Foreign Exchange

London 08:00

FX Daily Strategist: Europe
AUDUSD vs AUD rate expectations
3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 06 07 08 09 10 11 AUD rate expectations (12m) AUDUSD (RHS) 1.10 1.05 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60

  

Less hawkish RBA minutes can weigh on AUDNZD No tangible evidence of progress with US deficit/debt ceiling negotiations Gold now outpacing CHF, but in absence capital controls

Source: Reuters Ecowin Pro. The disconnect between AUDUSD and AUD rate (cut) expectations looks increasingly unsustainable, even allowing for the special factors such as increased reserve manager demand supporting AUD. We suspect that a reconnect when it comes is more likely via a forced revision to interest rate thinking than a fall in AUD, though in the meantime positioning for a reconnect via being tactically short AUD alongside a payer of front end rates has something to commend it.
GMT Country Release Mkt Spain to sell 12m and 18m bills ZEW Expectation -11.5 ZEW Current Ass 85.0 Housing Starts K 575 Leading Indicat % 0.8 (m/m) BoC Monetary Policy 1.00 Announcement % Last -9.0 87.6 560

08:30 ES 09:00 DE (Jul) 09:00 DE (Jul) 12:30 US (Jun) 12:30 CA (Jun) 13:00 CA


The RBA minutes released in Asia were considered to be “less hawkish”, with the RBA dropping their explicit view that policy would need to be tightened at some point, referring to a softer domestic economy and risks in Europe. However, the RBA did state that it had more time to assess inflation and hence the focus will invariably turn to the Q2 PPI/CPI releases next week. However, perhaps more important for the AUD besides the rates view is the terms of trade boom driven by higher commodity prices, and hence we do like AUD on certain crosses like short GBPAUD for instance. However, those wanting to play a less hawkish RBA would be well advised to do soewithin the commodity block; consider looking to get short AUDNZD following last week’s stronger GDP print given that RBNZ rate moves appear under priced given the recent strength visible in the New Zealand economy. There has so far not been any tangible evidence of progress with US deficit/debt ceiling negotiations. We did have platitudes about a ‘big deal’ but no sign of how it would be achieved and with the clock now ticking down more loudly given that Friday may be the last effective day for a deal to allow time for the necessary legislation to raise the debt ceiling by August 2 nd. We can fully expect this situation to persist until we hear news of an agreement on US deficit reduction (and of a magnitude that significantly reduces the threat to the US AAA rating) and the right form of words – if not yet hard actions – out of the planned EU Summit on Thursday that assuages some of the current concerns not just about the security of a second Greek bail out, but also helps bring GIPS spreads in general back down. See today’s Market Focus for more on the latter. On the former, it may be mere co-incidence, but we note that Monday’s May TICS data showed the lowest net long term capital inflow since January 2010, led by reduced appetite by private (not official) foreign investors for US securities. This was the first full month after S&P put the US on notice that its AAA status was under threat from failure to raise the debt ceiling in a timely manner as well as putting the US fiscal position on a sustainable long term footing. Turning to safe havens, considering that gold has hit a new nominal record high above $1600 but USDCHF and EURCHF did not sustain the push to new record lows, is arguably symptomatic of concern about capital controls in Switzerland that would drive a wedge between the currency and the gold price; but we’re not yet convinced that the Swiss authorities will go down this route (if they did, most likely via the attempted re-imposition of taxes on nonresident CHF deposits) until and unless upward pressure on CHF becomes even more intense (e.g. EURCHF below 1.10).

Data/events focus Tuesday, outside of Euro-peripheral and US deficit/debt ceiling headlines is on the German ZEW survey (which expected to drop sharply in July), the BoC’s rates announcement and US housing starts and building permits. The BoC announcement should be a side show; note that our economist feels that with core inflation subdued and growth likely to slow in H2, the BoC is expected to remain on hold until at least December. This is not classified as objective research. Please refer to important information at the end of the report. London: +44(0)20 7595 8086 NY: +1 212 841 2408 Sing.: +65 6210 3263/3347

