global fx strategy

8/8/2019 Global FX Strategy

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Global FX Strategy 2010

John NormandAC

(44-20) 7325-5222

[email protected]

Paul Meggyesi

(44-20) 7859-6714

[email protected]

Ken Landon(1-212) 834-2391

[email protected]

Tohru Sasaki(81-3) 6736-7717

[email protected]

Gabriel de Kock

(1-212) 834-4254

[email protected]

Arindam Sandilya

(1-212) 834-2304

[email protected]

Niall OConnor(1-212) 834-5108

[email protected]

www.morganmarkets.com/GlobalFXStrategy J.P. Morgan Securities Lt

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

Global FX StrategyNovember 24, 2009

ContentsGlobal FX Outlook 2010

Five global macro themes and top trades 1

Global FX Carry Trade Monitor 1

FX alpha strategies in 2010 1

Post-mortem: 2009 forecasts and trades 1

FX Derivatives 1

Long-term Technicals 2

JPY 3

EUR 4

GBP 4

CHF 5

SEK 5

Commodity currencies 6

Risk scenarios & hedging strategies 6

Event risk calendar for 2010 7

J.P. Morgan ForecastsFX vs Forwards & Consensus 7

Rates, Credit, Equities & Commodities 7

Global Growth and Inflation 8

Global Central Bank Rates 8


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Global FX StrategyGlobal FX Strategy 2010November 24, 2009

John Normand (44-20) [email protected]. Morgan Securities Ltd.

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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 aremispriced (GBP/CHF, AUD/NZD); the end of inflation targeting? (NZD/NOK); a CNY revaluations impact onG-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 OConnor,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 euros drivers are less idiosyncratic than other currencies, but it will still rise in an environment of broaddollar weakness. Most counterarguments export impact, China revaluation, euro break-up are overstated.

Sterling: Funding currency or investment vehicle? (Paul Meggyesi)Sterlings undervaluation limits the scope for further weakness, but it is premature to expect a rebound. Thetrinity 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 valuationchamp, 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 2009s 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. Currencymanagers, 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 ForecastsEUR/USD targets raised to 1.62 by Q2 and 1.50 by Q4. USD/JPY should reach 82 by Q2 before rebounding to89 at year-end. EUR/GBP should peak at 0.94 and AUD/USD at 1.02.


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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 rateenvironments have driven the dollars 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 couldoccur, 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. Currencymarkets 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 Japans exit from QE in 2006 is anyguide, 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 between10% and 14% (basis VXY for 3-mo implied), with

spikes more likely in Q3 Q4.

Alpha strategies: This vol environment impliesreturns of 8% on carry, which is less than 2009 but

still decent. Forward Carry returns will moderate

from 2009s 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 mid-

term elections impose fiscal discipline.

Five global macro themes and top trades: USD willundershoot (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

revaluations 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 decadedown 12% trade-weighted, its worst performance since

Bretton Woods collapsed in the 1970s. As cold comfort, atleast the 2009 bear market has been comparatively mild.The dollar has fallen only 5% trade-weighted this year andagainst 75% of currencies globally, compared to properrouts in the early 1970s, late 1980s and early 2000s whenthe dollar fell at least 8% and sometimes versus allcurrencies (chart 1).

Chart 1: Ranking USD bear markets: annual change in trade-weighted USD vs percentage of currencies against which USD roseBased on annual spot movements of G-10 and emerging market currencies vsUSD

0%

25%

50%

75%

100%

71 74 77 80 83 86 89 92 95 98 01 04 07

-25%

-15%

-5%

5%

15%

25%

% of currencies against which USD depreciated, lhs

change in USD trade-weighted, rhs

Source: J.P. Morgan

Naturally some think that the new year brings an inflection

point, particularly since the dollar has become slightlycheap (4% trade-weighted on J.P.Morgans fair valuemodel1). The dollar will turn in 2010, but not before nearingall-time lows trade-weighted and surpassing old lows versusthe euro, Swiss franc and possibly the yen. The Feds ratestance drives part of this move, but reducing the dollar to acarry trade ignores much of the story. The USs capitalaccount leaks on several sides (direct investment, portfolioequity) such that Fed policy may not drive a sustainedreversal unless the FOMC proves uncharacteristicallyaggressive or disruptive with its exit strategy.

We extend the trough in USD weakness from Q1 2010 toQ2 and move targets to 1.62 on EUR/USD, 82 onUSD/JPY, 0.91 on USD/CHF and 1.02on AUD/USD.GBP/USD will benefit from EUR/USDs rise (peak at

1.74 in June), but underperform due to EUR/GBP rally

to 0.94. These projections are more bearish than the USDlows we published this summer when we expectedEUR/USD to peak at 1.50 and USD/JPY to trough at 89, butthree issues have arisen since then. The Fed is proving more

1J.P.Morgans fair value framework is detailed inA new fair-value modelfor G-10 currencies, de Kock, September 6, 2008 and updated quarterly inWorld Financial Markets.


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comfortable with a zero rate environment than almost everyother G-10 or emerging market central bank but the Bank of

England; cash positions (domestic and cross-border) remaintoo high for the 2010 interest rate environment; and reservediversification has accelerated to a record pace. Althoughthe structural arguments for a dollar collapse (even crisis)are less credible than the alarmists claim, cyclical dynamicsare 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.Morgans VXY2 for 3-mo implied vol). Spike riskcenters on late Q2/early Q3 when the Fed beginsimplementing policy to reduce extraordinary liquidity, suchas altering the FOMC statement or undertaking repo

operations, even though rates are on hold until 2011. TheBank of Japans experience in 2006 highlights that exitsfrom quantitative easing inject considerable uncertainty,even when rate hikes are small or distant. This volatilityenvironment implies that alphastrategies such as carrywill perform worse than in 2009 (predicted returns of 7% in2010 vs 20% in 2009) but still benefit from the rise in cashrates in the current high-yielders. Forward carry (trading onrate momentum) also should perform worse in 2010(returnsof 10%) but still gain. Price momentum will struggle in H2when the dollar turns again.

The 2010 Outlook details these issues in six sections:

global FX outlookoutlining the case for a dollarovershoot, five global investment themes and the fivemost compelling strategic trades;

measures of the global FX carry trade based onpublic and proprietary data;

a macro model for implied volatility and projectionsfor 2010 based on growth surprises, central banksurprises and investor leverage.

long-term technical outlookfor G-10 and emergingmarkets currencies;

research notes on the major currencies and

recommended strategic (12-month) trades/hedges; and hedging strategies for three tail risks over the next

yearinflation surprise, a US funding crisis and USmid-term elections.

The bearish case: its more than carry

Judging from market patter over the past several months,the dollars decline simply reflects a burgeoning, even

2See Introducing J.P.Morgans VXYTM& EM-VXYTM, Normand andSandilya, December 2006.

bubble-like, carrytrade. 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 itspre- Lehman size when measured across the range ofinvestor-types such as dedicated currency managers, globalmacro hedge funds, CTAs, Japanese retail and US retail(see Global FX Carry Trade Trackeron pages 12-13).3Balance of payments data on short-term capital flows (UST-bills, deposits and commercial paper) also suggests thatdollar selling this year has been substantial but has not fullyunwound crisis-related dollar buying. As markets turned inQ2, the US posted $90bn of net short-term capital outflows,an amount equivalent to a quarter of the $360bn of inflowsfrom 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 reversedNet short-term capital flows (T-bills, CDs and commercial paper) on a quarterlybasis and as a four quarter rolling sum

226

-91

-200

-100

0

100

200

300

400

98 99 00 01 02 03 04 05 06 07 08 09 10

four quarter rolling sum quarterly flow

Source: J.P. Morgan, BEA

Chart 3: Foreign direct investment: Stronger US corporate profitshave revived net FDI outflowsS&P500 corporate profits growth year-on-year versus US net FDI flows. FDI shownas four quarter rolling sum. Dotted line shows J.P.Morgan projections based onJPM earnings forecasts and the historical relationship between profits and net FDI.

-200

-150

-100

-50

0

50

100

150

200

90 93 96 99 02 05 08

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

net FDI flows, $bn, 4 quarter sum, lhs

Corporate profits growth, % oya, rhs

Source: J.P. Morgan

3Several weekly and daily indicators for tracking the carry trades size andownership are detailed inKeeping up with the Watanabes: Who drives thecarry trade post-crisis?, Normand, May 15, 2009.


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unfolded (chart 2). More recent data are unavailable, butjudging from other cash indicators which correlate well

with balance of payments data (see chart 8 on page 6), it isunlikely that more than half of 2008s inflows have beenreversed.

Other components of the US capital account are

outright negative, or less dollar-positive than headline

figures suggest. For example net FDI flows, which havebeen negative for most of the past decade, are deterioratingagain. This development is cyclical: US corporates becomemore acquisitive internationally as profit growth improves,and this recovery is proving no different from previous ones(chart 3). Indeed, the pipeline of pending cross-borderM&A deals (announced but not completed) now stands at -$40bn for the US compared to net inflows for the Euro area

($60bn), Australia ($20bn) and UK ($10bn)One hopeful spot is net equity inflows, but foreign buyingis less dollar-bullish than it appears. Unlike the drain inequity capital that accompanied much of the 2002-2007expansion, the US is now attracting equity portfolio flowson a net basis. Net purchases are high outright ($9bn permonth) and relative to Japan (300bn or $3.3bn per month),but only a third of the 20bn ($30bn) per month which theEuro area gathers. Hence the negative correlation betweenequity movement and the dollar: the US attracts less globalcapital than other countries, even though flows are positive.

