next year. repatriation flows have been quite limited so far (table 1). the level seen in 1999 to 2000. if JGBs grow more attractive with higher yields.JPY-buying from central banks According to the IMF data. Indeed. If we assume JPY holdings by foreign central banks will rise to as high as the latest peak level. there has been a stronger correlation between JPY’s REER and 10-year JGB yield (0. As they are obliged to pay certain returns. however. 2009 Tohru Sasaki (81-3) 6736-7717 Junya Tanase (81-3) 6736-7718 Yoonyi Kim (81-3) 6736-7729 JPMorgan Chase Bank NA (where more than half is held by public sector).Global FX Strategy Global FX Strategy 2010 November 24. as some cases had been announced already. while Japanese government borrows a large amount of money from domestic investors. In particular. this should imply strong JPY. as long as Japan maintains ample foreign assets and enjoys current account surplus. We think this was because most part of foreign investors’ Japanese stock investments was FXhedged with the relatively wide interest rate spreads between Japan and major countries. leading to a modest widening in US-Japan 10-year spread. absolute level of JGB yields is more important than spreads. 3.Morgan HK FRN CAD UK RUB ITA USA Chart 4: JPY held by central banks as foreign reserve JPY trillion 16 15 14 13 12 11 10 9 8 2002/Q1 2003/Q1 2004/Q1 2005/Q1 2006/Q1 2007/Q1 2008/Q1 2009/Q1 Source: IMF.Morgan Currently. Chart 3: International investment positions of major countries JPY trillion 300 200 100 0 -100 -200 -300 -400 JPN CHN GER Sw iss Source: J. Therefore. they will be unwilling to take any FXrisk. We expect 10-year US Treasury yield to rise to 4. Under such circumstances. if we take the share of JGBs in the global bond market capital into account. J. FX-hedged Japanese stock investments have become less attractive with shrinking yield spreads. we believe majority of foreign investments in Japanese stocks since April this year should be without FX-hedges. Furthermore. Such discussion should also take into account moves in overseas interest rates given their impact on yield spreads.P. Morgan expects a tax relief introduced in April this year to generate about ¥4 trillion of repatriation of overseas retained earnings by Japanese corporates. It accounts for 41% of total JGB outstanding and 27% of total public debt where ¥108 trillion of ¥225 trillion comes from foreign bond investments by private sector (chart 3).5 trillion in 2Q08. As it should take several years to turn Japanese current account balance into deficit. it increased slightly 36 in 2Q this year (chart 4). it is possible for domestic players to start repatriating their foreign asset investments to invest in JGBs instead. however. At this time. once JGB yields reach the level close to this. 6% still looks extremely underweighted. we will see ¥2. we will see more than ¥10 trillion of JPY-purchases. in the long-run. In addition. as yield disadvantage has been diminishing and JPY has been trading firmly. it’s likely that central banks will raise the weight of JPY in their foreign reserves. Since a certain part of such offering is usually allocated for foreign investors. But this means that there remains a room for more repatriation flows supporting on JPY to take place in over the next year. . JPY continued to decline over the period. although JPY held in the foreign reserves by global central banks had declined after marking the latest peak at ¥15. Japan’s net foreign asset stood at ¥225 trillion as of the end 2008. 2.

Global FX Strategy Global FX Strategy 2010 November 24, 2009 Tohru Sasaki (81-3) 6736-7717 Junya Tanase (81-3) 6736-7718 Yoonyi Kim (81-3) 6736-7729 JPMorgan Chase Bank NA

Table 1: Repatriation of overseas retained earnings by Japanese corporates
JPY billion 2006 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source:BoJ 52 93 459 242 129 217 149 122 215 67 48 279 2007 56 77 492 419 242 315 211 130 340 166 105 329 2008 72 84 542 167 254 319 222 164 286 72 49 188 2009 76 50 798 196 262 407 251 112 312 Average (06-08) 60 85 497 276 208 284 194 139 280 102 67 265

5. The Fed’s low-for-long policy There has been a good correlation between the difference in US-Japan policy rate outlooks and USD/JPY. As we expect the Fed’s first hike to take place in 2011 at the earliest, relative outlooks for policy rates in the US and Japan will continue to weigh on USD/JPY, at least until 1H10. Spread between US and Japan in 3-month LIBOR has fallen into negative territory and this reverse in yield differential is now extending into 6-month yield. Note that, from 1990 to 1993 where the US-Japan 3-month LIBOR spread stood at around zero or negative territory, USD/JPY declined sharply (chart 5).
Chart 5: US-Japan 3-month LIBOR spread and USD/JPY
% points 8 7 6 5 4 3 2 1 0 -1 -2 -3 Jan-90 Jan-93 US3M-JP3M USD/JPY 180 160 140 120 100 80 60 Feb-96 Mar-99 Apr-02 May -05 May -08

6). Domestically, as Japan already has a huge short-JPY carry trade positions, which accounts for 18% of GDP in the FX special accounts (fund used for JPY-selling intervention is financed by issuance of FBs), Japanese officials seem unwilling to accumulate FX reserve further. Also, both in cases of massive JPY-selling intervention in mid-1990s and 2003-2004, JPY stopped its appreciation only after the MoF stopped JPY-selling intervention. These bitter experiences should have been enough to make the MoF to be more cautious about intervention. Therefore, we believe that JPYselling intervention is highly unlikely even if USD/JPY breaks the historical low. Note that, our view on intervention is not a factor supporting our forecast for USD/JPY declining to 82. In fact, if intervention is conducted against our view, history tells us that decline in USD/JPY is likely to be sharper and stubborn and the bottom of USD/JPY could be much lower than it would be without intervention.
Chart 6: FX intervention by Japan’s MoF
JPY billion 8,000 150

USD/JPY
6,000 4,000 2,000 0 -2,000 -4,000

140 130 120 110 100

intervention amount

90 80

Soruce: MoF, Bloomberg

Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09

Risk factors to our JPY-bullish view As discussed above, we expect JPY to trade firmly against the majors during next year and to see a relatively large upside against USD in particular. However, it should be worth pointing out some risk factors against our JPY-bullish view. 1. Earlier hike by the Fed As there has been a strong correlation between the difference in US-Japan policy rate outlooks and USD/JPY, if expectations for earlier Fed hikes heighten, it could lead to an earlier bottoming out of USD/JPY than we expect. Also, rising hopes for Fed hikes should lead to flattening of the US yield curves. Under such condition, domestic institutional investors, those who have invested in US bonds with FX-hedging, could buy USD and sell JPY to take out FX-hedging and these flows could push USD/JPY higher. However, as these moves mean that Japanese institutional investors will newly take FX risks, to materialize these moves, a notable rally in the Nikkei index, which could
37

Source: Bloomberg, J.P.Morgan

JPY-selling intervention remains highly unlikely In the past few years, J.P.Morgan has maintained the strong view that FX intervention by Japanese MoF is highly unlikely due to both international /domestic reasons. Regarding the international backdrop, the fact that the G7 publicly started criticizing China’s rigid FX policy in 2003 to 2004 has made Japan’s intervention more difficult. Indeed, Japan stopped FX intervention March 2004 (chart

Global FX Strategy Global FX Strategy 2010 November 24, 2009 Tohru Sasaki (81-3) 6736-7717 Junya Tanase (81-3) 6736-7718 Yoonyi Kim (81-3) 6736-7729 JPMorgan Chase Bank NA

result in an improvement in investors’ risk appetite, will also be needed along with heightening speculation for the Fed’s hikes. More specifically, we think if the Nikkei index rises to above 12000 along with heightening hopes for the Fed’s rate hike, USD/JPY buying from Japanese institutional investors will push USD/JPY above 100. However, we believe the probability of such scenario coming true, at least in 1H10, is quite low. 2. Acceleration in Japanese overseas investments Since 2Q this year, Japanese retail investors have resumed their investments in foreign assets as concerns over systemic risks for financial system receded and global economic recovery came back into their radar screen. Net purchases of foreign bonds and stocks by Japanese retail investors through investment trusts have amounted to ¥2.9 trillion between January and October this year; which is more than triple the net purchases last year (Note, however, that it is still about 50% of total net purchases in 2006 and 2007). If these trends continue, relevant flows could weigh on JPY. However, flows stemming from FX margin accounts which had contributed to JPY weakness until mid-2007 are not a factor necessarily suggesting JPY weakness for this time. This is because risk-taking activities by FX margin accounts have become more two-sided one compared with that until mid-2007 and as a result, we rarely observe any sharp accumulation in positions - typically in JPY shorts. These developments reflect that short JPY carry trades have become less attractive with shrinking yield spreads between Japan and other major countries amidst rising FX volatility. Moreover, while we can expect yield gap with some countries to widen next year, starting from August 2010, there will be a restriction limiting leverage to 50 times. Therefore, by the time yield differentials recover to attractive levels, retail traders will only be able to take smaller amount of positions. Separately, foreign direct investments by Japanese corporate have been relatively solid this year. Although the pace of relevant outflows this year (¥6.3 trillion, annualized figure between January and September) has been smaller than that in 2008 where the FDI-related outflows recorded a historical high at ¥10.7 trillion, it’s still comparable with outflows in 2006 and 2007. If JPY strength continues, it’s possible that the FDI outflows will be accelerated further. We target USD/JPY 82 with seeing downside risk Aside from the JPY bullish factors mentioned above, there are other upside risks for the yen which are not necessarily in line with J.P.Morgan’s official view. One risk is a possible decline in the U.S. long-term yield. Japan’s past experience suggests possible risk for significant decline in
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US long-term yields on the back of widening deposit/lending gap in the banking system. If this realizes, it should be an additional factor supporting JPY strength given the strong negative correlation between JPY and the US long term yields. Furthermore, if China allows greater CNY appreciation than we now expect (we expect USD/CNY to decline to 6.50 until the end of 2010), it could result in a broad appreciation in Asian currencies, elevating an upward pressure on JPY as well. Taking into account the fact that the next G20 summit will be headed by Korea in 2010, it may be natural to think that Korea and China will try to take leadership roles taking bold steps towards resolving global imbalances. If this happens or even just expectations for such movement were to heighten, market participants are likely to sell USD/JPY as a proxy trade. With our bearish view on USD, upside risks to JPY give more reasons to believe in possible sharp decline in USD/JPY. Unless we are faced with rising expectations over earlier Fed hikes and rallies in the Nikkei to above 12000, USD/JPY is likely to decline to 82 by mid-2010, before modestly rebounding towards 2H10 along with an expected rise in hopes for the Fed’s policy normalization. If USD/JPY reaches our target at 82, we should watch out for risk of USD/JPY making a further decline, as the market will keenly want to test the historical low at 79.75. In that sense, we should not rule out the possibility of USD/JPY trading below the historical low at least temporarily. Again, however, it is important to note that this still should not be perceived as a significantly high level for JPY, when taking the relative inflation trend into account; if we look at the “real” (price-adjusted) USD/JPY rates, USD/JPY at 79.75 now should be equivalent to USD/JPY at around 105 in November 1999 (chart 7).
Chart 7: Real USD/JPY rate
180 Price-adjusted (real) 160 140 120 100 80 Feb-90 Feb-94 Source: J.P.Morgan Feb-98 Feb-02 Feb-06 actual

Global FX Strategy Global FX Strategy 2010 November 24, 2009 Tohru Sasaki (81-3) 6736-7717 Junya Tanase (81-3) 6736-7718 Yoonyi Kim (81-3) 6736-7729 JPMorgan Chase Bank NA

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Global FX Strategy Global FX Strategy 2010 November 24, 2009 Paul Meggyesi (44-20) 7859-6714 paul.meggyesi@jpmorgan.com J.P. Morgan Securities Ltd

Research Note

EUR: Few obstacles to new highs
• J.P. Morgan’s forecast for new highs in EUR/USD reflects USD bearishness, ongoing reserve diversification and the absence of euro-specific headwinds. A commonly perceived risk to the euro from faster CNY revaluation is overstated, as is the threat to the region’s trade and capital flows from the euro’s valuation. Fears of EUR break-up are no longer credible. Reserve diversification is the factor most often cited as a cause of EUR’s persistent overvaluation in recent years. The empirical evidence has not been overwhelming until recently. EUR is typically weakest when central bank demand for EUR is strongest, suggesting that CB portfolio rebalancing has dominated. Such portfolio rebalancing has served to cap rather than exacerbate EUR strength and to limit EUR pullbacks. There was evidence from Q2, however, that diversification is becoming more aggressive, which could justify sustained EUR appreciation. Reserve accumulation is one facet of a broaderexplanation for “excess” upward pressure on EUR, namely the continued fixing of Asian exchange rates and the resultant re-channeling of USD-deprecation through floating currencies. The flaw in this explanation is the persistent positive correlation between EUR and CNY – there is no evidence that changing expectations about the pace and extent of CNY revaluation affect EUR on a sustained basis. Fade the inevitable EUR weakness should China escalate the pace of CNY revaluation. There is no evidence that FX valuation is depressing either trade or investment flows to the Euro area. External flows offer no resistance to new highs. Fears of a structural crisis are as long-standing as they are misplaced. What many feared would undermine cohesion – a severe and asymmetric recession – has actually served to reinforce it. Trade: buy a 6-mo 123-142 EUR/JPY range binary to leverage the lack of domestic drama in the Euro area.

How much have central banks distorted EUR/USD? On our estimates EUR remains moderately overvalued (+5%) relative to its equilibrium value. The most popular explanation for this apparent richness in the euro is the distortive effect of the de-facto Bretton-Woods II arrangement of (soft) dollar pegging in the Asian countries. This, the argument runs, prevents USD from appreciating against the fundamentally cheap surplus currencies in Asia and instead channels dollar depreciation through the path of least resistance in G10 floating exchange rates. EUR bears a disproportionate burden of this USD depreciation due to the demand for EUR from Asian and other central banks diversifying their USD reserves. This hypothesis is illustrated by charts 1 & 2 that compare the deviation of EUR/USD from fair value against the level of global FX reserves. The two are highly correlated – 85% in level terms and 70% in change terms since 1999.
Chart 1: EUR overshooting vs. fair-value appears related to global FX reserves, both in level terms…
30% 20% 10% 0% -10% -20% Dev iation of EUR/USD from equilibrium, % lhs Global FX reserv es, $ bn, rhs 8000 7000 6000 5000 4000 3000 2000 1000 0 00Q1 02Q1 04Q1 06Q1 08Q1

-30%

Source: IMF; J.P.Morgan

Chart 2: …and in change terms
Change in EUR/USD ov er/underv aluation, % oy a, lhs 20% 10% 0% -10% Change in FX reserv es, oy a, $bn, rhs 2000 1500 1000 500 0 -500 -1000 00Q2 02Q2 04Q2 06Q2 08Q2

-20% -30% -40%
Source: IMF; J.P. Morgan

This circumstantial evidence appears to support the hypothesis that reserve accumulation and diversification has been instrumental in driving the euro’s overvaluation, especially as EUR moved into overvalued territory only at the time that reserve accumulation really got into gear in the

40

and vice versa. most notably China. As is clear. in price and volume terms Quarterly change in EUR FX reserves. at least over short-medium term horizons. J. J. yet according to the COFER data. Nonetheless. chart 3 plots the change in EUR/USD against the reported accumulation of EUR reserves minus USD reserves (volume terms). Such an analysis is subject to the unavoidable limitations of the IMF’s Composition of Foreign Exchange Reserves (COFER) data.com J. FX adjusted. 4Q sum. central banks accumulated a record volume of EUR reserves.P. $bn 40 20 0 09Q1 -10% -5% -20 -40 0% 5% 10% 15% 09Q2 Source: IMF.meggyesi@jpmorgan. central banks physical accumulation of EUR reserves is greater when EUR is weaker. it seems that exchange rate changes influence reserve diversification. Reserve management may have been more bearish for EUR/USD vol than it was bullish for EUR/USD spot. (Chart 4 plots the quarterly change in EUR reserves. In addition. But correlation does not imply causation. Chart 4: Record EUR reserve accumulation in Q2. J.P.P. Morgan Securities Ltd middle of the decade. This is not to deny of course that more active diversification into EUR could yet generate a more substantial overshoot in EUR/USD. in particular the relationship between EUR/USD and USD/CNY. Chart 3: EUR strength is inversely related to the relative demand for EUR FX reserves Change EUR/USD ov er/underv aluation. % oy a. one would expect there to be a negative correlation between EUR and expected CNY appreciation. 2009 Paul Meggyesi (44-20) 7859-6714 paul. the activities of reserve managers may have served to compress its variability in both directions. But if central banks do switch more from portfolio rebalancing towards momentum investing. EUR/USD appreciated during the quarter. QoQ change. There was some evidence of just such a shift in central bank behavior in Q2. the reality or expectation of CNY appreciation should be expected to alleviate upward pressure on EUR/USD. they accumulated more EUR than USD reserves. which provides a currency breakdown for only 2/3 of global reserves and omits certain key players. Under this Bretton Woods II hypothesis. This proposition is of course testable. The hypothesis would be more compelling if there were also a strong positive relationship between the deviation of EUR/USD from fair-value and central bank demand for EUR itself. as centrals banks rebalance their reserves to maintain broadly steady reserve ratios in the face of fluctuating exchange rates. lhs 20% 10% 0% -10% -20% -30% -40% 99Q3 01Q3 03Q3 05Q3 07Q3 09Q3 EUR-USD reserv e accumulation. chart 5 the EUR/USD. Rather than over-inflating the value of the euro. there is a strong negative (-65%) correlation between these two series. given that we have four years in which USD/CNY has been allowed to depreciate to varying degrees. Unfortunately the data appears to show precisely the opposite – EUR is strongest relative to fundamentals when central bank demand for euros is weakest and vice versa. 41 . FX 80 60 adjusted. One quarter does not constitute a trend and Q2 could yet prove to be a fluke. $bn 150 100 50 0 -50 -100 2002 Source: IMF. 300 200 $bn 100 0 -100 -200 -300 -400 volume change in EUR reserves versus the change in EUR/USD). In other words.Morgan Rather than reserve diversification influencing the exchange rate.Global FX Strategy Global FX Strategy 2010 November 24. Morgan Unraveling the EUR-CNY nexus Another way of considering whether Asian FX fixing has artificially distorted EUR/USD is to examine the market based evidence. the impact would be to boost both EUR/USD spot and volatility. or at the very least that the correlation between the two should decline as CNY flexibility increased.Morgan Actual FX-adjusted 2004 2006 2008 Chart 5: An end to CB reserve rebalancing in Q2? Change in EUR FX reserves.P. If China’s currency pegging has indeed forced excessive USD depreciation onto EUR/USD. % Source: IMF.

the correlation of daily changes in EUR and CNY has actually increased. Morgan Nov -03 Nov -05 Nov -07 Chart 8: The positive correlation between EUR and CNY (has increased. 1Y rolling window 1. That after all was the response to the initial de-pegging in July 2005. Aside from a brief period in mid-2006 to 2007. not decreased. 2009 Paul Meggyesi (44-20) 7859-6714 paul.0 0.9 0. EUR has been positively correlated with expected CNY appreciation Correlation between EUR/USD and 1Y implied CNY appreciation vs.8 Nov -00 EUR/USD CNY .4 1. To illustrate this. A directional decoupling of EUR and CNY remains a distant prospect.7 1. In addition. the level of EUR/USD has been positively correlated with the expected degree of CNY appreciation vs. not decreased. chart 6 plots EUR/USD against the appreciation in CNY vs. In short.3 1. The most obvious question-mark surrounding the forecast of a new high in EUR/USD is whether the economy would be able to withstand the hit to external demand. more so in EUR/JPY. The market has on occasions fretted about local risks to the euro – hidden losses at Euro area banks and fears of euro break-up being the two most obvious. USD. which in a sense could be viewed as one of the single currency’s major attributes. There is little doubt that the knee-jerk reaction to either a step adjustment in USD/CNY or a faster rate of crawl would be a sell-off in EUR/USD.0 -0. Morgan Securities Ltd Once again the evidence does not appear to support the hypothesis.1Y appreciaiton v s USD implied by NDF. levels. As in 2005. the uptrend in EUR/USD resulting from the general USD downtrend? In recent years EUR has been devoid of domestic dramas. In addition. rhs 12% 9% 6% 3% 0% -3% -6% Nov -02 Nov -04 Nov -06 Nov -08 Chart 7: Aside from a brief period in 2006/2007. There is little evidence of directional decoupling of EUR and CNY Correlation between EUR and CNY via USD. 1Y window 40% CNY spot 30% 20% 10% 0% -10% -20% Nov -01 Source: J. But these concerns have generally come to nothing and the euro remains a stand-out strong currency.0 0. are the idiosyncratic Euro factors that could impede.5 0. Nov -03 Nov -05 Nov -07 Nov -09 Where’s the domestic drama? What. Morgan CNY 1Y fw d Source: J.5 1.Global FX Strategy Global FX Strategy 2010 November 24. if any. daily % changes. Chart 7 plots the correlation between these two. or indeed reinforce.meggyesi@jpmorgan.P. there is a natural concern that the apparent richness in the euro could damage investment flows to the region.P.P. we would expect this response to be quickly reversed as the market reverted to the singular dollar trend. can the region’s balance of payments withstand a continued appreciation in the currency to new record highs? 42 . %. In reality there has been one dollar trend and the fact that the positive correlation between EUR and CNY has increased through periods of both fast and slow CNY offers little prospect that this correlation will collapse or turn negative should Asian policymakers do the unexpected and sanction a much faster pace of local FX appreciation. Chart 6: EUR/USD and expected CNY appreciation are positively correlated 1.6 1. USD implied by the 1Y NDF. as this has left the euro free to function as a core anti-dollar currency.2 1.5 -1. the exact opposite of the Bretton Woods II distortion hypothesis.com J. Morgan The experience of the last few years tends to contradict the notion that Asian inflexibility has led to an artificial appreciation in EUR/USD. USD. over the past few years (chart 8).P. however.0 Nov -01 Source: J.1 1.