FX: Not much besides consolidation in Asia; USD mixed versus G10- USD gains versus NOK (0.40%), EUR, CHF (both 0.20%). USD flat against JOY, SEK, AUD. USD down near 0.08% vs. CAD, GBP. Asian FX is very quiet, but posting modest gains vs. USD led by THB, KRW (0.10-0.15%). PBOC set the yuan central parity rate at Cny6.4684 against the dollar today, compared with Cny6.4680 set for the previous trading day. Equities: Equity markets all trading around 0.50% in the red in Asia with SHCOM down 0.75%. US bourses overnight closed lower; SPX -0.81%, DHIA -0.76%, BOVESPA -1.08%. DATA/EVENTS IN THE DAY AHEAD (MNI) It is a fairly sparse calendar for Europe again on Tuesday with data limited to the 0900GMT release of both EMU construction output data for May and also the closerwatched German ZEW data for July, which is expected to show the expectations index decline to -12.0 and the current conditions slip to 85.0. US data starts at 1145GMT with the weekly ICSC-Goldman Store Sales data, which is followed at 1230GMT by Housing Starts and Building Permits data. The pace of housing starts is expected to rise to a 575,000 annual rate in June, which would be a second straight gain. US data then continues with the 1255GMT release of the weekly Redbook Average NEWS Australia/ New Zealand RBA minutes signal no immediate rate rise. A review of financial markets in the wake of European debt worries was the main topic of discussion at the RBA July 5 Board meeting indicating this would be main determinant of monetary policy in the near term, the minutes of the meeting showed. Domestic inflation took a backseat with the minutes making no mention of expectations of a pickup in inflation, rather saying there was more time at hand to assess the likely strength of inflationary pressures in Australia. The upcoming July 27 CPI data release would help shape views about inflation, and therefore the future path of interest rates, the minutes said. Japan Finance minister Noda cited by wires saying he will watch markets carefully. No comment if will intervene in FX market, recent forex moves one-sided, Comments come as dollar-yen slides to Y79.03 morning low, matching last night's NY low, while euro-yen has jumped to Y111.72 high from Y111.46 earlier. BoJ Deputy Governor Yamaguchi testifies at the House of Representatives Budget Committee. Must watch high yen's negative impact closely, watching firms moving operations overseas. To take appropriate policy action for economy. High yen has benefit, lowering import costs. Summer bonuses climbed 4.21% to an average of Foreign Exchange Strategy Tuesday, 19 July 2011

Y728,535 before taxes, rising for a second straight year, according to a survey of 645 firms by Nikkei Inc. Europe: ECB Trichet: Greek default or credit event "should be avoided". EUR continues to be "very solid currency". Euro area price stability underpins currency. Failure of US debt talks would create global problem. A state exiting euro "not an assumption I envision" Earlier, new French FinMin Baroin spoke to the press in Washington. He said talks were going well ahead of Thursday's EU leaders’ summit and he was confident EU leaders would respond to the crisis, with investors being reassured. He added that France would not back a solution leading to a "selective default". Eurozone governments are considering a levy on banks as a way to involve private creditors in a bailout of Greece, eKathimerini reports, citing a story in Germany's Die Welt newspaper. Greek fin min on the wires overnight says the US cannot do much when it comes to buying Greek bonds. Says Greece has not yet accepted a solution of selective default. Says if liquidity can't be secured by the ECB it should be secured by the EFSF or the Euro system Greek PM Papandreou might make another attempt to find some common ground with opposition leaders ahead of a euro zone summit in Brussels on Thursday, which Greek government sources referred to as the most important such meeting in the last 20 years, Kathimerini's English website reports. It is likely that the prime minister or Finance Minister Evangelos Venizelos will speak to opposition leaders, probably over the phone, before the summit, the website says. Germany's opposition Social Democrats (SPD) have offered Chancellor Angela Merkel their support to get a "Marshall Plan" for Greece through parliament amid growing nervousness in her own conservative camp, the Irish Times says. Ahead of Thursday's emergency summit, the offer to back substantial debt for Athens and other unpopular European decisions indicates that Berlin politicians are beginning to take to heart criticism of Germany's role in the euro zone crisis, the paper says. Italy: As the first unpopular elements of Silvio Berlusconis austerity drive come into force this week, hitting the pockets of lower-paid Italians, pressure is building to rein in the high cost of the country's politicians, who have amended the budget to protect their own interests, the FT says. UK George Osborne must reverse his VAT hike to restore confidence and boost growth, according to a leading business lobby group, the Guardian reports. The rise to 20% in January is battering hard-hit industries that have


