Currency Insights - April 2014 Issue

CURRENCY INSIGHTS Foreign Exchange Forecast and Analysis

April 2014

Not Out of the Cold Yet

Sluggish economy slow to rebound from a harsh winter

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CURRENCY INSIGHTS April 2014

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08

CAD

USD

The Fed continues to determine the relative value of the Dollar

The Loonie experiences downward pressure that has intensified as Q1 comes to a close

19

10

EUR

12

With fears of a Eurozone breakup now a distant memory and even the political landscape stabilizing, the Euro should be nowhere near as volatile as it has been in previous years

GBP

It is imperative for the Chancellor to pay close attention to the UK debt and current account deficit

13

CHF

The key risk to a weaker CHF in 2014 scenario are global growth concerns particularly from the US and China

14

SEK

As a smaller export based economy, Sweden’s success is based on global themes

Emerging Markets

As we begin the second quarter of 2014, a different mindset is beginning to creep in. With the taper upon us, emerging markets are experiencing capital flight

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Global Market Themes Yellen’s announcement that the Fed will likely begin to increase its benchmark interest rate by the middle of 2015 will not only have a lasting effect on the US Dollar but also ripple effects throughout the global currency markets

IN THIS ISSUE 15

NOK

The Norwegian Kroner enjoys a positive start to the new year

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JPY

The BoJ will have to become more accommodative towards monetary policy by the end of Q2

AUD

The Aussie Dollar hinges on a variety of economic factors including the RBA monetary policy, and the end of a mining investment phase as well as the concerns over China’s economic growth

18

NZD

RBNZ tightening is the sign of a tough quarter ahead that will see the NZD dip

20

BRL

In South America’s most populous economy, selling pressure on the Real is beginning to subside

13 12

CNY

A surge in crossborder arbitrage forced more money in China which has driven the value of the Renminbi up by more than 42%

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08 15

21

18 17 06

16 20 3

CURRENCY INSIGHTS April 2014

GLOBAL MARKET THEMES - Mark Frey, SVP Sales and Trading, Chief Market Strategist

Janet Yellen now sits upon the Iron Throne that is stationed at the head of the Federal Reserve Board and Open Market Committee, and if I continue with the analogy between the Fed and HBO’s hit show, Game of Thrones, the winter of contractionary monetary policy appears to be coming and it will indeed be a long one.

Though the market had expected the incoming Fed Governor to be almost unfailingly dovish in her policy decisions, Yellen managed to surprise more than a few market participants by somewhat boldly proclaiming that the Fed will likely begin to increase its benchmark interest rate within 6-months after winding down its asset purchase program. In our USD outlook in the pages ahead, we detail our views on Fed policy going forward and how it will have a lasting effect in terms of supporting the Big Dollar for years to come.

Now that the Fed is set upon a path of finally pushing USD yields higher, the trillions of dollars chasing carry

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will have to find a new funding source. Luckily for hedge fund managers the world over, the ECB and BoJ are not only moving to continually more accommodative policy stances, but they are both ideally looking for weaker local currencies to spur inflationary pressures as well. This is the type of set-up that trend following currency traders look for: an opportunity to sell or borrow a low yielding currency, buy or invest in a high yielding currency or asset (equities anyone?), with the spot price action likely to mirror the transaction flow for a sustained period. A weaker Euro and Yen would suit their respective central bankers and governments just fine, and traders will be more than happy to oblige them for every basis point that they can harvest.

Emerging markets are in turmoil. One media headline that garnered a great deal of attention over the past few weeks is that BRIC now stands for Basket Case, Ruffian and Inflation Central. Even China, the once

CURRENCY INSIGHTS April 2014

seemingly infallible engine of global economic growth is looking tired of carrying the world’s economy on its shoulders. Indeed, Chinese policy makers are now even starting to sound like those from the developed world, qualifying every growth and employment forecast and speaking more in terms of fuzzy objectives as opposed to their traditionally specific targets.

Downside risks abound and the global economy needs someone else to carry the torch.

“

...should the world’s largest economy fail in this quest, it will be a very long economic winter indeed for us all

That notion brings us back, full circle, to the USA. Once the engine of debt fuelled global economic growth for the better part of three generations before sagging under the weight of its spending excesses, the U.S. is once again likely in the best position to be the world’s driving economic force. That said, should the world’s largest economy fail in this quest, it will be a very long economic winter indeed for us all.

