Currency Insights January 2015

CURRENCY INSIGHTS Foreign Exchange Forecast and Analysis

January 2015

Against the Currents Finding Balance in the Waves of Volatility

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CURRENCY INSIGHTS January 2015

IN THIS ISSUE 4

GLOBAL MARKET THEMES

Mark Frey, SVP Sales and Trading, Chief Market Strategist

6

THE AMERICAS

Scott Smith, Senior FX Trader and Market Analyst

6 United States 6 Canada 7 Latin America

ASIA PACIFIC

8

Karl Schamotta, Director, FX Research and Strategy

9 Japan 9 10 11 11

India China Australia 2015 Outlook

EUROPE AND THE UK

David Starkey, Options Dealer and Senior Market Analyst

13 Euro 14 British Pound

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12

CURRENCY INSIGHTS January 2015

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CURRENCY INSIGHTS January 2015

GLOBAL MARKET THEMES Greed and Fear Override Rational Discipline Mark Frey, SVP Sales and Trading, Chief Market Strategist

Greed and fear are clearly evident in financial markets at present, which means that emotions are running high for both professional traders and casual investors alike.

Greed and fear can cause market decision makers to do strange and irrational things like chase losses by averaging down and by euphorically buying into rising markets that are already at stratospheric heights.

Currency markets are clearly seeing their fair share of such activities as the calendar turns over to 2015 with the Greenback printing fresh, multi-year highs against one far flung currency or another on an almost

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daily basis, if not by the session.

To that end, many customers and investors have recently asked if we have ever seen such trending volatility and how this market run may be different from other currency market panics.

To answer these key questions, it is important to understand that markets trade in cycles—and this time will be no different. It will be clear to most who have been around for a banking crisis or two that this bout of fear and greed is no different than every other such instance in recent memory. The

Dollar will rally until such time that it seems assured that it can go no direction but skyward, pushed ever higher by every piece of good news for the Greenback and every tidbit of negative news for the other major currencies. When sentiments could not be any more bullish and the lambs are dreaming of abnormal profits, the turn will come and the slaughter will follow. Marketmaking Institutional investors will get out first, then advise their own customers to follow suit and the huddled masses will be the last ones to know, getting trampled in a stampede for a single exit door

CURRENCY INSIGHTS January 2015

with the rest of humanity trying to fit through the one escape. This is the way markets work, in simplified and somewhat jaded terms of course, and it is also why currency markets especially tend to over and undershoot price levels hinted at by purchasing power parity models.

The magic is surely then in predicting the turn and getting out before the carnage to follow. If one can efficiently and consistently solve this market riddle, that market participant could achieve those desired abnormal profits, or economic rents, without taking the outsized losses that often accompany attempts to pick highs and lows. However, the real key for individual investors and traders alike is to fight the fear and greed and remain rational when all others seem to be losing their heads. Discipline is the only way to survive and thrive under such market circumstances, and indeed,

discipline is the result of process.

When it comes to currency risk management, discipline is achieved by adherence to a rigorous set of principles focused on the following: 1. Understanding the nature and scope of your underlying currency risks.

2. Developing a Risk Management framework or policy.

3. Specifying your budget rates and goals in terms of limiting risk.

4. Formulating a market strategy that bridges the gap between your risks and goals.

5. Selecting the tools and products that best express your market view for execution.

6. Evaluating your results and adjusting accordingly over time.

The real answer is that no one knows where or when the turn in the USD is going to come. We don’t know to what degree it will turn, we can only speculate. We can run models and debate various technical levels, but the simple truth of the matter is that global market participants will be best served by spending their time determining how best to position themselves in the market such that they will not be adversely harmed if the USD keeps rising, turns and collapses or sustains itself right where it is. Anything else is pure folly as the great economist Adam Smith once said, “Markets can remain irrational a great deal longer than I may remain solvent.” In other words, stop trying to predict the highs and lows and deal with the worst case scenarios proactively so that they don’t become your reality.

DIVERGENCE: HOW LONG WILL IT LAST?

Relative Exchange Rate Performance

8.9

USD = Federal Reserve Board Trade-Weighted Index Rebased, January 01, 2014 – December 31, 2014 Source: Federal Reserve 2015

JPY

MXN

BRL

EUR

AUD

CHF

CAD

NZD

GBP

CNY -2.6

-5.9

-9.1 -11.1

-10.9

-8.8

INR

USD

-2.0

-5.4

-8.5

-10.8

-13.0

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CURRENCY INSIGHTS January 2015

THE AMERICAS End of Oil Bull Market Leads to Dual Growth Trajectories Scott Smith, Senior FX Trader and Market Analyst

COMMODITY-LINKED CURRENCIES TUMBLE WHILE GREENBACK SOARS Relative Exchange Rate Performance USD = Federal Reserve Board Trade-Weighted Index Rebased, January 01, 2014 – December 31, 2014