yet to recover from the recession, the Federation of Small Businesses said after its quarterly survey showed a dramatic decline in business confidence in the three months to the end of June, the paper says. The FT says there is disappointing news for the Labour leader in Tuesday's Guardian where an ICM poll shows the Tories have actually increased their share of the vote in the last few weeks - seen by many as the best of Ed Miliband's leadership. It showed a three point drop for Labour on 36 and a four-point gain for the Lib Dems on 16 points, leaving the Tories one point ahead on 37 per cent. A Populus poll for the Times shows similar results, with a fall in Tory headline vote, but no great improvement in the fortunes for Labour or its leader. A plague on all your houses appears to be the public's response. China The yield on the CNY5 billion in one-year paper sold by the People's Bank of China remained unchanged at auction Tuesday for a third week at 3.4982%, traders said. The bank earlier drained CNY25 billion via 28-day bond repurchase agreements, they said. China's money supply should be reduced while production should be increased in order to curb inflation, an advisor with the PBOC advisor Zhou Qiren recommended in comments published today. US/Canada: Foreigners net sellers of US assets in May – Treasury for the first time in 11 months. Selling was heaviest in short-term assets such as bills and deposits, contributing to an overall net outflow of $67.5 billion. That was the first net outflow since June 2010, and it reversed a $66.6 billion inflow recorded in April 2011. Republican lawmakers moved ahead Monday on a doomed plan to amend the US Constitution to require a balanced federal budget, one day after President Obama met with the top two House GOP leaders in hopes of reaching a debt-limit agreement that could win approval from the hostile House, the Washington Post says. Obama wants big debt deal but open to fallback plan White House spokesman Jay Carney said while Obama would prefer the biggest possible package, he is leaving room open for a safety valve to get an increase in the debt ceiling by Aug. 2, when the federal government will run out of money to pay its bills. "We must pursue a fallback or last-ditch option," Carney said. "Conversations have been going on about that." He also said there must be a mechanism in place to ensure the United States does not default on its debt obligations.

Few Signs of Progress in U.S. Debt Talks With few signs of movement over the weekend on negotiations to raise the federal borrowing limit, Senate leaders are planning this week to unveil a backup plan that would force more budget wrangling before the end of the year. Washington seems rudderless just two weeks before an Aug. 2 deadline for Congress to increase the $14.29 trillion borrowing authority or risk having some government bills go unpaid Moody's suggests US eliminate debt ceiling on government debt to reduce uncertainty among bond holders. The United States is one of the few countries where Congress sets a ceiling on government debt, which creates "periodic uncertainty" over the government's ability to meet its obligations, Moody's said in a report. We would reduce our assessment of event risk if the government changed its framework for managing government debt to lessen or eliminate that uncertainty," Moody's analyst Steven Hess wrote in the report. Foreign investors poured cash into Canadian debt markets in May, boosting overall securities purchases to their highest level in a year at C$15.44 billion ($16.08 billion), compared with C$8.52 billion in April.