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CURRENCY INSIGHTS April 2014

USD

- Mark Frey, SVP Sales and Trading, Chief Market Strategist

To almost no-one’s surprise, the ruling by the IRS dictating that Bitcoin should be taxed as an asset, similar to any other “investment” security, failed to generate a material bounce in the USD. Not because the ruling doesn’t materially erode the fundamental argument that Bitcoin is a long term challenger to the Greenback’s role as the world’s currency – it certainly does. The ruling failed to deliver more than a ripple in financial markets because the alternative form of payment just became even more irrelevant as both an asset (store of value, medium of account) and a medium of exchange.

What matters in terms of determining the relative value of the Dollar is the Fed. One might say it is almost all about the Fed and its future policy path as the central bank’s grand experiment, with respect to extraordinary balance sheet expansion, quantitative easing and sustained near zero benchmark interest rates, finally begins to wind down in earnest. While we now have some reasonable clarity from the incoming Fed Governor with respect to not only the pace of tapering but the timing of rate increases as well, there are still many uncertainties looming on the horizon that will have profound implications for markets across all time horizons.

Janet Yellen has affirmed the Fed’s preference for “tapering” its asset purchases by $10B USD per meeting. She has also now indicated that the Fed will likely be looking to move its benchmark rates higher within 6-months of winding down new asset purchases, meaning that rates should begin to creep up in a little more than a year’s time. That said, both items have clearly been communicated with updated forward guidance, reiterating that the Fed’s path is not set in stone and will be altered as financial conditions require, thus ensuring the economy continues to grind its way back toward full employment growth and the 2% inflation target.

What still remains unclear, and what financial market participants have yet to veer their attention towards, is how and when Yellen and company intend to right-size or shrink the Fed’s balance sheet from the bloated, post-

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QE version before us today. Remember, the Fed is now tapering or slowing the pace of new asset purchases, but it is still rolling over all of the paper it has acquired since the onset of QE as it comes due in an effort to suppress longer-term rates. Thus, the monetary contraction with which markets will be contending becomes three-fold, in that the taper (and subsequent rate increases) will at some point have to morph into disposal of Federal Reserve controlled assets, thus marking the beginning of truly unwinding the greatest monetary policy experiment in history, for which we have no true precedent in terms of understanding the potential impacts.

With this in mind, monetary conditions and therefore money supply is set to constrict very materially over a number of years, not months, in all likelihood.

While a good portion of the initial process related to tapering and rate increases has been priced into the Greenback’s strength as of late, the fact that there will be fewer Dollars sloshing about the liquidity pool will be fundamentally supportive for the Big Dollar in years to come as the Fed’s balance sheet contracts.

In this context, the current bout of relative strength of the dollar, driven by moderately improving economic performance and the notion of monetary contraction, will likely remain in place for much longer than what’s currently being priced by the market.

CURRENCY INSIGHTS April 2014

“

USD daily

…it is almost all about the Fed and its future policy path as the central bank’s grand experiment…

80.9000 Q2

81.2500 Q3

Expec te

d Targ

et

82.5000 Q4

Economic Indicators

2.6

1.1

GDP

Inflation

6.7 Unemployment Rate

0 - 0.25 Central Bank Interest Rate

7

CURRENCY INSIGHTS April 2014

CAD

- Scott Smith, Senior FX Trader and Market Analyst

There has been little in the way of reprieve for the Loonie in 2014, with downward pressure on the Canadian unit intensifying as Q1 comes to a close.

Although the Canadian economy finished 2013 on firm ground, sluggish business investment and lackluster export expansion will see GDP growth retrace somewhat, keeping the Bank of Canada in a neutral stance unwilling to close the door on the potential for rate cuts. While consumer debt levels and elevated housing prices in certain areas of the country have not deflated to levels that, in our view, would support an additional rate cut, Stephen Poloz’s persistent references to the downside risks for inflation have pushed back expectations, sending the Loonie to four-and-a-half year lows. Running in conjunction with a more dovish BoC than we saw under the direction of Mark Carney, the Federal Reserve continues to push ahead with the unwind of their monthly asset purchases, while at the same time, ratcheting up forecasts as to when interest rates in the United States will begin to rise. The timeline delineated by Janet Yellen at her first FOMC press conference suggests that interest rates could begin their climb as early as mid-2015, making it plausible for the US to inaugurate a tightening of policy ahead of their neighbours to the north. The widening divergence in monetary policy prescriptions has led yields on the long end of the curve in the US higher, diverting capital flow from Canada to the US and battering the Loonie in the process.