% oy a Source: J. Recent trade numbers tend to confirm this analysis and support the outlook for an extended euro uptrend through at least H1 next year.P. however. The exchange rate is a key determinant of export market share. net portfolio flows over the past year have approached a record €500bn. global growth) rather than relative price (i. Morgan Securities Ltd Exchange rate appreciation is certainly a drag on Euro area exports. the trade balance has returned to a reasonable surplus. 2009 Paul Meggyesi (44-20) 7859-6714 paul. The current account. % oy a Euro area ex ports. the exchange rate). October 2009) found the dominant driver of export growth to be foreign demand (i.meggyesi@jpmorgan. Morgan Chart 11: Healing in the Euro area’s external accounts Euro area external balances.P. Since then. not surprising given the unprecedented flight to quality demand for bonds in the face of near economic and financial collapse. meanwhile. And due to the still low level of exports (20% below their peak) the risk is for even stronger growth. primarily due to a surge in debt inflows (€440bn).e. Given our forecasts for global growth next year it is not a stretch to get to 8% growth in Euro area exports even with a stronger EUR. A similar effect from the exchange rate requires a sizeable 6% trade-weighted adjustment in the euro. 3mo moving average.1% change in Euro area exports.P. since then the turnaround in the external accounts has contributed to the euro’s rehabilitation. Chart 11 shows the region’s trade and current account balances. Mackie.Global FX Strategy Global FX Strategy 2010 November 24. Morgan 43 . A 1% change in global growth results in a 2. 1999=100 130 120 110 100 90 80 70 Source: J.com J. Chart 9 shows that the inverse relationship between the region’s relative export performance and the exchange rate is exceptionally strong. a collapse which itself also undermined the euro. Chart 9: The Euro area’s relative export performance is inversely related to the level of the euro 160 150 140 130 120 110 100 90 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 EUR REER Dev eloped/Euro area ex ports. A recent analysis by our chief Euro area economist (See Currency unlikely to prevent strong Euro area export growth. as one would expect given the conflicting nature of bond and equity flows. Capital flows offer no solace to Euro skeptics What of capital flows? The overall portfolio flow position is extremely strong. After falling sharply as global trade imploded last year. has returned to balance for the first time since late 2007.P. But the consequences of this for the absolute export performance. should be more than offset by the boost to exports from global economic recovery (chart 10). and vice versa (19992007).e. The unprecedented collapse in the region’s surplus last year no doubt exacerbated the deleveraging-led collapse in the euro in late 2008. Morgan Chart 10: But the global business cycle is the key driver of exports 40 30 20 10 0 -10 -20 -30 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Global IP. The relationship between the currency and net portfolio flows is however inconsistent (chart 12). EUR bn 15 Current account Trade balance 10 5 0 -5 -10 -15 -20 Jan-99 Jul-00 Jan-02 Jul-03 Jan-05 Jul-06 Jan-08 Jul-09 Source: J. which is what matters for economic growth and presumably also for policymakers. the relationship has flipped. Indeed. For the bulk of the life of the single currency strong and rising net portfolio inflows were associated with EUR appreciation.

2009 Paul Meggyesi (44-20) 7859-6714 paul.meggyesi@jpmorgan.P. 12m sum. who were quick to repatriate overseas equities last year. The message here is not particularly worrisome for the single currency. Putting local and foreign equity flows together. For now M&A activity looks to be a broadly neutral factor for EUR/USD. That said. net equity and net FDI flows. It remains to be seen whether genuine M&A outflows from the Euro area will resume in the face of the global upswing. a reinvestment rate that exceeds that of the US.com J. the basic balance collapsed during 2008/early 2009 but has since recovered sharply. FDI flows. EUR bn 40 20 0 -20 3m -40 -60 Jan-00 Source: J. Morgan Securities Ltd Chart 12: Euro area portfolio inflows at a record high. neither does this support any form of outperformance from the euro versus non-USD currencies. it confirms that there is no obvious balance of payments headwind for the euro.P. are still negative (EUR 134bn over the past year) but the bulk of these flows are now accounted for by intercompany loans rather than fresh outward investment by Euro area companies. and quick to reinvest Euro area equity flows. What price EUR break-up risk now? Ever since its inception EUR has attracted a group of hardcore skeptics. lhs 20% EUR NEER. Euro area current account. Nonetheless. Morgan 12m Jan-02 Jan-04 Jan-06 Jan-08 The overall state of the Euro area’s balance of payments in so far as it drives demand/supply for EUR can best be summarized by a broad basic-balance concept that aggregates the current account. net equity and FDI flow. Morgan Euroarea purchases foreign equity Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Source: J. EUR bn. Of the €142bn of foreign equities that were sold between Sep 2008-Apr 2009. % oy a 15% 10% 5% 0% -5% -10% -15% Chart 13: Foreign investors were quick to sell EUR equity. The surplus is not sustainable at these levels. but the relationship to EUR is inconsistent 600 400 200 0 -200 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Net Euroarea portfolio inflow s. by the first severe recession or asymmetric shock to 44 . only €1bn has been reinvested. even at these seemingly expensive levels. The reason is that Euro area equity investors. As chart 14 highlights. have been exceptionally slow to reinvest. so much so that the combined surplus over the past 3 months is at a record high. unconvinced that the Euro area constituted an optimal currency area and that cohesion of the single currency area would be severely tested.P. it makes sense to consider equity and FDI flows in isolation. net equity and FDI flow has surged to a record high in recent months. They have since reinvested 45% of this. EUR may well appreciate to new highs but most likely not on a wall of equity money. There is no evidence here that currency valuation has adversely affected foreign demand for EUR investments. 12m sum. That said it would be unrealistic to expect equity flows to drive a sharp EUR appreciation from here. EUR bn Foreign purchases EUR equity 400 300 200 100 0 -100 -200 -300 Jan-99 Source: J. Equity flows turned sharply negative during the crisis as foreign investors sold nearly €250bn of local equities. Morgan From the perspective of assessing whether EUR valuation is adversely affecting investors’ perception of the region’s growth prospects and therefore the real rate of return on euro investments.Global FX Strategy Global FX Strategy 2010 November 24. Chart 14: Combined demand for EUR from the current account. monthly average. not least because equity re-investment will winddown. and potentially even broken. meanwhile. 90% of the equity capital that left the region during the crisis has already been reinvested.P.

More objectively.P. Morgan Chart 16: The divergence in unemployment is more pronounced Dispersion of intra-Euro area unemployment rates (% oya. 2009 Paul Meggyesi (44-20) 7859-6714 paul. one that would raise more valid doubts about countries’ continued participation in the single currency. Chart 15: Growth divergence within the Euro area has increased.P.com J. rhs 3% 15% 10% 2% 5% 0% 1% Feb-96 Feb-98 Feb-00 Feb-02 Feb-04 Feb-06 Feb-08 Source: J. Break-up risk has been the euro’s ultimate domestic drama. nonetheless doubts about cohesion of the single currency have been the basis for intermittent bouts of pessimism towards the currency.meggyesi@jpmorgan.P. rhs 19 17 15 13 11 9 7 5 Source: J.P. Standard dev iation. but remains with historic norms Dispersion of intra-Euro area GDP growth rates (% oya. It is not particularly obvious that these structural reservations have had any negative bearing on EUR’s average valuation in recent years. lhs Max -min. lhs Max -min.Global FX Strategy Global FX Strategy 2010 November 24. 16 and 17 illustrate this with a time series of the standard deviation of GDP growth. One of the lasting legacies of this crisis may therefore be to end the intermittent speculation of EUR break-up. lhs 5 Max -min. 6 5 4 3 2 1 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Standard dev iation. 4q MAV). Calculations use the current composition of the euro area for consistency 4% 20% Standard dev iation. especially as a source of stability for smaller countries. Such skepticism towards the long-run viability of the euro looks ever more unjustified in the light of recent events. either as an economic inevitability or a political possibility. one has to question what potentially could. Morgan Chart 17: Fiscal cohesion has not been threatened Dispersion of intra-Euro area GDP public sector deficits (% GDP). If the worst recession of the post-war period has been incapable of undermining EUR cohesion. Morgan Securities Ltd hit the region. both current and aspiring members. Rather than exposing economic and political fault-lines in the Euro area. unemployment rates and fiscal deficits throughout the Euro area. it is not obvious that the recession has resulted in a potentially fatal divergence in economic performance amongst Euro area members. rhs 4 20 15 3 10 2 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Source: J. Morgan 5 45 . 4q MAV). Charts 15. the crisis has served to reinforce the political attachment towards the euro.

P.P. and also over the past month.meggyesi@jpmorgan. 1Y rolling window 30% 25% 20Y average 20% 15% 10% 5% 0% -5% -10% -15% -20% Jul-90 Jul-93 Jul-96 Jul-99 Jul-02 Jul-05 Jul-08 Source: J. or is sterling’s future now defined as one of that select group of funding currencies (primarily USD) whose fortunes are inversely related to that of the global economy and asset prices? Chart 1: GBP’s correlation to equity markets rose to a multi-decade high during the crisis. • clearly traded as an investment currency during this period. GBP 46 . The structural state of public finances is particularly hostile for GBP. The currency endgame from this is either slow-burning pressure on GBP due to an adverse shift in the fiscal/monetary policy mix should policymakers undertake fiscal consolidation (a la Canada in the mid 1990s) or a faster depreciation should policymakers sidestep the problem and risk a loss of foreign investor confidence. GBP’s undervaluation may limit the scope for a renewed sharp depreciation. the expected rate of return on UK assets will be determined primarily by the UK’s relative economic performance and the resultant trajectory for relative interest rates. since the market is too optimistic on the UK’s exit from QE and not keen enough on Switzerland’s.45 RKI on the lower strike. GBP and stocks moved higher in tandem – GBP continued to perform as an investment currency.Morgan GBP’s future as a funding currency? What determines a currency’s status as a funding or investment currency is the expected rate of return on its assets vis-à-vis international counterparts. The issue of unresolved balance sheet leverage questions the prospects for a quick normalization in interest rates and as such it is doubtful whether GBP can regain its former high-yield status. which stands to benefit from a continued healing in the global economy and financial markets. How GBP behaves relative to risk markets reduces to the GBP’s rate advantage – the higher GBP’s carry. This distinction between GBP as funding or investment currency remains pivotal to how one thinks about GBP’s prospects next year. But beyond this.50 GBP put/CHF call spread with a 1. Is this a confirmation that GBP remains an inherently procyclical currency whose undervaluation sets the stage for an extended appreciation next year as the global recovery unfolds? We are not convinced.60 – 1. The UK is poised for its greatest economic underperformance in the last two decades. the more effectively it should function as an investment currency and the higher its correlation to risk markets. and in this sense GBP’s current undervaluation versus equilibrium exchange rate models is one factor which has the potential to support demand for GBP should investors anticipate capital gains from a reversion to long-run fair value. with • GBP’s history as an investment currency One of the key issues for GBP throughout this year has been its relationship to the global business cycle and asset prices. Morgan Securities Ltd. 2009 Paul Meggyesi (44-20) 8769-1906 Paul. banking and public sectors remains a powerful obstacle to a sustained cyclical rebound in GBP. But for a three month period between July and September the correlation between GBP and the stock market flipped as traders started to use GBP as the funding currency counterpart to their reflation trades. Research Note GBP: Funding currency or investment vehicle? • GBP has defied the doomsters this year. The relationship between GBP and equity markets has been more mixed since stocks turned around in March. banking and credit market collapses in 2007/2008. Without this GBP’s positive correlation to risk markets is liable to weaken substantially. Should GBP be regarded as an investment currency. posting a 4% trade-weighted appreciation so far. but the relative headwind to the UK economy from a trinity of deleveraging in the household.com J. In the early part of the rally. • • Correlation between daily changes in GBP NEER and S&P500. In the process the correlation between GBP and risk markets surged to its highest level in recent decades (chart 1). Exchange rate valuation provides one component of this expected return. A lower level of carry should reduce GBP’s sensitivity to risk markets. At a simplistic level the UK was positioned near the epicenter of the housing.Global FX Strategy Global FX Strategy 2010 November 24. an uncomfortable proximity which caused GBP to slump as stock markets went south. Trade: Buy a 6-mo 1.

albeit weak. a trinity of deleveraging that threatens to depress relative UK 47 Growth outperformance turns to underpeformance So much for the current trivial level of spreads – does the UK have the capacity to deliver above average growth in the next few years and in doing so to re-establish GBP as a higher-yielding investment currency? The omens for this are not good. % oya. Morgan Securities Ltd.5 2. In addition. when the correlation to risk markets rose to a new high even though the carry on GBP collapsed to a multi-decade low.2 1Y rolling correlation betw een GBP and S&P500 0% -10% -20% -30% -4% Source: J.2 0.com J.0 0. as a structurally large deficit has been further stretched by an outsize banking crisis and the attendant economic recession. Chart 2: GBP is a now a low-yielding currency. That .Morgan 2008 -3% -2% -1% 0% 1% 2% 3% Aug-02 Aug-05 Aug-08 A Beaufort scale for balance sheet headwinds Pivotal to GBP’s prospects as the global recovery unfolds is the number and magnitude of unresolved balance sheet tensions in the UK economy.P. 2009 and 2010 are JPM forecasts 3% 2% 1% 0% -1% -2% -3% -4% Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Source: J. In a worse case scenario the UK is faced with the need for a simultaneous deleveraging by the household. The UK was in the vanguard of the global housing bubble and as a consequence its household and banking sectors are amongst the most levered in the world. %.5 0.3 0. which justices a much lower or even negative correlation to risk markets 3. albeit more noticeably in the first half of the decade than in the second. 1975-1979 1980s 1990s 2000s 30% 20% 10% 2009 UK-G7 2Y sw ap differential. a fact which should depress appetite for GBP as a carry trade and put downward pressure on GBP’s correlation to risk markets. lhs 0.5 1.Morgan the UK is lagging the global recovery is worrying enough.1 0 -0.P. Chart 3 compares the difference between GDP growth in the UK and the rest of the developed world. banking and public sectors. as happened briefly in the summer. But there is no symmetric reason to suppose that GBP should rally just because stocks are now rebounding. there is the potential for this correlation to turn negative should the paltry level of UK rates encourage a broader use of GBP as a funding currency. that it is doing so despite the advantage of a competitive currency and more aggressive monetary stimulus than elsewhere is even more concerning. Chart 3: UK is faced with the sharpest growth underperformance since the late 1980s/early 1990s UK minus developed world GDP growth. Investors will not be squeezed back into GBP in the same way they were squeezed out last year barring an interest rate justification for them to reload on GBP longs.P. but this year and next JPMorgan expects the UK to deliver its sharpest growth underperformance since the ERMhousing related recession in the late 1980s/early 1990s. Now the relationship between relative UK growth and GBP’s performance may be rather weak (chart 4). As chart 2 details.Global FX Strategy Global FX Strategy 2010 November 24. 2009 Paul Meggyesi (44-20) 8769-1906 Paul.0 Aug-99 Source: J. Positioning can explain this divergence as stock markets melted down last year – the carry on GBP may have collapsed but investors nonetheless had an accumulated overhang of long GBP positions which were unwound as stock markets went south. it is difficult to see sterling appreciating for the second consecutive year in the face of the second consecutive year of sub-par growth.1 -0. relationship between relative UK growth and GBP’s trade-weighted performance The scatter diagram plots the growth gap between the UK and the developed world on the horizontal axis and the annual change in GBP’s REER on the vertical axis. As chart 2 makes clear. UK public finances have unraveled at a faster rate than anywhere else in the developed world. The UK broadly outperformed over the last decade. the average carry on GBP is at its lowest level in over a decade. nonetheless.0 1. this relationship between GBP’s yield pick-up and its sensitivity to risk markets has held well over the past decade. the correlation turning negative in the extreme case in which GBP offers negligible or even negative carry and is transformed into a funding currency. In the extreme.0 2. with the notable exception of the past year.meggyesi@jpmorgan.Morgan Chart 4: There is a positive.P.