Foreign Exchange Strategy Tuesday, 19 July 2011


CDS Play a Large Part in EURUSD Decline
• Our credit risk-adjusted yield spread explains the recent decline in EURUSD. Further bond market concerns likely will push EUR lower. • Markets will need to shift back to focus on ECB tightening prospects for the EUR to rally. Over the past week, we have argued that the relative size of the Italian bond market increases the gravity of the debt issues facing the eurozone. Additionally, we have noted that the EUR is unlikely to rally until European policy makers successfully contain contagion fears that are weighing on the bond market. We now analyse the link between specific bond market developments and the outlook for EURUSD. Our 5 year risk-adjusted eurozone US yield spread has shifted significantly in favour of the US over the past month and is consistent with the move lower in EURUSD to 1.40 (Chart 1). Indeed, if eurozone bond market concerns increase over coming sessions, this measure likely will shift to signal EURUSD below 1.40. As Italian and Spanish bond yields have reached new highs, CDS (the cost of insuring against default) has spiked accordingly. Our GDP-weighted measure of Eurozone CDS has spiked from a low of 141 bps in June to above 240 bps today (chart 2). Mounting concerns in the Italian and Spanish bond markets are largely responsible for the widening of the eurozone spread. Italy (16%) and Spain (11%) together represent around 27% of the GDP-weighted measure – the same as Germany at 27%. It is the extra cost of insuring against default in the two former countries that is effectively reducing the adjusted risk advantage of the eurozone. If European officials do successfully address the current bond market malaise through policy measures, eurozone CDS will likely fall back towards more moderate levels. Such a move would bolster the eurozone’s yield advantage according to our risk-adjusted measure. This analysis is consistent with our macro based opinion that the foreign exchange market remains event driven at present and that EURUSD is trading at a discount to nominal yield spreads. The analysis also suggests that the foreign exchange market has shifted focus away from a EUR bullish view driven by expectations the ECB will continue to hike policy rates while the Fed remains on hold. An eventual shift back to such a view will likely be the event that re-establishes the EUR rally. In the interim, we expect the EUR will remain under pressure and we continue to focus on short exposure. Our favoured trades include short EURJPY and EURCAD.

Chart 1: EURUSD vs. Relative Risk Adjusted 5y Nominal Yields
1.60 1.10 0.60 0.10 -0.40 Jul-2010 Nov-2010 Mar-2011 Relative Risk Adjusted Nominal Yields EURUSD (rhs)
Source: BNP Paribas: Risk adjusted nominal yield differentials have moved in the direction of a lower EURUSD. The EMU risk adjusted spread is calculated by subtracting the respective EMU country 5Y sovereign CDS rate from its nominal bond yield, and then weighting the country components relative to their contribution to EMU GDP. The US risk adjusted yield is formed by subtracting the 5Y sovereign CDS rate from the 5Y nominal US Treasury yield. The spread of these two have correlated reasonably well with EURUSD.

1.50 1.45 1.40 1.35 1.30 1.25

Chart 2: 5y US Sovereign CDS vs. 5y Sovereign GDP Weighted CDS.
250 200 150 100 50 0 Jan-10 Jul-10 Jan-11 US EU

Source: BNP Paribas

Foreign Exchange Strategy Tuesday, 19 July 2011


Daily Currency Summary
The recent decline in EURUSD can be explained by the credit risk adjusted yield spread. Peripheral bonds sold off on Monday keeping EURUSD under pressure. Now, markets will await the special summit meeting on Thursday. A spokesman for Chancellor Merkel said that Thursday's meeting is about agreeing precisely on the main points of a new program for Greece. Reports suggest that politicians are edging towards a solution that includes a Greek default. Meanwhile, ECB Head Trichet has reiterated his opposition to accepting defaulted Greek bonds as collateral, saying that it will be up to governments to provide their own backstop for the Greek financial system if they insist upon private sector participation. Unless and until there are signs of progress, we expect EUR to remain under pressure with initial EURUSD support at 1.4010. USDJPY traded within a very tight range despite a rally in the 10yr yields. We see little chance of immediate intervention with the stance inconsistent with monetary policy following the BoJ upgrade to economic assessment earlier this week. But the authorities might take a different view in the event of a more significant risk-off move that saw USDJPY fall through 78 against the backdrop of a broader USD rally. We continue to call for a lower EURJPY but are less bearish on other yen crosses. The key will be the extent to which EUR is the driver as euro-concerns mount over the upcoming week and whether a more significant washout of retail JPY shorts takes place. EURJPY´s recent move to 112.30 last week appears to have been a retracement which has now ended, suggesting a greater risk of 110 support being taken out.