While the direction of monetary policy in the US has influenced price action in USDCAD, the upward momentum of the pair is more to do with domestic weakness than USD strength. Over the past sixmonths the CAD has been the notable laggard in the developed currency space, with sentiment turning sour upon the realization that the domestic consumer will not be able to perpetually drive the economy. Canada’s export sector has showed only a slight improvement as of late, with the trade balance continuing to print in deficit territory going back all the way to the middle of 2012 (minus a small foray into a surplus for March of 2013). In addition, competition in the retail sector has kept a lid on prices, with excess

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slack in the economy forcing inflation to bounce along the bottom-end of the BoC’s target range.

Adding salt to the wound, the steady depreciation of the CAD has done little to boost foreign demand and stimulate growth, raising concern there are deeper structural issues holding the economy back.

As such, there is likely more pain on the horizon for Loonie bulls, with the economy muddling along until global growth can find its footing and Canadian exports are finally revived. The rebound in Canada will be driven largely by the speed of the recovery in the United States, with the spillover effects, facilitating a predicted rebound in the Loonie late-2014 and into early-2015.

“

The Federal Reserve continues to push ahead with the unwind of their monthly asset purchases…

CURRENCY INSIGHTS April 2014

CAD daily

1.1475 Q2

1.1350 Q3

Expec te

d Targ

et

1.0900 Q4

Economic Indicators

2.9

1.1

GDP

Inflation

7.0 Unemployment Rate

1.0 Bank of Canada Rate

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CURRENCY INSIGHTS April 2014

EUR

- Darryl Hood, Options Dealer

The latest decision by the FOMC to reduce their monthly bond buying by $10 billion USD to $55 billion USD, the third such cut in the last four months, has seen the Dollar strengthen against the Euro, and incidentally most of its peers during March 2014, and this trend should continue throughout the year. The question is: to what extent? Let’s look at the Eurozone for answers…

EUR daily

The recent Italian GDP figure of 0.1% ended a recession which started in 2011, and the French GDP and Eurozone GDP both recorded 0.3% growth, having been in a recession nine months prior. But what of the powerhouse that is Germany, on which all Eurozone hopes appear to be pinned? It has experienced a similarly anaemic expansion of 0.4% and in fact it’s been three years since the German GDP figure exceeded 1%.

Recent Manufacturing and Services data shows there is a general improvement but Germany’s star is on the wane. The concern for having one country carry an entire economic union would appear to be fading and the contribution is becoming more balanced. However, can the Eurozone really grow in line with its peers if Germany is floundering and what does it mean for the recovery?

Eurozone unemployment has stabilised at 11.9% but is still struggling to decrease and there are now fears of disinflation with the recent CPI YoY figure at 0.5%, far below the existing 2% target. With fears of a Eurozone breakup now a distant memory and even the political landscape stabilizing, the Euro should be nowhere near as volatile as it has been in previous years, however, the prospect of negative overnight deposit rates remain and would appear to be the only tool in Draghi’s kitbag for 2014, should he choose to use it.

10

1.3550 Q2

1.3300 Q3

Expec te

d Targ

et

1.3200 Q4

Economic Indicators

0.3 GDP

1.2 Inflation

11.9

0.25

Unemployment Rate

ECB Rate

CURRENCY INSIGHTS April 2014

Contrast this with the semi-aggressive unwinding of bond buying in the US and the expectation of interest rates rising in 2015 and the call for EURUSD is lower as the year goes on. The rhetoric of the Fed Chair will never have been listened to quite so intently.

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‌the Euro should be nowhere near as volatile as it has been in previous years...

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CURRENCY INSIGHTS April 2014

GBP

- Jason Conibear, Director – Sales and Trading

Sterling’s performance during the early weeks of Q1 carried its momentum from Q4 2013, eventually reaching north of 1.67 by mid-February against USD. This continued GBP strength was exacerbated by strong UK and less than certain US data releases during the period. The UK’s housing market continued to accelerate, especially in the more affluent South East of the UK, partly driven by the controversial government backed “…Sterling weakened “right to buy” from its mid-February deposit guarantee highs back down to scheme, further below 1.65 for the first time since the beginning underlining the detractors view of the year.” that a housing price bubble could be imminent. However, at the same time, further consecutive monthly falls in the unemployment levels led to speculation that an earlier than expected rate rise was a possibility. The Bank of England governor, Mark Carney, was forced to quickly release a statement disconnecting the rate of unemployment from the BoE forward guidance policy.

As Q1 drew to a close, the UK 2014 budget was announced by the Chancellor, George Osborne. With the UK general election due next year, this was widely regarded as a political rather than an economic budget with major benefits for savers and the retired prior to the expected interest rate increases slated for spring 2015. The tone of the Chancellor’s speech however was considered by the markets to be somewhat sombre as he highlighted that the UK’s strong performance and growth over the last three quarters have been unbalanced, primarily driven by consumer spending from debt as well as a suspected South East employment and property boom.