110

105

100

BRL CAD

95

MXN USD

90

Source: Federal Reserve 2015 85

Jan 2 Feb 2

The broad narratives that have dictated price action across global markets for the better part of 2014 are set to remain well anchored heading into the New Year, though it would be unwise to assume the acknowledgment of the well-entrenched storylines driving currency movements are by anyway an indication volatility will be constrained. The emergence of heightened volatility in the Americas region has arisen as a factor of dual speed economic growth trajectories between the North and the South, while the end of a cyclical bull market in commodities, with a specific emphasis on crumbling energy prices, has put pressure on resource intensive exporting nations. The most recent slide in oil prices represents a wealth transfer from producers to consumers, and effectively will be a somewhat painful rebalancing for regions reliant on energy exports,

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Mar 2 Apr 2

May 2 Jun 2 Jul 2 Aug 2 Sept 2 Oct 2 Nov 2

as capital investment makes a one-way flight to the exits in the search of greener pastures and more promising returns. The silver lining is that regions that have been experiencing symptoms of “Dutch Disease” will gradually rebalance and sectors of the economy that have been struggling will become more competitive as exchange rates adjust to the new macroeconomic environment.

United States While the USD dominance that was exhibited throughout the latter half of 2014 will be set to continue in the year ahead, the path higher is likely to be a road containing potholes and detours. Highlighting the current frothiness of the greenback is the fact that the rotational voting members on the Federal Reserve who have hawkish viewpoints are set to be replaced by dovish

Dec 2

counterparts in 2015, leaving a bias on the voting committee that will likely exude caution when it comes to embarking on the much anticipated tightening cycle. Should a prolonged slide in oil prices deanchor inflation expectations, or a correction in equities elevate risk aversion, we expect the Federal Reserve to push their tightening cycle back slightly from where participants currently anticipate liftoff to occur, potentially causing the USD to hit an air pocket that pauses the rally.

Canada Coming off its worst year since 2008, the dark clouds that have engulfed the loonie are unlikely to dissipate in the near future. Lower energy prices will help inflation edge back within the Bank of Canada’s target band, which will allow the central bank more flexibility

CURRENCY INSIGHTS January 2015

in keeping their accommodative monetary policy conditions in place.

While we have cautioned that market participants might be slightly premature in pricing in a rate hike from the Fed, the tightening cycle in the US will kick-off before a similar move in Canada, and the divergence in monetary policies is likely to lead the loonie lower against its dollar counterpart. Though there may be some short-term pain as the broader Canadian economy rebalances and contends with lower oil prices, we favor the prospects of the loonie against other developed currencies outside of the greenback, as the underperforming manufacturing sector that has been weighed down by a strong Canadian dollar is set to regain traction. Although rig closures in some of the more expensive oil plays will lead to softness in the Western Canadian labor market, the benefits of lower input costs and a weaker Canadian dollar for Eastern Canada’s manufacturing sector will help reign in some of the slack. So while the end of the commodity super-cycle and sluggish demand from China

will negatively affect Canada’s energy sector, the non-energy export side of Canada’s overall GDP has a lot of ground to make up once unshackled from the burden of a strong loonie which has plagued non-energy exports since the early 2000s.

Latin America

Heading further south, the outlook for developing economies like Mexico and Brazil is more ominous, and like many export-intensive economies, they have been plagued by capital flight on global demand concerns. The calamitous fall in commodity prices and prospects of interest rate hikes in the United States has spurred a massive carrytrade unwind, leading to sharp devaluations in their domestic currencies. Like Canada, Mexico should find some reprieve as the purchasing power of the American consumer surges and the export of services rises alongside the uptick in demand. The ongoing challenge for Mexico and Brazil is that the benefits of a weaker domestic

currency seen in respect to trade balance figures could be dwarfed by the negative implications of runaway inflation, leaving the central banks for the aforementioned countries in a precarious position. Banco Central do Brasil and Banco de Mexico run the risk of choking off the already feeble GDP growth if they look to head off frothy consumer prices by prematurely tightening monetary policy, yet at the same time both need to keep inflation from spiraling out of control so the investment climate doesn’t scare away capital looking to take advantage of attractive valuation opportunities.

Both central banks have facilities in place to combat excessive volatility in their domestic currency markets, and that will likely be the preferred method of corralling inflation expectations, given the hazard rising rates pose to domestic demand.

We expect the currency market tide to ebb against the loonie, peso, and real relative to the greenback in the year ahead, though volatility will remain elevated as the speed of monetary policy divergence dictates capital flows.

CANADIAN DUTCH DISEASE: A REBALANCING OCCURS Net Exports, Millions CAD 1996 Jan - Sep 2014 Energy Non-Energy Source: Statistics Canada 2014

8,000 6,000 4,000 2,000 0 -2,000 -4,000 -8,000

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CURRENCY INSIGHTS January 2015

ASIA PACIFIC

Cross Currents Triggering Turbulence Karl Schamotta, Director, FX Research and Strategy

After a deceptive period of calm early last year, several cross-currents are now triggering turbulence under the Pacific Ocean. Japan and India are slowly waking themselves out of slumber, while the Chinese and Australian economies decelerate – and currency volatility is rising.

