monthly forex update by saxo bank

January 18, 2011

FX Monthly – January 2011

FX month(s) in review: Wild transition to the New Year

The two months since our November report saw remarkable developments in FX. The post QE2 announcement

environment saw a sharp reversal in some of the correlations we’ve been so used to, particularly the US

dollar’s correlation with risk and even correlations across markets in general. Other key developments included

a strong rise in interest rates and risk appetite into year end. Then to start the year, someone pressed the “all

change” button in FX and we’ve seen a sharp reversal in many of the trends that persisted into year-end –

particularly a sharp weakening in both the Swiss Franc and Australian dollar. Below are a few highlights of

what has transpired since our last report.

What goes up must come down? We saw a sharp rally into year-end by both the Swiss Franc and the

Australian dollar, both (with some measure of 20-20 hindsight) clearly driven to some degree of fixing

interest or positioning squeezes aggravated by thin liquidity in the close of the year. The strong franc was

also driven by the renewed EuroZone sovereign debt pressures and the Australian dollar rally by the

commodity rally that ended the year with a flourish with copper, for example, trading to new all time

highs. Then, after the calendar rolled into 2011, these two currencies were the weakest of the G-10 by

mid-month, with Australia suffering from a commodity sell-off and a series of flood disasters and the franc

consolidating on European attempts (though somewhat feeble) to get ahead of the curve on its sovereign

debt crisis.

Interest rates higher. At the time of our last report in mid-November, the US treasury market had

consolidated sharply from its heady gains going into the November 3 FOMC meeting – a move that was

clearly (with the wonderful aid of 20-20 hindsight) a buy-the-rumor, sell-the-fact reaction to the

confirmation that the Fed planned to move ahead with the QE2 policy of massive renewed bond purchases.

But in December, we were faced with a treasury sell-off that looked more like a rout than a mere

consolidation and this begs important questions for the USD and for major FX pairs. One the one hand,

higher interest rates in the US are a fundamental support for the currency on interest rate spread

comparisons, which in the past only favoured the USD when interest rates were falling because US rates

were almost as low as they could theoretically go and other countries’ rates generally fell faster. On the

other hand, if the higher interest rates are a reflection of bond buyers going on strike, we have an entirely

different scenario – one that is far more sensitive to the credit worthiness of the various nations and their

sovereign debt. The Japanese Yen could be particularly vulnerable in such a scenario.

A USD/risk divergence. This is related to the point just above on interest rates. The market is a bit

confused as to what to do with the USD as interest rates in the US have risen faster than for some of the

other countries (at least at times – in the final days ahead of this report, some of this effect was fading).

This is a USD positive. But equity markets – at least in the US and Germany and a few other countries –

have marched to new highs for the cycle, which has time and time been associated with USD weakness

over the last couple of years or more of the USD carry trade. We’ve been so trained to see all markets as

one hyper-correlated mass that moves like a school of fish that this new divergence in the USD and risk

John J. Hardy

Consulting FX Strategist

[email protected]

+45 3977 4000

January 18, 2011


appetite is a signal event we must pay close attention to in coming weeks. See more on the USD and risk

divergence in our Carry Trade Model article below.

Themes for 2011

As this is our first monthly of the New Year, we try to look at the bigger perspective and mull some of the

biggest issues that that the market will be chewing on this year:

To QE or not to QE? – It is abundantly clear from the latest batch of rhetoric that even the new purpoted

hawks among the voting FOMC members (Kocherlakota, Plosser, Fisher) expect for the QE2 program to run to

completion. The degree of dissent within the FOMC is so far less than we imagined would be the case, but the

more important question going forward is whether the Fed’s QE policies will end with QE2. If the economy

weakens again, Bernanke and company would likely feel the itch for another round of QE, perhaps aimed at

buttressing local and state finances, but we suspect that would be a political impossibility and that the Fed’s

maneuverability from here on out is extremely limited. Alternatively, if the US economy performs relatively

well, the Fed won’t find the justification for moving in the first place. We are expecting that this will eventually

support the USD, both because it is a sign that the Fed will be halted before it prints the greenback into

oblivion (just yet. anyway). We maintain the simultaneous assumption that growth expectations elsewhere

may fall relative to those for the US. These two factors, combined with at least a sideways if not falling risk

appetite in the months ahead are the preconditions for a stronger dollar.

Chart: Shanghai composite vs. MXEF vs. S&P500 – Since the QE2 announcement of early November, the

divergence in equity market performance around the world and correlations across markets in general has

been disrupted relative to the past couple of years. Are China and the emerging markets the leading indicator

here on risk?

China and Emerging Markets/Commodities: Here we throw a few themes together, but they are all

related. China is clearly grappling with problematic inflation levels from its property bubble and hot money

inflows aggravated by its dirty peg to the US dollar and the implications of hyper-easy Fed monetary policy.

Meanwhile, external demand is not growing at a rate sufficient to pass on strong price increases and domestic

consumers risk getting squeezed by commodity price rises and a high cost of rent from the property bubble.

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January 18, 2011


This margin squeeze for companies and on consumer is going to mean increasingly inferior growth rates with

every uptick in cost push inflation and every tightening of the screws on credit. In 2011, will China move more

forcefully to avert inflation risks by slowing credit markets and economic growth and overinvestment in real

estate projects? It will be tough for the country to engineer a soft landing and as China goes, so goes the EM

trade. Another issue for China and many other EM countries like Korea and Brazil is the inconveniently large

inflows of capital that are making life difficult, though these problems could quickly reverse a la late 2008 as

capital flows will take flight and could aggravate a sell-off.