While the UK was delivered this reality check, Sterling weakened from its mid-February highs back down to below 1.65 for the first time since the beginning of the year. This move was further accelerated by a strengthened Dollar helped by the announcement from New Fed Chair, Janet Yellen, that despite the weaker than hoped for economic data from the U.S, there would be no change to the Fed tapering policy.

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As we approach Q2 it will be imperative for the Chancellor to pay close attention to the UK Debt and current account deficit. UK debt is currently at an unsustainable level of over 88% of GDP and still climbing. This is one of the highest debt levels of any of the developed nations and is neutralizing much of the positivity emerging from the UK. Should this situation remain unchecked in the medium to longer term, Sterling will continue to pay the price and further move from the mid 1.60’s to key support levels at 1.6250; 1.60 and beyond could be a very real possibility.

GBP daily

1.6250 Q2

1.6000

Q3 Exp ected Targe t

1.5800 Q4

Economic Indicators

0.7

1.7

GDP

Inflation

7.2

0.5

Unemployment Rate

Central Bank of England Rate

CURRENCY INSIGHTS April 2014

CHF

- David Starkey, Options Dealer and Senior Market Analyst

The Swiss Franc has remained resilient in the early stages of 2014 and in fact was one of the best performing currencies over the period. Previously expectations had been for the Swiss unit to capitulate at the beginning of the year, as capital flight out of emerging markets ran its course and American monetary policy signalled global economic “Domestically, deflation optimism. This failed in Switzerland remains a to materialize however concern…” as economic jitters out of China and more recently tensions in Ukraine, fuelled persistent ‘risk-off’ trading. In addition, weather related economic setbacks in the United States, though seemingly transitory as it turns out, supported the CHF. Action over the last few months doesn’t change the outlook for this currency but rather only postpones it.

In light of the most recent US Federal Reserve meeting we may finally be seeing a turning of the tide as far as Swiss Franc values are concerned. Projections and comments from Fed policymakers suggested that the world’s largest central bank is on pace to hike interest rates in mid-2015, both pushing up previous expectations of a late-2015 hike and giving a degree of certainty to policy expectations that didn’t previously exist. This lends to the notion that investor confidence and desire for yield will draw interest away from the Franc. Generally speaking, in much the same way that the CHF was amongst the best performers in time of tension, it is set to suffer worse as the global economy picks up steam.

Domestically, deflation in Switzerland remains a concern, following last year’s -0.2% CPI, expectations for 2014 put CPI at +0.8%. As such, the Swiss National Bank (SNB) is unlikely to abandon its dovish stance and accommodative policies—the current benchmark interest rate is effectively 0%. Furthermore the SNB is unlikely to change the EURCHF floor, which given the constraints of a 0% interest rate environment, remains one of the best ways to keep Swiss goods competitive on the global stage. All of these factors again point to a weaker Franc in 2014.

As it was in late 2013, the key risk to a weaker CHF in 2014 scenario is persistent global growth concerns, particularly from the United States and China. However returning to the base case, investor sentiment, continuing accommodation from the SNB, and tightening from the US Federal Reserve are positioned to drive the USDCHF higher, back toward 2013 highs in the 0.94 handle.

In line with previous forecasts EURCHF is positioned to move back to the mid-1.20s, driven by the relative underperformance of the USDCHF versus the EURUSD.

CHF daily

0.9100 Q2

0.9400 Q3

Expec te

d Targ

et

0.9600 Q4

Economic Indicators

1.7

-0.2

3.45

0.25

GDP

Inflation

Unemployment Rate

Swiss National Bank Rate

13

CURRENCY INSIGHTS April 2014

SEK

- David Starkey, Options Dealer and Senior Market Analyst

The Swedish Kroner underperformed its primary cross, the Euro, in Q1-2014. This was driven by broader Euro strength and low domestic inflation, which led to a more dovish Swedish central bank (Riksbank). The Kroner however outperformed the Greenback over the same period as a function of concerns that the American recovery might have been derailed by extreme winter weather.

Low core inflation remains the key headwind facing the Swedish economy in 2014. As such the Riksbank is expected to maintain its current benchmark interest rate of 0.75% through the end of the year, and perhaps even loosen policy if exports don’t pick up as forecasted in the latter part of 2014.

The primary factor influencing the inflation outlook is weak external demand for Swedish exports, which has resulted in excess domestic economic capacity.