JPY Crosses

EUR Bloc
Sterling has lost traction against both USD and EUR. This could be explained by the weak performance of financial equities as the performance of financials does have a strong link with the performance of GBP. We remain unconvinced that there will be a more autonomous bid for GBP; at the moment, it simply appears less ugly. The upcoming BoE minutes are likely to be the trigger to pull GBP lower as the BoE is likely to become more dovish. However, EURGBP has been driven by European problems, and the bigger risk in the weeks ahead still appears for a break of 0.8650 support. EURCHF opened sharply lower in illiquid early Asian trading, marking another new low at 1.1375. While the pair may have some upside if there is some closer resolution on Greece, the next few days should see it remain under pressure. While SNB officials say they are concerned about CHF strength, they remain vehemently opposed to calls to peg the EURCHF as it impinges on monetary policy independence. If CHF strength is driven by a trend move of savings migrating to Swiss deposits, it is hard to see what the Swiss can do - barring taking deposit rates into the negative to dissuade CHF strength. NOK has failed to regain momentum against EUR. With little upcoming data, EURNOK remains hostage to developments within the eurozone. With little sign of progress, the bias is for a move back towards the top of the range at 7.95. Riksbank minutes were, on balance, a tad hawkish with the risk scenario showing that Governor Ingves gives "priority to developments in inflation." The Riksbank noted that economic growth is still good. However, SEK was the under performer by far today with liquidity tensions hurting the most. USDSEK continues to remain well bid, with 6.6949 (12 July high) likely the next target.





USD Bloc
Concerns over peripheral Europe kept risk under pressure, pulling USDCAD higher. Looking ahead, the path for energy prices will more likely determine the path forward for CAD. The BoC meeting this upcoming week will be important given the recent global developments. We believe that the BoC will remain on hold until December. Markets now price in over 35bp of rate cuts over the balance of the year; the RBA minutes will provide insight on the RBA's latest thinking and, if in fact, the recent re-pricing is warranted. We continue to see inflows into commodity currencies as reserve managers diversify into more fiscally responsible states; we expect dips in AUD to remain shallow as it remains supported by the sovereign bid and by mining investment inflows. Kiwi continues to outperform its cross-Tasman cousin as relative expectations for rate hikes are repriced. While NZDUSD remains at risk from further risk aversion, we continue to see outperformance against AUD and European currencies as insurance and sovereign inflows lend support.