The IMF in its recent Global Financial Stability Report attempted to quantify the relative extent of the credit crunch in the major economies. expressed a percentage of GDP – it is a quite striking that UK bank losses are estimated to be three times as large as in the US or Euro area.Global Financial Stability Report. October 2009 Additional ex pected Q2 2009 Chart 7 The resultant credit crunch is more severe in the UK IMF’s estimate of the credit shortfall. the outsize losses faced by UK banks compromises their relative ability to create credit – in short. As chart 5 details.Global FX Strategy Global FX Strategy 2010 November 24. October 2009 Source: National central banks. Chart 6 compares the IMF’s estimate for banks losses. is it any wonder that the BoE has had to undertake such aggressive QE.meggyesi@jpmorgan. with total bank liabilities as a % of GDP falling from 500% of GDP to 470%. The banking sector has contracted but the extent of the deleveraging is relatively small. but without a meaningful reduction in leverage it is difficult to see how the UK can recapture its former status as a higher growth/higher yield economy. and still does Banking sector liabilities. Headwinds from the banks At the start of the crisis.Morgan The disproportionate size of the banking system matters for two reasons. % of GDP 25% 20% 15% 10% 5% 0% US UK Euro area Source: IMF. Balance sheet issues may have taken something of a backseat in recent months. the larger the losses Bank losses. the UK had the second largest banking system out of the major countries. J. derived from an estimate of bank losses adjusted by an estimate for new bank capital and bank profits. 800% 600% 400% 200% 0% Chart 6: The larger the banks. this year? Headwinds from household leverage The extent of household leverage is another potential relative headwind for the UK economy. Secondly. To do this it first calculated the potential supply of new credit from financial systems in the US. growth prospects vis-à-vis those countries where private and public balance sheets are less stretched. and in the UK this is six times as large as the US this year and nearly four times greater than in the Euro area. partly because ultra-low interest rates have alleviated their debt-servicing symptoms. The IMF then compared this potential supply of credit with the ex-ante demand for credit.P. UK consumers were not the most voracious borrowers during the credit boom– that dubious honor falls to Ireland where household ar ea UK pa n Sw ize rla n Sw ed e tra 48 Eu ro Au s Ca na Ja US lia da d n . the larger the banking system. Chart 5: The UK had an outsize banking system. 0 -5 -10 -15 2009 2010 2007 2008 2009 -20 US Euro UK Source: IMF Global Financial Stability Report. as % GDP. 2009 Paul Meggyesi (44-20) 8769-1906 Paul. Given the importance of these balance sheet issues it is worthwhile considering them in slightly more detail. Firstly it has increased the cost to the taxpayer of stabilizing the banking system. Given this disproportionate inability of the UK banking system to create credit.com J. Euro area and UK. the banking system has shrunk from 670% of GDP to 580%. This credit gap can in some senses be regarded as a measure of the severity of the credit crunch. The resultant credit gap – the difference between the domestic supply of credit and the domestic demand for credit – is shown in Chart 7. by contrast. or ¾ of the credit gap. little has changed in the intervening period. the worse the resultant credit crunch. thereby worsening the UK’s fiscal positions (more on this later). The credit shortfall is expected to decline next year but will remain near 10% of GDP compared to less than 1% in the US and 3% in the Euro area. providing monetary financing to the government worth some 15% of GDP. Morgan Securities Ltd. This is the difference between the potential domestic supply of credit and the domestic demand for credit. UK banks are still 75% larger as a proportion of the economy than they were a decade ago. In Switzerland. as % of GDP.P.

Chart 11: The UK runs the largest fiscal deficit this year and the second largest next year Public sector financial position. Chart 8 UK household debt is high relative to history and international peers Household debt/GDP ratio.meggyesi@jpmorgan. household leverage in the UK is high both by international standards and relative to UK history (chart 8). This hardly constitutes a . the UK is suffering the worst deterioration in public finances of any major country. % oya Current 16% 12% 8% 4% 0% -4% -8% USD Source:J.P. balance sheet problems in both the banking system and household sectors threaten to impair credit growth to varying degrees in the main economies. As chart 9 highlights. Chart 11 shows the deficit position in 2009/10. Chart 10: Balance sheet problems translate to outright credit contraction in the UK Bank lending to individuals and non-financial corporations. J. On both fronts the UK is relatively exposed and as such it should be no surprise to learn that UK credit growth is virtually the weakest of all the major countries (chart 10). 2009 Paul Meggyesi (44-20) 8769-1906 Paul.Morgan Chart 9: Leverage depresses growth on the way down in the same way it boosts growth on the way up 2% Australia Norw ay France Canada Italy US UK NZ 2009 GDP growth. 10Y av erage Source:OECD.com J. The impact of such a process on relative economic performance is already being felt this year.Global FX Strategy Global FX Strategy 2010 November 24. a fact which threatens to depress UK growth relative to many other counttries should consumers seek to delever more aggressively.Morgan In summary.P. the severity of a country’s recession is inversely related to the scale of leverage in its household sector.P. chart 12 the projected increase in public debt between now and 2014. Morgan Securities Ltd. the recession and the bank bail-outs. % GDP 10 2010 5 -5 Ireland Household deb/GDP ratio v s. J. The more severe the balance sheet strains.e 2 Au Ita 0 str ly T u alia So Sw rkey ut ede h Ge Af r n rm ica an y Ca N na Z C da M hin a e R uxic o ss i Ar Kor a ge ea In nt do in ne a s Br ia N o az rw il ay Source: IMF 49 Household debt/GDP ratio v s. with bank credit to the private sector now falling quite sharply in outright terms. Nonetheless.Morgan Pre-crisis av erage GBP EUR AUD NZD JPY CHF SEK NOK The drag from public finances Excess leverage in the UK is not confined to the private sector. 10Y av erage Source:OECD. % 120% 100% Australia UK US NZ Canada 80% Norw ay Sw eden Japan 60% France Germany 40% Italy 20% 0% -20% 0% 20% 40% 60% 80% Ireland convincing basis for a resumption of UK economic outperformance nor a renaissance of GBP as a carry currency. debt as a percent of GDP rose by 54% between 2001 and 2008 – nor do they have the highest debt/GDP ratio (Australia tops this list at 106% with the UK in third place at 100%). % oya 0% -2% -4% 2014 Sw eden Germany -6% Japan -8% -10% -20% 0% -10 80% 20% 40% 60% -15 Ja UK pa In n dia Fr US an c G. As a result of the structural expansion in the size of the public sector in recent years. the weaker the outlook for credit expansion and by extension overall economic performance.P.

Debt servicing may be far less of an issue for the UK currently (debt servicing absorbs only 5% of tax revenues). the UK will need to improve its primary budget balance by 13% of GDP per annum by 2020 to ensure stabilization in debt/GDP at 60% by 2030. and the resultant need for remedial action. 50 Ja Source: IMF A fiscal lesson from Canada Public sector delevering is not the only balance sheet issue facing the UK but it the one that will capture much of the market’s attention in the run up to the General Election (which has to be held by 3 June 2010). 16 14 12 10 8 6 4 2 0 -2 pa n I re U K la S nd Gr pain ee ce US Po G-2 r 0 F r t uga a Be nce l lgi Au um s tr ia I ce I taly N e Aus land the tra l Ge rlan ia rm ds C a any n F i ada nla nd Sw N ed Z e D e Kor n nm ea ar k pa n UK F U Ge r an S rm ce an y Ita ly NZ Au G-2 st 0 T u ralia So Sw rkey ut ede hA n M f rica ex ic K o C a ore na a C h da R u ina ss I n In ia do di ne a s Ar Bra ia ge zi N o ntin l rw a ay Ja Source: IMF The BoE may be fully monetizing this deficit for now but whichever Party wins the General Election next year faces the substantial task of stabilising public finances. the required tightening is 9% of GDP in the US. For instance. with debt-servicing costs absorbing neatly 40% of tax revenues at the peak. What then did Canada do to stabilize its finances and what effect did this have on the exchange rate? The deficit peaked in 1992 but the real turning point was the 1995 budget. Canada substantially expanded the size of its public sector through the 1980s and early 1990s. as the above figures demonstrate. two years after which the government had managed to balance its books. The UK may not be alone in having sacrificed its public finances in the interests of sustaining economic growth. nonetheless in many other regards the deterioration in the UK’s public finances mirrors that of Canada. To note. if currently above 60%. nonetheless it also demonstrates the importance of political will to take painful measures and the risk should the UK election fail to deliver a government with a strong majority and mandate to act. either because the new government addresses the imbalances. The deficit peaked at 9% of GDP in 1992 while public debt exploded from 46% in 1980 to 102% in 1995. 6% in France and 3% in Germany. That Canada eliminated a double-digit deficit in a matter of just a few years provides some reassurance not to panic over the UK position. % GDP 60 40 20 0 -20 -40 Chart 13:Debt stabilization is a high hurdle for the UK Required improvement in primary fiscal balance between 2010-2020 to stabilize public debt/GDP ratios at either 60%. The scale of the task facing the new government can perhaps best be appreciated by recognizing that the bulk of the UK’s deficit is actually structural in nature and will not be cured automatically by a resumption of economic growth (the IMF puts the structural primary deficit at 8% of GDP compared to a G20 average of 3%). the vast bulk of the improvement in Canada’s deficit came from a hefty reduction in government spending . The state of public finances is likely to adversely influence GBP.). A number of countries have undertaken sizable fiscal consolidation in the past but one that is often mentioned when discussing the likely impact on GBP is that of Canada in the mid 1990s. there is a pressing need for discretionary fiscal tightening in coming years of a scale exceeded only in Japan. foreign central bank selling etc.P.com J. the scale of the damage. with public expenditure as a share of GDP rising from 42% in 1989 to a peak of 53% in 1993. with the attendant pressure this will place on both growth and monetary policy. Deleveraging by the public sector is unavoidable in coming years. a reality that is likely to have a major bearing on the all-important fiscal/monetary policy mix in the UK vis-à-vis other economies where the financial collapse and recession has left less of a mark on the public balance sheet. 2014-2007. By comparison.Global FX Strategy Global FX Strategy 2010 November 24.meggyesi@jpmorgan. Based on IMF analysis. or because it neglects the problem and precipitates some form of financing crisis (debt downgrade. Various forecasts such as the IMF’s have UK public debt rising to 100%. a level at which ratings agencies may struggle to justify a continued AAA rating. or at end-2011 levels if currently below 60%. Nonetheless. while the deficit is 13% of GDP and debt on course to rise to nearly 100% of GDP by 2014 compared to a trough of 40% in 2001. the UK public expenditure/GDP ratio is currently at 52% compared to 37% in 2000. Morgan Securities Ltd. Given this. Chart 12: The explosion in UK public sector debt in coming years is exceeded only by Japan Projected change in gross public sector debt. 2009 Paul Meggyesi (44-20) 8769-1906 Paul. At this stage Canada was facing real issues of debt servicing and crowding out. is greater in the UK than most other countries.

the converse is likely to be true as balance sheets are pared back. Throw in the additional headwinds from delevering in the banking and household sectors and the likelihood of GBP recapturing its high yield status in the coming few years are even lower. in other words. % GDP BoC policy rate v s G7 av g policy rate 1988 1991 1994 1997 2000 Chart 15:Fiscal consolidation and a shift in the fiscal/monetary policy mix resulted in a multi-year depreciation for CAD CAD REER. Throughout the decade CAD was essentially transformed from a country with high deficits and high yields to low deficits and low yield. Morgan Securities Ltd.meggyesi@jpmorgan. albeit with a temporary reprieve in 1995/1996 (chart 15). Not surprisingly this policy shift resulted in CAD depreciating for the best part of the decade. In short. GBP enjoyed relatively high growth and high yield as balance sheets were expanded during the good years.Morgan Canada v s OECD public sector deficit. this though is a very different proposition from assuming GBP can resume the mantle of investment currency and participate in continued asset price reflation. the G7 average).Global FX Strategy Global FX Strategy 2010 November 24. CAD was transformed from an investment currency to a funding currency courtesy of fiscal consolidation. rather than an increase in taxes. the improvement in Canada’s fiscal position went hand in hand with deterioration in CAD’s interest rate advantage. lhs 140 130 120 110 100 90 80 1982 Source:J. the marked relative tightening in Canadian fiscal policy forced an offsetting marked relative loosening in Canadian monetary policy. Chart 14: Canadian fiscal consolidation in the mid-1990s triggered a marked switch from internationally loose fiscal/tight monetary policy to tight fiscal/loose money 6 4 2 0 -2 -4 1985 Source:J. the Bank of Canada’s policy rate vs. GBP’s undervaluation and current stabilization in the economy should prevent a fresh GBP crisis.P. the Canadian experience provides a useful template for thinking about the end-game for GBP from current fiscal excesses in the UK.com J.P. Nonetheless. The impact of this on Canada’s financial markets can best be explained with reference to chart 14. which plots the relative fiscal and monetary position in Canada versus other major economies (Canada’s fiscal deficit versus the OECD average.P. 2009 Paul Meggyesi (44-20) 8769-1906 Paul. Canadian fiscal deficit v s OECD av erage deficit. % GDP 6 4 2 0 -2 -4 1985 1988 1991 1994 1997 2000 51 . As is clear.Morgam History rhymes rather than repeats. with Canadian government spending as a percent of GDP slumping by just over 10 percentage points in a decade.

Global FX Strategy Global FX Strategy 2010 November 24. other developed countries. Devoid of a growth or interest rate impediment. Whether it behaves as a funding currency with a negative risk correlation or an investment currency with a positive risk correlation comes down to carry.meggyesi@jpmorgan. The changing relationship between CHF and risk markets can be seen in chart 1. or at least EUR/CHF. Chart 1: Changing relationship between CHF and risk Correlation between daily changes in CHF NEER and S&P500 30% 1Y 6m 20% 10% 0% -10% -20% -30% -40% -50% Aug-00 Source: J.P. indicating the extent to which CHF has ceased to behave as an anti-cyclical currency in recent months. Research Note The changing structural nature of CHF For most of this year we have been broadly neutral towards CHF. Switzerland’s will soon have a double digit current account surplus again. an indefinite extension of this policy cannot be justified. 2009 Paul Meggyesi (44-20) 8769-1906 Paul.P. CHF’s NEER has retraced only one-quarter of its own crisis-led appreciation. or anti-cyclical. Switzerland has a relatively small output gap. Whilst successful. CHF was perfectly positioned for sizeable outperformance as equities crashed. tag. We have revised down our forecasts for EUR/CHF and USD/CHF to a floor of 1. Morgan Securities Ltd. Having lost control of interest rate differentials. Global recovery boosts Switzerland’s external surplus without delivering yield differentials capable of generating offsetting capital outflows The key for CHF lies with the SNB. Recycling of this will remain problematic given that other industrialized countries will offer no growth or interest premium over Switzerland. As a funding currency going into the deleveraging crisis. CHF has been remarkably stable in recent months as the irresistible force for CHF appreciation (a record basic balance surplus and non-existent interest rate differentials to recycle this surplus) met an immovable object (the SNB).com J. The rolling one-year correlation is still highly negative but the 6-month correlation has risen to almost zero. which plots the correlation between daily changes in CHF NEER and the S&P500.Morgan CHF: Franc to rally as SNB steps off the brakes • A post-crisis world changes the rules of engagement for CHF. CHF is transforming to a pro-cyclical currency with a trade surplus (as is JPY) rather than an anti-cyclical funding currency. We see continued balance of payments pressure for CHF appreciation next year. It would be a stretch to yet describe CHF as an investment currency but it appears to be shedding its funding currency. We then played the range in EUR/CHF as the SNB decided to take matters into its own hands and help recycle Switzerland’s current account surplus via FX intervention. We downplayed fears early in the year that Switzerland’s vast banking system would drag down the economy and in turn the currency. Currency pegging in the late 1970s was ultimately inflationary.46 and 0. a bitter experience which will make the SNB wary of overstaying its welcome in the FX market this time around. expect CHF to become more positively correlated to risk markets in the same way as the yen. While this policy has proved remarkably successful – EUR/CHF vol has collapsed from 11% at the start of the year to less than 5% – it should not detract from the transformation in the relationship between CHF and risk markets that has occurred this year. But the converse has not held – despite a near 60% retracement of the S&P’s peak-to-trough decline and the SNB’s helping hand. long-term capital flows have turned in favor of CHF following five years of growth outperformance in Switzerland vs. the SNB had to resort to direct intervention to control CHF. Trade: Position for eventual withdrawal of the intervention ceiling via a 6-mo 0.89 USD/CHF onetouch. little obvious deflation and a record trade surplus. This 52 . • • • • • Aug-03 Aug-06 Aug-09 • • The changing structure of growth and interest rate differentials in a post-crisis world There is nothing structural about a currency’s sensitivity to risk markets. If anything. Without wider interest rate differentials. Its monetarist leanings mean that the recent sharp acceleration in broad money growth will not be ignored.91.

comprises not only short-term interest rate differentials. such a shift in long-term flows would make it harder for Switzerland to neutralize the positive effect on its currency from the outsize current account surplus that Switzerland still runs. forcing the SNB to switch to an alternative form of exchange rate control – namely direct FX market intervention. It may also reflect the improvement in Switzerland’s relative growth performance.com J. when the country persistently underperformed the rest of the developed world. Switzerland boasted a record net inflow of equity capital last year. in recent years.Morgan CHF NEER. But once the crisis hit and global central banks raced to implement ZIRP. Spreads collapsed and CHF appreciated (chart 2). In particular. Morgan Securities Ltd.P. Inflows last year can be put down to repatriation amid depressionary fears. or at least the elimination of the previous decades of underperformance. continued inflows this year are harder to dismiss out of hand. J. 3% 2% 1% 0% -1% -2% -3% -4% 1981 1985 1989 1993 1997 2001 2005 2009 Source: J. This matters because sustained growth outperformance from Switzerland.P. the SNB lost its ability to control interest rate differentials (nominal rates being floored at zero). to the extent that last year and this Swiss consumption has exceeded the OECD average. but Swiss GDP growth has exceeded the developed world average in each of the past five years (chart 3). Interestingly. the net FDI outflow has dwindled to a bare trickle this year (chart 4). The SNB was easily able to position CHF as a funding currency in the lead-up to the global meltdown in 2008.5 -3 Chart 4: Switzerland’s long-term investment flows have improved Net investment flows. Forecast for 2010.Global FX Strategy Global FX Strategy 2010 November 24. should be expected to depress outflows of long-term capital from Switzerland on a more sustained basis. the Swiss economy has outperformed its developed world peers. an ideal and in some senses necessary condition for CHF to function as a funding currency. So the changing sensitivity of CHF to risk markets may not merely reflect the obvious collapse in short-term interest rate differentials. Skeptics may 53 . which influence equity and FDI flows and are in some sense related to the long-run growth prospects of the economy. % oya. Allied to the collapse of short-term interest rate differentials. This categorization may have been valid through the 1990s and the early part of this decade. This. the capital flow data provide some evidence in support of just such a hypothesis. 2009 Paul Meggyesi (44-20) 8769-1906 Paul.P. moreover. The widespread perception is of Switzerland as a low growth country. Chart 2: Negative carry is no longer an impediment to CHF 125 120 115 110 105 100 Aug-99 Source: J. which influence hot-money flows.meggyesi@jpmorgan. % GDP 5% 0% -5% -10% Net equity flow -15% 1990 1993 1996 1999 2002 2005 2008 Source: SNB.Morgan Net FDI Aug-01 Aug-03 Aug-05 Aug-07 Aug-09 This much is conventional wisdom. and is on course to do so again this year. all it had to do was to set short-term interest rates at a sufficient discount to global rates. But it is also quite striking how.P. but also the long-run expected rates of return on capital. Similarly.Morgan Chart 3: Switzerland has grown faster than the developed country average for the past five years Swiss-developed world GDP growth.5 -2 -2.5 -1 -1. lhs CHF-G7 2Y sw ap spread 0 -0. is not merely a function of export growth encouraged by an undervalued currency – domestic consumption growth in Switzerland has picked up substantially relative to other countries.