Euro PIGS crisis – our forecasts for the Euro generally suggest that the Euro crisis will come to a head sooner

rather than later in 2011. A crisis meeting will apparently be held by EU leadership in February to discuss ways

in which to get ahead of the curve on the sovereign debt problem as it is widely agreed that a Spanish default

would be too large for the current rescue funds and EFSF to handle. There have been signs of a softening

stance from Germany on the idea of expanding EU commitments, but the efforts thus far from EU leadership

have underwhelmed and the German politicians are fully aware of the political suicide that awaits any carte

blanche approach to bailing out the periphery.

One of the next key events will be the Irish election, possibly as early as late March. Ireland has no incentive

to live with its current bailout arrangement other than pride and the inertia of the EuroZone experiment and

the political opposition in Ireland is virtually guaranteed a victory. Will Ireland reschedule its debt already by

mid-year or even threaten to leave the EuroZone somewhere down the line? Credit default swaps on Irish

sovereign debt are trading higher and higher as the markets ponder this question – they were in the high 600’s

at the time of this writing compared to sub-300 levels last summer and are sharply higher even since the

EU/IMF arrangement was agreed on back in late November. (see a chart in the Forecast section for the Euro

below).

Carry Trade Model – coming unhinged

This time around, we note that the market correlations seem to be shifting more profoundly than we have seen

in some time – at least the kneejerk correlation in the USD and risk appetite. Our model clearly shows that risk

appetite remains very strong globally, but that the USD has failed to fall to new lows. There are a couple of

explanations or potential predictions we can try to extract from this:

The USD is no longer the ideal funding currency – this is a bit of a tough one to argue for. As long as risk

appetite remains robust (which favours being long carry trades), there is plenty of evidence to argue that the

US currency is an ideal funding currency, considering that it still has a very low interest rate, that the market

expects it to move very slowly to raise rates considering that the Fed is still in quantitative easing mode while

other banks have been raising rates for some time, and due to its lack of fiscal discipline. Still, US interest

rates have jumped sufficiently higher to improve its standing in spreads versus some of the other major

currencies, and this has clearly been instrumental in some of the USD’s relative resilience in this market. Also,

US economic fundamentals have perked up somewhat. Theoretically, if the US recovery blossoms from here,

then the popularity of using the USD as a funding currency could fade and other currencies, potentially the

Japanese Yen or Swiss franc could become more popular funding currencies if interest rates head higher.

The stronger USD is a leading indicator on the direction of risk - When we say “stronger USD” here, we

merely mean relative to its past correlation with risk appetite, as the USD has yet to consistently rally versus

the market, though it has been relatively stable while risk appetite has gone into overdrive (at least in the

developed equity markets – some divergences exist elsewhere). Since the Fed’s easy money policies have

provided the liquidity for a good portion of the rally in risk appetite since the anticipation of QE2 set in, one

January 18, 2011


could argue that the anticipated withdrawal of that liquidity as June approaches means a stronger USD and

lower risk appetite and the unwinding of some of the huge short USD/long risk trades out there.

The weak Euro is grabbing the spotlight – this is one of the more likely explanations for the relative USD

strength and certainly explains some if not all of the greenback’s relative resilience. Flows into the Euro have

doubtless slowed from the largest potential buyers – central banks, who are likely having a hard time justifying

Euro purchases as the continent is racked with its sovereign debt convulsions. The Euro has been the only

plausible alternative to the USD as a major reserve currency, so any Euro weakness will inevitably be

expressed to some degree as USD strength.

Carry Trade Outlook – the cart leading the horse?

Again, we wonder here whether the USD has become a leading indicator on risk appetite. We would suggest

that to some degree it has, as the Fed’s very loose monetary policies have been a key element in keeping

global risk appetite at the boil - particularly in the last huge rally from late August of last year, when it became

clear that QE2 was on the way – and now that it is rather clear that the Fed plans on carrying the debt

monetization program to completion. Eventually, however, the market will move on to focus on other drivers of

global risk. While the USD still plays a prominent part in setting the agenda, commodity prices and interest

rates will exercise increasing influence if they continue to head higher from here as risk appetite can’t possibly

like the thought of a margin squeeze and decrease in liquidity.

If, on the other hand, commodity and interest rate prices fail to head higher, it is likely due to an increasing

worry that China will suffer a setback and that global growth will disappoint on weak end demand. If those

themes begin to dominate, carry trades will likely suffer steep losses, since they are generally a pro-cyclical

barometer to begin with. There are signs that worries in China are growing, but major equity markets and

many of our risk appetite measures have failed to pick up on this consistently. This scenario is USD bullish if no

sovereign debt worries come into play. The truly chaotic scenario would be risk aversion combined with

sovereign debt worries, a scenario that is less USD bullish if those worries affect the assessment of the US’

ability to ever pay back its debts.