Central banks remain significant buyers of dollars but

there is mounting circumstantial evidence that they arehedging their bets. Net official purchases of US securitiesrun at roughly $50bn per month, which is high relative tothe USs trade deficit (roughly $30bn per month) but lowcompared to the nearly $100bn of forex reserves thatemerging market central banks have been accruing monthlysince June due to intervention (chart 5).4 The differencesuggests reserve diversification, which now runs at a recordpace (seeReserve diversification is back,FX MarketsWeekly, Sept 18, 2009).

If this story sounds familiar, it should. Similar capitalaccount strains appeared after the 2001 recession when thedollar was cyclically weak due to low rates and structurally

weak due to the current accounts size and its financingmix. Since little has changed since 2001 except that theUS current account deficit has dropped by half dollarbearish during a recovery was the obvious view (seePost-mortem on 2009 forecasts and trade recommendations onpage 16). Expensive, low-yield assets of debtor countriesshould typically fall in that environment either throughcarry trades or the hedging of long-term capital inflows.

4 This figure controls for the valuation effect on reserve from a weakerdollar. We assume that central banks hold a roughly 25% allocation toeuros, per the IMFs COFER estimates.

The greater challenge in 2009 was pegging the timing andstrength of the recovery.

2010 dilemma: recovery discounted, USD cheapbut cash piles enormous

The 2010 outlook is more challenging for two reasons:

recovery is mostly discounted, and the dollar is already

slightly cheap. The average investor expects US growth of2.8% over the next four quarters, up significantly from the0.5% expected six months ago. Forecasts for othereconomies have risen significantly too and now stand at1.2% for the Euro area, 1.4% for Japan, 5% for EmergingAsia and 3.5% for Latin America. In theory a further dollardecline should require another few quarters of upsidegrowth surprises, since changes to growth expectations havebeen positively correlated with stock prices and negatively

correlated with the dollar this decade (charts 6 and 7).

Chart 4: The USs net equity flows are weaker than Euro areas butstronger than JapanNet equity inflows, 3-month moving average

EUR20bn

USD9bn

JPY0.3trn

-40

-30

-20

-10

0

10

20

30

40

06 07 08 09 10

-3

-2

-1

0

1

2

3

Euro area US Japan

Source: J.P.Morgan, US Treasury (TIC), ECB and Ministry of Finance

Chart 5: Global reserve accumulation vs foreign official purchases ofUS securities, $bn, 3-month moving average basisGlobal reserves calculated as sum for 15 emerging markets with reserves greaterthan $50bn, plus G-10 central banks which intervene (Japan, Australia, Norwayand Switzerland). Foreign official purchases is sum of weekly Fed custody holdingsof Treasuries, bills and Agencies plus TIC-reported holdings of corporate bonds,equities and short-term USD deposits.

-100

-50

0

50

100

150

00 01 02 03 04 05 06 07 08 09 10

Foreign official purchases of US securities

Monthly reserve accumulation in EM

gap between reserve accumlation and US

purchases is near record wide

Source: J.P.Morgan, Federal Reserve and national central banks


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That move could occur next year because consensusforecasts are still low relative to the growth economies

typically achieve in the first year of a recovery.

5

In practice, the bar for dollar depreciation isnt so high

that it requires a growth upgrade. The reason isevidence of a still-sizable cash overweight. By now themarket impact of excess liquidity is well accepted; the onlydisagreement centres on whether this process is natural andpositive, or engineered and sinister. Central bankers call themove from cash to financial assets a transmissionmechanism or asset reflation that stimulates growththrough lower borrowing costs and positive wealth effects.Many investors characterise the switch more cynically asthe wall of money, as if the move is inexorable but alsoirrational. It is neither. The flow continues as long as the

growth and policy environment are stable, but not if theyworsen. And the move is rational because investors tend toseek assets offering the highest risk-adjusted return. Duringa recovery, this asset is not cash, nor a low-yield currencyof a debtor country.

The critical issues for 2010 are (1) what is the

appropriate cash allocation, and (2) can benign asset

reflation become a destabilising bubble. Chart 8 plots thetwo concepts of cash relevant for the dollar one cross-border and one domestic. The cross-border series tracks USnet short-term capital flows from the balance of payments,comprising T-bills, certificates of deposit and commercialpaper (same series as chart 2 on page 4). Short-term capital

inflows should rise if central banks are buying US assets forreserve accumulation, if investors buy dollars during arising rate environment or if investors accumulate dollarsduring a financial crisis due to short-covering or flight toliquidity. The domestic series represents US householdbalances in retail money market funds, demand deposits orcheckable deposits.

The two series ran counter to one another after the 2001recession because recovery pushed funds from moneymarkets into stocks (particularly international ones) andcredit, while central banks purchased short-term USD assetsas part of their intervention policy. The two cash measuresconverged during the crisis, reflecting the domestic switch

from stocks and credit into US cash, US investorrepatriation of non-US investments and foreign demand fordollars as flight to liquidity. Short-term capital inflowstotalled $360bn from 2008 Q1 through 2009 Q1 while UShousehold cash holdings rose by roughly $250bn over thesame period. Note that the figures are not additive, since

5The first year of recovery brings growth twice the pace of the decline,implying that the US should be expanding by at least 6% in 2010. So whileJ.P.Morgans projections are more bullish than the consensus, they aremore bearish than the historical norm.

Chart 6: Each percentage point increase in the consensus view onUS growth generates a 10% move in stocksMonthly change in consensus forecasts on US growth vs monthly returns on the

S&P500. Consensus projections based on monthly Blue Chip surveyy = 11.36x + 0.01

R2

= 0.54

-15%

-10%

-5%

0%

5%

10%

-1.2% -1.0% -0.8% -0.6% -0.4% -0.2% 0.0% 0.2% 0.4%

monthly change in consensus US growth forecast

monthlychangeinS&P500

Source: J.P.Morgan

Chart 7: and -2.5% on USD trade-weightedMonthly change in consensus forecasts on US growth vs monthly returns on USD.

y = -2.79x - 0.00

R2

= 0.26

-4%

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

-1.2% -1.0% -0.8% -0.6% -0.4% -0.2% 0.0% 0.2% 0.4%

monthly change in consensus US growth forecast

monthlychangeinUSDtrade-w

td

Source: J.P.Morgan

Chart 8: Cross-border and domestic cash holdings of dollar still looktoo high relative to the rate environmentUSD billion, cumulative figures since January 1999 (starting point chosen by dataavailability). Short-term capital flow data from US balance of payments data. USmoney market and demand deposit data from Federal Reserve.

-200

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0

100

200

300

400

500

600

01 02 03 04 05 06 07 08 09 10

short-term capital flows (US balance of payments)

US household cash

Source: J.P.Morgan, BEA, Federal Reserve


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some of the household cash increase probably reflectedrepatriation of foreign equity investments.

Nine months into the dollars decline, cash liquidationsare very advanced relative to their pre-Lehman levels,

but balances are still too high for a zero-rateenvironment. US household cash has fallen by $250bn thisyear, mostly to fund bond purchases. (US retail haspurchased $160bn of bonds, $65bn of credit but sold $21bnof equities year-to-date). This is the fastest pace of cashliquidations post-recession in the past forty years (chart 9),and more than reverses the cash hoarding which Lehmansbankruptcy inspired. But Lehman is the wrong anchor.Because household cash balances track money market rateswith a lag, and since the funds rate is 200bp lower than itwas in September 2008, cash balances should fall well

below pre-Lehman levels. If the historical beta betweencash balances and money market rates holds, another$300bn could flow into asset markets over the next year(chart 10). Flows into US stocks would be dollar-neutral,but those into international equities, higher-yieldinggovernment bond markets (particularly emerging markets)or pure currency allocations (ETFs) obviously would beUSD negative.

The path of cross-border short-term capital flows is harderto predict because they do not track the funds rate nor US vsrest-of-the-world spreads tightly. This disconnect reflectsthe offsetting sources of dollar demand in a low-rateenvironment: private investors sell USD to fund non-US

investments, but official investors recycle some of theseflows into US T-bills and deposits as part of theirintervention practices. As a baseline we assume that the fullamount which entered post-Lehman ($360bn) will beunwound. Only $90 was liquidated in Q2. Q3 data are notyet available but the correlation between US household cashand balance of payments flows (chart 8) suggests that theprocess has another two quarters and tens of billions left torun.