Switzerland’s relative growth performance both before 54 Source: J.9% below. the SNB adopted its own version of quantitative easing which involved it becoming the first G-10 central bank since the Bank of Japan in the middle of the decade to intervene in its currency.Global FX Strategy Global FX Strategy 2010 November 24. when measured by the peak-current decline in GDP (chart 6). Set against this. Switzerland suffered a less severe recession than any other major economy bar Australia. As shown in chart 3.P. When faced with a fundamentally justified appreciation in CHF. argue that this improvement is only due to deterioration in growth prospects in the rest of the world.P. J. % 2% 0% -2% -4% -6% -8% Sw iss current account. Morgan and during the crisis has actually been rather good. Morgan Chart 7: Switzerland has seen less core CPI disinflation than other developed countries Core CPI. in addition to which core CPI is 0.meggyesi@jpmorgan. A comparison of Switzerland’s inflation performance with other developed countries offers no reason to alter this judgment. The move was criticized in some quarters at the time but it seems that the SNB was able to appease its critics by refraining from chasing CHF lower. certainly not when set against the 5-6% declines endured by European neighbors such as the UK and Sweden. % GDP Eu ro Jan-04 US Is SNB paranoia towards CHF justified? What gave over the past year was the SNB’s nerve. The combined demand for CHF arising from the current account surplus and long-term investment flows (equity and FDI) is running at a record rate this year. Chart 5: Demand for CHF from Switzerland’s basic surplus is running at a record level this year 20% 15% 10% 5% 0% -5% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: SNB. rather than towards the back. This is not entirrely true. it is not unreasonable to ask whether economic conditions in Switzerland are any worse than in other countries sufficient to justify the SNB’s singular emphasis on the exchange rate. but even if it were. it would not negate the bullish implications for CHF of a more sustained post-crisis narrowing in growth potential and interest rate differentials between Switzerland and other developed countries. In summary. some 12. That Switzerland has a much smaller output gap than most other countries should place the SNB towards the front of the queue to normalize unconventional monetary policies. Morgan tr Sw alia itz er lan d Au s Jan-98 Jan-01 UK Sw ed en Ja pa n Jan-07 NZ No rw ay Ca na da . As detailed above. A 2% drop in GDP scarcely constitutes an economic emergency. % oya 3% Sw itzerland Dev eloped countries 2% 1% 0% -1% Jan-95 Source: J.5% of GDP (chart 5). in its case by abandoning FX intervention. Chart 6: Switzerland in line for early policy normalization? Peak-current decline in GDP. Morgan Securities Ltd. Indeed. % GDP Current a/c+equity +FDI. 2009 Paul Meggyesi (44-20) 8769-1906 Paul. short-term interest rate differentials are at a record low. Switzerland is a country with a large and rising current account surplus which is finding it harder to neutralize the resultant upward pressure on the currency because there is no longer any meaningful carry to encourage short-term outflows nor any growth underperformance to encourage longer-term outflows.com J.P. The question now for the SNB is whether further FX intervention is either justified or desirable? Given that the SNB is the only major central bank to have resorted to FX intervention.P. we disagree with the notion that CHF appreciation was or indeed is speculative or unjustified.2% above its long-term average in Switzerland whereas in other develop countries it is 0. A fear of disproportionate deflation hardly justifies an extended period of exchange rate targeting. Something has to give. As chart 7 shows. core CPI has fallen far less in Switzerland than in other developed countries (chart 7).

56 in EUR/CHF terms). It would hardly seem to be an appropriate goal of monetary policy to correct for a structural loss in export competitiveness unrelated to the exchange rate. politicians and eventually the SNB. The policy proved very successful– the Swiss monetary base exploded and DEM/CHF rallied sharply. It embraced monetarism but found that its hair-shirt policies during this period of rampant global inflation generated substantial capital inflows and a huge appreciation in the currency. which in September 1978 abandoned money supply targeting in favor of a formal target for DEM/CHF. 12m sum. not just in banking and financial industry.P. which the SNB is starting to take note of. the SNB committed to keeping DEM/CHF well over 0. but we would expect its forays in the market to become less frequent and less aggressive. But the success in weakening the currency eventually backfired as the rapid growth in money supply required to control the exchange rate eventually fuelled a sharp rise in inflation (chart 10). but also in the household and corporate sectors. from just below 0. To this extent the context in which CHF is appreciating is likely to matter for the SNB. Moreover. following which the SNB abandoned its exchange rate experiment in favor of a return to more orthodox money supply targeting in the early 1980s. In summary. As the SNB wrote in its last quarterly monetary policy assessment. This was not so much a peg but rather a ceiling for CHF – formally. and likely to become weaker still as next year progresses. which argues against any form of rapid retreat from the market. This is reflected in the increasingly rapid growth of the monetary aggregates since the beginning of the year. Nonetheless.80 in September to 0. relatively little disinflation and a record trade surplus. The argument for continued FX intervention in light of this is weak. opening the way for gradual downside in EURCHF and more pronounced downside in USD/CHF. CHF bn Jan-86 Jan-91 Jan-96 Jan-01 Jan-06 claim that CHF is either unreasonably strong or severely impeding the absolute performance of the export sector. there has been a conspicuous acceleration in broad money growth this year. In the mid 1970s the SNB struggled to define monetary policy in the chaos that followed the collapse of Bretton Woods. The M3 aggregate. a fact which sits uneasily with the Chart 9: Record Swiss trade surplus 20 15 10 5 0 -5 -10 -15 Jan-81 Source: SNB Swiss merchandise trade balance. ‘The amount of liquidity is significant. which was still increasing at a moderate rate at 55 What. The SNB will wish to manage the exit from unconventional policy gracefully. This proved too much for Swiss businesses.50 EUR/CHF) irrespective of broader economic conditions. the SNB should have less to fear . of the export sector – is the desire to insulate this not at the heart of the SNB’s FX policy? The Swiss export sector has certainly underperformed the developed country average in recent years but it would be wrong to wholly attribute this to the exchange rate. 1998=100 CHF REER 125 115 105 95 85 Jan-93 Jan-98 Jan-03 Jan-08 from a cyclical CHF appreciation that accompanies economic recovery than it did from the anti-cyclical appreciation in the face of a deep recession. The relative performance was very much correlated with the exchange rate up until 2005 but after that point CHF depreciated yet Swiss exporters continued to lose market share. Chart 8 plots the relative developed country/Swiss export performance against the franc’s real effective exchange rate.80 (which equates to 1.90 by December of that year.meggyesi@jpmorgan. Chart 8: The link between CHF and Swiss export performance has broken down since 2005 160 140 120 100 80 Jan-88 Source: J. it should not be overlooked that the Swiss trade surplus is currently at a record high (chart 9). from 2% last December to 8% currently. Moreover. or at least what was expected to be a deep recession. Morgan Securities Ltd. Morgan Dev eloped country ex ports/Sw iss ex ports. It should not be assumed that there is a fixed line in the sand (around 1. Few would argue that Switzerland is faced with a repeat performance. finally. the real exchange rate leapt by 50%. 2009 Paul Meggyesi (44-20) 8769-1906 Paul. Switzerland has a relatively small output gap.P. A cautionary tale from the 1970s There is one other piece of context to the SNB’s intervention policy which is worth considering and this is the central bank’s experience with exchange rate pegging in the tail end of the 1970s.Global FX Strategy Global FX Strategy 2010 November 24.com J. In the four years to September 1978.

2009 Paul Meggyesi (44-20) 8769-1906 Paul. J. Morgan M3. nonetheless.com J.Global FX Strategy Global FX Strategy 2010 November 24. domestic considerations. Chart 10: The SNB is watching the rise in money supply with caution 14% 12% 10% 8% 6% 4% 2% 0% -2% -4% Jun-78 Jun-83 Jun-88 Jun-93 Jun-98 Jun-03 Jun-08 Source: SNB. The SNB is keeping a close watch on the monetary aggregates’.P. lagged 2 y ears. Morgan Securities Ltd.P. has begun to advance more rapidly. and as the central bank recognizes that this was less serous than feared.meggyesi@jpmorgan. it is reasonable to expect the SNB to reorientate policy away from the exchange rate towards more traditional. such a policy shift should prove bullish for CHF against a backdrop of strong external surpluses and a reduced capacity of the private sector to recycle such surpluses. lhs Core CPI. our last assessment in June. The circumstances behind such a reorientation may be less dramatic than they were in the early 1980s. % oy a 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% 56 . As the economic emergency recedes.

the issue of Swedish krona valuation has occupied the minds of both the Riksbank and the markets. Swedish growth over the same time horizon averaged 2.5% year on year.00 for a sustained period of time. benefiting from strong fiscal and Global Dev eloped Sw eden EMU 4.0 3.7% of GDP since 2000 and is behind only Norway within Europe as having the most structurally sound fiscal position. the bulk of the recovery will occur in 2010 and that by Q4 2010.P.sharma@jpmorgan. Buy a 12-mo EUR/SEK ratio call spread in 1x1. 160 155 150 145 140 135 130 125 120 115 2000 2002 2004 2006 2008 2010 2012 • Source: Riksbank Monetary Policy Report. external surpluses over the past decade. thus limiting the upside that many expect.com J.0 • • Exploding the myth For many years.Global FX Strategy Global FX Strategy 2010 November 24. driving the view that the krona is failing to deliver the kind of performance that one would expect from a currency with such strong structural underpinnings. This has been due to the trend deterioration in Sweden’s terms of trade.80 without clear recognition that EUR/SEK has rarely traded much below 9.0 2000 2001 2002 Source: J. Indeed Sweden growth has outpaced Euro area growth for much of this period.1%. At the heart of this debate has been the observation that traditional exchange rate valuation models have concluded that the krona is persistently and significantly undervalued. the forecasts laid out in the Riksbank’s Monetary Policy Report have for many years stated that the krona should be stronger over the longer-term. October 2009 • International macro comparisons are favourable The backdrop to the argument that the krona has been persistently undervalued rests on cyclical and structural factors. The argument centres around the fact that Sweden has been amongst the most structurally sound economies in G10.0 2. %oya 5. Swedish growth has been impressive. Chart 2: Swedish growth has kept pace with the rest of the world Growth in real GDP.5 notional for 0. Chart 1: Riksbank projections for real SEK TWI Rising TWI implies SEK depreciation and vice versa. The established view has been that the krona has been persistently undervalued over that period and will significantly appreciate over the mediumterm. According to the model. This is supported by the recent improvement in the terms of trade. the krona has not been as persistently or as significantly undervalued as many have suggested. The JP Morgan fair value model suggests that the real TWI krona is currently undervalued by 9%. such facts have not prevented many forecasters from projecting that the krona will appreciate on a trend basis over the medium-term. 2009 Kamal Sharma (44-20) 7777-1729 kamal.88%. Indeed. Research Note SEK: The myth of krona undervaluation • Sweden has run strong structural surpluses since 1994 with the current account running at 8% of GDP.0 0. Trade and forecasts: EUR/SEK to 9. Morgan Securities Ltd. Indeed.6 by end-2010.50 and 8.7%.0 -1. Longer term projections suggest that Sweden’s terms of trade position will deteriorate again over the coming years. averaging 1. in 2006. which compares favourably to the Euro area (average 2%). Morgan 2003 2004 2005 2006 2007 2008 From a structural perspective. Indeed the market has been infatuated with the view that a fair value for EUR/SEK is estimated to be between 8. Sweden has recorded a succession of fiscal surpluses since the start of the decade. Based on previous episodes of krona undervaluation.x. matching the pace of global growth since the start of this decade. Global growth between 2000 and 2008 averaged 2. Swedish growth was the strongest in G-10.9% whilst developed world growth averaged 2.0 1.P. Nonetheless. rising 4. the krona will be fairly valued. This strength in the fiscal outlook is in 57 .

a period which coincided with deficits on both the current account and on the fiscal balance in addition to Swedish inflation being persistently higher than the average for the OECD. Many observers have argued that current account deficits do not result from over-spending by the deficit country but rather should be seen as capital account surpluses reflecting international investor demand for the deficit country’s assets. 15% 10% 5% 0% -5% -10% -15% 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 Source: J. the krona has never been more than 10% undervalued or overvalued and immediately challenges the long held view that the currency has persistently deviated from its fair value.0 NOK NZD SEK Source: J.P.5% of GDP. with the degree of undervaluation slightly higher than that observed in 2001.0 5. The real TWI was broadly overvalued between 1985 and towards the end of the 1990’s. Looking at the periods of approximately 10% undervaluation of the krona (Dec 1982 and June 2001). it took between 18-21 months for the krona to recover back to fair value from the maximum degree of undervaluation.34 for EUR/SEK and 6.P. there have been five occasions where the krona REER has deviated by around 10% from fair value: three periods where the krona has been undervalued and two periods where the krona has been overvalued. the autonomous capital inflows (capital account surplus) appreciate the currency. Morgan The krona and the JP Morgan fair value model Since 1982.P. resulting in current account deficits. we estimate that the krona TWI is around 9% undervalued. net international investment income and inflation. The second is a decomposition of the data into permanent and transitory components. Morgan Our Fair Value Model does not support more extreme valuation measures which suggest that the krona could be as much as 30% undervalued at present. 130 Actual 120 FV 120 130 110 110 100 100 90 AUD CAD CHF EUR GBP USD JPY 90 1985 1990 1995 2000 2005 2010 1980 Source: J. Chart 4: SEK REER versus JP Morgan fair value estimate.0 -5. Chart 4 shows the long-term development of the krona real effective exchange rate (REER) versus the JP Morgan Fair Value (FV) Model estimate. the current account surplus turns into a capital account deficit as the former implies domestic investor interest for overseas assets. 2000-2008 15.x. Since 1982. The model inverts the sign on the current account to reflect the mirror opposite which is the capital account balance. Since then there has been some recovery.0 0. government debt. The peak in recent krona undervaluation occurred in Q1 2009. This implies 9. Chart 3: Sweden has enjoyed sound fiscal balances Average fiscal balance as %GDP.P. stark contrast to the preceding decade where the average fiscal deficit between 1990 and 1999 was 3. 2009 Kamal Sharma (44-20) 7777-1729 kamal. The first is a long-run econometric relationship between the real exchange rate and economic drivers: the terms of trade. current account balance. If previous corrective episodes are any guide then the krona is set to recover through much of 2010 with the bulk of the undervaluation likely to have been eliminated by Q4 2010. The treatment of the current account balance is worthy of mention. Since 2000.0 10.com J. Some of the moves in the fundamental drivers are transitory which reduces their weight in the FV model.28 for USD/SEK Chart 5: FV Model residuals for krona REER Deviation of actual krona REER from FV model estimate. So in the case of Sweden.sharma@jpmorgan. %. Viewed from this perspective. the According to current calculations. Morgan actual real TWI krona exchange rate has broadly followed the levels predicted by our model.0 -10. Morgan Securities Ltd.Global FX Strategy Global FX Strategy 2010 November 24. 58 . The FV model is based on two elements.

2009 Kamal Sharma (44-20) 7777-1729 kamal. it has little influence in affecting the price of its imports or its exports. the Swedish household savings rate will be the highest in the OECD area at 15.6%. Trend depreciation of the krona Notwithstanding the cyclical divergences between the actual level of the krona and our fair value model. we have looked at the fair value model residuals in relation to the main cyclical drivers for Sweden: equity prices and interest rate differentials. a key element of the JP Morgan fair value model is the development in a country’s terms of trade position.x.sharma@jpmorgan. the S&P need not move from current levels for the residual to normalise given the strong recovery in the S&P since Q4 2008. the chart clearly highlights that Sweden has suffered the most significant deterioration in its terms of trade position since 1990. Chart 6: FV Model residuals versus the S&P Chart show the residuals from the JP Morgan Fair Value Model plotted against the y/y changes in the S&P. the speed of that depreciation both in the actual REER and the fair value model coincided with the point at which the Swedish current account balance was posting healthy and rising surpluses. Consequently. 130 120 110 100 90 80 1990 1993 1996 1999 2002 2005 2008 US Sw iss Germany UK Sw eden Source: J. Secondly. A brief respite following the surge in global telecommunications prices in the late 1990s provided some support to the Swedish terms of trade position (due largely to the status of Sweden as the world leader in the telecommunications market).Global FX Strategy Global FX Strategy 2010 November 24. With inflation levels also in line with those in the OECD. According to OECD projections for 2009. Terms of Trade rebased to January 1990 = 100. Sweden’s household balance sheet shows a near 80% increase in social insurance reserves since 2000.com J. Chart 7 shows developments in the terms of trade for the noncommodity exporting G10 economies. with an Rsquared of over 70%. but this boost has proved fleeting as the technology boom burst. thus driving the improvement in the current account over the past decade. As chart 6 highlights. Indeed. Morgan Such developments in Sweden’s terms of trade look at odds with the rising current account surplus.P. Firstly. In an attempt to understand the key drivers behind such deviations. According to our calculations a 5% year on year appreciation in the S&P would be sufficient for the residual to normalise to zero. Morgan Our analysis shows that deviations in the krona REER from fair value have been driven by cyclical factors. 15% 10% 5% 0% -5% -10% -15% 1994 1996 1998 2000 2002 2004 2006 2008 FV Model Residuals. At the same time. Chart 7: Swedish terms of trade have deteriorated by more than other commodity importing G10 economies. Regressing the fair value model residual on the year on year change in the S&P and Sweden rate differentials versus a weighted average of G10 yields strong results. the retirement population (65+) rose by less than 8%. Between 1990 and 2008 the population of the age 45-64 category rose by 25%. the fair model residuals have shown a close correlation to the year on year change in the S&P500. % (lhs) SPX %y /y (rhs) 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% it is amongst the worlds most open economies and given its size relative to the global economy. In level terms. Demographics have certainly played a significant part in this dynamic. this is particularly important as Source: J. The obvious omission is Japan due to distortions to the chart given the significant deterioration to its terms of trade over the past 20-years. a noticeable feature of chart 4 has been the depreciating trend of the krona in real effective terms since 1980. the Swedish household savings rate has risen significantly since 2005. from just under 7% to nearly 16%. 59 . the largest per cent rise for any age category. Part of the explanation for this rise has been due to the increase in pension contributions in recent years.P. With the exception of Japan. For Sweden. what can explain this trend depreciation of the krona? As highlighted above. Morgan Securities Ltd. In broader terms.P. We can attribute these dynamics to two major developments in Sweden in recent years. the breakdown of the Swedish national accounts data reveals that export volumes have consistently outpaced import volumes since 2000.

forecasts for a renewed deterioration in the terms of trade as forecasted by the NIER will weigh on the REER.sharma@jpmorgan. The chart would suggest the krona will recover over the year ahead. we do not believe that this will be the start of a multi-year era of krona appreciation for the reasons stated above. Should the terms of trade remain deteriorate more quickly then the REER will peak earlier.80. Chart 9: Path of the krona REER under various assumptions on the y/y change in the terms of trade 105 100 95 90 85 80 2008 Source: J. Given modest krona upside. Although there has been some recent improvement in the terms of trade position this has also proved temporary and the rebound in energy prices has seen a resumption of the downtrend. Though our directional bias is for a lower EUR/SEK.com J. Morgan Securities Ltd. strong productivity gains in Sweden have also been a significant driver for the deterioration in the terms of trade as export price growth has slowed. we can project the path of appreciation of the krona REER through to Q3 2009. %y /y (lhs) Terms of Trade. in Q3. the Swedish National Institute of Economic Research (NIER) forecasts that the terms of trade will improve over the coming year. Morgan SEK REER. Chart 8 shows the relationship between the krona REER and the terms of trade. See Five global macro themes and top trades on page 11.Global FX Strategy Global FX Strategy 2010 November 24. we disagree with the view that a fundamentally fair level for EUR/SEK is between 8.P. Chart 8: krona REER versus Sweden terms of trade.88%. Thereafter. The key take away from the above analysis is that the krona is set to appreciate in 2010 as favourable terms of trade developments in recent quarters combine with some cyclical undervaluation.5 notional for 0. Morgan Steady Rev ersal 2009 2010 2011 60 . but will then deteriorate again thereafter. the preferred trade is a 12-mo EUR/SEK ratio call spread in 1x1. the longer depreciating trend is likely to continue as the terms of trade begins to deteriorate again.P. We project a higher krona over the course of 2010 as the economic recovery in Sweden gathers momentum and the currency benefits from the recent improvement in the terms of trade position. The current undervaluation of the krona has been driven by cyclical factors such as equity market moves. 2009 Kamal Sharma (44-20) 7777-1729 kamal.50 and 8. The second assumes that the terms of trade deteriorate at a sharper pace. Our 2010 view on the krona is bullish. In the absence of another technology led boost to the terms of trade. The first assumes that the year on year growth in the terms of trade remains steady around current levels. A cyclical upturn but trend depreciation likely Our analysis of the long-term performance of the krona exchange rate has challenged the prevailing market view that the krona has been persistently undervalued despite the many structural positives for the currency. the future terms of trade trends will determine at what point the REER will peak in 2010. Chart 9 shows this path of the krona REER under two different assumptions on the path of the terms of trade. However. However. in line with our own forecasts for SEK. The long-term deterioration in the terms of trade has been the major driver for the trend depreciation of the krona and though our analysis suggests that the recent improvement in Sweden’s terms of trade should provide a lift to the krona over the coming year.P. the analysis suggests that the krona REER will peak in Q4 2010 before reversing course. in year on year terms. 20 15 10 5 0 -5 -10 -15 -20 -25 1993 1995 1997 1999 2001 2003 2005 2007 2009 Source: J.x. % y /y adv 12mths (rhs) 7 6 5 4 3 2 1 0 -1 -2 -3 -4 -5 -6 -7 Under the assumption that the year on year growth in the terms of trade remains steady. with a year-end target for EUR/SEK of 9.60. Using the 12-month rolling beta of a regression of the year on year change in the krona REER on the year on year change in the terms of trade (advanced by 24-months).