As for the components of the carry trade model, all of them are in relatively risk-willing territory – not a huge

surprise considering the very positive reading for the carry trade index. There are a couple of laggards, though,

including a emerging market bond spreads, which are well off the lows of the recent range, and FX volatility,

which has decreased somewhat, but not to the kind of extremely low levels we are seeing in equity market

volatility indicators

January 18, 2011


Saxo Bank Carry Trade Model Chart

Chart: Saxo Bank Carry Trade Model- Longer term view. This time around, we decided to display the

longer term perspective, which shows that global risk appetite, as measured by our Carry Trade Index, is

still very much in risk hungry terrain. The last time it was near this high was in March-April of this year,

which preceded the May 6 “flash crash” and weak equity market of the early summer. (The Sample US

Carry Trade shows the carry-less performance of a basket of 7 currencies (AUD, NZD, PLN, TRY, MXN,

IDR, BRL) vs. the USD and JPY.) Chart derived from data from Bloomberg.

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Carry Trade Index

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January 18, 2011


Central Bank Watch: Expectations shifting higher

Chart: Central Bank expectations have certainly shifted higher since our last couple of reports, with the

market beginning to price in non-trivial moves from a number of banks – even the ECB, after Trichet

turned hawkish on inflation despite all of the sovereign debt woes facing the Euro Zone.

Chart: G-10 CB rates and rate expectations in aggregate: We’re seeing a sizable increase in

expectations for the G-10 central banks in aggregate as the blue line above indicates. The market is

looking for some 500 bps of rate hikes in aggregate for the year forward on top of recent hikes. Charts

above derived from data from Bloomberg

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Central Bank Rate Expectations

Rate Now (17 Jan. 2011)

1-yr. Forward Exp.

Expected Change

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G-10 CB Rates and Expectations

Forward CB Expectations 1-yr. (bps - left axis)

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January 18, 2011


Saxo Bank G-10 FX Forecasts

Base Case: Our basic premise that the post QE2 announcement would see a continued retrenchment in risk

appetite was more or less wrong, as the adjustment higher in interest rates and the US dollar rally after the

announcement proved indecisive and as risk appetite charged higher once again (with a couple of notable

exceptions – especially China, which is a critical driver of the future of global growth). China should be getting

a lot of focus now and in the months ahead, as the regime is trying to engineer a soft landing in the country’s

overheating, inflation-ridden economy. China is the lynchpin of the emerging market trade, and the US dollar

as well, due to carry positions and capital flows out of the US and into emerging markets. As China slows and

grapples with its economic imbalances, this could severely affect the trajectory of risk appetite as it impinges

upon the major currencies. A weaker EM trade would like be USD supportive. Also USD supportive would be a

significant consolidation in risk appetite in general – something we have yet to see since last summer. Such a

development is overdue. The question, as always, is one of timing.

Alternative Scenario(s): The alternative scenario is that we have an incipient bubble in equities and

particularly in commodities in progress and that we may have reached a point where the market boils over into

a full-blown bubble mentality of price gains feeding further price gains. In this kind of market, all attempts to

fight the trend are futile and this could go on for another one week, one month, or three months. The

persistence in the price action in US equities of late argues in favour of this view. It must be noted that the

climax and reversal off of such non-consolidating rallies is often spectacular, if not fearsome. Until the

EM/Commodity/major equity markets consolidate more convincingly, the USD will have a hard time achieving

any altitude and most of the alternative scenarios below for each currency discuss the potential for the existing

market environment to persist for a time.

Table: Saxo Bank G-10 FX Forecasts

Currency Pair 1M 3M 12M Alternative (1-2M)

EURUSD 1.3000 1.1800 1.1400 1.3400

USDJPY 85.00 89.00 100.00 80.00

EURJPY 111.00 105.00 114.00 107.00

EURGBP 0.8500 0.8000 0.7800 0.8650

GBPUSD 1.5700 1.4800 1.4600 1.5500

EURCHF 1.3000 1.3400 1.3700 1.2400

USDCHF 1.0000 1.1400 1.2000 0.9300

AUDUSD 0.9300 0.8200 0.7500 1.0200

AUDJPY 79.00 73.00 75.00 82.00

AUDNZD 1.2700 1.2600 1.2100 1.3100

NZDUSD 0.7200 0.6400 0.5800 0.7800

USDCAD 1.0200 1.1000 1.1500 0.9600

EURNOK 8.00 7.75 8.00 7.50

EURSEK 9.00 9.25 9.00 8.75

January 18, 2011


Currency Pair 1M 3M 12M Alternative (1-2M)

EURPLN 4.00 4.50 4.75 3.75

USDZAR 7.00 7.50 8.00 6.75

Saxo Bank G-10 FX Outlook

Note that all of the charts below show the currencies versus an evenly weighted basket of the remainder of the

G-10 currencies with an Index of 100 approximately 10 years before the present date. All chart content is

derived from Bloomberg data

USD – US Dollar

In the post QE2 environment of November, the USD saw a relief bounce. Since then the USD

has been largely mixed – still a relatively strong performance as we have also seen a

continued surge in risk appetite, suggesting that the market is giving the rising interest

rates in the US some credibility and that the use of the USD as a funding currency for carry

trades is waning in popularity.

Over the last couple of months, the USD’s behaviour versus other markets has changed drastically. That is at

least partially due to some signs of improvement in US data and a strong move higher in US interest rates all

along the yield curve, a move that has outpaced the moves higher in interest rates in some of the other major

economies, which improves the appeal of the greenback against their currencies. Among the G-3, the USD has

more or less won out in recent weeks as the Euro is mired in yet another spasm of sovereign debt worries, and

the JPY has a hard time maintaining any measure of credibility when interest rates are on the rise.