Calibrating an undershoot

Projecting how far the dollar could fall in this

environment requires calibrating an undershoot, since

the dollars long-term drivers have not worsened materially.Short-term cyclicals drive this move. Our long-term fairvalue model based on some of the standard, quarterlyvariables current account, net investment income, debt-to-GDP levels and inflation suggests that the dollar is only3% cheap in trade-weighted terms (chart 11), even though ithas fallen 15 % trade weighted since March.6. This

6The same argument applies to credit and equities: markets are notexpensive because they have experienced an unprecedented rally from theirlows. Valuation must be judged relative to a markets long-term drivers.For example, high-yield credit has rallied 1100bp from its wides in

Chart 9: US retail cash positions have dropped this year morerapidly than after any recession of the past three decadesx-axis shows number of months before and after the recession ends, with zero

marking the last month of NBER-dated recessions. Y-axis shows US retail holdingsof demand deposits, other checking accounts and money market funds indexed to100 at t=0 (end of recession). Current series assume the 2008-09 recession endedJun 2009.

85

90

95

100

105

110

-12 -9 -6 -3 0 3 6 9 12

average of 1980-2001 recessions

current

Source: J.P.Morgan

Chart 10: US household cash tracks Fed funds with a lagUS household cash calculated as sum of retail money market funds, demanddeposits and other checkable deposits (USD bn) plotted against Fed funds ratelagged one year.

1200

1300

14001500

1600

1700

1800

1900

2000

00 01 02 03 04 05 06 07 08 09 10

0%

1%

2%

3%

4%

5%

6%

7%US household cash, $bn, lhs

Fed funds rate lagged 1yr, rhs

Source: J.P.Morgan

aggregate valuation reflects offsets from an expensive euro(+6%) and yen (+10%) versus cheap sterling (-14%) andfairly-valued commodity currencies. Purchasing powerparity approaches suggest that the dollar is much cheaper(7% below its long-term average) but pure price-basedapproaches to valuing currencies are flawed for reasonswhich are well-known: if an economys structure evolvesover time, the real exchange rate will trend rather thanmean-revert.

Deviations around fair value occur in every asset market. InFX they resurface each decade. Their duration is quite

December 2008 but is still cheap since current spreads (750bp)overcompensate for the 4% default rate like this year. Equities are fairlyvalued despite a 65% rally from their March lows, since 2009 deliveredearnings of $62 on an end-recession P/E of 16.5 implies an S&P target of1010.


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variable and they sometime bear no link the US businesscycle. But they do share one commonality: overshoots tend

to occur as a lagged response to an extreme policyenvironment (chart 12). In the mid-1980s the dollarsovervaluation reached 20% due to record interest ratesunder Volcker and record fiscal deficits under Reagan. Inthe late 1980s, the dollars undervaluation reached 7%following the threeyear easing cycle which accompaniedPlaza Accord intervention. In 2001 the dollarsovervaluation reached 10% as a lagged response to the USrate advantage that persisted until that year. In 2004 thedollar undershot fair value by some 5% as the funds rate hit1%. The extension of that move to 12% cheapness in 2008occurred alongside unilateral Fed easing.

Given the historical experience, 2010 looks like a year of

unfinished business as the dollar contends with thelagged effects of an extreme rate environment. True, thedollars current yield deficit versus the rest of the world (-1% as a weighted average) has closed from the -3% extremeof late 2008. But with two central banks having tightened in2009 (RBA, Norges Bank), others to follow in 2010 (mostemerging markets) and some to simply turn more hawkish(ECB), the rate deficit will widen over the next year. Thisenvironment could produce an overshoot as large as thetypical ones, which delivered a dollar 10% cheap to fairvalue in trade-weighted terms, some 7% weaker thancurrent levels. Normally such a move should be spreadequally across the USs major trading partners, butemerging market intervention and subsequent reservediversification shifts more of the adjustment to G-10currencies. For simplicity we assume G-10 currencies willappreciate roughly 8% by Q2 to 1.62 on EUR/USD, 82 forUSD/JPY, 1.74 on GBP/USD, 1.02 on AUD/USD and

0.99 on USD/CAD (see full forecast profile on page 71).

USD reversal in Q3: The Feds graceless exit fromQE may mirror the Bank of Japans in 2006

If extreme rate environments drive overshoots around

fair value, then normalisation should drive a reversal.That normalisation could come in late Q2/early Q3 as theFed begins to exit from exceptionally low levels of policythrough some combination of FOMC statement changes and

repo operations to reduce excess reserves. Rate hikes shouldwait in 2010, but that patience does not guarantee tranquilmarkets or a trend dollar decline through end-2010. Theresulting rise in volatility against a backdrop of much largerdollar shorts could easily drive the dollar some 5-10%higher in Q3 and Q4. Indeed, the experience of Japan set theprecedent for a messy, albeit brief, QE exit. Ahead of itsfirst interest rate hike in mid-2006, the Bank of Japan beganreducing commercial banks target for current accountbalances (excess reserves) from a record 35trillion.Although the BoJ had been explicit in stating that QE would

end when Japan emerged from deflation a notable contrastto the Fed and Bank of Englands vagueness the liquidity

withdrawal nonetheless sparked a 9% drop in USD/JPY anda 2 point rise in implied volatility in 2006 Q2 as short yenpositions were covered (chart 13 and 14). Those movesreversed within three months, but the analogy to dollar-funded carry by the time the Fed begins to withdrawliquidity next year should be obvious. Despite the bestefforts at transparency and signaling, the Feds exit isunlikely to be entirely graceful.

Chart 11: USD real effective exchange rate: Actual vs predictedPredicted value based on J.P.Morgan estimates as outlined inA new fair-valuemodel for G-10 currencies, de Kock, September 6, 2008.

90

100

110

120

130

140

150

160

80 84 88 92 96 00 04 08

actual fair value

Source: J.P.Morgan

Chart 12: USD deviations from fair value have corresponded topolicy extremes of very tight or very loose Fed policy vs the rest ofthe world

USD deviations from fair value (positive indicates overvaluation) versus spreadbetween Fed funds rate and policy rates in the rest of the G-10 (weighted average).

-25%

-15%

-5%

5%

15%

25%

80 84 88 92 96 00 04 08

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%USD deviation from fair value model

Fed funds spread to G-10 cash rates,lagged 1 year

Source: J.P.Morgan

Three misconceptions about the dollar

Dollar bulls will counter that an undershoot is unlikely dueto three constraints: most investors are extremely bearish,and therefore short; currency markets are experiencing anunsustainable bubble which will soon be punctured; andnew lows on the dollar will motivate G-3 intervention. Eachis a misconception. We address each in turn.

1. Everyone is bearish and therefore short. By the usualcover story test a trend reverses once it becomes a cover


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9

story in the popular press the dollars decline should haveended this fall. But despite the bearish dollar patter, there is

little evidence that views are so extreme or positions soshort that they should impede the current bear trend.Consensus expectations are, in fact, dollar-bullish, withend-2010 forecasts of 1.45 on EUR/USD, 98 on USD/JPY,1.64 on GBP/USD, 0.88 on AUD/USD and 1.06 onUSD/CAD. Even amongst the emerging market currencies,the only consensus bearish USD call comes againstEmerging Asia (chart 15). Being non-consensus in thisinstance is no great shame, since the average forecaster hasbeen too conservative in anticipating USD weakness, evenwhen they correctly predicted the dollar decline (chart 16).This conservatism usually corresponds to positions, whichis 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.

2. Currencies are in bubble trouble. Related to the fear ofexcessive USD bearishness and USD shorts is thecharacterisation that currency markets are experiencing aspeculative bubble. The label has been applied to almostevery asset market this year except housing, since equities,credit, some commodities and most high-yield currencieshave posted unprecedented gains since March. Identifyingasset bubbles ex ante is, of course, impossible. Manymarketsexhibit tremendous price rises, but the only oneswhich earn the label of a bubble are those which crashed(Japanese real estate in the last 1980s, internet stocks in thelate 1990s, housing in the 2000s). Thus we can onlydistinguish bubbles from more ordinary bull markets expost.

Markets that crashed shared three characteristics, however:extreme valuation, extraordinary momentum and high

leverage. 7 Applying this scratch test to currencies, thedollar flunks all sections. As noted earlier, the dollar ischeap, but far from the extremes of 10% - 15%undervaluation (charts 11 and 12). Short dollar/long carrypositions have risen quickly but only to about half their pre-Lehman levels (see Global FX Carry Trade Monitoronpage 14). And price momentum, measured as rolling 12-month returns, are far from the -10%to -15% annual moves

which have marked turning points in the past (chart 17). ByQ2 2009 this scratch test could yield a different judgment,but for now, the currencies look like most other assetmarkets heady but hardly bubble-like.

3. G-3 central banks would intervene at new lows for the

dollar. Intervention is standard practice for many emergingmarkets central banks and some G-10 banks (SNB, RBA).The intervention which drives the USD trend, however,requires the Treasury, Bank of Japan and ECB. Our view on

7SeeAre alternatives the next bubble?, Loeys, September 2006.