2009 Kamal Sharma (44-20) 7777-1729 kamal.Global FX Strategy Global FX Strategy 2010 November 24. Morgan Securities Ltd. This page is intentionally blank 61 .x.com J.sharma@jpmorgan.P.

see A new fair-value model for G10 currencies. and AUD and NZD against long-term macro drivers as well. the G10 commodity currencies have been more tightly related in 2008-09 than in earlier global recessions. of the four G-10 commodity curren cies only NZD still stands more than 10% below its 2008 peak. Structural foundations: Sand or rock? Valuations relative to long-term macroeconomic fundamentals do not appear to be a serious constraint on commodity-currency performance within the G10 near term. like NZD. we include the global growth cycle and attitudes toward risk as reflected by equity markets.4% and 3.or under-performance relative to commodityprice and long-term macroeconomic fundamentals. NZD and CAD is mixed: they appear overvalued relative to cyclical commodity price drivers. AUD is rich to commodity prices and long-term drivers. these valuation metrics. to pick commodity FX winners and losers. CAD and NOK gained about 17%. can we identify global and local economic trends that will drive divergence within the G10 commodity currency group and pick winners and losers? 62 9 For a detailed discussion of the J. It is fairly valued relative to oil and underpriced compared to long-term macroeconomic fundamentals given Norway’s sound fiscal policy and outsized international assets. but not outperform uniformly. rate hikes and robust exports.P. while CAD and especially NOK remain undervalued. However. Also. NOK should be the best-performing G10 currency in 2010. performance gaps should widen over 2010. . we assess how much valuations are stretched both relative to cyclical commodity price drivers and the longterm structural fundamentals captured by J. but had fallen less during last year’s deleveraging frenzy – about 25% compared to AUD and NZD’s 38% falls. in an environment where the USD overshoots to the downside but the recovery is discounted and commodity prices are roughly flat. And as a group. along with an analysis of forces that could drive over. and AUD should outperform CAD and NZD. even though the global recovery largely is discounted. However AUD benefits disproportionately from falling risk aversion and should get a further boost from Australia’s close trade links with rapidly-growing EM Asian economies and from RBA policy tightening. Among these forces. It also will get a boost from Norges Bank rate hikes after a shallow recession. by a relatively dovish central bank. the monetary-fiscal policy mix. AUD and NZD appear only somewhat overvalued (6. Against this backdrop.or underperformance vs. Gabriel de Kock. but the USD overshoots to the downside? Second. The valuation picture for AUD. Our analysis suggests that the commodity currencies will rally.P. • • • • The commodity currencies have performed spectacularly in the headlong rush into risk assets since March. We use a long-term macroeconomic fundamentals model and cyclical commodity price-driven models.2%) on a real trade-weighted basis. Morgan fair-value model. Second. will commodity currency outperformance persist in an environment where the global economic recovery largely is discounted. 2009 Gabriel de Kock (1-212) 834-4254 Matthew Franklin-Lyons (1-212) 834-4565 JPMorgan Chase Bank NA Commodity currencies: Where’s the gold? • The commodity currencies were the strongest G10 performers during the 2009 scramble for risk. The NOK should be the strongest G-10 currency in 2010. outpacing other G10 currencies by a wide margin. and inflation. NOK is undervalued relative to long-term structural fundamentals and fairly valued against oil.Global FX Strategy Global FX Strategy 2010 November 24. on a tradeweighted basis.9 Despite the commodity currency rally since March and the steep terms of trade-driven decline in fair values from their 2008 highs. Canada’s close trade ties with the US should cap CAD performance when the USD overshoots to the downside. September 6. CAD will be held back by its relatively slow-growing trade partners and. 2008 and updated quarterly in World Financial Markets. international investment income. CAD and NZD should lag both on valuations and dovish central banks. reflecting both the impact of the global financial crisis and the unusual synchronicity of the economic cycles around the world. and post-crisis headwinds from deleveraging. regaining much of the ground lost in the crisisdriven deleveraging of 2008 and early 2009. regional growth and trade patterns. Table 1 compares the real trade-weighted exchange rates for the AUD CAD. NZD and NOK to fair value estimates that reflect long-term structural fundamentals: the terms of trade. AUD and NZD surged more than 33% and 25%. current account balances. Rate hikes after a shallow recession also will lift NOK. government debt ratios. but should outperform on falling risk aversion. Indeed. we analyze forces that could drive over. Commodity FX as a group should do well while the USD overshoots to the downside. • We use a two-pronged approach to answer these questions: First. investors face two key questions: First. Morgan’s G10 fair-value model. respectively.

NZD or NOK. in line with their inflation-adjusted commodity export prices.P.8 132. Morgan Not all commodity currencies are created equal The commodity currencies.0 117.0 100. Source: J. 2Q08-4Q09 AUD 2Q 08 1Q 09 4Q 09* Actual Fair Value Actual Fair Value Actual Fair Value 134. but the NOK appreciated only about 10% in real tradeweighted terms despite the fact that oil makes up roughly 70% of Norway’s merchandise exports. The bullish assessment if NOK’s longer term prospects.2 100. their performance over the global business cycle often diverges significantly.3 NZD 125. 63 .0 122. The oil price more than doubled. Current AUD and NZD overvaluation also is close to the EUR’s and smaller than that of the JPY. current cycle 120 115 110 105 100 95 90 85 80 75 -24 -20 -16 CAD AUD NZD NOK -12 -8 -4 0 4 8 12 120 115 110 105 100 95 90 85 80 75 Months from recession trough Source: J. as Table 1 shows.5 100.0 118.9 118.1 125. last winter the G10 commodity currencies were undervalued by margins ranging from 12% to 22%. The divergence reflects both the make-up of their commodity export baskets and the size of their commodity export sectors relative to the overall economy. suggesting that they would fully reflect the roughly 7% downside USD overshoot that we expect over the coming six months. The importance of commodity export composition is illustrated in Charts 1 and 2. which largely reflects Norway’s strong fiscal fundamentals. Morgan 10 For a discussion of export composition and the economic and FX impact of commodity price swings for the dollar bloc.4 128. Global commodity price increases drive up profits in the commodity sector attracting foreign capital and stimulating demand. are the most procyclical of the G10 currencies. AUD. New Zealand’s over 45% and Australia’s more than 30%. suggests that NOK could outperform the dollar bloc over the medium term.7 123. from March 2007 to July 2008. Table 1: Commodity currencies actual and fair-value real tradeweighted exchange rates (1Q09 =100). June 4. which in return reflect the commodity-intensive manufacturing sector’s predominant role in cyclical fluctuations of global economic activity.P.0 112. not all commodity currencies are created equal: while conforming to a common cyclical pattern.5 121. as a group.5 112. Gabriel de Kock.10 Canada’s and Norway’s international trade exceeds 60% of GDP. NZD and NOK already stand above their early-2007 levels in real trade-weighted terms.Global FX Strategy Global FX Strategy 2010 November 24. However.3 * denotes preliminary estimates. The US role as Canada’s dominant trade partner implies that a USD drop against the CAD is a much bigger competitiveness shock and more damaging for economic growth and profits than a similar move against AUD. In fact.1 127. 2008. Morgan CRB CAD AUD OIL NZD 225 200 175 150 125 100 75 50 CAD 121. The currency impact of commodity price swings also reflects government policies.7 100.0 112. inflation-adjusted.6 144. The magnitude of capital inflows and hence pressures on the currency will be greater the larger the Chart 2: Real trade-weighted exchange rates (recession trough-24 months =100).4 relative size of the commodity sector. In contrast.P. The response Chart 1: Inflation-adjusted commodity price indices in the 2008-09 global cycle (recession trough -24 months =100) 225 200 175 150 125 100 75 50 -24 -20 -16 -12 -8 -4 0 4 8 12 Months from recession trough Source: J. 2009 Gabriel de Kock (1-212) 834-4254 Matthew Franklin-Lyons (1-212) 834-4565 JPMorgan Chase Bank NA The degree of AUD and NZD overvaluation is small relative to historical misalignments. CAD undervaluation is less constructive than might appear in an environment where the USD undershoots to the downside.5% and than 4% respectively.5 117.6 NOK 117. see Drilling for commodity currency value in the dollar bloc. The NOK and CAD are undervalued by about 8. Outperformance during business cycle upswings and underperformance during downturns largely reflect cyclical swings in commodity prices. while CAD remains below its early-2007 level largely because the prices of Canadian wood and base metals exports have not recovered to their early-2007 levels.2 125.

while cyclical.02) 0. The net effect will be a lower national savings rate and the currency appreciation needed to widen the non-oil trade deficit. It may appear surprising that our cyclical model indicates that NOK is a touch rich to the oil price while our long-term macro-fundamental fair-value model suggests that it is one of the most undervalued G10 currencies.21 (4. Given the JP Morgan commodities team’s broadly flat outlook for commodities. Keeping oil revenues offshore dampens NOK’s response to oil price swings. where we measure Canadian. The disconnect implies that global economic activity affects the attractiveness of commodity producers’ local asset markets in ways that are not captured fully or in a timely manner by commodity price moves.54 (10.15 0.70) -0. Australian commodity export prices rose more than 50% from March 2007 to mid-2008. When global equity prices rally on rising growth expectations. partly ratifying commodity currency valuations.72 NOK commodity FX gains over a six-month horizon in an environment where the USD overshoots to the downside. The cycle beyond commodity prices I: Risk and growth expectations Commodity prices. Variables are measured in inflation-adjusted terms and as monthly percent changes. Source: J.5% rich relative to the prices of New Zealand’s export commodities. the price gains needed to sustain current CAD and AUD valuations (16% for Australian commodity prices and 13% for Canada) appear large.98 -0. One channel appears to be shifts in investor risk aversion and capital flows from core G10 countries.81) 5.98) NOK -0. Most likely such a USD overshoot will be accompanied by rising USD prices for commodities.3%.34) Note: The coefficient estimates are derived from a cointegrating equation linking real bilateral exchange rates to inflation-adjusted USD commodity prices.33 (3. with the possible exception of NOK.03 (2. Morgan Note: Estimates based on an error-correction equation. Interest rates are 3-month treasury bill rates. The four crosses are overvalued relative to their cyclical commodity-price fundamentals.04 (1.02 (0. Australian and New Zealand commodity prices by the BoC. while capturing the trend in commodity FX. but builds up a large stock of government-owned foreign assets that yields substantial investment income.99 CAD -0. largely driven by the prices of its coal and iron exports to Asia. as is the case for our long-term G10 fair value model. A 10% commodity price increase appreciates AUD and CAD by about 5% and NZD by 12½%. Table 2 also shows the cyclical fair values for AUD/USD. USD/CAD. Norwegian foreign investment of oil revenues caps the currency impact of a 10% oil price increase on NOK at 3. Over time. are a lot less variable than the export prices of the other G10 commodity exporters. 2009 Gabriel de Kock (1-212) 834-4254 Matthew Franklin-Lyons (1-212) 834-4565 JPMorgan Chase Bank NA is muted because the Norwegian government (after a severe bout of Dutch disease in the wake of the discovery of North Sea oil in the 1970s) purposefully keeps much of its oil revenues abroad to mitigate the FX impact of oil price swings.92 0. the government will spend part of these earnings or return some of it to taxpayers. Table 2 captures the impact of business-cycle frequency changes in dollar commodity prices on commodity currency valuations against the USD.P.12 (3.67 (2. By the same token.54 (8.4%. RBA and ANZ commodity prices indices.75) CAD -0. But the NOK overvaluation is slight at 1. FV denotes the equilibrium error form the cointegrating equations show in Table e. fall well short of the fully explaining price action over the business cycle.69 0.P. the commodity currencies most likely will not escape a 2H10 USD rally. Morgan 64 . we do not see currency misalignment relative to commodity prices as an insurmountable hurdle to Table 2: Commodity-based fair values vs USD and long-run elasticity with respect to commodity price indexes AUD Commodity Index Oil Price Commodity-based FV 0. CAD and AUD appear more significantly overpriced with 7% and 8½% deviations from their commodity-based equilibrium values. Table 3: Short-run elasticity of exchange rates vs USD with respect to equity prices and interest-rate spreads AUD FV deviation MSCI World Local-MSCI gap Interest Spread R2 0. and strong demand from China has kept them at or above their March 2007 level since. This contrast captures the currency tensions associated with Norway’s foreign investment of oil revenues. USD.84 1. Nevertheless. Finally.98) NZD 1. By contrast the 4% oil price increase discounted by NOK appears well within reach.07) 0.24) NZD -0.15) 0. however. JPY and the CHF) depreciate as local investors diversify into peripheral markets that offer more attractive risk-reward trade-offs. NZD is about 4.81) 0.08 (3.25 (6.Global FX Strategy Global FX Strategy 2010 November 24. Source: J.99 0. the prices of New Zealand’s agricultural exports. the currencies of core G10 countries (EUR.30 (6.12) 0. and USD/NOK implied by October commodity price levels. NZD/USD.

5 9 8. Since the end of December. would lift AUD/USD by 3% over and above commodity price-driven gains.5 90 92 94 96 98 00 02 04 06 08 Note: Estimate based on error-correction model.5 8 7. however. By the same token. 2009 Gabriel de Kock (1-212) 834-4254 Matthew Franklin-Lyons (1-212) 834-4565 JPMorgan Chase Bank NA Table 3 quantifies the commodity-currency impact of capital flows spurred by cyclical shifts in attitudes towards risk as well as the impact of shifts in short-term real interest rate differentials. 1994-Oct 09 1.5 1.9 0. the lift from increased risk appetite fades over time but the small estimated coefficient on the FV deviation indicates that it fades very slowly.9 0.5 0. Source: J.P. Morgan NZD/USD Model Estimate Chart 6: USD/NOK and commodity price-based estimate incorporating equity prices and momentum. Our estimates suggest that CAD benefits much less from more robust risk-taking. the MSCI global index has rallied about 19% in local currency terms and the All Ordinaries has outperformed global equities by about 8%.2 1.5 0. Chart 3: AUD/USD and commodity price-based estimate incorporating equity prices and momentum. as illustrated in Charts 3. according to our estimates. export performance diverged dramatically in the global downturn Chart 4: USD/CAD and commodity price-based estimate incorporating equity prices and momentum.4 90 92 94 96 98 00 02 04 06 08 Note: Estimate based on error-correction model. CAD and NZD most likely will lag. Morgan USD/NOK Model Estimate AUD/USD Model Estimate 65 . This year’s rally in global equities would justify CAD trading 2% rich to commodities.9 94 96 98 00 02 04 06 08 Source: J.4 1.7 0.1 1.7 0.0 1.6 0. Source: J.Global FX Strategy Global FX Strategy 2010 November 24.0 0.5 5 89 91 93 95 97 99 01 03 05 07 09 Note: Estimate based on error-correction model. we do not see currency overvaluation relative to commodities as an insurmountable hurdle to commodity FX gains in an environment where the USD overshoots to the downside. at least to the extent that such shifts are uncorrelated with broad equity indices and commodity prices. Surprisingly. kiwi and NOK appear not to benefit at all from shifts in global risk aversion. interest rate spreads.9 0. enough to put on par with NOK. Together these equity prices moves are worth 7% on AUD’s short-term fair value.6 0. The measured impact on AUD is striking: A 10% rally in global equities. current commodity FX valuations do appear broadly consistent with commodity price fundamentals if we expand our valuation model to allow for the impact of equity prices.8 0.6 0. partly ratifying commodity currency valuations.8 0.7 0.P.P. Most likely such a USD overshoot will be accompanied by rising USD commodities prices.6 0. On balance.P.5 6 5. 1990-Oct 09 0. Source: J. which were broadly similar for the G10 commodity producers. and market momentum. as is the case for our long-term G10 fair value model. Of course. AUD’s gains would be even bigger if Australian equities outperform global indices. Finally.7 0.8 0.3 1. 1990-Oct 09 1.0 0.5 7 6. 5 and 6.6 1. 1994-Oct 09 10 9. Morgan USD/CAD Model Estimate Chart 5: NZD/USD and commodity price-based estimate incorporating equity prices and momentum.8 0. Morgan The cycle beyond commodity prices II: Living in the right neighborhood In contrast to commodity export price trends. 4.

while the interest rate spread vs the US is a statistically significant currency driver only for NZD in Table 4. if more than our economists forecast. while domestic forces dominated New Zealand’s recession. attracting capital to Australia and. see Chart 9). But. The pace of policy tightening also will depend on fiscal policy. export performance also will drive profits and equity market performance. Watch the monetary-fiscal policy mix The sentiment shift from deep pessimism to discounting a solid. while less dramatic. consistent with our call for significant RBA rate hikes. If so. if only temporarily. When all is said and done. given that Canada and New Zealand had greater-than-5% GDP gaps in 2Q 09 and still have below-target inflation. Strong export performance will lift overall economic activity. respectively). Unsurprisingly. As a result. to a lesser extent. Australia and Norway experienced the shallowest recessions in the G10. The Norwegian government has spent aggressively to support economic activity. Source: J. Canadian export volumes. But we should expect more policy tightening where GDP gaps are the narrowest and are disappearing rapidly (see Chart 10). New Zealand. in contrast to the US and Europe.P. reflecting its close trade ties with Germany and the UK. translating excess capacity into policy actions may be more art than science. monetary policy should be a significant source of support for AUD and NOK in 2010. rate hikes and rate expectations should lift NOK and AUD against CAD and NZD next year. Indeed. the RBA and the Norges Bank were first out of the starting gate in the race to normalize policy. which could 10 Quarters from recession Source: J. and by mid-2009 already stood 7% above their level a year before the onset of the global recession (see Chart 7). their margins of excess capacity at the start of the recovery were much smaller than elsewhere in the G10 (2Q09 GDP gaps below 2% and 1% of GDP. Chart 7: Export volumes in the 2008-09 global cycle (cumulative % change from eight quarters before the recession trough) 10 5 0 -5 -10 -15 -20 -25 -8 -7 -6 AUD NZD CAD NOK -5 -4 -3 -2 -1 0 1 2 5 0 -5 -10 -15 -20 -25 Chart 8 underlines that export growth gaps. 2007-2010F 6 5 4 3 2 1 0 -1 -2 AUD F = forecast. Exports slipped 3% from 2Q08 to 4Q08. Canada and New Zealand to consolidate their finances. On this basis. Norway also suffered. Australian export volumes declined only modestly in the throes of the world recession. Indeed. naturally has turned FX market attention to central banks and the prospect that divergent rate paths will be a key driver of currency trends in 2010. perhaps more important. cushioning Australia’s downturn. plunging more than 20% as US auto demand and residential construction imploded. suggesting that risks to Australia and New Zealand’s exports are skewed to the high side. in contrast. were a major drag on economic activity. As a result. Australia has embarked on the recovery path with limited excess capacity. 2009 Gabriel de Kock (1-212) 834-4254 Matthew Franklin-Lyons (1-212) 834-4565 JPMorgan Chase Bank NA and the early stages of recovery. Indeed. We suspect markets will be disappointed. Morgan 2007 2008 2009 2010 NZD CAD NOK 66 .P. as rapidly growing Chinese demand offset the fall-off in purchases from Japan. Markets also price significant BoC and RBNZ tightening even though the BoC has committed to hold rates steady through June and the RBNZ through year-end. But with substantial budget surpluses and a large (125% of GDP) net asset position. lifting the Australian economy and the AUD. will persist in 2010 as EM Asia leads the global recovery. they are under less pressure than Australia. EUR and SEK. EM Asian economic data continue surprising to the upside.Global FX Strategy Global FX Strategy 2010 November 24. export performance held the key to differences in overall economic performance since early 2007 and most likely will remain a major driver of growth divergence as recovery unfolds. Morgan Chart 8: Export-weighted economic growth in commodity exporter trading partners (Q4/Q4 %). And the markets price further rate hikes. global economic recovery. easing excess capacity and feeding though to monetary policy. if sub-par. few would deny that a surprise rate hike or a jump in rate expectations will lift the currency. which should support AUD and NOK against other G10 currencies that suffered deeper downturns (USD.