Still, strong risk appetite has been almost as much of a drag on the US currency as higher interest rates have

supported the currency’s case. (see our monthly look at our Carry Trade Model for more on this) For the

greenback to escape new multi-year lows here, we will need to continue to see an improvement in US

fundamentals relative to other countries, or we will need to see a strong bout of risk aversion that sees the

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January 18, 2011


market unwind still very large outstanding USD shorts. In the past, our outlook has favoured USD strength

through risk aversion, but the merciless charge of the bulls has made that proposition appear hopeless for the

time being. Going forward, however, we wonder how long the market can continue to bid commodities and

equities higher simultaneously, especially in an environment of rising interest rates. At some point, the

pressure of a rise in commodity prices will be felt in margins and in end demand – particularly in the emerging

market trades – many of which are funded in part with short USD positions.

Outlook

We assume the economic trajectory for the US will look better than that of the G-3 and perhaps better than

many other countries as well after the Obama administration primed the pump even further with the extension

of jobless benefits and the payroll tax exemption, not to mention the extension of the Bush tax cuts that would

otherwise have expired. By the same token, those latter measures make us worry about the longer term

prospects for the USD when the federal government has failed to show the least whiff of the kind of austerity

we are seeing Europe attempt (although this is happening at the local and state level in the US by necessity in

many instances). This has us adjusting our USD forecasts for the longer term a bit lower than they were

previously.

Ahead of 2011, we speculated that the Fed would find more dissent within its ranks than it saw previously with

the yearly shuffle in voting member composition. But so far, the rhetoric from two of the expected hawks is far

more cooperative than we imagined, with even Plosser saying that he was all for keeping QE2 on schedule

even though he is not sure that it will help. So the only apparent forces keeping the Fed from moving again to

keep the liquidity gravy train rolling will be the new Congress just convened on Capitol Hill and positive

economic data. Even without major dissent within the Fed, we suspect the political environment will keep the

Fed more sidelined than the market is counting on, even if the US economy proves weaker than currently

expected.

The other major force acting on the USD is the direction of risk appetite – which has only been up, up, up since

last summer. Our assumption is that a more two-way market for risk develops soon at minimum as the market

is getting ahead of itself with interest rates on the rise and margins getting squeezed.

Next FOMC Meeting: January 26

Alternative scenario: the USD makes a serious attempt at its lows for the cycle amid an attempt by the

market to get back on the rally train as the risk bulls and growth Pollyannas talk up global growth prospects

January 18, 2011


EUR – Euro

The Euro dropped to the lowest level vs. a basket of the rest of the G-10 since 2002 before

rallying strongly in the wake of a couple of “successful” sovereign debt auctions from

Portugal and Spain. Has the market priced in too much pain in the short term for the single

currency?

The Euro weakened anew in recent weeks on “Take Three” of the PIGS debt crisis as we have progressed from

Greece to Ireland and now Portugal, which is in the throes of rumors on whether it will also require a bailout

sooner rather than later. While the situation in Euroland looks dire and sovereign debt spreads and default risk

measures are at close to their widest ever, there are a few rays of light for the Euro in mid-January. After very

little progress from EU leadership on addressing the issues back in December, we have a few signs that

Germany’s stance on the idea of expanding the rescue facility is softening. We also have the odd couple of

China and Japan willing to sink funds into the Titanic of PIGS sovereign debt. This will not end well further

down the road (as we discuss below), but the question, considering where Euro is trading in some of the

crosses (particularly EUR/commodity currencies, EUR/SEK, etc.) is how much pain is already priced in and

whether we might have enough positive news in the short term to at least put a floor under the Euro for a

while. Indeed, in the final days of our preparation of this report, the Euro was sharply stronger across the

board. Another round of broad Euro weakness may have to wait another couple of months, depending on the

news flow.

While growth is struggling in Europe at the periphery as austerity measures bite on the need to confront the

public debt situation, the growth in Germany continues to astound – to such a degree that further upside

surprise from current activity levels and survey readings will be hard to come by from here on out.

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January 18, 2011


An intriguing divergence: while German-Irish debt spreads appear somewhat under control

in mid-January as the ECB and possibly China and Japan prop up the debt “market” for Irish

debt, the fear in the CDS market is clearly that the risk of an Irish default remains on the

rise. CDS prices may be a better measure of Euro sovereign debt stress than interest rate

spreads.

Outlook

We continue to expect that the longer term solution for Europe to its sovereign debt challenges – whether it’s a

massive increase in bailout funds combined with new ECB easing, or we see PIGS countries themselves

throwing up their hands and demanding a restructuring of their debt – will mean either easier monetary

conditions in Europe relative to the US or chaos – effectively a lose/lose situation for the Euro regardless of the

path taken. Outside the EURUSD cross, we also expect EURGBP to fall in coming months for the same reason.

But against the more pro-risk currencies, we wonder if most of the downside potential for the short to medium

term is fully priced in. Only a really chaotic scenario for the Euro combined with an extension of this very long-

toothed rally in risk appetite would justify a further stretching of valuations in crosses like EUR/AUD, EUR/NZD,

EUR/SEK and possibly even EUR/CHF.

While the EU leadership may manage to move ahead with a new and bigger bailout package in the weeks to

come (which could give the Euro some very temporary relief), we have to ponder the concrete risk from a Irish

election (possibly as early as late March) and its potential to produce a new government and political process

that aims at throwing the yoke of the Euro and the impossible burden of public debt (much of it bad debts

unwisely transferred from the private sector topped off now with high interest-bearing EU/IMF bailout-related

debt). If the Irish move to default, it is quite possible that the other PIGS countries – and perhaps even Italy –

eventually begin to look at Ireland with envy and consider the wisdom of a EuroZone exit themselves.