Chart 13: The end of Japanese QE in Q1 2006 prompted a spike inUSD/JPY volatilityCommercial banks current account balances with Bank of Japan versus USD/JPY

3-mo implied vol

0

5

10

15

20

25

30

35

01 02 03 04 05 06 07

5%

6%

7%

8%

9%

10%

11%

12%

13%

bank reserves, JPY trillion, lhs

USD/JPY 3-mo implied vol, rhs

BoJ reduces reserve balance

targets

Source: J.P. Morgan

Chart 14: and a liquidation of yen-funded carryIMM net speculative positions in JPY vs USD/JPY spot

-200

-150

-100

-50

0

50

Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 100

104

108

112

116

120

124

IMM positions in JPY, thou contract, lhs

USD/JPY spot, rhs

BoJ reduces reserve

balance targets

Source: J.P. Morgan

Chart 15: Consensus expectations for currency movements versusUSD over the next 12 months%, positive (negative) indicates that the consensus expects foreign currency to appreciate(depreciate) versus the dollar by end-2010.

-9%

-6%

-3%

0%

3%

6%

9%

12%

SEK

NOK

CAD

GBP

EUR

CHF

AUD

NZD

JPY

KRW

IDR

TWD

CNY

INR

MXN

BRL

TRY

ZAR

Source: J.P. Morgan, Bloomberg


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10

intervention during this dollar decline is the same as ourview during the dollars 2008 rise: G-3 central banks will

not intervene in currency markets unless FX moves raisevolatility and drive other asset markets lower. The rationaleis simple: G-3 policymakers know that interventionsimpact is fleeting without a sea change in monetary policy,such as Fed hikes. Japan also faces considerable domesticopposition to further USD accumulation, as discussed in

JPY: Can it reach new all-time lows? on page 34.

Where are we wrong?

The most significant risks to the bearish view are thefollowing:

1. Corporates fail to spend bumper profits, leading to agrowth slowdown in early 2010. The dollar would

appreciate as carry/cyclical trades are unwound.

2. The dollars decline becomes volatile, possibly due to

a US financing issue next year. The dollar would riseversus the high-yield currencies and commodity currenciesgiven the increase in volatility. The dollar would probablyfall versus the euro and Swiss franc since the underlyingcause of the move is a US sovereign risk issue. Eventuallysuch a move could prompt G-3 intervention, but not beforethe dollar posts a sizable H1 fall. SeeRisk scenarios onpage 70 for the most efficient hedging strategy.

3. A significant upturn in inflation. The consensus expectglobal inflation to turn higher in 2010, but to only 1.9% in

the US and 1% in Europe. Dollar weakness and resultingcommodity price strength render that projection a movingtarget, however, while the long-standing anxieties aroundfiscal policy and exit strategies raise questions about howmuch inflation expectations can or should decline. Whetherinflation rises gradually (a low-volatility event) or abruptly(a high-volatility event) drives the feedback to currencies asthe CPI trend evolves. SeeRisk scenarios for the mostefficient hedging strategy.

4. China surprises with a +10% one-off revaluation ofthe yuan. The immediate reaction would be a lower euro,since a stronger yuan would reduce Chinas buying of non-USD assets as part of its reserve diversification. We suspect

that such a policy move would be a low-probability eventgiven Chinas skepticism about the global recovery and itslack of meaningful inflation. We continue to expect theyuan to appreciate next year (forecast: USD/CNY at 6.58 byDecember 2010), but that baseline move is too modest andgradual to impact the euro. Only a significant- step-wiseappreciation (10% or more) would impact EUR/USD. See

EUR: Few obstacles to new highs on page 38.

5. A divided USD government after mid-term elections.Politics is rarely a consistent G-10 FX influence, but whenfiscal policy is a central issue, elections assume greater

Chart 16: Forecast errors: the consensus has been too conservativein forecasting USD weakness this decadeConsensus error on G-10 and emerging market FX forecasts vs USD, where error is calculated

as difference between actual rate and forecast r ate over horizons of one quarter to two years.A positive (negative) value indicates that the consensus underestimated (overestimated)foreign currency strength vs USD.

0%

2%

4%

6%

8%

10%

12%

Current qtr 1 qtr ahead 2 qtrs ahead 1 yr ahead 2 yrs ahead

G-10 FX EM FX

Source: J.P. Morgan

Chart 17: Bubble test for excess momentum: USDs move this yearhas not been excessive by historical measure

Annual returns on trade-weighted dollar and 2-sigma bands

-20%

-10%

0%

10%

20%

30%

70 75 80 85 90 95 00 05

average plus 2 sigmas

average minus 2 sigmas

Source: J.P. Morgan

importance. US mid-term elections in November couldresult in a divided Congress, which may then result in moreconservative fiscal policy in 2011. Coming at a time whenexpectations of Fed tightening are building, this electoraloutcome could aid the dollars rebound late in the year. See

Risk scenario 3 .

We are not worried about premature tightening, or a

more meaningful shift to asset price targeting in the G-3central banks that control global liquidity. Many smallercentral banks already have cited asset price inflation asmotivations for recent tightening, and the ECB has alwaysexpressed more concern about excess liquidity than the Fed.Even the most hawkish central banks, however, will avoidsetting policy next year with asset prices in mind becausefew markets exhibit extreme overvaluation. Their comfortlevel may change in 2011 if price trends continue at the2009 pace.


11/88


Paul Meggyesi (44-20) 7859-6714

John Normand (44-20) 7325-5222J.P. Morgan Securities Ltd.

11

Five global macro themes

and top tradesOur short-term trade recommendations are outlined andmarked to market each Friday inFX Markets Weekly. Onaverage we have held cash trades for three weeks andoption trades for two months (see Table 1 inPost-mortem: 2009 forecasts and trade recommendations onpage 16). This section focuses instead on five globalmacro issues which we expect to define 2010, soaccordingly the tenor is longer (6-12months) than thetypes of trades we typically recommend inFX MarketsWeekly.

1. The dollar will undershoot.As detailed in the Outlook (pages 3-10), the dollar isheaded for another undershoot of fair value, even if it isalready slightly cheap. Low rates, weak long-term capitalflows, high cash levels and EM intervention policy willdrive this move in Q1/Q2, with decent odds of a sharpreversal only later in the year.

We focus fresh USD shorts in one of the few currenciesto be undervalued vs. USD (CHF) and in a worst-ofbasket to benefit from de-correlation savings. The broadUSD trend will dominate currency-specific factors,especially amongst the group of former fundingcurrencies (CHF and JPY) whose inverse correlation torisk markets has/will break down, leaving USD as the

pre-eminent funding currency. Buy 6-mo 0.8900 USD/CHF one-touch for 16.7%.

Buy a 6-mo USD put/worst-of basket call wherethe basket comprises CHF, AUD and JPY. Strikesare 0.9762, 0.9426 and 85.21 (35 delta). Cost 0.83%vs. 2.36% for the cheapest vanilla.

2. Global recovery is discounted but country exit

strategies are mispriced.The consensus has marked up its growth forecastsconsiderably over the past six months (page 7) and wehave little quibble with current estimates. The more

significant mispricing, in our view, concerns exitstrategies. OIS curves imply almost 175bp of tighteningby the RBNZ over the next year, 140bp by the RBA,60bp by the BoE and 25bp from the SNB. It seemsunlikely that the RBNZ would tighten more than theRBA given Bollards commitment to keeping rates onhold through mid-year. BoE tightening in the next year isat odds with a central bank still concerned enough aboutthe recovery to leave open the possibility of further QEasset purchases. And the lack of term premium in theSwiss curve is unusual for a country which sufferedrelatively little damage from the Great Recession.

Buy a 6-mo 1.60-1.50 GBP put/CHF call spreadwith a 1.45 RKI on the lower strike. Cost 1.35%.

Buy a 6-mo 1.30 AUD call/NZD put, RKO 1.41.Cost 0.68%.

3. The end of inflation targeting?Although central bank mandates are not officially underreview, they are certainly under legislators microscope.New Zealands Labour Party has already withdrawn itssupport for inflation targeting, whilst the NZ Treasury iscognisant of the dangers of continued over-reliance onanti-cyclical monetary policy. Norway by contrast is theonly major country where unemployment is below itslong-term average, leaving the Norges Bank relativelyfree to normalise policy in pursuit of medium-term price

stability.

Buy a 6-mo 3.90/3.60 NZD put/NOK ratio callspread in 1x1.5 notional. Cost 1.50%.

4. A CNY revals impact on G-10 FX is overstatedAs discussed in the euro section (page 40), we believethat the impact of CNY revaluation expectations on EURand JPY is overstated and that the broad dollar trend willdominate these and other idiosyncratic factors. Weexpect EUR/JPY to remain rangebound as a result.

Buy a 6-mo 123-142 EUR/JPY range binary for23.3%.

5. Valuation gaps will close in the next yearSeveral currencies are misaligned on our fair valuemodel, with the most overvalued being JPY (+12%),AUD (+6%) and EUR (+5%), and the most undervaluedbeing GBP (-15%), NOK (-9%) and SEK (-5%). Theobvious mean reversion trade would be to purchaseGBP/JPY, but since valuation gaps rarely close without acyclical or policy trigger, this trade is premature.(Sterlings re-rating requires Bank of Englandtightening.) Selling USD/NOK or EUR/NOK arecandidates, but we hold these elsewhere. We thereforesell EUR/SEK through a ratio put spread, consistent with

the view that SEKs undervaluation is smaller thanpresumed but still worth capturing (see SEK: The myth ofkrona undervaluation on page 57).