0 USD EUR Source: J.0 -3. 2009 Gabriel de Kock (1-212) 834-4254 Matthew Franklin-Lyons (1-212) 834-4565 JPMorgan Chase Bank NA have put a damper on growth in 2011 and slowed the pace of Norges Bank rate hikes (see Chart 11). Morgan Source: J. 2Q09 & 4Q10F 2. central banks may pull their punches.P. and Norway suffered minimal crisis-related losses. But Norwegian corporates carry surprisingly low debt. fearing that rate hikes would elicit a disproportionate response from still-fragile consumers. Morgan AU D C AD NZD N OK Chart 11: Central government budget balances (% of GDP) 20082010F 5 0 -5 -10 -15 -20 AUD CAD NZD NOK Source: J.0 -4. 2007-08 200 180 160 140 120 100 80 2007 2008 Market Pricing JPY GBP CHF CAD AUD NZD NOK SEK Chart 10: Estimated G10 GDP gaps (% of potential GDP). Chart 12: Household debt (% of disposable income).P.0 1.0 0.0 -2.P. Canada. whose debt-toincome ratios range from 142% to 157%. Or.0 0.0 JPY USD CAD NZD SEK EUR GBP AUD NOK CHF 2Q09 4Q10 60 40 20 0 Estimates based on 2Q08 OECD figures and J. Chart 9: JPM forecast and market pricing for G10 policy rate hikes through Dec 2010 (%) 2.5 0. Sources: OECD and J.0 -5.P. Norway’s consumers are significantly more indebted than their counterparts in the dollar bloc.Global FX Strategy Global FX Strategy 2010 November 24.0 1. slow economic growth.5 JPM Forecast 2. which should be an offset (Charts 12 and 13). however. Morgan Will balance-sheet headwinds make a difference? The global financial crisis wreaked havoc with household balance sheets and has reduced banks’ willingness to lend.0 -7. Morgan 67 . that differences in consumer and corporate debt levels across the commodity producers are wide enough to be relevant for FX markets. Morgan Chart 13: Nonfinancial corporate debt (multiple of gross operating surplus). In this environment. highly indebted consumers and companies may opt for an extended period of balance sheet repair. Morgan forecasts for actual and potential GDP growth.0 -1. and delayed policy tightening as the result. 2007-08 16 14 12 10 8 6 2007 2008 2008 2009F 2010F 4 2 0 AU D C AD N OK NZD F = forecast.P. with lacklustre spending.5 1. even though banks in Australia. We suspect not. New Zealand. It is not obvious.P.0 -6. Source: J.

If demand for cash liquidity declines along with a reduction of risk aversion accompanying a pick-up in global growth. OECD CPI.P. With gold and commodities prices once again trending higher. then central banks will be challenged to withdraw the appropriate amount of money from the system. Gold performs well in the year before and after major inflection points in global inflation. EUR/USD and USD/CHF stand out from the crowd. on average.com Arindam Sandilya (1-212) 834-2304 JPMorgan Chase Bank NA Risk scenario 1: Global inflation starts major uptrend • • • OECD CPI has turned negative for first time in post-Bretton Woods era Massive deficit spending and debt monetization increases chance of inflation turning higher EUR. GBP/USD also performs well. Recent manifestations of those concerns have been a rebound in commodities prices and moderately rising inflation breakeven rates. the level of resource utilization does not occur in a vacuum. Morgan Jan-73 Apr-86 Oct-06 Apr-79 Mar-94 Av erage As for currency pairs that most consistently perform at cycle turns in inflation. Central banks’ withdrawal of liquidity in an amount insufficient to balance a possible decline in demand for money could result in higher rates of inflation. The mirror image of the dollar’s decline in FX markets is also evident in Chart 3. If so.P. mild deflation as measured by CPI. 1971-2009 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% Jan-71 Jan-77 Jan-83 Jan-89 Jan-95 Jan-01 Jan-07 Massive deficit spending with concurrent aggressive debt monetization in many countries around the world has caused concerns among investors that inflation could move much higher over the coming three to five years. hard assets would perform well if that were to occur. but not as consistently as the former two currency pairs. As shown in Chart 2. Mitigating inflationary expectations is the widespread belief that a trend increase in the general price level is unlikely during a period of low rates of resource utilization. then an inflection higher in the major inflation cycle could occur over the course of 2010. the focus is on a risk scenario in which inflation starts to move higher and exceeds current expectations. has fallen to the lowest levels in the post-Bretton Woods era. Morgan Chart 3: Gold in 12-months before & after bottom of OECD CPI cycle (rebased to 100 at bottom of cycle) 250 200 150 100 50 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 x -ax is: months from bottom of inflation cy cle Source: J. since June 2009. global inflation. the purpose of this section is not to debate the theoretical arguments for either higher or lower inflation.P. which shows the price of gold over the same time periods.Global FX Strategy Global FX Strategy 2010 November 24. as proxied by OECD CPI. the dollar DXY index tends to decline in the 12 months before and after major bottoms in OECD CPI. OECD Chart 2: DXY dollar index in 12-months before & after bottom of OECD CPI cycle (rebased to 100 at bottom of cycle) 125 Jan-73 Apr-86 Oct-06 100 Apr-79 Mar-94 Av erage 75 -12 -10 -8 -6 -4 -2 0 2 4 6 8 x -ax is: months from bottom of inflation cy cle 10 12 Source: J. the move into mild deflation is not likely to be a long-lasting phenomenon. CHF and gold options stand out as costeffective instruments to hedge inflation risk Chart 1. USD/JPY on average moves 68 . In any case. Rather. As Chart 1 shows. OECD nations have witnessed. Morgan. However.landon@jpmorgan. Even if inflation does not immediately show up in indices such as CPI. Source: J. In fact. which is shown in Charts 4 and 5. 2009 Kenneth Landon (1-212) 834-2391 kenneth.

P. we discuss cost-effective ways of implementing this strategy. Morgan Source: J. Given the current low level of resource utilization and on-going global economic recovery. CHF & Gold vs. Morgan Jan-73 Apr-86 Oct-06 Apr-79 Mar-94 Av erage Chart 7: Basket of EUR.P. The question boils down to one’s framework for anticipating inflation before the fact. In the following section. which implies that it is growth that drives commodities and not the absolute level of capacity usage. and Gold. A short position in the USD makes sense if one wishes to hedge against a possible inflection higher in global inflation. USD in 12-months before & after bottom of OECD CPI cycle (rebased to 100 at bottom of cycle) 175 150 125 Jan-73 Apr-86 Oct-06 Apr-79 Mar-94 Av erage 100 70 -12 -10 -8 -6 -4 -2 0 2 4 6 8 x -ax is: months from bottom of inflation cy cle 10 12 100 75 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 x -ax is: months from bottom of inflation cy cle Source: J. commodities-based FX can still be an attractive investment during those times. The key is marginal changes in utilization. Although we are cognizant of the empirical data indicating more subdued rates of measured inflation during times of low rates of resource utilization. CHF. the likely trend in capacity utilization is higher over the coming 12 months. there is little correlation between the level of resource utilization and future changes in commodities. Historically. which in turn implies higher commodity-FX levels. the commodities-linked AUD/USD performs well during major cycle turns in global inflation. but the performance also is not as consistent as with EUR and CHF. but slightly less consistently than either EUR/USD or USD/CHF (see chart 6) Investing on the assumption of higher future rates of inflation requires timing well in advance of the final evidence of such. Morgan 69 .Global FX Strategy Global FX Strategy 2010 November 24. As expected.com Arindam Sandilya (1-212) 834-2304 JPMorgan Chase Bank NA JPMorgan Chase Bank NA lower after inflections in the inflation cycle. 2009 Kenneth Landon (1-212) 834-2391 kenneth. Chart 4: EUR/USD in 12-months before & after bottom of OECD CPI cycle (rebased to 100 at bottom of cycle) 130 Jan-73 Apr-86 Oct-06 Apr-79 Mar-94 Av erage Chart 5: USD/CHF in 12-months before & after bottom of OECD CPI Cycle (rebased to 100 at bottom of cycle) 150 Jan-73 Apr-86 Oct-06 Apr-79 Mar-94 Av erage 125 100 75 -12 -10 -8 -6 -4 -2 0 2 4 6 8 x -ax is: months from bottom of inflation cy cle 10 12 Source: J. Morgan Chart 6: AUD/USD in 12-months before & after bottom of OECD CPI cycle (rebased to 100 at bottom of cycle) 130 120 110 100 90 80 -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12 x -ax is: months from bottom of inflation cy cle Source: J.landon@jpmorgan.P. We prefer to express this view through a basket of long EUR.P. the historic performance of which is illustrated in Chart 7.

the cost of entering into them is a key strategic consideration for portfolio managers. Morgan 70 . The starting point of the analysis is to price up 1Y ATMF options for all assets considered in the chart. where the resulting volatility might place more pro-cyclical assets like commodity FX at risk. In such a setting. No transaction costs. The cost-effectiveness tradeoff is captured by a return on investment (RoI) metric. meaning that hedge gains are likely to be well preserved even in the unlikely scenario of an inflation scare morphing into a funding crisis (see Risk Scenario 2 below). Though unlikely to be the actual hedge instrument deployed. measured as the ratio of option P/L in an inflation shock to its upfront premium.Global FX Strategy Global FX Strategy 2010 November 24. call or put) as dictated by the signs of their betas with respect to inflation. Under the drastic assumption that we currently stand at or close to the bottom of the inflation cycle. calculated as the P/L from buying and holding to maturity a 1Y ATMF option (call or put depending on whether the underlying rallies or sells-off in response to inflation). and that all assets will exactly track the average post-inflation trough trajectories over the course of the next year as described in charts 2 through 7. Chart 8 ranks the inflation hedges discussed earlier along such bang-for-buck lines. EUR and CHF calls are the most efficient option-based inflation hedges for next year Return on investment from various inflation hedges. Chart 8: Gold. 500% 400% 300% 200% 100% 0% -100% Gold [Gold EUR CHF DXY AUD NZD JPY GBP CAD EUR. followed by those in EUR and CHF. being among a handful of underlyings where the expected at-maturity RoIs are in excess of 1. the cost of hedging is the option premium paid upfront. 2009 Kenneth Landon (1-212) 834-2391 kenneth. divided by its current premium. At-expiry P/L calculations assume that we are at the bottom of inflation cycle at present. are an inflation hedger’s best friends. and that each underlying will evolve over the course of the year exactly along the average trajectories in Charts 2 through 7. in the correct direction (i.e. Tail risk hedges are generally executed through low-delta option structures that provide lottery ticket style payoffs in the event of the unlikely turning imminent. CHF & Gold Aside from the responsiveness of potential hedges to an upturn in the inflation cycle.com Arindam Sandilya (1-212) 834-2304 JPMorgan Chase Bank NA Cost-effective hedges: EUR. it is then simple enough to compute atexpiry P/Ls from these options. a simple gauge of hedge efficiency is the P/L that it stands to generate in a shock scenario.CHF] Source: J. and is the variable along which chart 8 ranks our hedge universe. ATMF option premia are an acceptable proxy for comparing the nominal cost of option-based hedging across underlyings.P.landon@jpmorgan. The message from the chart is unambiguous – gold calls. They also have the advantage of not being traditional risk assets.

Commodity currencies generally do well during periods of rising inflation. the greater will be the risk of a financing crisis. fiscal deficit as percentage of total federal spending 60% 50% 40% 30% 20% 10% 0% -10% 1962 1966 1970 1974 1977 1981 1985 1989 1993 1997 2001 2005 2009 est Source: J.S. coincides with the strategy to hedge against inflation. Charts 2 and 3 rank G-10 currencies and benchmark commodities by two criteria: their profitability. there is considerable difficulty in predicting a funding crisis. but not if it leads to a growth-sapping funding crisis The U. US Treasuries and the S&P 500 declined simultaneously. episodes of such a crisis in a G3 country upon which to base a definitive trading strategy. Federal spending relative to GDP has reached 28% in 2009. For example. the U. which is a post-war high. it makes sense to focus on shifts in the market’s perceptions that could lead to the pricing of significant funding stress. The longer this continues. if any.S. federal government is financing over 50% of its overall spending with debt. policymakers are not passive observers of the budget. bonds and equities since the 1970s that provides a template of possible outcomes. 2009 Kenneth Landon (1-212) 834-2391 kenneth. The most consistent hedges are EUR. By currency crisis standards.Global FX Strategy Global FX Strategy 2010 November 24. which is a post-War high • Predicting a funding crisis is subject to considerable error for the obvious reason that trajectories of deficit spending are subject to a number of countervailing forces. FX Markets Weekly (September 16. commodity currencies are poor hedges since the rise in volatility could undermine cyclical assets and the carry trade. Currencies such as AUD would come under selling pressure if investors revert to risk aversion. CHF and gold. as that shock would coincide with an obvious source of leverage – government debt. then there could be simultaneous concerns about the sustainability of fiscal policies in both the United States and other countries that are running large budget deficits. EUR and CHF. In that case. However. and their consistency.P. Morgan If investors perceptions about inflation shift radically over the coming year. those episodes were mild – average monthly moves of -3% for the trade-weighted dollar. The strategy to hedge against a funding crisis in the U. any significant shift higher in the rate of inflation would bring with it concerns that the interest burden of existing and new debt will further boost the deficit. Furthermore. The most profitable hedges have been the same three: Gold. the pace of economic growth affects both the level of spending and tax collections. Similarly. They have the power to make changes that could significantly change the level of deficit spending. government is funding over 50% of its spending with debt.S. there is a high enough probability of passage for investors to be concerned about the sustainability of the U. +30bp for the US 10-yr and -2% for the S&P500. Additionally.S. then currencies that are tied to global growth could be harmed. However. there are few. an inflation surprise in 2010 would be the most likely trigger for similar conditions. 1976-80. Investors around the world are watching with particular interest whether or not the government of the United States will implement healthcare and energy reforms that could push the deficit significantly higher. The historical record suggests a handful of possible hedges. there were 21 months in which the trade-weighted dollar. or the percentage of crisis-like months in which these assets delivered positive returns.S. Although legislation has yet to be signed into law. For the purposes of this section. 71 .com JPMorgan Chase Bank NA Risk scenario 2: Funding crisis in the US • Higher inflation is generally good for commodity currencies. Treasuries and stocks sold-off simultaneously. Unsurprisingly. it is revealing that almost all of the crisis-like months occurred during periods of rising inflation such as 1972-74. Since 1971. Profiling a funding crisis As noted. As it stands today and as shown in Chart 1. Additionally.5% and 5% in those crisis-like months. However. should a funding crisis accompany the higher inflation.landon@jpmorgan. or average returns in months when the trade-weighted dollar. a long position in less cyclically exposed currencies such as EUR and CHF would make sense. 2009) provided a useful guide to financial markets when crisis-like conditions hit. 198690 and 1994. which rallied in at least 75% of those months. which returned between 3. budget. the US has experienced several months of crisis-like conditions in FX. Chart 1: U.

P. 2009 Kenneth Landon (1-212) 834-2391 kenneth. based on 21 occurrences since 1971 Gold EUR CHF JPY Oil GBP NZD AUD CAD Copper -4% Source: J. bonds and equities decline.Global FX Strategy Global FX Strategy 2010 November 24.P. bonds and equities declined Consistency defined as percentage of events in which currency has appreciated vs USD or commodities have risen.com JPMorgan Chase Bank NA Chart 2: Most-profitable hedges: Currency and commodity returns in months when trade-weighted USD. 19712009 %.landon@jpmorgan. EUR CHF Gold JPY NZD GBP Oil AUD CAD Copper 50% win/loss mark 0% Source: J. Morgan -2% 0% 2% 4% 6% Chart 3: Most-consistent hedges: percentage of months in which each currency pair or commodity delivered positive returns as tradeweighted USD. Morgan 20% 40% 60% 80% 100% 72 .