Next ECB Meeting: March 3

Alternative scenario: With the involvement of China and Japan in propping up public debt markets across

Europe, the bearish bets on the Euro and its debt are squeezed mercilessly and EUR rallies strongly across the

board in the shorter term.

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January 18, 2011


JPY – Japanese Yen

The JPY is on a road to nowhere, which is actually a fairly strong performance, considering

the degree to which interest rates have risen in the US and elsewhere and the strong

continued rise in risk appetite (mostly concentrated in the US, we must note). The direction

in interest rates may dominate the JPY outlook going forward.

US interest rates rose sharply in late November and into December, but have since range traded – and in

USDJPY this has resulted in a solid bounce off a throwback sell-off toward the 80 level. Elsewhere, the JPY has

largely been a passive participant in the currency market and hardly cut a profile as the market has failed to

find any strong new Japanese theme.

The economic outlook for Japan is not particularly encouraging, with deflation still in full swing while higher

commodity prices and a still fairly strong currency are crimping Japanese profits. With China on a policy

warpath aimed at breaking the back of the inflation threat and the property bubble, the outlook for Japan and

its export economy aren’t particularly encouraging. Unlike the US Fed, which may find itself facing increasing

headwinds on further action from an irate Congress in the coming year, the Bank of Japan would be happy to

throw another log on the QE fire after already having practiced a round of unsterilized currency intervention

and other easing measures. The political environment in Japan is also so shaky that at some point, if the

economy dips again, we can’t rule out more drastic measures. Meanwhile, the debt continues to accumulate on

an already world-beating debt load with no credible program for bringing public sector revenues in line with

costs. When do we get the wake-up call? Credit default swaps on Japanese public debt are rising in price, but

not to a sufficient degree to show up on the market’s radar screen. Watch for this possible eventuality by the

end of this year.

Outlook

Japan’s debt is a time bomb with an unknown trigger date – a date that will move closer if interest rates

continue to rise from here and that will be delayed if interest rates fall again. Higher rates even bring the risk

of a disorderly decline in the JPY under the right circumstances as loss of confidence can be a sudden thing, as

we experienced back in the fall of 2008. In the longer term perspective, the government has soaked up as

much of the country’s domestic savings as it can and new debt will have to be printed into existence or funded

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January 18, 2011


from beyond Japan’s borders. This does not add up to a bullish scenario for the country’s currency. Any

strength in the currency will likely be relatively fleeting, even if we can’t rule out one more sizable surge in the

JPY if we see a government bond rally sometime this year as the world goes into risk aversion mode and

possibly unwinds some of its bets on emerging markets. The repatriation trade could provide a temporary

resuscitation of the JPY before it heads weaker.

Next BoJ Meeting: January 25

Alternative scenario: Bonds make a strong stand while risk appetite shows signs of rolling over into a major

consolidation. This kind of scenario could see the JPY make one more dash to the strong side and USDJPY

headed below its all-time low in 1995 of 79.95.

GBP – British Pound

After dipping yet again to an all time low heading into 2011, sterling has since risen very

sharply, driven by a combination of tighter liquidity conditions perhaps as well as a “good

thing it’s not the EuroZone” mentality. Has the currency finally put in a real low for the

cycle?

The pound was sharply weaker heading into year-end for no particular apparent reason, but has since

rebounded. A couple of possible reasons included far tighter liquidity conditions for the currency relative to

recent moves elsewhere as 2-year interest rates have increased more sharply than for any other currency in

recent months. Some of that has to go down to the apparent tightening in bank credit. As well, the renewed

woes in the EuroZone meant that the pound found strength in the important EURGBP pair. Finally, many of the

new austerity measures are set to take effect this year, and the market is perhaps rewarding the currency for

the government’s fiscal probity. The latter is an important feature missing in the US picture.

On the negative side, the ugly trade balance numbers keep getting uglier and mean that the UK will have to

find a way to attract capital flows to offset such a large trade deficit. After the implosion of the UK financial

services sector and so many of the nation’s banks, will the country ever be able to rebuild what it once had?

These are important questions for the longer haul, as is the question of whether the paradox of savings means

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that austerity measures end up meaning a shortfall in tax revenue and fail to improve the country’s fiscal

imbalances. Also pulling to the negative side are signs that consumers are increasingly negative on the future

and that housing faces gathering declines.

Charting GBPUSD versus the spread of the UK vs. the US CDS prices shows us an interesting

divergence of late – a divergence explained in part by interest rate spreads widening as

well in favour of the UK. The 2-year swap spread favors GBP by almost 90 basis points – the

most since January of 2009. Which development wins out?

Outlook

Our assumption is that the pound will continue to trade more or less in correlation with the USD due to the

similar themes the two currencies face (twin deficits, post bubble banking sector, lower interest rates and

relatively active central banks). The currency may find a tailwind this year due to its very cheap valuation and

as the EuroZone must work its way through a sovereign debt crisis. The highest volatility may be seen in

crosses like GBP/AUD and GBP/NZD if the commodities rally comes undone at some point during the year. If

risk aversion strikes especially hard, however, the pound will have a hard time keeping up with the US dollar.

The currency is entering an important period as the world waits and watches to see how deeply austerity

measures, tighter control of bank credit, and a rise in the VAT affect the country’s growth and markets.