Buy a 12-month EUR put/SEK ratio call spreadin 1x1.5 notional. Cost 0.88%.


12/88


Yoonyi Kim (81-3) [email protected] Chase Bank NA

12

Global FX Carry Trade Monitor

Chart 1: Japanese retail market capitalisation of 100 largest FX-denominated Its

Chart 2: Japanese retail aggregate retail margin shorts in JPY

trn; market capitalization of 100 largest investment trusts excluding fundsinvesting in equities; ranked in the order of total asset as of Nov 17 th 09

trn, Japanese retail measured by positions in USD, NZD, EUR, GBP and AUDon Tokyo Financial Exchange; positive indicates shorts in JPY

10

15

20

25

06 07 08 09 10

70

80

90

100

110

120

Market cap of top 100 ITs, JPY trn, lhs

JPY trade-w td index , inv erted rhs

-2

0

2

4

6

8

06 06 07 08 08 09

Aggregate JPY shorts in Japanese margin accounts, JPY trn

Source: J.P. Morgan, Bloomberg Source: J.P. Morgan, TFE

Japanese retail exposure to foreign currencies via investmenttrusts has been rising since January at a moderate butconsistent pace. The current level of 18.8trn is slightly lessthan the year-to-date high of 19.4trn reached in late October.This years peak is 80% of the pre-Lehman high of 24.2trnreached in August 2008.

Despite fluctuations between long and short positions thisyear, Japanese margin traders have been building JPY shortssince August. The year to date peak in JPY shorts (4.1trn)marked in September is roughly 57% of the pre-Lehman peakof 7.1trn reached in Aug 2007. Current JPY shorts at 3.0trn(Nov 19) is 74% of the year-to-date peak.

Chart 3: Japanese retail margin shorts in JPY vs USD, GBP,AUD

Chart 4: Global retail issuance of FX-linked structured notes

bn local currency. positive indicates long in local currency/short in JPY $bn, region is where the note was issued

-15

-10

-5

0

5

10

15

20

25

30

08 08 08 09 09 09

USD

GBP

AUD

0

5

10

15

20

25

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Asia ex Japan

Latin America

North America

Europe

Source: J.P. Morgan, TFE Source: J.P. Morgan

Japanese retail margin shorts in JPY against USD, GBP, andAUD recorded new historical peak in the later half of 2009.USD/JPY longs and GBP/JPY longs each reached a historical

peak at $27.3bn in Oct and 8.5bn in September, while

AUD/JPY longs marked a new record peak most recently onNov.19 at A$16.7bn, eclipsing the previous record in July. Asof November 19, longs in USD and GBP stands at $4.8bn and

3.3bn, equivalent to 18% and 38% of their historical highs.

Total issuance in FX structured notes globally reached $21bnin 2009, which is roughly 80% of the record 2008 issuance of$27bn. Issuance in Latin America doubled from last year,reaching a record high at $7.6bn whilst issuance elsewheredeclined sharply. Issuance in Europe, North America and Asiaex Japan this year stands at 36%, 76% and 69% of theirrespective peaks reached in 2008 for Europe and Asia ex-Japan and in 2007 for North America.


13/88


Yoonyi Kim (81-3) [email protected] Chase Bank NA

13

Chart 5: CTAs aggregate IMM shorts in USD Chart 6: US retail market capitalization of US-listed FX ETFs$ bn as the sum of net speculative positions on the IMM in AUD, NZD, CAD,EUR, GBP, JPY, CHF and MXN.

$bn. Positive value indicates longs in foreign cur rency, shorts in USD

-$40

-$30

-$20

-$10

$0

$10

$20

00 02 04 06 08 10

Aggregate USD shorts on IMM, $ bn, lhs

0

1

2

3

4

5

06 07 08 09 10

75

80

85

90

95

100

Market cap of US-listed FX ETFs, $bn, lhs

USD trade-wtd index, inverted, rhs

Source: J.P. Morgan, CME Source: J.P. Morgan, Bloomberg

Since turning flat in May, CTAs have been rebuilding USDshorts with aggregate IMM position rising to year to date peakat $22bn in October, which is equivalent to 60% of the pre-Lehman peak at $36bn in Nov 07. While the current level ofUSD shorts has fallen to $18bn or 15% off from the recent

peak, CTAs continue to hold a large stake in USD carry trade.

US retail exposure to foreign currencies via ETFs enjoyed amoderate but consistent up-trend since the equity market rallyin March. USD short positions reached a year to date peak at$3.7bn in October, which is 70% of the pre-Lehman peak inAugust 08 at $5.0bn. Most recent data shows the current

position at $3.1bn, roughly 15% down from the recent peak.

Chart 7: Currency managers and global macro hedge funds beta

with G-10 carry strategies

Chart 8. Currency managers and global macro hedge funds Beta

with emerging markets carry strategiesPositive beta implies a long in carry, a short in dollars HFR used for global macrohedge funds. Barclay BTOP Index and Parker Blacktree Index used for currencymanagers.

Positive beta implies a long in carry, a short in dollars HFR used for global macrohedge funds. Barclay BTOP Index and Parker Blacktree Index used for currencymanagers.

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

05 06 07 08 09

Currency managers Global macro hedge funds

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

05 06 07 08 09

Currency managers Global macro hedge funds

Source: J.P. Morgan Source: J.P. Morgan

Currency manager and macro hedge fund exposure to G-10carry, as proxied by their return beta with a carry basket, hastrended higher throughout the year. But with betas of 0.2 to0.5, exposure appears to be a fraction of the highs reached in2007-2008. Prior to the Lehman shock, hedge funds betas

peaked at 2.5 while those of currency managers peaked at 1.3.

Betas for currency managers and macro funds with respect toemerging markets carry baskets has alone been rising steadily

but is well off the 2007-2008 peaks. Current betas of 0.3 to0.4 are well below the pre-Lehman peaks of 1.8 for globalmacro funds and 1.1 for currency managers.


14/88


John Normand (44-20) 7325-5222

Matthew Franklin-Lyons (1-212) 834-4565J.P. Morgan Securities Ltd., JPMorgan Chase Bank NA

14

FX alpha strategies in 2010

After the carry trades appalling performance in 2008, mostmodel-driven strategies staged a comeback in 2009,delivering higher absolute and risk-adjusted performancethan many industry composites (table 1). Standard carrystrategies delivered returns of 20% on a G-10 basket and9.5% on emerging markets (table 1). Forward carry, whichtrades currencies based on momentum in interest ratespreads, returned 10%, roughly equivalent to last yearsperformance of 12%. (See next page for descriptions ofJ.P.Morgans rule-based strategies.)

Simple price momentum performed the worst this year,losing 10% year-to-date. We expected as much: medium-

term price momentum models almost always underperformat turning points because the lookback period used togenerate signals places too much weight on a mature trend.An alternative to simple price momentum, which we callForward Momentum Overlay because it uses the short-term rate signal from Forward Carry to confirm pricemomentum, performed relatively better. It lost only 0.4%because rate signals often contradicted medium-term pricemomentum, which until mid-year was still recommendingto buy dollars because of the currencies strong performancein late 2008.

Previous J.P.Morgan research has explored the issue offorecasting returns from various alpha strategies, since

excess returns tend be regime-dependent (see Currencymanager returns, trading styles and Fed cycles, Normand,August 2006 andFX in a world with less leverage and moreregulation, Normand and Sandilya, January 2009). Carryperforms best when volatility is declining but policy ratesincreasing, thereby boosting the rate advantage of high-yielders. Forward Carry tends to perform best when centralbank cycles are unsynchronised, thus causing rate spreads totrend for several months. Price momentum tends to performbest in periods of declining interest rates, probably becausesuch an environment drives long-term bear markets for thedollar.

If historical betas hold, then carry returns could reach8%, which is higher than average but lower than this years

returns. We assume that implied volatility will rangebetween 10% and 14% in 2010 (seeFXDerivatives sectionon page 19), which limits the upside on carry relative to2009s unprecedented decline in volatility. The averagecarry on G-10 and emerging markets baskets will rise byabout 150bp due to monetary tightening, thus raising therunning yield.

Econometric models for predicting the returns to

forward carry and price momentum are less robust.More qualitatively, we suspect returns to both strategies willbe average in 2010. For forward carry, interest rate marketswill deliver less powerful signals in 2010 since a majorrepricing has already occurred this years shift in front-

end rates to imply more aggressive tightening in mostcountries relative to the US. The strategy would onlydeliver above-average returns if central banks surprisemeaningfully next year, which is unlikely in the currentinflation environment.

Simple price momentum should perform better in early2010 than in 2009 since lookback periods now incorporate abearish dollar trend. But these models are vulnerable in thesecond half of the year because price signals alone will notwarn of an impending dollar turn in H2 as the Fed beginswithdrawing excess liquidity and volatility rises. TheForward Momentum Overlay model, which uses short-terminterest rate expectations to confirm price signals, is

preferred in such an environment. Any move in rate spreadsin the dollars favour around mid-year would neutralisebearish dollar signals from medium-term price momentumand thus induce the model to take profits on dollar shorts.