The softer exports have also manifested in a weaker current account balance, which dropped 7% yearover-year to SEK 49.2-billion in Q4-2013. As a smaller export based economy, Sweden’s success is based on global themes. With that in mind and in line with general market consensus, as the global economic recovery picks up momentum towards the end of 2014, it should lead to incremental growth in demand for Swedish exports. This in turn should help address the country’s economic slack and thereby drive inflation, which printed +0.4% in February 2014, towards the Riksbank’s +2.0% target.

“…elevated export demand coupled with anaemic economic expectations for the Eurozone position the Kroner for gains against the common currency…”

Off of charts, elevated export demand coupled with anaemic economic expectations for the Eurozone position the Kroner for gains against the common currency through the balance of 2014. Key EURSEK support levels to be aware of are the January & February double bottom at 8.7600 and the Q4-2013 low near 8.6000. In light of recent data, as well as March’s Federal Reserve activity, the weather issue that defined USD action in Q1-2014 doesn’t look

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to have any legs. As such, the Greenback is broadly expected to rally against the market, the SEK included.

This could lead the USDSEK back towards the Q42013 high of 6.6500 this spring.

The primary risk to the base case comes from external factors, namely if the global economy stagnates and the forecasted pick up in export demand doesn’t materialize. This is particularly true for the EU and USA, which account for about 65% of Sweden’s exports.

SEK daily

6.5200 Q2

6.6500 Q3

Expec te

d Targ

et

6.700

Economic Indicators

Q4

3.13

0.4

8.5

0.75

GDP

Inflation

Unemployment Rate

The Riksbank Rate

CURRENCY INSIGHTS April 2014

NOK

- David Starkey, Options Dealer and Senior Market Analyst

The Norwegian Kroner has performed well in January and February, taking ground from both the American Dollar and the Euro on the back of a rally in commodity prices, specifically hydrocarbons. Oil products are Norway’s main export, making up approximately 65% of total outgoing trade. Salmon prices, Norway’s other key export (fish products make up nearly 5% “…the Norwegian unit of Norway’s exports), is stronger now than it have also rallied in Q1was at the beginning of 2014. In fact, Salmon the year.” prices reached new all-time highs in January 2014, contributing meaningfully to Norway’s trade surplus as well as strength in the NOK. March however saw oil prices give back, leading the Kroner to do the same, though when the dust has settled, the Norwegian unit is stronger now than it was at the beginning of the year.

After a mixed 2013, domestic economic data has been constructive during the first part of 2014. While inflation last year posted near target at 2.1%, GDP was disappointing at 0.7%. 2014 on the other hand looks positive. All else equal, markets anticipate Norwegian GDP accelerating to 2.5% in 2014, while inflation is expected to remain stable at 2.0%. This scenario is a product of expectations that commodity prices will be supported at current levels by resurgent global demand.

Given the domestic growth outlook, expectations are that Norges Bank, the central bank of Norway, may tighten monetary policy with a 0.25% rate hike in the second half of 2014.

seems likely to rally in 2014 driven by a less dovish Federal Reserve in the United States. Both the repricing of Federal Reserve rate expectations in light of the most recent policy announcement and an expected end to its massive quantitative easing program this autumn point to a stronger Greenback in the balance of 2014. Despite strong commodity prices, renewed interest in the Greenback, via interest rate speculation, could see USDNOK push back towards 6.1500 in the coming months.

NOK daily

6.1500 Q2

6.2100 Q3

Expec te

Elevated commodity prices and the possibility of tighter monetary policy on the part of Norges Bank versus continued dovish sentiment from the European Central Bank positions the Norwegian Kroner to outperform the common currency in 2014. This could drive EURNOK back down to 8.2000 in Q2-2014 and 8.0500 by the end of the year. The primary risk to this scenario is the possibility that global growth deteriorates. This would weigh on oil prices, which in turn would likely obstruct possible gains for the Norwegian unit.

Economic Indicators

0.7

2.1

While Kroner expectations versus the Euro are optimistic, that same cannot be said about USDNOK. This pair

GDP

Inflation

d Targ

et

6.2400 Q4

2.9

1.5

Unemployment Rate

Norges Bank Rate

15

CURRENCY INSIGHTS April 2014

JPY

- Scott Smith, Senior FX Trader and Market Analyst

After a rough end to 2013, which saw the Japanese Yen hit lows not seen since late 2008, the slide was halted shortly thereafter, and the currency was able to rebound in the first quarter of 2014. The decision to leave the Bank of Japan’s asset purchases unchanged, while inflation developed in a positive manner, helped underpin the Yen to begin the year, dragging USDJPY back into the 102 region. Although tailing off near the end of last year, GDP growth has perked up and is forecast to remain well supported in Q1 2014, while retail sales continue their upward trajectory, providing hope that Prime Minister Shinzo Abe’s three-arrow approach to economic growth will achieve success with the nation’s revival. While inflation, retail sales, and industrial production are all progressing in a constructive manner, there are storm clouds gathering on the horizon, threatening to stomp-out the economic green shoots Abe has nurtured.