Considering where the currency is coming from, it is tough to find a downside scenario unless the wild global

bullishness continues unabated or the sovereign debt theme becomes applied more generally.

Next BoE Meeting: March 10

Alternative scenario: Wild bullishness keeps up a head of steam, which sees the market looking elsewhere

for better yield.

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January 18, 2011


CHF – Swiss Franc

The Swiss Franc saw a spectacular spike into year-end with the renewal of the EuroZone

PIGS and EURCHF selling as well as USDCHF selling, possibly on the fiscal profligacy of the

new stimulus measures from the Obama administration. But the franc has started the year

on a very weak footing – perhaps due to excessive valuation and higher interest rates

elsewhere moving against the franc’s favour?

The Swiss franc outperformed until the beginning of the year, when it went from profound strength to profound

weakness. Some of the move lower was in the days before this report, when the Euro was also surging, as the

CHF seems to trade as a kind of anti-Euro, trading exceptionally weak when the Euro is strong and vice versa.

That “Anti-Euro” trade seems to be the main theme going for the franc, though we wonder if some measure of

its weakness in the beginning of the year may be on the realization that it yields virtually nothing and interest

rates and commodity prices have been heading higher, giving it the appearance of a tempting funding

currency. Also, at some point, a currency’s strength becomes an economy’s weakness, particularly an economy

that is highly reliant on exports.

Outlook

The highs may be in now for the Swiss franc versus the broader market. While another round of the Euro crisis

could potentially see the EURCHF pair to new lows, we have technical signs of trend exhaustion in the crosses

like USDCHF and GBPCHF, which may have now put in significant lows. For EURCHF, the move back higher (a

couple of days before this report was published) through 1.2765 is promising for those looking for a reversal,

though eventually the pair needs to work north of the 200-day moving average (currently around 1.3475) as a

stronger indication that the franc’s strength is fading against the single currency as well.

The Swiss government has expressed profound concern about the level of the currency’s strength, though

recent history suggests there is little the government can do about it as the market has overwhelmed previous

attempts by the SNB to manage the currency. Rather, the natural forces of the market may be the only thing

that can see the franc weaker in the months ahead. It’s behaviour certainly seems to suggest that it is far from

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January 18, 2011


being the safe haven currency of yore – we suspect that any potential for risk aversion will do little to help the

currency in coming cycles.

Next SNB Meeting: March 17

Alternate scenario: EURCHF collapses back towards the lows on renewed PIGS sovereign debt worries and

CHF heads to a new high versus the G-10.

AUD – Australian Dollar

The Aussie outdid itself with a new all-time peak right at year-end. But with the transition

to the New Year, the currency is struggling from a batch of weak data and a flooding

disaster. Has the miracle currency had its last hurrah?

AUD defied gravity yet again, riding the enthusiasm for precious metals and other industrial commodities and

risk appetite into year-end. The currency touched a new multi-decade high against the USD and the EUR. A

good portion of the strength has faded since the beginning of the year, however, as commodity market

performance has turned patchy, but also as a number of Australian economic activity surveys (the AiG surveys

for Manufacturing, Services and Construction) suggest a strongly slowing non-mining economy. Finally, after a

string of very positive employment reports, the December employment report showed virtually no payroll

growth.

The catastrophic Queensland floods are a one-off development that risk warping data both ways in coming

months (to the downside due to interruptions and then possibly some measure of upside activity down the

road on rebuilding). The worst damage besides the immediate human and residential costs are that key mining

areas for coal and iron ore have been affected. This could even have implications for Chinese growth if coal

prices spike further as the country is a huge consumer of these Australian imports.

On the housing front, which is one of the country’s main vulnerabilities (outside of potential for commodity

price drops), activity remains sluggish with very high, but stagnating prices, a classic sign of a peaking market.

The RBA has been removing accommodation for 15 months now and may nudge the rate to 5.00% at its

February meeting.

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January 18, 2011


Outlook

After the ramp up into year-end and subsequent drop (the most significant drop in the Aussie since last

summer), it appears we have a significant area of resistance for the currency. We can buttress this argument

with clear evidence that yield expectations for Australia are beginning to underperform a majority of other G-

10 currencies.

Going forward, there are two main threats to the Australian economy: a correction in commodity prices, which

is inevitably a question of Chinese demand, and the threat of an unwinding in the Australia housing bubble,

which by itself could see the country’s banks in sufficiently dire straits to require the RBA to change course

(and if the RBA does not change course, it could be because of high inflation elsewhere, making the threat one

of sharply inferior growth). Either way, the currency is still priced for perfection, and only a sharp renewal in

commodity prices and risk appetite would see the AUD making another ascent to the strong levels at which it

closed 2010. (We argue elsewhere in this publication that at some point not terribly far from where we are now

in energy prices in particular, a rally in both commodities and risk appetite are incompatible on the implications

for margins from cost-push inflation).

In China, authorities are concerned about recent inflation rates and are cracking down on credit and bank

reserve requirements, both to cool inflation and the risks of a housing bubble (too late, actually, but zero cost

of carry on Chinese apartments and local officials neck deep in a personal financial interest in keeping the

bubble alive will make the price discovery mechanism very tricky indeed). The Chinese regime is also

concerned with keeping their economy growing strongly at all costs and shifting growth over to the consumer,

which it will be hard pressed to do with consumers handing over an increasing percentage of their earnings to

food and rent. Australia trades like a China derivative in many ways.