The performance and signals from each models are reportedweekly in theFX Alpha Strategies section ofFX MarketsWeekly.


15/88


John Normand (44-20) 7325-5222

Matthew Franklin-Lyons (1-212) 834-4565J.P. Morgan Securities Ltd., JPMorgan Chase Bank NA

15

Table 1: Performance of rule-based FX alpha strategies, currency managers and global macro hedge funds, 1999 - 2009Betas are calculated between monthly returns on strategies/manager composites and the level of volatility/interest rates.

2009 YTD

Avg annual return 20.0% 9.4% 10.4% -10.4% -0.4% 0.7% 0.9% 0.1% 3.3%

Std dev 11.7% 5.8% 10.8% 11.5% 7.2% 1.6% 1.0% 1.6% 4.7%

IR 1.7 1.6 1.0 -0.9 -0.1 0.4 0.9 0.1 0.7

Beta with respect to

Equity vol (VIX) -0.13 -0.07 -0.11 0.01 -0.05 -0.01 -0.01 0.01 -0.05

Rate vol (MOVE) -0.03 -0.03 0.01 0.00 0.00 0.00 0.00 0.01 0.01

FX vol (VXY) -0.62 -0.37 -0.44 0.15 -0.14 -0.01 0.00 0.09 -0.08UST 2-yr -3.42 -2.34 0.72 2.42 2.21 -0.86 0.07 0.00 -1.35

2004 - 2008 (5 years)

Avg annual return -3.2% 9.5% 7.0% 2.0% 4.4% 1.4% 0.7% 4.3% 7.1%

Std dev 12.0% 15.7% 7.0% 7.2% 4.8% 2.0% 1.5% 1.6% 2.7%

IR -0.3 0.6 1.0 0.3 0.9 0.7 0.5 2.6 2.7


Equity vol (VIX) -0.15 -0.18 0.00 0.09 0.05 0.01 -0.01 0.00 -0.01

Rate vol (MOVE) -0.03 -0.04 0.00 0.02 0.01 0.00 0.00 0.00 0.00

FX vol (VXY) -0.42 -0.51 -0.05 0.22 0.09 0.04 -0.01 -0.01 -0.02

UST 2-yr 0.61 0.41 0.00 -0.26 -0.14 -0.05 0.03 -0.02 0.08

1999 - 2008 (10 years)

Avg annual return 2.9% 10.4% 5.5% 4.5% 5.0% 3.4% NA NA 8.9%

Std dev 10.8% 16.2% 5.4% 7.8% 4.8% 3.4% NA NA 6.1%

IR 0.3 0.6 1.0 0.6 1.0 1.0 NA NA 1.5


Equity vol (VIX) -0.06 -0.11 0.00 0.04 0.02 0.02 NA NA -0.01

Rate vol (MOVE) -0.02 -0.03 0.00 0.01 0.01 0.00 NA NA 0.00

FX vol (VXY) -0.20 -0.38 -0.04 0.09 0.02 0.08 NA NA -0.02

UST 2-yr -0.01 -0.17 -0.07 -0.04 -0.06 -0.09 NA NA -0.06

Alpha strategies Manager performance

Price

momentum

Forward Momentum Overlay

(price momentum plus

Forward Carry)

Barclay Currency

Traders Index

HFR global

macro hedge

fundsG-10 carry EM carry

Forward Carry (rate

spread momentum)

Barclay Group

BTOP FX

Parker

Blacktree CMI

Strategy descriptions

G-10 and Emerging Markets Carry strategies select fourcurrencies with highest ratio of carry (1 mo rate differential)to volatility (annualized spot vol over past 30 days).

Forward Carrybuysthe currency in whose favor rateexpectations have moved over the past month. Expectationsare based on 1mo rates 3mos forward.

ForwardCarry Overlay only buys high yield currencies ifrate expectations are also moving in that currencys favor,so combines standard carry and Forward Carry concepts.

Forward Momentum Overlay only buys currencies whichhave appreciated in spot terms and are experiencing risingrate expectations relative to another currency. Thus itcombines the standard price momentum framework with

Forward Carry.

All strategies are described inAlternatives to StandardCarry and Momentum in FX(Normand and Ghia, August 8,2008).


16/88


John Normand (44-20) 7325-5222

Kamal Sharma (44-20) 7777-1729J.P. Morgan Securities Ltd.

16

Post-mortem: 2009 forecasts

and trade recommendationsThis time last year we expected deleveraging to push thedollar higher versus all currencies but the yen in Q12009, following by dollar weakness as the recoveryunfolded. This view was shared partially by theconsensus, although J.P.Morgan forecast for dollarweakness was broader and more aggressive than theaverage forecast. We expected EUR/USD to fall to 1.28by end Q1 from 1.35 at the start of the year. In the event,EUR/USD ended Q1 at 1.33, equivalent to the consensusforecast.

From Q2 onwards, however, we projected a muchstronger recovery and therefore dollar sell-off thanthe consensus, so forecast 7% EUR/USD appreciationthrough year-end. The consensus forecast was flat around1.33. The euro well exceeded both, rallying over 12%from Q2 to Q4 (chart 1).

Our forecast profile forUSD/JPY assumed that thedollar would weaken in the first half of the year beforerecovering modestly towards the end of 2009. Theconsensus was much more bullish, expecting continuousUSD/JPY appreciation through Q4. We were wrong inQ1 as USD/JPY rallied following a collapse in Japanesegrowth and the countrys trade surplus. By year-end,however, our forecast was much closer to the mark than

the consensus (JPM 90, consensus 97).As with our forecasts for EUR/USD, we overestimatedthe Q1 decline and the Q2 recovery in commoditycurrencies, even though we pegged the turning pointcorrectly. For example with AUD/USD, weexpected7%appreciation in Q2 but AUD/ USD rallied by over 16%.Given the lower starting point of our forecast by end Q1,our projections trailed actual AUD/USD moves by anaverage of 22%. This compares to an average miss of24% by the consensus. However, from Q1 to Q4 we hadcorrectly forecasted the degree of the AUD/USDrecovery. From end Q1 to Q4 2009, our forecasts hadlooked for a 27% appreciation in AUD/USD which

compares favorably to the 31% actual appreciation. Theconsensus lagged well behind, forecasting only a 4%appreciation over the same period.

Table 1: J.P.Morgan and consensus forecasts in January 2009

Q1 09 Q2 09 Q3 09 Q4 09EUR/USD

JPM 1.35 1.28 1.30 1.35 1.37

Consensus 1.35 1.33 1.32 1.33 1.33

Actual 1.35 1.33 1.40 1.46 1.48

USD/JPY

JPM 90 88 85 85 90

Consensus 90 92 94 96 97

Actual 90 99 96 90 89

AUD/USD

JPM 0.71 0.60 0.64 0.70 0.76Consensus 0.71 0.65 0.65 0.66 0.68

Actual 0.71 0.69 0.81 0.88 0.91

Spot on Jan

1, 2009

Forecasts for

Source: JP Morgan

Chart 1: JP Morgan forecasts for EUR/USD versus consensus

1.25

1.30

1.35

1.40

1.45

1.50

01 Jan 09 Q1 09 Q2 09 Q3 09 Q4 09

JPM

Consensus

Actual

Source: JP Morgan

Chart 2: JP Morgan forecasts for USD/JPY versus consensus

82

84

86

88

90

92

94

96

98

100

01 Jan 09 Q1 09 Q2 09 Q3 09 Q4 09

JPM

ConsensusActual

Source: JP Morgan


17/88


John Normand (44-20) 7325-5222

Kamal Sharma (44-20) 7777-1729J.P. Morgan Securities Ltd.

17

Trade recommendations are detailed each Friday in FXMarkets Weekly and are classified as macro directional

trades (cash and options); derivativesrelative valueand technical trades.

I. Macro trade recommendations

This year we recommended fewer cash trades (59) thanin 2008 (85). Nonetheless, our success rate was higher, at63% compared to 59% in 2008. The average return pertrade was 1% compared to 2% in 2008. In weightedterms, our trades have delivered a 61% success rate over2008-2009, whilst weighted average returns were 1.6%over the same period.

In 2009 we issued more derivatives trades than in2008:19 non-digitals (vs 3 in 2008) and 18 digitals (vs 5

in 2008). Success rates were high (63%) and averagereturns per trade decent (0.6%) for non-digitals, but notfor digitals (success rate of 44% and average loss of -3.5%).

II. Relative value derivatives recommendations

In 2009, our relative value recommendations focused onnon-digitals. The number of recommendations more thandoubled to 28, whilst the success rate was marginallylower at 68% (from 77% in 2008). The average returnwas 0.5% lower than in 2008 at 0.1%.

III. Technical trade recommendations

In 2009, we recommended half the number of technicaltrades as we had done in 2008, at 44. Nonetheless, oursuccess rate improved by over 10% to 55%. However,the average return on each trade was close to flat versus+0.2% in 2008.