The largest upcoming challenge for the administration will be navigating the new consumption tax set to be implemented on April 1st, raising the charge levied at the till from 5% to 8%. The ambitious approach to working the country out of its fiscal woes threatens to choke economic growth just at a time when we’re seeing favourable developments, and with household spending accounting for 60% of GDP, the sales tax increase could potentially erode 2.5% of GDP this year as consumers and businesses reign in their spending.

Couple this with languishing household spending, wage increases in the region remain tepid, further threatening the positive gains made by the BoJ as it hones in on its 2% inflation target.

The precarious situation of enhancing the country’s fiscal position while at the same time trying to stimulate growth and reflate the economy, lead us to believe the BoJ will have to become more accommodative towards monetary policy by the end of Q2, and look to increase their monetary base at faster clip, most likely in the neighbourhood of ¥80-90tn per year. As such, we see the Yen strength exhibited during Q1 as a slight pause in the underlying upward trend of USDJPY, with the domestic currency likely to retest the lows seen last December. We would also caution that the Japanese economy faces structural headwinds that are

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unlikely to improve in the short-term, and that currency depreciation is not a panacea for prosperity. This is evident in the country’s lack of export growth to date, with the flow-through effects of a weaker Yen pushing up energy import costs because of issues with Japan’s nuclear plants that have forced the country to seek energy outside of its borders. As a result, there have been concerns from board members at the BoJ as to the efficacy of further QE on long-term economic prospects, and worries the incremental benefits won’t offset the perceived costs.

JPY daily

104.5000 Q2 108.2500 Q3 Expe

cted T arget 105.0000

Q4

Economic Indicators

1.0

1.4

3.7

GDP

Inflation

Unemployment Rate

<0.1 Bank of Japan Rate

CURRENCY INSIGHTS April 2014

AUD

- Richard Breen, Manager – Treasury and Risk Management

The Aussie Dollar had a rough ride throughout the latter half of 2013 on the back of RBA loosening of monetary policy, the end of the mining investment phase, and concerns over the pace of Chinese growth.

Outside of mining, domestic growth has been soft for some time and confidence amongst consumers and businesses at very low levels. One factor that has turned confidence sharply higher in 2014 has been the pace of house price appreciation; with interest rates at record low levels and foreign investors, particularly Chinese, driving prices higher and creating a wealth effect amongst households.

This foreign investment in the housing sector is just the beginning of a wall of money that is leaving Asia destined for Australia over the next decade. The talk of a housing bubble is forever present and will deflate at some stage but we are not there yet.

“The mining investment boom is slowing but Australia is now moving into the production phase...”

Many are quick to point out that Fed tightening will put the AUD under pressure, but what matters here are spreads. As we move into 2015 and expectations that the Fed Funds Rate will increase, it will be accompanied

by RBA tightening. This will aid the AUD over the course of 2014.

Over the next quarter expect to see AUD/USD back up towards 0.9200-0.9300 with the danger of an overshoot to the upside in a market that is still caught short.

AUD daily

The mining investment boom is slowing but Australia is now moving into the production phase. Even with Iron Ore and Coal prices well off their highs (and the latter hovering at very low levels) you will be hard pressed to find any available supply. For the time being, Chinese demand still well outstrips supply despite what you read in the mainstream media.

From an interest rate perspective, the RBA is at the bottom of their easing cycle and price pressures are starting to feed through to the economy after a long period of depressed rates. The dropping of their easing bias in February has seen the AUD yield curve shift markedly higher. Attempts at verbal intervention this year have proven futile; comments from Glenn Stevens at the last senate hearing were indicative of the situation the RBA faces. He said, “the AUD above 0.9000 remains at historically high levels,” and “I have nothing more to say about the level of the Australian Dollar.” The RBA is concerned about rising house prices but cannot raise rates in the short to medium term for fear the AUD will rally back towards parity with the USD.

0.9350 Q2

0.9135 Q3

Expec te

d Targ

et

0.9500 Q4

Economic Indicators

2.9

2.8

6.1

2.5

GDP

Inflation

Unemployment Rate

Reserve Bank of Australia Rate

17

CURRENCY INSIGHTS April 2014

NZD

- Richard Breen, Manager – Treasury and Risk Management

For the last quarter, NZD appreciation has been all about interest rates. The RBNZ became the first central bank in the developed world to raise rates since the GFC and the move was extremely well communicated to the market. At the March meeting, Governor Wheeler also said further increases of 125 basis points should be expected this year. This factor alone will aid to keep the NZD well supported over the next six months.

to see a parity party anytime soon. We like buying AUD/NZD at current levels and we’re looking for a significant rebound in this pair as Aussie/Kiwi interest rate spreads are not correctly priced for RBA tightening over the next 12 months.