Next RBA Meeting: February 1

Alternative scenario: The goldilocks scenario for Aussie continues and it has another go at its highs as

natural resource prices arch higher again.

January 18, 2011


CAD – Canadian Dollar

The broad comeback in CAD faltered somewhat just ahead of this report, perhaps as the

rally in the US dollar also failed to follow through by mid January. The currency may keep

its weak correlation with the USD, outperforming other commodity currencies when the

USD is strong and underperforming when the USD is weak.

The fundamental position of the Canadian currency looks rather strong, with its strong mix of commodities

(energy in particular) in an environment of strong commodity price increases and with the much touted

“world’s most solid banks”. These qualities as well as the improvement in some of the US data has seen the

currency tracking generally higher for the last few months versus the broader market, though it has seen a bit

of a swoon by mid January on the spike in European currencies after the January ECB meeting. Against the

USD, the currency was able to take out the parity level and USDCAD remained below that psychological

threshold for a number of days ahead of this report. An additional factor in favour of the currency includes the

pro-business plan to ratchet corporate tax rates lower in coming years, already starting this process with a

drop in corporate tax rates to 16.5% this year from 18%. Compare that to 35% in the US.

While most factors look positive for Canada and its currency if current conditions continue, particularly if crude

oil prices can rally and stay above 100 dollars per barrel, we are concerned about a number of factors that may

see the currency lower versus the USD and other currencies in coming months. Eventually, the commodity rally

will become self-correcting on the destruction of demand from higher prices (and we are particularly concerned

about China’s potential for a rough ride in coming months as authorities there try to engineer a soft landing).

In addition, while the Canadian government has been very prudent since its fiscal crisis of the 90’s and its

public debt loads are very modest by US and other standards, the private sector in Canada is the world’s most

leveraged, as a housing bubble has taken house prices into extremely unaffordable territory and private debt

loads are very heavy from housing and other types of consumer credit. Any bump in the road on real estate

prices and suddenly the “world’s most solid banks” will appear far less sturdy. It is remarkable that the housing

market is already showing signs of topping out and correcting despite Canadian interest rates having only been

hiked to 1.00% . On the downside of a housing bubble, this also shows how little easing the BoC will have to

work with compared to the US, where the Fed was able to drop rates 500 basis points to ease the pain. (In the

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January 18, 2011


day head of this reports publication, the government announced important new measures aimed at reducing

mortgage credit and we are reminded that the CMHC is much like the US’ Fannie Mae, meaning that price

declines on the order of those in the US after its housing bubble could suddenly make the entire country’s

balance sheet look completely different in a year’s time).

Outlook

Previously, we expected that the Canadian dollar would be unlikely to trade as a particularly high beta currency

on the expectation that it would tend to follow the lead of the US dollar. But the extreme swings in the Euro

and a sudden reassessment of Canadian fundamentals in light of the continued strength in risk appetite and

commodity prices has seen plenty of volatility and USDCAD has headed below parity again.

We would still expect that the Canadian dollar has more middle-of-the pack potential going forward: it’s

overvaluation versus the market is less stark than that for Australia (AUDCAD shorts are an interesting idea on

this theme and have shown a lot of traction over the last month) and its exposure to China is far less direct,

but an eventual correction in the bubble-like commodities markets (an eventual expectation) would weigh

heavily on the currency, as would the threat of an unwind of the country’s housing bubble. The market is

expecting more than 80 basis points of tightening from the Bank of Canada – so if conditions fail to continue to

improve to the degree expected, USDCAD’s stay below parity could prove a short one.

Next BoC Meeting: March 1

Alternative scenario: Oil goes to 110 dollars a barrel and the market believes that this won’t lead to any risk

of a slowdown as CAD rallies sharply across the board.

NZD – New Zealand Dollar

NZD has pulled higher once again versus the broader market on still buoyant expectations

for RBNZ rates and the commodities (particularly food commodities) rally has helped boost

the currency. But should we really be closing in on an all time high for the currency

considering the potential risks out there?

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January 18, 2011


The kiwi had a roller coaster ride since our November report – weaker for a time perhaps on the New Zealand

drought and a muted view on the potential for the RBNZ to hike going forward, but then stronger as

commodity prices – and particularly milk prices - have rebounded strongly and risk appetite has maintained a

strong head of steam in to mid January. AUDNZD flows may have also heavily influenced the currency’s overall

level, as a strong new high in that pair in December above 1.35 was roundly rejected as Australia hit a few

speed bumps to start the year.

The domestic economy is not performing particularly strongly, but the market may not be focusing much on

the basic growth data as it is on commodity prices – particularly for foodstuffs, which have risen to high

enough levels to trigger riots in some food insecure countries like Tunisia and Jordan. This may mean that the

currency is becoming a bit one-dimensional in its behaviour and may correlate with food commodity prices

going forward – for better or worse. Elsewhere in the economy, house prices are in a persistent, if slowly

grinding, downtrend, and could continue to weigh on growth, as will the currency’s strength.

Outlook

NZD and AUD look overvalued, but both will require a more persistent correction in risk and perhaps on top of

that, signs of a real slowdown in China before any lasting sell-off can develop. In the kiwi’s case, a slowdown in

key food commodity prices will also be a necessary component of a further search for lower valuation. We

stated back in mid-November that “the NZD may act as a kind of lower beta version of the Aussie – the one G-

10 currency it is likely to appreciate against if risk appetite/competitive devaluation trades beat a hasty retreat

due to the Aussie’s poster child status in this market” Since then, the NZD weakened a bit against the Aussie

into December, but then came storming back due to problems special to Australia, but also possibly because of

the increased focus on food prices, which are so important in New Zealand’s export mix. From here on out,

NZD may continue to outperform the Aussie for the same reason. Elsewhere, the currency is overvalued and

may be set for a fall once food prices hopefully revert back to the mean.