Chart 1: 2008-2009 performance summary: Average returns pertrade

0.2%

0.6%

-3.6%

-0.6%

2.0%

0.0%

0.1%

-3.5%

0.6%

1.0%

-5% -4% -3% -2% -1% 0% 1% 2% 3%

Technical

RV (non-digital)

Digital

Non-digital

Cash2009

2008

Source: J.P. Morgan

Table 1. Performance statistics 2008 2009

2009 YTD 2008

2008-2009

weighted avg

I. Trade Recommendations portfolio

Cash

# of trades 59 85 144

Success rate 63% 59% 61%

Average return per trade (%, unweighted) 1.0% 2.0% 1.6%

Average holding period (days) 18 31 26

Derivatives (non-digital)

# of trades 19 3 22


Average return per trade (bp, unweighted) 0.6% -0.6% 0


Derivatives (digital)

# of trades 18 5 23


Average return per trade (%, unweighted) -3.5% -3.6% -3.5%Average holding period (days) 56 54 56

II. FX Derivatives portfolio (relative value)

Non-digital

# of trades 28 13 41


Average return per trade (%, unweighted) 0.1% 0.6% 0


Digital

# of trades NA 3 3

Success rate NA 33% 33%

Average return per trade (%, unweighted) NA 8% 8%

Average holding period (days) NA 33 33

III. Technical Strategy portfolio

# of trades 44 87 131


Average return per trade (%, unweighted) 0.0% 0.2% 0.1%


Source: J.P. Morgan

Chart 2: 2008-2009 Performance summary: Success rate by typeof trade

43%

77%

20%

0%

59%

55%

68%

44%

63%

63%

0% 20% 40% 60% 80% 100%

Technical

RV (non-digital)

Digital

Non-digital

Cash 2009

2008

Source: J.P. Morgan


18/88


Arindam Sandilya (1-212) 834-2304Talis Bauer (44-20) 7777-5276JPMorgan Chase Bank NA

18

FX Derivatives: A macro

model for volatility andstrategy implications

The unexpectedly strong economic recovery in 2009sponsored a dramatic decline in volatility across

asset classes and proved our forecasts too cautious.

We conceptualize volatility at a fundamental level asthe product of the supply of macroeconomic

surprises and the vulnerability of markets to such

surprises, as measured by leverage.

We envision growth surprises to be fairly muted in

2010 as the recovery matures, but some shocks inmonetary 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.

Currency relevant leverage resides in two pockets the overhang of dollar shorts among investors, and

the massive build up of public sector debt.

Our model linking currency volatility to leverageand surprise factors finds current VXY levels close

to fair value. Our economic forecasts lead us to

believe that VXY should stay within a 10-14 range

in 2010, with upside risks in H2.

Lack of any real directional momentum in vols islikely to reduce the efficacy of gamma trading

strategies. Focus on vol carry for instance the

premium (discount) of forward vols to spot vols as

a more reliable generator of trading returns. Own

long-dated EUR and CHF vols as portfolio hedges.

Back from the brink

After the annus horribilis that was 2008, most marketparticipants would have settled for a 2009 that offered littlemore than a modicum of stability. As it turned out, thestrength of the economic recovery caught a very cash-

overweight market by surprise, and sponsored a decline involatility across asset classes that was nothing short ofdramatic (chart 1). Such multiple vega annual declines infinancial market volatility have not been the norm in post-recession years over the past two decades, but the depth ofthe latest recession compared to those in the recent past andthe pace of the rebound that followed rendered suchhistorical calculus irrelevant. We were admittedly in thecautious camp as far as vol forecasts went, expecting a 3-4vol decline in the VXY from the unsustainable early 2009highs based on usual normalization dynamics aroundrecessions, and our underestimation of the post-QE

Chart 1. The decline in volatility across asset classes in 2009 wasnothing short of dramatic, and G10 FX was no exception3M ATM implied volatilities in equities (S&P 500), US interest rates (2Y and 10Y

tails), FX (VXY G7) and commodities (gold and copper), indexed to 100 as of 01-Jan-09.

40

60

80

100

120

140

Jan-09 Mar-09 May -09 Jul-09 Sep-09 Nov -09

S&P US 3M2YUS 3M10Y GoldCopper VXY G7

Index

Source: J.P. Morgan

Chart 2. 2009 was a stellar year for gamma sellingShort gamma returns calculated as the P/L from selling a basket of 3M deltahedged ATM straddles, with the basket composition mimicking that of JPMorgansVXY G7 index. Options are re-struck at the start of the month, and assume notransaction costs.

(bp USD) AUD EUR GBP NZD CAD CHF JPY NOK SEK Basket

Ann. Return 506 754 400 230 439 376 432 162 -138 554

IR 0.7 1.7 0.5 0.3 1.0 0.7 0.7 0.2 -0.2 1.3

5% Tail Loss* -73 -26 -70 -70 -30 -43 -80 -59 -67 -41

Max Loss* -100 -83 -214 -234 -46 -115 -112 -229 -190 -79

* Weekly stats

-100

-80

-60

-40

-20

0

20

40

60

80

100

Jan-09 Mar-09 Jun-09 Aug-09 Nov -09

-100

0

100

200

300

400

500

Weekly short gamma P/L(LHS)

Cumulativ e short gamma P/ L(RHS)

bp USD bp USD

Source: J.P. Morgan

euphoria cost us full-blown participation in the gammaselling fest that followed (chart 2). Lower vol is however afavorable environment for relative value trading styles, andmany of our RV trade recommendations benefited indirectlyfrom the reduced uncertainty in the macro environment. Inthe sections that follow, we outline our framework foranalyzing currency volatility and draw some conclusions onthe likely trajectory of vol next year.


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19

Volatility = Surprise X Leverage

Previous JPMorgan research has conceptualized volatility at

a fundamental level as the product of the supply of surprisesand the vulnerability of markets to these surprises (seeVolatility, Leverage and Returns, Loeys and Panigirtzoglou,October 2005). This approach aims to link views onvolatility to the macroeconomic reading of financialmarkets, and is different from the dominant time-seriesapproaches to forecasting volatility that is best representedby the GARCH class of models. In this framework, shocksor surprises in the form of news or unexpected eventsprompt revisions in expectations of cashflows from an asset,leading to variability in its price. The magnitude of thisvariability also depends on the degree of wrong-footednessof the market in absorbing these revisions in other words

leverage. Larger the surprise and more levered the market,the greater should be the resulting volatility. The outlookfor FX vol next year therefore rests on two key questions:

Where can currency-relevant surprises springfrom?

Where does leverage reside in the system?

Surprises where from?

One can think of surprises as the supply of market relevantexogenous events or news, either in the form of unexpecteddevelopments in macroeconomic variables such as growthor inflation, and unanticipated policy actions by the

government. Along the lines of Loeys et al, we focus on themacroeconomic forces of the surprise production functionto project changes in the supply of these surprises. Charts 3and 4 depict these surprise production functions for USgrowth and monetary policy by looking at the impact ofmonthly flow of information on market expectations overthe coming year. Given the linkages of the rest of the worldto the business cycle in the US, these US-based measuresare likely a good proxy for economic surprises even forworld markets. Ideally, one would like to record surprises inreal time as we do for monetary policy expectations in chart4, using standard deviation of monthly changes in 2-yrtreasury yields. In the absence of a liquid real time marketfor growth expectations however, we rely on Blue Chipconsensus forecasts instead in chart 3.

Broadly speaking, both surprise functions exhibitreasonable correlation to the business cycle. The sampleperiod includes three recessions 1991, 2001 and thecurrent one which seem to define the peaks in growth andmonetary policy surprises. Entering into the second year ofrecovery, our economists remain upbeat on growth forecastsand anticipate US labor markets to stabilize by the end ofthe year, with the unemployment rate falling from 10.2%

Chart 3. Growth surprises in the US are highly correlated to thebusiness cycle..Growth surprises defined as the rolling 12M standard deviation of monthly changes

in the 1-year ahead consensus expectations for US growth. Shaded areasrepresent NBER recessions. Exit from the current recession assumed to be Jun09.

0.0

0.1

0.2

0.3

0.4

0.5

0.6

Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10

-1.5

-0.8

0.0

0.8

1.5

2.3

3.0

3.8

4.5Growth

Surprise

YoY change in US

Unemployment

F'cast

% %

Source: J.P. Morgan, Blue Chip Indicators

Chart 4. .as are monetary policy surprisesMonetary policy surprises defined as the rolling 12M standard deviation of monthlychanges in 2Y US swap rates. Shaded areas represent NBER recessions. Exitfrom the current recession assumed to be Jun09

10

20

30

40

50

60

Jun-91 Feb-95 Oct-98 Jun-02 Feb-06 Oct-09

-2

-1-1

0

1

2

3

3

4

Monetary Policy

Surprise

bp %YoY change in US

Unemployment

Source: J.P. Morgan

Chart 5. Currency managers and global macro hedge funds haveincreased their holdings of pro-cyclical FX post-QE, but positionsare still only half the size of those at the height of 2007 frenzyRolling 30-day betas from regressing daily returns for i) a composite of 25dedicated currency funds compiled by JPMorgan and ii) HFR global macro hedgefunds on returns from JPMorgans IncomeFX and IncomeEM carry baskets.