In November 1994. 1968. Since floating FX rates were established in the early-1970s. we have to be cognizant of the fact that there are few observable points. One possible result of the passage of an unpopular healthcare Bill would be a shift in political power at the mid-term elections in November 2010. The purpose is to shed some light on possible market reactions should Congress push through healthcare legislation that is opposed by the overwhelming majority of “swing voters” (unaffiliated. 1952. Although 79% of registered Democrats support such reform. one party – the Democrats – controls both houses of Congress and the White House. Morgan The House of Representatives recently passed a healthcare reform bill that polls indicate is opposed by approximately 50% of the U. the one-party rule of Republicans was overcome when Democrats took control of both the House and the Senate. the White S&P 500 Gold USD 3y r prior 2y r prior 1y r prior 1y r post 2y r post 3y r post 4y r post Another important aspect of one-party versus divided government is the impact on the budget. Chart 1 also indicates that the USD tends to be weaker and gold stronger during one-party rule as compared to the following years of divided government.P. gold was stronger and the USD was weaker during one-party rule. 1994. When Republicans took control of Congress. The entire House of Representatives and one-third of the Senate is up for re-election.g. 2009 Kenneth Landon (1-212) 834-2391 kenneth. there were six occasions in which an election resulted in the overthrow of one party rule and in favor of divided government. one pattern that has consistently repeated is that the growth of Federal spending slows after the start of divided 73 . bearish or neutral for markets? Many people recall a similar situation as today. surveys suggest that most Americans support reform of some sort. Would return to divided government be bullish. there have been only three instances of the overthrow of one-party rule (i. Gold & USD in the years prior and post a switch to divided government (1946 – present) 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% 4y r prior Source: J. As shown in Chart 2. The four-year cumulative change in the S&P 500 was 41% before divided government was instituted in 1994 and an outsized 156% in the four years after. independents).com). During those three instances.. A possible shift to divided government would have important implications for financial markets. but there are times when it can be a strongly positive factor (e. Global investors may welcome a divided government. and 2006). but investors were comforted by the fact that divided government lessened the chances of radical shifts in important policies such as taxes and regulations. Potential healthcare reform as put forth by Democrats played a part in that upset victory. mid-term elections in November 2010.e.S. 1980. The purpose of this section about risk scenarios is not to debate the merits or demerits of the current healthcare reform plan that is making its way through Congress. the average annual increase was 32% in the four years prior and just 8% in the four years post the shift to divided government. Over the course of the past six months. Chart 1: Average yearly change in S&P 500. In 1946.. Currently. When examining the USD and gold. the average annual increase in the S&P 500 was 30% in the four years prior to the switchover to divided government and 24% in the following four years. 1980. An examination of the entire post-war period indicates that the above pattern is not consistent. but not the kind currently making its way through Congress. Leaving out the experience of 1994. the plan is opposed by 78% of Republicans and. thus helping the USD. by 61% of unaffiliated voters (source: rasmussenreports.landon@jpmorgan. Policies of the executive branch moderated and the markets responded in a very positive way. As shown in chart 1. and 1994.com JPMorgan Chase Bank NA Risk scenario 3: Divided US government after November’s mid-term elections • • • Political risk will increase with the approach of the U. In the post-war period. most ominously for Congress. Obviously. The political environment was not the only factor driving investment returns. House veered sharply toward the middle of the political spectrum from its previous stance. the equity market is not necessarily comforted by divided government. population. the one-party rule of Democrats was demolished when Republicans took control of both houses of Congress.Global FX Strategy Global FX Strategy 2010 November 24. 1994). In 2006. the oneparty rule of Democrats was overturn when Republicans took control of either the White House or of at least one house of Congress.S.

1952 1968 1980 1994 2006 74 .landon@jpmorgan. 2009 Kenneth Landon (1-212) 834-2391 kenneth.P. the dollar could conceivably benefit from a shift in political power in November if it allays global investors’ concerns about runaway deficits in the US. Morgan Before After est.com JPMorgan Chase Bank NA government. In this respect. Divided government results in restraint that otherwise would be lacking when one party controls Washington.Global FX Strategy Global FX Strategy 2010 November 24. Chart 2: 4-year percentage change in Federal spending before & after switch to divided government (1946 – present) 120% 100% 80% 60% 40% 20% 0% -20% -40% 1946 Source: J.

landon@jpmorgan. 2009 Kenneth Landon (1-212) 834-2391 kenneth.Global FX Strategy Global FX Strategy 2010 November 24.com JPMorgan Chase Bank NA This page is intentionally blank 75 .

2009 Matthew Franklin-Lyons (212) 834-4565 matthew.franklin-lyons@jpmorgan.d.Global FX Strategy Global FX Strategy 2010 November 24.com JPMorgan Chase Bank NA Event risk calendar for 2010 Month November 2009 December 2009 Date 30 1 10 22 31 Country Norway New Zealand New Zealand Angola Norway Norway Australia United Kingdom Norway New Zealand Austria Norway United States Japan Norway United Kingdom Australia United Kingdom Norway Canada Australia Norway Japan Norway Australia United Kingdom Norway New Zealand Sweden Norway Brazil United States Norway Korea United States Australia United Kingdom Japan Norway New Zealand Event Norges Bank foreign exchange purchases Fronterra dairy auction RBNZ Monetary Policy Statement Notes 155th (extraordinary) meeting of the OPEC Conference in Luanda Norges Bank foreign exchange purchases Norges Bank foreign exchange purchases RBA's Quarterly Statement of Monetary Policy Bank of England Inflation Report Norges Bank foreign exchange purchases RBNZ Monetary Policy Statement 156th (ordinary) meeting of the OPEC Conference in Vienna Norges Bank foreign exchange purchases Spring Meeting of the International Monetary Fund and the World Bank Group Bank of Japan publishes outlook report Norges Bank foreign exchange purchases Parliamentary elections (must be called by May) RBA's Quarterly Statement of Monetary Policy Bank of England Inflation Report Norges Bank foreign exchange purchases G8 and G20 summit to be held in Muskoka RBA's Quarterly Statement of Monetary Policy Norges Bank foreign exchange purchases Upper-house legislative elections Norges Bank foreign exchange purchases RBA's Quarterly Statement of Monetary Policy Bank of England Inflation Report Norges Bank foreign exchange purchases RBNZ Monetary Policy Statement General election Norges Bank foreign exchange purchases Legislative election 2010 Annual Meeting of the International Monetary Fund and the World Bank Group Norges Bank foreign exchange purchases G20 summit to be held in Seoul Midterm elections RBA's Quarterly Statement of Monetary Policy Bank of England Inflation Report APEC summit in Yokohama Norges Bank foreign exchange purchases RBNZ Monetary Policy Statement January 2010 February 2010 29 5 10 26 March 2010 11 17 31 April 2010 24-25 27 30 May 2010 7 10 31 June 2010 25-27 10 30 July 2010 30 August 2010 6 11 31 September 2010 16 19 30 October 2010 3 9-11 29 November 2010 2 5 10 13-14 30 December 2010 9 76 .

franklin-lyons@jpmorgan.com JPMorgan Chase Bank NA Central bank announcement dates in 2010 United States ECB Japan United Kingdom Switzerland Canada Australia New Zealand Norway Sweden 2009 DEC 16 3 18 10 10 8 1 10 16 16 2010 JAN 27 14 26 7 19 2 28 3 11 FEB 4 18 4 MAR 16 4 17 4 11 2 2 11 24 APR 28 8 27 8 20 6 29 20 MAY 6 21 6 JUN 23 10 15 10 17 1 1 10 23 JUL 8 8 20 6 29 2 AUG 10 5 5 SEP 21 2 9 16 8 7 16 22 OCT 7 7 19 5 28 27 NOV 3 4 4 DEC 14 2 9 16 7 7 9 15 4 5 3 11 2 77 .Global FX Strategy Global FX Strategy 2010 November 24.d. 2009 Matthew Franklin-Lyons (212) 834-4565 matthew.

78 6.25 1.1% 3.00 1.4% 0.58 7.5% 3.8 74.80 1.4% 1.6 69.1% 14.0% 0.40 4.00 1.P.1 ↓ ↓ ↑ ↑ ↑ ↑ JPM forecast gain/loss vs Dec-10* forward rate 0.26 5.8% 9.5% 16.00 6.00 2.40 7.33 2.7% 0.95 3.55 85 1.20 ↑ ↑ ↑ ↑ ↑ ↓ ↑ 133 0.6% Actual change in local FX vs EUR 4.6% 14.0% 0.S dollar Current Majors EUR JPY GBP AUD CAD NZD JPM USD index DXY Nov 24 1.20 3. J.2% Actual change in local FX vs USD Past 1mo -0.1% 29.** Consensus Economics Publication: Foreign Exchange Consensus Forecasts November 2009 Source: J.80 7.76 78.7% Past 12mos 14.0% 3.33 2.50 32.4% -0.90 1.4% 2.99 0.0% -6.55 165 26.1 Mar 10 1.0% 2.1% 34.9% 7.2% 4.1% 0.3% -11.3% 7.68 1.8% -4.8% 13.95 1.3 ↑ ↑ ↑ ↑ ↑ ↑ ↓ ↓ Sep 10 1.7% -0.6% 5.02 0.50 89 1.4% 2.5% 7.0% 2.34 30.8% 1.5% 0.0% 0.P.75 7.85 1.65 6.2% 3.75 9475 46.70 7.49 10.73 493 1965 13.80 2.3% 7.25 45.90 25.7% 14.35 46.2% -0.7% 4.90 1.6% 0.5% 3.45 1.00 25.5% 0.4% 6.0% 7.8% 2.9% 3.65 0.2% 6.80 255 4.30 45.3% 4.3% 3.0% 0.4% -13.0% 6. Forwards & Consensus Exchange rates vs.33 8.0 1130 3.8% -0. U.3% -6.4% -0.00 ↑ ↑ ↑ ↑ ↑ ↑ -1.00 ↑ ↓ ↑ ↑ ↑ ↑ ↓ ↓ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ 3.5% 5.40 5.39 32.77 9000 45.7% 1.4 ↑ ↑ ↑ ↑ ↑ ↑ ↓ ↓ Jun 10 1.7% Consensus** 4.5 1130 3.0% 2.6% 18.3% 6.5% 3.37 25.4% 0.94 1.2% 31.3% -28.0% -2.40 4.9% 2.1% 1.0% 0.7% 3.74 80.51 10.5% -9.76 180 28.5% 4.0% -10.0% 17.6% 1.20 4.00 2.4% 0.7% 4.7% 8.15 6. Morgan FX Forecasts vs.01 1.4% 5.1% 13.8% 10.9% 7.50 2.80 3.7% 0.4% 5.25 33.73 80.9% -9.95 1.2% 0.4% -0.95 255 4.1% 0.4% -2.2% -1.73 82.3% 8.1% -2. Middle East & Africa CHF ILS SEK NOK CZK PLN HUF RUB TRY ZAR Americas ARS BRL CLP COP MXN PEN VEF Asia CNY HKD IDR INR KRW MYR PHP SGD TWD THB Exchange rates vs Euro JPY GBP CHF SEK NOK CZK PLN HUF RON 132 0.41 1.65 475 1925 12.1% 33.0% -0.74 1.1% 2.0% 2.65 7.50 1.3% 30.7% 25.65 500 1950 12.45 5.1% -3.75 500 2000 13.75 2.7% 12.1% 2.0% -12.3% -0.4% 4.1% 1.47 9.88 2.8% -3.7% 7.2% 9.2% -0.0% 23.8% -1.23 0.3% 0.55 85 1.3% 0.3% 5.9% -5.7 1.8% 26.50 1.80 3.4% 1.6% 4.00 8.9% 41.78 9000 43.0% 9.2% 8.5% 0.4 72.0 ↑ ↑ ↑ ↑ ↑ ↑ ↓ ↓ Dec 10 1.80 2.8% -5.9% 1.16 16.88 15.35 7.1% 5.96 3.4% 5.14 6.5% 19.0 1120 3.00 1.65 168 26.43 2.5% 4.00 32.0% 4.39 47.26 2.0% -0.01 0.10 ↑ ↑ ↑ ↑ ↑ ↑ 134 0.7% -0.00 33.91 3.9 4.8% 0.2% 4.6 1156 3.3% 30.8% 5.06 0.50 ↓ ↓ ↓ ↑ ↑ ↓ ↓ ↓ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ 0.4% 9.92 1.15 6.6% 0.27 132 0.67 1.1% 37.00 ↓ ↓ ↓ ↑ ↓ ↑ ↓ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ 0.51 3.92 1.50 32.61 17.35 30.9% 5.10 260 4.7% Europe.7% -0.0% 10.1% -2.0% 10.8% 3.9% 11.15 6.47 157 25.12 268 4.8% -0.9% 9. Morgan Securities Ltd.45 7.80 9500 42.05 4.65 0.5% -2.Morgan 78 .2% -1.00 255 4.0% -7.4% 7.80 24.7% -0.1% 5.3% 2.3% 0.3% 32.5% -8.8% 2.70 7.4% 6.9% 5.1% 0.4% -0.7% 14.0% 10.3% 5.46 9.Global FX Strategy Global FX Strategy 2010 November 24.10 1.5% -0.6% -6.50 3.53 170 26.7% 5.8% -0.3% -1.0% 16.80 2.9% 1.78 2.62 82 1.36 31.6 72.00 1. ↓ indicates revision resulting in weaker local FX * Negative indicates JPM more bullish on USD than consensus.5% YTD 6.49 88.8 1100 3.9% 4. 2009 John Normand (44-20) 7325-5222 Kamal Sharma (44-20) 7777-1729 J.P.0% 5.33 30.2% 24.4% -0.1% 3.3% 13.94 1.03 16.1% 6.5% 11.40 7.7% 14.40 4.92 5.25 45.97 3.00 0.0% 34.50 7.0% 9.6% 0.3% 14.09 2.0% -0.01 3.4% 0.1% -0.83 7.5% 16.4% 0.00 4.93 1.60 6.1% 6.9% ↑ indicates revision resulting in stronger local FX .5 75.0% 0.5% 8.4% 15.0% 13.8% -1.9% -0.2% 7.2% 4.1% 4.60 6.8% 2.1% 11.4% -2.80 9200 42.00 16.02 0.48 9.85 1.50 24.2% 13.04 1.10 ↑ ↑ ↑ ↑ ↑ ↑ ↑ 132 0.00 ↓ ↓ ↓ ↓ ↓ ↓ ↓ ↑ ↑ ↑ ↑ ↑ ↑ ↓ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ 0.9% 12.3% -2.5% -4.60 7.76 79.55 6.60 490 1850 12.5% 3.4% 4.1% 0.2% 8.

UST) Current 191 173 92 745 771 318 Index JPMorgan US Index (JULI) JPMorgan Euro Credit Index (MAGGIE) JPMorgan Global High Yield Index JPMorgan Euro Credit Index (MAGGIE) EMBI Global Quarterly Averages YTD Return* 16.4% 20.30 Jun-10 0.125 3.8% 34.Global FX Strategy Global FX Strategy 2010 November 24. Telecommunications Utilities US OW OW OW OW UW UW OW OW N UW YTD ($) 14.5% 24.2% 85.0% YTD Return* United States Credit Markets US high grade (bp over UST) US high grade (bp over swaps) Euro high grade all (bp over swaps) USD high yield (bp vs.8% -2.02 0.7% -22.01 1.6% 18.0% 102.75 4.4% 79.1% 27.4% 44.4% -12.9% 69.65 0.0% 18.1% 28.6% 102.38 1. Equities & Commodities Interest rates Current Fed funds rate 10-year yields Euro area United Kingdom Japan Refi rate 10-year yields Repo rate 10-year yields Overnight call rate 10-year yields 0.P.1% 51.7% EM OW UW OW UW UW OW OW UW UW YTD ($) 88.68 1.0% -12.30 0.5% 32.74 YTD Return Sector Allocation * Energy Materials Industrials Discretionary Staples Healthcare Financials Information Tech.x.15 10Q3 70.30 0.55 85 1.00 1.P.125 3. Datastream.66 0.P. Standard & Poor's Services.65 0.5% 53.50 0.00 3.50 4.00 3.62 82 1. 2009 Grace Koo (44-20) 7325-1362 grace.125 3.6% 16.3% 53.8% 58.36 1.8% 4. J. Credit.28 0.28 0.2% 36. Morgan estimates 79 .73 Jun-10 1.4% 23.125 4.2% 15.2% 10.9% 14.5% 21.1% 2.1% 5.6% 27.2% -16.00 3.7% 6.125 4.9% -12. UST) Euro high yield (bp over Euro gov) EMBIG (bp vs.50 88.2% 4.4% 26.0 1000 5750 4.75 1.0% Europe YTD ($) OW N OW N UW UW N N OW OW 45.00 3.40 Sep-10 0. J.25 1.1% 19.05 0.50 89 1.10 1.13 09Q4 70.10 1.8% 10.8% 92.com J.2% 1.67 1.31 Dec-09 0.8% 53.7% 17.65 0.2% 74.3% *Levels/returns as of Nov 19.4% 28. IBES.1% 45.4 1165 6820 4.10 1.5% Equities S&P Topix FTSE 100 MSCI Eurozone* MSCI Europe* DAX CAC MSCI EM* MSCI EM $* Current 1091 839 5337 154 1087 5754 3792 41999 965 (local ccy) 20.95 1.99 0.05 JPMCCI Index Energy Precious Metals Industrial Metals Agriculture YTD Return* 8.10 1.00 10Q2 65.73 Mar-10 1.74 1.92 1.8% 35.0% 17. Morgan Securities Ltd.76 Dec-10 1.2% Commodities WTI ($/bbl) Gold ($/oz) Copper ($/metric ton) Corn ($/Bu) Current 78.2% 2. Morgan Forecasts: Rates.76 Sep-10 1.9% 7.8% 18.6% 1.3% 36.0 1000 6000 4.50 4.02 0.3% -2.9% Foreign Exchange EUR/USD USD/JPY GBP/USD AUD/USD USD/CAD NZD/USD Current 1.0% Japan N N N UW UW OW N N UW n YTD (¥) -0.31 Mar-10 0.2% 37.06 0.45 0.40 0.koo@jpmorgan.6% 56.00 3.45 0.55 85 1.50 3. 2009 Source: Bloomberg.00 0.9 1.6% 17.10 1.8% 3m cash YTD Return* index in USD EUR JPY GBP AUD CAD NZD 9.01 0.0 1050 6250 4.0 1000 5950 3.7% 66.00 1.50 3.65 10Q1 70.