On the interest rate front, the RBNZ is clearly uncomfortable with the strong currency and complained strongly

about it strength preventing a “rebalancing” of the economy back toward stronger exports. As long as the

currency continues to see the kind of strength we have seen lately, the bank is unlikely to change its tune

much on a cautious approach to further rate rises, and if rate expectations head lower (regardless of the

currency level), that would likely only be on fears of slower economic growth generally, usually a kiwi-negative.

Next RBNZ Meeting: January 26

Alternative scenario: Food prices continue to ratchet higher and equity markets arch to new highs, taking

NZD to a marginal new high versus the rest of the G-10 currencies.

January 18, 2011


NOK – Norwegian Krone

The Norwegian krone greeted its new central bank chief (who took office at the first of the

year) with its weakest levels since late 2008, but the currency has since rallied on the

strength in crude oil prices and renewed projections that the Norges Bank leadership may

move again to raise rates.

The Norwegian krone finally bottomed out around the time of our last report and has been generally stronger

since then. The persistent rise in oil prices back to 90 dollars per barrel has been the critical factor in that

renewed strength, as well as perhaps a focus on its solidity relative to the fragility of other European

sovereigns at the EuroZone periphery. Important as well, interest rate expectations from Norges Bank have

moved from a near complete lack of expectations for the last several months to now looking for slightly more

than 50 basis points of tightening in the coming 12 months. The expectation is that strength in the economy

and the continued risk of overheating in the housing market will mean that Norges Bank may raise rates

despite EURNOK trading close to its lowest levels of the last five years (in the past NB chief Olsen has stated

that the currency’s strength or weakness would be instrumental in setting interest rate policy. Watch the next

Norges Bank meeting for any follow up on that rhetoric or lack thereof.)

Outlook

Now that the Norwegian krone has rebounded from levels we considered undervalued the last time around, our

outlook is a bit more neutral. We are still generally positive on the currency as the only significant downside

scenario for the krone is a market in which risk appetite and commodity prices are collapsing in an absence of

sovereign debt worries. Such a scenario will be difficult to come by in this world of enormous debt public debt

burdens. On the upside potential, we have to consider what happens if oil goes to well over 100 dollars per

barrel.

Perhaps the most interesting scenario for NOK is an investment environment in which the market worries about

sovereign credit ratings again, in which case NOK has few peers. At the extreme, an out-and-out global

sovereign debt crisis could mean that JPY and NOK become the two poles of the G-10 universe - NOK on the

strong side and JPY on the weak.

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January 18, 2011


We reiterate our view that long NOK versus the most overvalued corners of the market – particularly Aussie,

but possibly also NZD and SEK, could be an interesting way to trade relative valuation. We mentioned this idea

two months ago and the NOK was weaker still against these currencies into December but now seems to have

turned the corner – quite significantly in the case of AUDNOK. NOK still looks relatively attractively valued

versus the pro-risk currencies almost regardless of whether things turn out well or poorly down the road.

Next Norges Bank Meeting: January 26

Alternative scenario: oil accelerates to well over 100 dollars per barrel and the market starts to heavily

favour any currency with a positive correlation with energy prices.

SEK – Swedish Krona

The krona was back on the up-and-up with a steady stream of robust data, a central bank

that continues to hike rates, and on renewed Euro woes. As well, the krona’s general

positive correlation with risk appetite has seen the currency remain relatively strong while

major global equity markets have been very strong. But is it reaching the top of its

potential against the rest of the major currencies?

After a period of consolidation against the broader market late last year, the krona regained its legs and has

rallied back towards its 2010 highs against the rest of the G-10 currencies. Against the very weak Euro, the

currency touched its strongest level in almost 10 years. The country is in a remarkably strong position relative

to the weaker countries of the EuroZone periphery and almost has the fundamentals of booming Germany, but

with better demographics and lower debt levels. Also, the Riksbank is looking to continue its hiking ways due

to the strength in the economy and in housing prices in particular.

Outlook

Everything looks great for the Swedish krona at present, but this is more or less fully priced into the currency

now that it has rallied back to the top of the longer term range – particularly in light of its valuation against the

Euro, which is at longer term highs. Down the road, the risk of a weaker European economy has to rate as one

of the larger risks to continued strength in the currency due to potential implications for the exports.

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January 18, 2011


Eventually, as well, the country will need to confront its housing bubble, though the question is how much

more accommodation (or alternative policies aimed at clamping down on credit related to real estate

purchases) will need to be removed before this really bites into home prices. Another potential overhang is the

selling of the country’s currency by the Swedish National Debt Office, which acquired billions of SEK in an effort

to smooth the currency’s decline during the 2008-09 crisis. The currency will likely find a more permanent top

around the time the Euro finds a bottom and/or when risk appetite goes at least sideways and stops its

seemingly ever-upward spiral.

Next Riksbank Meeting: February 15.

Alternative scenario: if Europe manages to stave off sovereign debt worries for another quarter or two and

equity markets fail to blink, the currency could post new highs versus the rest of the G-10 currencies before

fading again.

January 18, 2011


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