NZD daily

On an economic front, New Zealand is very similar to that of Australia; it is heavily reliant on export markets, particularly agricultural products, and the country has also witnessed extreme house price “…what’s happening appreciation after a on the other side of long period of low the pond in terms of rates coupled with the Fed?” an influx of foreign investment. Macro prudential tools in the form of LVR ratio limits have been introduced to curb prices and are having some effect as the latest house price data shows. Bubble concerns continue to linger, but like the Australian story, money is expected to continue flooding in from Asia, which will only add fuel to the fire.

So with prices running hot, what exactly is the source of this growth? The rebuild of Christchurch after the 2011 earthquake continues to add significantly to GDP and the benefits are being felt right across the economy. Strong demand out of China for dairy products (think Fonterra) will also keep growth rates above trend throughout 2014.

Also important to address is what’s happening on the other side of the pond in terms of the Fed and again we follow similar analysis to the AUD. Fed tightening is going to be accompanied by further RBNZ tightening, therefore spreads will remain in favour of the NZD. With so much RBNZ tightening already in the price, gains in the NZD/USD are going to be tough for the quarter ahead and we prefer to buy dips toward 0.8000-0.8200. Against the AUD, do not expect

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0.8450 Q2

0.8125 Q3

Expec te

d Targ

et

0.8650 Q4

Economic Indicators

3.2

1.7

5.9

3.0

GDP

Inflation

Unemployment Rate

Reserve Bank of New Zealand Rate

CURRENCY INSIGHTS April 2014

EMERGING MARKETS

- Karl Schamotta, Director of FX Strategy and Structured Products

‘Re-emerging Economies?’ — “If there is one thing we know about the sentiments of crowds, it is that they change. Today it is greed. Tomorrow it is fear. But rarely is it doubt”. The authors of Mobs, Messiahs, and Markets might have been describing the developed world’s relationship with the emerging markets over the past decade.

First it was greed. Attracted by strong growth rates, low debt ratios, and an extremely simplistic advertising slogan, Western investors poured trillions of dollars into countries which had hitherto been on the outer edges of the global financial system. Despite limited institutional infrastructure, unbalanced political incentives, and highly concentrated financial markets, the BRIC countries were positioned to tap a seemingly endless supply of foreign capital – and did.

Emerging market equity indices soared, bond yields plummeted, and consumer societies popped into existence virtually overnight. As money sloshed into relatively small economies, growth rates surged, and more money was attracted.

As we begin the second quarter of 2014, a different mindset is beginning to creep in. With the taper upon us, countries with large current account deficits and limited central bank reserves are continuing to experience financial devastation, while others are seeing a recovery in investment appetites.

We would suggest that this is short-sighted. Many countries have put policies in place that should help them ride out the old-school emerging market storm, but this is not the crisis of previous generations.

Instead, financial decision-makers should think about private sector balance sheets. Where extreme leverage levels have become concentrated in the household and corporate sectors, tertiary damage is likely to be uncovered over the coming months.

In other words, as global monetary policy tightens, it is the re-emergence of the emerging markets that we really should be concerned about. As Mark Twain put it – “History doesn’t repeat itself, but it does rhyme.”

In the foreign exchange markets, traders forgot the old adage about emerging markets being difficult to emerge from in an emergency, and bid rates skyward. Many of the largest developing economies saw their currencies rise by more than 35% in real terms, making them the best performers in the post-2008 world, by wide margins.

Then it was fear. In early 2013, investors began to worry that the Federal Reserve would suddenly start tightening policy. With funding costs going up, and investment prospects in the United States becoming more attractive, asset managers began to withdraw money from the more volatile corners of the world.

At first a trickle, the capital flow reversal soon became a flood. Equity indices plunged, current accounts collapsed, and exchange rates cracked under the pressure. Fear ruled the markets, and investors were undiscerning; virtually every developing country saw massive outflows, despite widely varying fundamentals.

As the Federal Reserve moved closer to tapering, the selling deepened.

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CURRENCY INSIGHTS April 2014

BRL

- Mark Frey, SVP Sales and Trading, Chief Market Strategist

The selling pressure on the Real began to subside and consolidate somewhat in the first quarter of 2014 after the local unit lost close to a third of its value over the past 18 months. Though the mass exodus of capital has slowed to a more normalized exit, global investors have plenty of reasons to worry about capital still deployed in South America’s most populous economy.