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Feb-05 Jan-06 Jan-07 Dec-07 Nov -08 Nov -09

Currency ManagersGlobal Macro Hedge Funds

Fed announces

QE

Source: J.P. Morgan, Bloomberg


20/88


21/88



21

behind us, and save in a few pockets, 2010 should begin tosee an upturn in the leverage cycle.

As private sectors retrenched violently over the past twoyears, public sectors have of course done the opposite. Withrates at or close to zero, Central banks resorted tounconventional measures such as quantitative easing(US,UK) and governments virtually everywheresupplemented these efforts through looser fiscal policy. Asa result, public sector leverage has balooned across thedeveloped world (chart 8), with US and UK being thebiggest culprits. Financing this massive government debt isnot a problem as long as weak loan demand maintains thecommercial bank bid for government paper, foreign centralbanks remain committed to reserve accumulation anddeflation remains the reality for next year. However an

inflation scare could be a game changer as financing costsrise and rollover risks come to the forefront. Broad moneysupply growth and inflation expectations therefore meritclose tracking to gauge the risks of such an event unfolding.

A Macro Model for FX Volatility

Chart 8 presents a regression model linking the VXY to thesurprise and leverage factors discussed earlier. All variablesare statistically significant, have intuitive signs and theadjusted R2 is more than acceptable in the context ofeconometric models in academic literature that attempt tocapture the macroeconomic/financial market volatility link.At current levels, VXY looks fair to modestly rich to

model fair value, but the deviation is insignificant giventhe standard error around the estimate. Note that theleverage variable used in the model suffers from twohandicaps:

(a) it measures only investor leverage, ignoring the fiscalleverage buildup altogether largely because public sectorleverage measures are too low frequency compared to otherinputs, and too slow moving to be a signficant explanatoryvariable in a G7 context.8

(b) the measure of investor leverage is not a currencyspecific metric like those outlined in chart 5, but rather thebroad beta of the entire universe of hedge funds (proxied bythe CSFB Tremont Hedge Fund return index) to FX carry,

once again necessitated by the lack of a longer history ofcurrency manager return data.

The latter is less of an issue since it only forces theregression coefficient of the leverage variable to capturespillover effects from other asset markets not in itselfterrible given the one-factor nature of most portfolios atpresent but the omission of public sector leverage is

8 Unlike in an EM setting where external vulnerability has been welldocumented to be key factor in past crises

Chart 9. VXY current looks about fair given the investor leveragestock and the supply of surprisesGrowth surprises as defined in Chart 3; Monetary policy surprises as defined in

Chart 4; Investor leverage taken to be the average beta of CSFB Tremont hedgefund index on JPMorgans IncomeFX and IncomeEM carry baskets

Coefficient t-stat p-v alue

Intercept 2.06 2.60 0.01

Monetary Policy Surprise 0.16 6.36 0.00

Grow th Surprsise 4.63 2.56 0.01

Inv estor Lev erage 3.42 8.25 0.00

5

10

15

20

25

Jul-96 Mar-99 Nov -01 Jun-04 Feb-07 Sep-09

VXY Actual

VXY Model = 2.06 + 0.16*Monetary Policy Surprise +

4.63*Growth Surprise + 3.42*Investor Lev erage

+/- 1 Std. Error BandsAdj R2 = 51%

Source: J.P. Morgan

Table 1. Our expectations for modest US unemployment in 2010 leadus to a forecast for nearly unchanged VXY levels by next year

All variables as defined in Chart 9. The monetary policy surprise forecast assumesthat the 18 bp current dislocation from levels justified by unemployment figures willcorrect over the course of 2010.Growth Surprises vs. Unemployment


Intercept 0.14 35.9 0.00YoY Unemploy ment 0.08 21.2 0.00

Monetary Policy Surprises vs. Unemployment


Intercept 0.14 35.9 0.00

YoY Unemploy ment 0.08 21.2 0.00

Forecasts

Umeploy-

ment (%)

YoY

Unemp. (%)

Growth

Surprise (%)

Monetary Policy

Surprise (bp)

Investor

LeverageVXY

9.8 -0.4 0.11 42 0.93 12.3

Source: J.P. Morgan

signficant in the context of the current environment andlikely biases model fair value estimates lower.

With these model parameters, it is possible to run volprojections using our base case growth and policy forecasts.This is a two stage process, involving first quantifying thesurprises vs. business cycle relationship depicted in charts 3and 4 to predict the extent of macro-surprises in store nextyear, and then plugging in those surprise readings into thevol model described in chart 8. Table 1 tells the story in anutshell: our economic forecasts translate into mutedgrowth surprises next year and some pickup in


22/88



22

monetary policy surprises, and together with an

unchanged leverage factor point towards a VXY

forecast for YE 2010 at 12.3, with sizeable +/- 1 std.error tolerance of 2 vol pts in other words roughly a 10

14 vol range for the vol index. No doubt this is a blandoutcome given that VXY is currently trading close to thoselevels, but not unreasonable that the sizeable correction invol levels from late 2008 highs is already behind us, andthat large vol moves are unlikely from levels that are not farfrom long-term averages (15-year average close to 11).

If we are correct on the VXY, beta vol trading strategieslike outright short-gamma will have a hard time deliveringthe stellar returns that they did this year, and even moremarket-neutral trading styles are likely to find 2010challenging. Our analysis of strategy returns in various vol

regimes shows that the lack of vol momentum tends to actas drag on these trading styles, rendering stable volenvironments unfriendly towards gamma trading (Chart 10).Granted that the long/short gamma trading scheme used asproxy for relative value vol trading returns is too simplisticfor style analysis, but the broad conclusion from the chart that gamma trading strategies irrespective of flavor tend toyield low absolute returns when vol is rangebound, but thatRV tends to underperform short gamma in vol sell-offs andoutperform in vol rallies probably holds.

However if vol levels do not shift radically, vol carry tradeslikely stand to perform resaonbly well. A typical example ofearning 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 forwardvols to spot implied vols if vol curves remain unchangedover the trade horizon. Vol curves in G10 are currentlyclose to historic highs in steepness, and while some of thisis doubtless attributable to portfolio protection drivendemand for long-dated dollar calls that is likely to reversenext year, we do not view a deluge of long-end vol supplyto the street as likely given the markets memory of thehavoc that the past two years wrought. Coupled withanchored front-end vols, this likely means that vol curvesare likely to retain their upward sloping shape next

year, making short FVA a likely source of alpha for

currency option portfolios.Finally, the twin themes of earning positive vol carry andlack of back-end vol supply dovetail nicely to suggest

value in owning long-dated (10-year) EUR/USD andUSD/CHF vols. EUR and CHF are the two currencies thatare most responsive to a dollar crisis scenario (seeRisk

Scenarios section) and long-dated vols in both slidepositively along inverted vol curves. In addition, the tail risk

scenario mentioned above is likely to involve a decouplingof the dollar and US rates as foreign holdings of US assetsare liquidated en masse (stocks, bonds and currency). Suchdecorrelation between FX and rates is positive for long-dated vols as it increases the volatility of forwards; furtherout in tenor the forward, higher the impact9. Thecombination of positive slide, thin supply and sensitivity toa disorderly dollar decline make long-dated vols attractiveportfolio hedges for 2010.

Chart 10. Short-dated volatility strategies are likely to find 2010challenging, as the lack of vol momentum acts as a drag on usualtrading styles

Average yearly P/L from outright short gamma and long/short gamma strategiescontingent on the magnitude of the YoY change in VXY. Outright short gamma

returns computed as the P/L from selling a basket of 3M delta hedged ATMstraddles, with the basket composition mimicking that of JPMorgans VXY G7index. Long/short relative value returns computed as the P/L from buying 3M deltahedged ATM straddles in the two best long gamma currency pairs among the G10majors and selling3M delta hedged ATM straddles in the two best short gammacandidates. Good gamma sells (buys) defined as those that rank high (low) on acomposite metric given by rolling 1-yr z-score of 3M implied vol * 3M implied vol /realized vol ratio. Options are re-struck at the s tart of the month, and assume notransaction costs.

-20

-15

-10

-5

0

5

10

15

20vol pts.

10

Short gammaRelative Value

Source: J.P. Morgan

Chart 11. Positive slide at the back-end of vol curves, coupled withlikely lack of vol supply, makes long-dated EUR and CHF volsattractive to own as portfolio hedges

8

9

10

11

12

13

14

1 3 5 6 8 10

EUR/USD

USD/CHF

Tenor (Y)

Vols (%)

Source: J.P. Morgan

9From the standard forward spot relationship: F = S *exp (-rate diff)*T,

one canwrite the variance equation as: F2 = S

2 + rate diff2T2 2 Srate

diffTS,rate diff. From the equation, it is clear that lowerS,rate diff leads tohigherF. Also, the presence of the Tterm in the equation means thatlonger tenor vols benefit more than shorter-dated vols from

global fx strategy

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