Foreign Exchange Strategy Tuesday, 19 July 2011


FX Forecasts*
USD Bloc EUR/USD USD/JPY USD/CHF GBP/USD USD/CAD AUD/USD NZD/USD USD/SEK USD/NOK EUR Bloc EUR/JPY EUR/GBP EUR/CHF EUR/SEK EUR/NOK EUR/DKK Central Europe USD/PLN EUR/CZK EUR/HUF USD/ZAR USD/TRY EUR/RON USD/RUB EUR/PLN USD/UAH EUR/RSD Asia Bloc USD/SGD USD/MYR USD/IDR USD/THB USD/PHP USD/HKD USD/RMB USD/TWD USD/KRW USD/INR USD/VND LATAM Bloc USD/ARS USD/BRL USD/CLP USD/MXN USD/COP USD/VEF USD/PEN Others USD Index *End Quarter Q3 '11 1.50 78 0.83 1.65 0.98 1.09 0.82 5.93 4.98 Q3 '11 117 0.91 1.25 8.90 7.47 7.46 Q3 '11 2.60 24.3 275 6.80 1.52 4.20 27.51 3.90 7.8 100 Q3 '11 1.22 2.95 8500 29.80 42.50 7.80 6.40 28.00 1060 45.50 20500 Q3 '11 4.18 1.58 450 11.40 1730 4.29 2.70 Q3 '11 72.30 Q4 '11 1.55 83 0.83 1.68 0.93 1.13 0.84 5.48 4.77 Q4 '11 129 0.92 1.28 8.50 7.40 7.46 Q4 '11 2.48 24.5 275 6.60 1.50 4.15 27.25 3.85 7.8 100 Q4 '11 1.21 2.90 8400 29.50 42.00 7.80 6.31 27.50 1050 45.00 20000 Q4 '11 4.25 1.55 435 11.10 1690 4.29 2.65 Q4 '11 70.76 Q1 '12 1.45 85 0.90 1.59 0.95 1.07 0.81 5.93 5.07 Q1 '12 123 0.91 1.30 8.60 7.35 7.46 Q1 '12 2.69 24.1 269 6.55 1.56 4.20 27.86 3.90 7.5 98 Q1 '12 1.21 2.87 8300 29.30 41.50 7.80 6.25 27.00 1040 44.50 20000 Q1 '12 4.34 1.53 425 11.00 1690 4.29 2.63 Q1 '12 74.87 Q2 '12 1.40 90 0.93 1.56 0.97 1.04 0.80 6.21 5.26 Q2 '12 126 0.90 1.30 8.70 7.37 7.46 Q2 '12 2.75 23.9 265 6.60 1.59 4.25 27.97 3.85 7.5 97 Q2 '12 1.20 2.85 8200 29.00 41.00 7.80 6.21 26.70 1030 44.00 20000 Q2 '12 4.43 1.55 430 10.90 1700 4.29 2.63 Q2 '12 77.62 Q3 '12 1.35 95 1.00 1.53 1.01 0.99 0.76 6.67 5.56 Q3 '12 128 0.88 1.35 9.00 7.50 7.46 Q3 '12 2.81 23.8 265 6.50 1.63 4.15 28.08 3.80 7.5 96 Q3 '12 1.19 2.83 8100 28.70 40.50 7.80 6.17 26.50 1020 43.50 20000 Q3 '12 4.51 1.56 435 11.00 1710 4.29 2.64 Q3 '12 80.72 Q4 '12 1.35 95 1.00 1.53 1.01 0.99 0.76 6.67 5.56 Q4 '12 128 0.88 1.35 9.00 7.50 7.46 Q4 '12 2.78 23.5 260 6.50 1.65 4.10 27.65 3.75 7.5 95 Q4 '12 1.18 2.80 8000 28.50 40.00 7.80 6.13 26.00 1010 43.00 20000 Q4 '12 4.60 1.58 440 11.10 1720 4.29 2.66 Q4 '12 80.72 Q1 '13 1.30 95 1.04 1.53 1.04 0.96 0.74 6.92 5.77 Q1 '13 124 0.85 1.35 9.00 7.50 7.46 Q1 '13 2.85 23.7 260 7.20 1.65 4.20 28.19 3.70 7.5 93 Q1 '13 1.17 2.77 7900 28.30 39.50 7.80 6.23 26.00 1000 43.00 20000 Q1 '13 4.69 1.59 442 11.10 1725 8.80 2.67 Q1 '13 82.99 Q2 '13 1.30 95 1.04 1.53 1.04 0.96 0.74 6.92 5.77 Q2 '13 124 0.85 1.35 9.00 7.50 7.46 Q2 '13 2.77 24.0 255 7.10 1.67 4.20 27.75 3.60 7.5 92 Q2 '13 1.16 2.75 7800 28.00 39.00 7.80 6.20 26.00 1000 42.50 20000 Q2 '13 4.78 1.60 445 11.17 1730 8.80 2.68 Q2 '13 82.99 Q3 '13 1.30 95 1.04 1.53 1.04 0.96 0.74 6.92 5.77 Q3 '13 124 0.85 1.35 9.00 7.50 7.46 Q3 '13 2.85 23.5 260 7.00 1.69 4.10 29.07 3.70 7.5 91 Q3 '13 1.15 2.73 7800 28.00 39.00 7.80 6.17 26.00 1000 42.50 20000 Q3 '13 4.86 1.61 447 11.25 1740 8.80 2.69 Q3 '13 82.99 Q4 '13 1.30 95 1.04 1.53 1.04 0.96 0.74 6.92 5.77 Q4 '13 124 0.85 1.35 9.00 7.50 7.46 Q4 '13 2.85 23.3 260 6.90 1.69 3.95 27.75 3.70 7.3 90 Q4 '13 1.14 2.70 7800 28.00 39.00 7.80 6.15 26.00 1000 42.00 20000 Q4 '13 4.95 1.62 450 11.30 1750 8.80 2.70 Q4 '13 82.99 Q1 '14 1.34 114 1.09 1.70 1.21 0.78 0.56 6.94 5.07 Q1 '14 153 0.79 1.46 9.30 6.80 7.46 Q1 '14 2.65 23.1 250 6.69 1.54 3.90 27.75 3.55 7.4 85 Q1 '14 --------------------------------------------Q1 '14 ----------------------------Q1 '14 83.88

Foreign Exchange Strategy Tuesday, 19 July 2011


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Foreign Exchange Strategy Tuesday, 19 July 2011