Surprising almost no-one, Standard “As we begin the second quarter of 2014, a different & Poor’s recently downgraded mindset is beginning Brazil’s sovereign to creep in. With the debt rating to taper upon us, emerging BBB-, the final markets are experiencing notch belonging to capital flight.” investment grade, as a result of the enormous economic imbalances that have been allowed to develop.

like a near emergent situation in terms of geopolitical stability, or the lack thereof.

While there has been plenty of pain and investment accounts have shed plenty of blood already in country, more pain seems to be on the horizon. The Real has shown some signs of recovery from a pure momentum and technical perspective but the fundamental signs are all pointing to continued selling pressure and a further rally in the USDBRL rate going into the latter half of 2014.

BRL daily

Though the ratings agency somewhat mercifully changed their outlook from “negative” to “neutral,” that should by no means be taken as a sign that the worst pain in terms of the required economic adjustment is in the rear view. From our perspective, the ratings outlook would likely still be negative and the other agencies would likely follow suit if there wasn’t a critical Presidential election coming up in October, where the situation requires a meaningful debate with respect to a realistic economic road map to guide the country through the current turmoil.

Inflation remains persistently high, just north of 6%. The central bank’s benchmark interest rate is approaching 11% and GDP growth remains underwhelming at around 1.6% per annum. These metrics alone paint a grim picture but when combined with a prolonged drought causing economic hardship across numerous sectors, declining tax receipts, massive imbalances with respect to welfare and social security transfers and the rather blatant lack of political will or strength to tackle dire fiscal issues, the entire situation begins to look even more acute.

Throw in some general social unrest surrounding rising income inequality and youth unemployment and a series of economic problems begins to look more

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2.3200 Q2

2.4500 Q3

Expec te

d Targ

et

2.5500 Q4

Economic Indicators

1.58

6.o1

4.8

10.75

GDP

Inflation

Unemployment Rate

Central Bank Rate

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CURRENCY INSIGHTS April 2014

CNY

- Karl Schamotta, Director of FX Strategy and Structured Products

Paper Tiger – Roughly translated, the ancient Chinese proverb “Ch’i ‘hu nan hsia nei” means “He who rides the tiger finds it difficult to dismount”.

China’s monetary mandarins must know the feeling.

Since allowing the renminbi to take its first halting steps toward international usage in 2009, policymakers have seen the currency hurtle toward global dominance.

Starting from a non-existent position in offshore markets less than five years ago, it has become the eighth-most used payment unit and is rivaling the dollar for dominance in trade finance. Businesses were able to lower costs and share currency risks with international partners, and onshore enterprises gained access to global markets.

This has been a trend with many benefits, but these gains aren’t necessarily aligned with the country’s policy objectives.

To paraphrase Winston Churchill, we cannot forecast the renminbi’s future. It is a riddle, wrapped in a mystery, inside an enigma but perhaps there is a key – Chinese national interest.

In the coming months, policymakers will undoubtedly seek to stabilize the economy, potentially using a number of levers. Accelerated stimulus spending and additional monetary easing are highly likely, but with exports suffering and the domestic economy weakening, the case for further currency depreciation is strong.

In other words, the renminbi could roar yet, but for the immediate future, it more closely resembles a paper tiger.

CNY daily

By breaking down the Great Wall of capital controls that protected the Chinese economy after the post-Mao reform period, liberalization effectively diminished political hegemony over large swathes of the financial system.

A surge in cross-border interest rate arbitrage turned the currency conversion channel into something akin to a high-pressure hose – forcing more and more money into China. This has driven the value of the renminbi up more than 42% in inflation-adjusted terms in the last eight years, taking a serious toll on the country’s external competitiveness.

Since the economy began to slow in early 2014, the strain has become increasingly visible. Exports are stagnating, industrial production has fallen, and growth estimates are being repeatedly revised lower.

In February, policymakers decided to shift direction. The People’s Bank of China stepped into the market and drove the currency down by almost 3% in two months. During the third week of March, the exchange rate suffered its largest weekly fall in more than 20 years. Speculators with large positions took billions of dollars in losses, and markets fell around the world as stunned participants wondered what would come next.

6.2500 Q2

6.3000 Q3

Expec te

d Targ

et

6.3500 Q4

Economic Indicators

7.7

2.0

4.1

6.0

GDP

Inflation

Unemployment Rate

People’s Bank of CHina

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CURRENCY CURRENCY INSIGHTS INSIGHTS April 2014 January 2013

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