9 5.5 2.4 3.0 7.0 4.5 2.1 5.6 0.6 ↑ 0.0 3.9 5.4 1.2 … 0.0 3.4 3.0 1.3 4.9 -0.2 ↓ -4.2 2.6 -3.4 ↑ 2.5 0.4 -1.3 3.1 -4.0 2.7 1.3 5.0 3.8 6.1 5.2 4.9 2.0 3.0 7.5 3.9 4.0 5.8 0.9 ↑ -1.9 3.3 … 3.3 1Q10 3.6 -0.1 0.0 ↓ 2.5 5.4 2.4 5.3 11.5 -0.3 4.5 3.0 3.3 4.0 2.4 4.4 1.2 5.0 5.0 3.5 1.2 0.0 3.3 0.3 0.0 -7.3 7.0 6.2 ↑ 1.3 ↓ -0.9 0.5 4.9 … 5.3 1.4 -0.7 3.9 ↓ ↑ ↓ ↑ ↑ ↓ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↑ ↓ ↓ ↑ ↑ ↓ ↑ ↓ ↑ ↓ 2.0 4.8 6.0 5.6 1.9 3.4 4.8 -1.8 3.8 3.2 4.4 2.2 ↑ 6.9 ↓ 8.6 1.3 1.3 6.0 5.5 5.7 -5.8 4.0 0.7 2.8 2.6 2.7 9.9 1.4 7.9 … 3.0 5.0 ↓ 1.9 4.5 1.6 6.5 3.6 1.5 4.6 5.8 1.0 2.8 7.Global FX Strategy Global FX Strategy 2010 November 24.0 9.5 4.3 12.8 -1.9 5.1 -3.1 6.3 6.0 -2.0 3.5 … 4.0 0.9 -4.3 2.8 6.0 2.0 -2.7 2.8 5.0 2.4 -0.5 0.0 2.8 ↓ 4.1 6.5 3.6 -1.9 ↓ 3.0 ↓ -1.3 3.5 0.7 1.0 -0.0 1.0 ↑ 2Q10 2.3 2.2 0.2 10.3 0.4 5.6 6.0 3.0 5.0 6.7 -2.2 1.5 ↑ 3Q09 3.3 -5.7 12.1 29.9 1.5 3.1 3.5 5.0 3.7 -2.0 7.0 4.1 0.4 -2.7 -6.2 -7.1 8.8 2.0 3.9 3.0 -3.6 3.5 7.0 3.8 4.6 1.4 0.0 4.9 ↑ 9.6 2.3 ↑ 7.1 ↓ 2.1 -1.7 … 3.0 6.0 3.6 ↑ 7.3 -1.1 2.0 4.0 4.1 ↓ 10.5 13.6 ↓ 4.0 ↑ 6.0 2.0 4.0 3.0 3.0 4.5 1.6 ↑ 2010 3.0 ↑ 2.0 0.8 2.5 2.5 3.5 … 3.8 … 4.4 2.0 1.4 0.1 7.8 4.2 … 1.0 10.3 3.1 -1.2 ↑ 0.5 3.9 4.7 2.3 -0.9 28.8 0.3 -4.0 2.3 3.3 6.0 4.0 2.2 ↑ 0.5 -5.5 4. Morgan 2009 -2.5 34.4 3.5 5.2 5.9 ↑ 1.3 2.0 3.5 -2.0 3.4 -1.8 ↓ 10.9 11.5 … 3.0 -2.7 5.8 -1.1 2.6 10.3 7.6 11.0 3.0 4.3 1.6 3.3 9.9 3.3 0.0 ↓ 3Q09 -1.8 4.0 10.0 3.3 6.1 … 1.5 ↓ -5.8 2.7 3.8 -3.6 ↑ 2.0 4.5 1.6 4.5 0.1 10.4 6.5 4.2 3.4 -0.8 -1.4 … 2.6 9.0 3.0 5.5 4.2 1.0 7.5 9.6 3.3 -0.0 ↑ 1.5 -0.5 4.1 -1.3 9.3 -1.0 3.1 5.5 3.0 5.4 2.4 0.0 1.5 … 1.9 5.5 3.0 3.7 3.7 0.4 4.3 3Q10 4.6 5.3 4.0 ↓ 1.5 3.1 5.5 2.2 ↑ 2.0 ↓ 4.0 5.1 0.2 0.8 9.6 -4.0 2.0 3.8 2.0 3.5 3.4 ↓ 2.5 2.1 5.0 37.4 6.9 2.2 6.3 … 2.2 1.0 0.4 4.5 4.6 3.9 5.4 4.2 0.2 3.5 0.0 0.0 3.4 3.2 -2.6 4.9 5.0 -0.4 6.0 3.0 7.5 3.4 4.4 2.0 5.2 11.0 5.3 2.6 1.6 3.6 5.1 2.0 -2.7 1.3 ↓ -10.5 3.5 7.5 3.0 … 6.0 3.8 -1.2 -1.5 … 4.7 -1.5 5.4 ↓ 3.8 2Q09 -0.8 -0.0 6.8 7.5 1.1 1.5 4.6 14.7 3.5 ↑ -3.5 3.3 -2.5 3.0 -0.5 4.1 2.1 2.5 7.0 3.1 3.4 3.3 9.1 ↑ 2.5 3.7 3.8 2.0 3.3 9.5 4.8 1.0 ↑ 4Q10 1.1 1.3 9.0 ↑ 4Q09 3.0 21.8 6.1 2.5 -1.9 ↓ 3.0 ↓ 2.1 5.7 1.5 5.7 20.8 2.5 3.5 2.7 5.6 -3.0 3.5 3.7 4.5 3. saar Consumer prices % over a year ago 2008 The Americas United States Canada Latin America Argentina Brazil Chile Colombia Ecuador Mexico Peru Venezuela Asia/Pacific Japan Australia New Zealand Asia ex Japan China Hong Kong India Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand Africa/Middle East Israel South Africa Europe Euro area Germany France Italy Norway Sweden Switzerland United Kingdom Emerging Europe Bulgaria Czech Republic Hungary Poland Romania Russia Turkey Global Developed markets Emerging markets Source: J.3 12.P.2 2.5 … 4.7 -3.0 8.1 4.5 2.0 3.5 2.0 3.0 -3.3 2.0 2.0 -7.7 9.5 4.7 1.2 0.0 3.0 4.0 3.5 2.3 -0.4 0.0 4.3 0.4 ↑ 2.5 2.0 4.0 1.4 0.7 3.0 4.7 2.5 5.5 … 3.5 7.1 5.0 … 3.0 3.9 -2.0 1.4 ↓ 80 .4 1.2 6.2 2.8 1.0 … 0.0 -2.5 ↑ 4Q09 1.0 -1.7 2.8 ↓ 2.8 -4.5 4.5 5.2 2.0 6.0 1.9 1.6 2Q10 4.6 1.5 9.5 1.6 0.0 1.5 -0.0 5.2 -7.7 4Q10 3.5 2.8 14.0 3.8 5.5 1.9 2.6 4.5 5.5 … 7.0 -6.7 6.5 2.8 3.0 4.0 3. 2009 David Hensley (1-212) 834-5516 Carlton Strong (1-212) 834-5612 JPMorgan Chase Bank NA Global Growth and Inflation Forecasts Real GDP % over a year ago Real GDP % over previous period.5 -1.3 0.0 -3.0 2.4 -0.5 2.2 4.0 2.0 -1.2 3.1 5.3 -2.6 6.0 3.4 -1.3 -0.0 … 4.0 4.8 1.2 2.4 5.8 9.0 4.3 -0.4 0.5 7.0 6.0 3.0 3.0 3.0 -8.2 1.7 0.6 3.2 2.3 2.2 ↑ 10.3 -4.0 3.6 ↓ 2.4 ↑ 2.3 1.0 1.0 11.0 5.4 3.3 0.6 … 2.5 4.1 3.2 … 2.9 1.6 ↓ 1.0 1.1 6.9 ↓ 4.0 3.4 12.8 ↑ -4.5 ↓ 2.8 5.7 ↓ 1.5 4.0 -4.4 5.8 7.4 1.5 2.0 3.0 3.2 8.2 ↓ -1.6 4.0 5.0 4.2 -1.0 5.2 2.8 2.0 14.0 … 3.2 ↑ 3.

00 1.50 3.50 5.51 4.10 0.31 2.25 4.25 10.42 5.5bp) 21 Apr 09 (-25bp) 22 Jul 09 (-50bp) 17 Jul 09 (-25bp) 9 Jul 09 (-25bp) 23 Nov 09 (-50bp) 6 Aug 09 (-75bp) 16 Dec 09 8 Dec 09 9 Dec 09 27 Nov 09 10 Dec 09 10 Dec 09 on hold on hold Jan 10 (+50bp) Jun 10 (+25bp) 2Q 10 (+50bp) on hold on hold Last change Next meeting Forecast next change Dec 09 Mar 10 Jun 10 Sep 10 Dec 10 1.00 0.00 1.00 7.00 1.50 4.25 3.25 1.13 7.32 1.09 3.00 4.50 7.50 1.85 0.85 0.75 7.75 4.25 5.32 1.75 0.50 0.54 5.00 1.50 0.50 2.00 25 Jan 10 (+25bp) 1.36 1.10 0.88 0.50 2.75 2.50 2.00 3.75 6.00 5.75 5.50 1.50 5.00 0.25 8.71 6.00 4.00 0.44 4.25 -188 18 Feb 09 (-25bp) 4Q 09 4Q 10 (+12.52 4.25 9.39 1.00 3Q 10 (+25bp) 1Q 10 (-25bp) 24 Nov 09 (-50bp) 4Q 10 (+50bp) on hold 3Q 10 (+50bp) 3.47 5.50 1.00 1.50 5.25 1.25 1.87 4.50 1.00 0.00 0.31 1.00 0.50 5.00 3.00 4.P.25 2.75 3.50 0.75 3. Morgan 81 .04 0.25 3.00 4.25 3.5bp) Bold denotes move since last GDW and forecast changes.50 3.00 3.14 4.31 2.50 3.10 0.00 6.12 0.25 8.75 2.50 0.Underline denotes policy meeting during upcoming week.00 4.17 0.25 1.31 2.50 5.75 0.25 6.50 3.25 1.25 6.10 0.25 1.75 4.50 4.75 1.00 7.25 4.78 4.50 2.50 0.50 1.75 1.50 8.48 2.25 -200 8 Apr 09 (-25bp) 2 Dec 09 2Q 10 (+25bp) Taiwan Official discount rate 1.00 1.25 1.50 1.79 0.50 0.50 4.25 1.86 0.53 0.50 0.75 5.50 1.00 7.00 0.08 3.Global FX Strategy Global FX Strategy 2010 November 24.25 6.25 2.25 2.50 2.50 0.25 10.125 0.25 1.25 2.50 4.00 6.00 4.29 4.125 0.36 1.125 0.00 7.94 4.75 0.31 2.50 0.31 4.43 2.00 2.50 6.00 0.50 1.10 0.125 0.25 1.57 5.88 0.23 4.75 4.00 -341 -257 -365 -246 -306 -222 -232 -484 -512.31 1.75 3.58 4.75 4.50 5.50 2.50 3.25 1.50 5.00 0.75 4.34 0.03 4.00 0.94 0.25 8.25 1.66 4. Source: J.00 7.75 4.50 0.50 0.50 2.00 3.00 6.75 1.00 4.00 0.25 6.50 7.50 5.50 5.00 1.50 1.21 4.50 0.00 4.50 5. 2009 David Hensley (1-212) 834-5516 Carlton Strong (1-212) 834-5612 JPMorgan Chase Bank NA Global Central Bank Forecasts Change from Official interest rate Global excluding US Developed Emerging Latin America CEEMEA EM Asia The Americas United States Canada Brazil Mexico Chile Colombia Peru Europe/Africa Euro area GDP-weighted average GDP-weighted average GDP-weighted average GDP-weighted average GDP-weighted average GDP-weighted average GDP-weighted average GDP-weighted average Federal funds rate Overnight funding rate SELIC overnight rate Repo rate Discount rate Repo rate Reference rate GDP-weighted average Refi rate Current Aug '07 (bp) 1.5 -425 -275 -275 -500 -575 -350 -323 -300 -525 -325 -325 -200 -125 -300 -125 100 150 -300 -225 -1100 -147 -300 -575 -40 -625 -171 -300 -175 -300 -150 -200 16 Dec 08 (-87.50 3.50 0.375 7 May 09 (-25bp) 5 Mar 09 (-50bp) 2 Jul 09 (-25bp) 28 Oct 09 (+25bp) 6 Aug 09 (-25bp) 23 Nov 09 (-50bp) 23 Nov 09 (+25bp) 24 Jun 09 (-25bp) 29 Sep 09 (-50bp) 29 Oct 09 (-50bp) 13 Aug 09 (-50bp) 12 Mar 09 (-25bp) 19 Nov 09 (-25bp) 3 Dec 09 10 Dec 09 16 Dec 09 16 Dec 09 16 Dec 09 21 Dec 09 28 Dec 09 25 Nov 09 5 Jan 09 24 Nov 09 17 Dec 09 10 Dec 09 17 Dec 09 on hold 3Q 10 (+25bp) on hold 3 Feb 10 (+25bp) 2Q 10 (+25bp) United Kingdom Repo rate Sweden Repo rate Norway Deposit rate Czech Republic 2-week repo rate Hungary Israel Poland Romania Russia South Africa Switzerland Turkey Asia/Pacific Australia New Zealand Japan Hong Kong China Korea Indonesia India Malaysia Philippines 2-week deposit rate Base rate 7-day intervention rate Base rate 1-week deposit rate Repo rate 3-month Swiss Libor Overnight borrowing rate GDP-weighted average Cash rate Cash rate Overnight call rate Discount window base 1-year working capital Base rate BI rate Repo rate Overnight policy rate Reverse repo rate 21 Dec 09 (-50bp) 6.25 1.25 2.56 6.00 0.30 1.00 2.125 0.25 1.58 2.25 3 Nov 09 (+25bp) 30 Apr 09 (-50bp) 19 Dec 08 (-20bp) 17 Dec 08 (-100bp) 22 Dec 08 (-27bp) 12 Feb 09 (-50bp) 5 Aug 09 (-25bp) 21 Apr 09 (-25bp) 24 Feb 09 (-50bp) 9 Jul 09 (-25bp) 1 Dec 09 9 Dec 09 18 Dec 09 17 Dec 09 2Q 09 9 Dec 09 3 Dec 09 1Q 10 24 Nov 09 17 Dec 09 1 Dec 09 (+25bp) 8 Jul 10 (+50bp) on hold on hold 3Q 10 (+27bp) 1Q 10 (+25bp) on hold 1Q 10 (+25bp) 2Q 10 (+25bp) 4Q 10 (+25bp) Thailand 1-day repo rate 1.75 5.50 5.50 1.10 0.25 2.89 0.25 2.25 2.25 7.49 4.50 7.50 2.25 6.00 0.30 1.25 10.85 3.75 2.50 3.25 1.07 0.50 8.25 6.25 3.50 7.50 1.13 4.54 4.46 1.00 2.125 0.50 4.94 6.00 0.

Aug 14. Oct 23. 09 Hedging & trading long-term FX with J. Tanase. Ho. Normand. 2009 Gauging the FX impact of M&A announcements. 2009 Japan flow backdrop yen bullish beyond fiscal year-end.morganmarkets. Mar 27. Normand and Sandilya. 2009 The month-end effect in FX: small but predictable.P. cautious hedging of 2010 exposure. Sharma. Sasaki. Tanase May 29. De Kock. Sharma.normand@jpmorgan. 2009 Will Japan’s new finance minister adopt strong-yen policy? Sasaki and Tanase. still big opportunities. May 15. Sep 4. 2009 Keeping up with the Watanabes: Who drives the carry trade postcrisis? Normand. Meggyesi. Jan 16. Oct 9. Jan 16. Watanabe undermine AUD/JPY & NZD/JPY again?. Mar 9. 2009 Gold: New upleg highs – should we expect more? Jansen. Jansen. Jun 5. 2009 Corporate Hedging Survey: Japanese corporates increase ’09 hedging ratios. 2009 Does the turn in housing mark the turn in FX?. Sharma. Oct 2. not break. Meggyesi. Ping Ho. 2009 Positioning for the growing risk of Swiss QE. Tanase. 2009 G-10 fair value update: Smaller misalignment. Mar 13.com Currency unlikely to prevent strong Euro area export growth. 2009 Norges Bank will not derail NOK strength. 2009 Corporate Hedging Survey: US corporates boost ’09 hedge ratios. Meggyesi. 2009 Cross-border M&A: USD and GBP are the biggest losers. Mar 9. 2009 How will the upcoming Lower House election affect the yen? Tanase. 2009 Japanese retail may again drive yen higher. 09 Fiscal stimulus may lift Japanese economy but drag down JPY. De Kock & Tanase. 2009 KRW: Under the microscope. Jan 30. Meggyesi. Jan 9. De Kock. 2009 John Normand (44-20) 7325-5222 john. Piron. Jun 12. 2009 82 . Oct 16. Sasaki. Sharma. Sharma. 2009 Preview of Japanese lower house elections. Sasaki. Meggyesi. Jan 30. Sep 18. Apr 3. Tanase. 2009 Firm foundations: AUD and NOK to capitalize on revival in house prices. Normand. Sharma. 2009 Central bank support for GBP evaporates. Jul 24. 2009 EMU to bend. May 21. Tanase. Oct 30. 2009 Has HIA-related repatriation started already? Sasaki. Normand. Oct 2. Sasaki and Tanase. Tanase. 2009 Base metals in H2: Feast or famine? Jansen. Jan 23. 2009 Precious Metals Outlook H2. Jul 31. Aug 28. Morgan Securities Ltd Prior Research Notes available on www. 2009 Scope for divergence in the dollar bloc. 2009 How far can SEK fall? Sharma. 2009 Under-hedged IT exporters: Dry tinder to INR spark. 2009 Baltics give SEK noise but not trend. Apr 24. 2009 Central banks still leaning against the wind. 2009 Risk factors for JPY: HIA. Meggyesi. 2009 Japan passes HIA: What impact on JPY? Sasaki. Apr 24. 2009 JPY: Safe Haven no more? Sasaki and Tanase. Kim. De Kock. Jul 10. Feb 27. Huffman. seasonals and more. Sharma. Tanase. Aug 21. 2009 Earning the liquidity premium in FX. 2009 Nikkei – USD/JPY correlation to break down. Jul 10. 2009 Government deficits & debt will sink the dollar and other fairy tales. Feb 20.Morgan’s Fair Value Model. 2009 FX in a world with less leverage and more regulation. Feb 20. 2009 Implication of FSA’s cap on FX margin leverage. 2009 JPY: Three reasons why Japan would not intervene Sasaki. 2009 Japanese lifers hesitate to take FX risks. Oct 23. 2009 Sterling: Queasy sailing on the QEII. offensive Q3 Piron.P. 2009 Will Mrs. Sep 18. 2009 Sell USD when central banks buy. Apr 3. Huffman. May 1. De Kock. Franklin-Lyons & Sharma. Oct 9. Jun 4. Jan 9. 2009 Asia FX Forecasts: Stay defensive Q2. 09 The inflation trade in FX: cheap and early. De Kock. Mackie. Jul 2. Piron.Global FX Strategy Global FX Strategy 2010 November 24. May 13. Aug 7. 2009 Corporate hedging survey: 2010 USD bounce. May 14.com J.

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com yenping.com junya.d.s.com thomas.x.kock@jpmorgan.sandilya@jpmorgan.kim@jpmorgan.com New York Ken Landon Gabriel de Kock Niall O’Connor Arindam Sandilya Matthew Franklin-Lyons MD ED ED VP Analyst G-10 FX Strategy G-10 FX Strategy Technical Strategy FX Derivatives Strategy G-10 FX Strategy (1-212) 834-2391 (1-212) 834-4254 (1-212) 834-5108 (1-212) 834-2304 (1-212) 834-4565 kenneth.tanase@jpmorgan. Morgan Global FX Strategy London John Normand Paul Meggyesi Thomas Anthonj Kamal Sharma Talis Bauer Robert Beange MD ED ED VP VP ED (Emerging Markets Research) Head.meggyesi@jpmorgan.Global FX Strategy Global FX Strategy 2010 November 24.x.anthonj@jpmorgan.x.com Asia Tohru Sasaki Junya Tanase Claudio Piron Yen Ping Ho Yoonyi Kim ED ED ED (Emerging Markets Research) VP (Emerging Markets Research) Analyst G-10 FX Strategy G-10 FX Strategy Asia FX Strategy Asia FX Strategy G-10 FX Strategy (81-3) 6736-7717 (81-3) 6736-7718 (65) 6882-2218 (65) 6882-2216 (81-3) 67367729 tohru.sharma@jpmorgan.sasaki@jpmorgan.com kamal.com J.bauer@jpmorgan.P.s.com claudio.piron@jpmorgan.com yoonyi.m.com arindam.landon@jpmorgan. Global FX Strategy G-10 FX Strategy Technical Strategy G-10 FX Strategy FX Derivatives Strategy CEEMEA FX Strategy (44-20) 7325-5222 (44-20) 7859-6714 (44-20) 7742-7850 (44-20) 7777-1729 (44-20) 7777-5276 (44-20) 7777-3246 john.com robert.franklin-lyons@jpmorgan.ho@jpmorgan.com niall.beange@jpmorgan.P.normand@jpmorgan.com 88 . Morgan Securities Ltd J.com paul.com matthew.com gabriel.normand@jpmorgan. 2009 John Normand (44-20) 7325-5222 john.de.e.oconnor@jpmorgan.com talis.

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