VOLATILITY TO CONTINUE AS ECONOMIES DECELERATE Relative Exchange Rate Performance USD = Federal Reserve Board Trade-Weighted Index Rebased, January 01, 2014 – December 31, 2014

CNY

110

INR JPY

105

AUD USD

100

Source: Federal Reserve 2015

95

90

85

8

Jan 2 Feb 2

Mar 2

Apr 2

May 2 Jun 2 Jul 2 Aug 2 Sept 2

Oct 2

Nov 2

Dec 2

CURRENCY INSIGHTS January 2015

Japan: The Struggle Continues With lackluster growth, a depressing demographic outlook, and government debt approaching 245% of gross domestic product, there are few reasons to expect a complete reversal in Japanese economic fortunes in the year ahead, but we are cautiously optimistic nonetheless. Domestically, two of Shinzo Abe’s three economic arrows have left the quiver, while the third is on its way. Monetary conditions will continue to ease as the Bank of Japan struggles to meet its inflation target, stimulus spending programs are underway, and reform measures

are slowly winding their way through the political system.

After losing more than a fifth of its value in the last two years, the lower yen is likely to begin delivering gains in the months to come, while depressed commodity prices should continue to provide relief on the import side of the equation.

Having seized an opportunity to repair balance sheets, auto exporters have started to slow the shift in production overseas, and are adjusting prices just as

American demand rebounds. With oil imports providing almost 40% of the country’s energy supply and contracts set to expire through the year, costs are set to fall sharply.

A brighter future beckons for the real economy, but further turbulence is likely to strike the financial markets.

The Nikkei has doubled in value over the past two years, leading us to believe that further gains may be difficult to maintain, while the yen’s weakness is heavily predicated on ever-increasing monetary easing measures. Reversals are in the offing.

India: Robust Growth to Support Rupee After experiencing a slow-motion economic crisis in 2013, India looks set to be one of the rare emerging market winners in the year to come.

With a heavy dependence on imported oil, the country has seen its energy costs cut in half, helping to send inflation down to multi-year lows. Compounding this, strict capital controls are acting in its favor for once, insulating it from the foreign investment withdrawals that are devastating currencies across the developing world. Price pressures are lifting, giving widely respected central bank governor Raghuram Rajan the latitude to begin easing monetary policy.

With a solid electoral mandate

behind it, Narendra Modi’s Baratiya Janata Party is enacting reforms at a whirlwind pace, helping to boost hopes for an economic renaissance.

We suspect that Modi-mania is likely to dissipate somewhat as the implementation process becomes bogged down in the mire that is Indian politics, but a service-focused business sector is likely to help the country distinguish itself against its emerging market peers through the year ahead.

As such, the rupee’s recent record of outperformance may weaken somewhat over the coming year, but we expect that the currency will prove more robust than many observers expect.

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CURRENCY INSIGHTS January 2015

China: Weaker Growth to Drive Yuan Volatility The Chinese economy is likely to continue decelerating through 2015, with policymakers struggling to manage competing policy goals; enacting structural reforms, while also supporting short-term growth.

Economy-wide debts have soared to 250% of gross domestic product; up by 100 percentage points since 2008, putting the financial system under severe stress. Growth is slowing as property prices fall across the country, and nonperforming loans are forcing local governments to cut infrastructure investment plans. Manufacturing producer prices have fallen steadily.

Against this backdrop, investors are increasingly convinced that officials are beginning a massive

surreptitious quantitative easing program aimed at boosting the economy - early in 2014, the People’s Bank of China wrote a trillion yuan loan to the statecontrolled banking system and followed it with a 769 billion yuan medium-term lending facility for smaller enterprises. This comes as President Xi’s anti-corruption drive has cut trips to the baccarat tables in Macau, helping to trigger a spectacular surge in onshore stock indexes – and in offshore commodity markets.

We suspect that the sugar rush won’t last long, however. The easing program’s impact has been underwhelming. Short-term interest

rates have fallen, but the rate at which banks lend to businesses has remained stuck at about 7%. It has not reached the real economy. At the same time, investor inexperience with capitalism has made for bubbleprone markets, with rallies prone to collapse in short order. Without fundamental economic improvement to match policymaker largesse, it is likely that momentum will be lost as the year progresses.

Instead, we expect weaker, but more sustainable growth. Two-way movement in the renminbi is likely to remain a feature through the year ahead, while the Middle Kingdom will undoubtedly remain a flashpoint for global market volatility.

SOARING DEBT A CAUSE FOR CONCERN Gross domestic Product / Private Sector Debt Billions Renminbi Source: Bank for International Settlements 2014

100

80

60

40

20

1988

10

1993

1998

2003

2008

2013

CURRENCY INSIGHTS January 2015

Australia: The Bursting Bubble In today’s global economy, no country is an island, and no nation demonstrates this truth more clearly than Australia. Asian demand for raw materials helped it emerge from the most devastating financial crisis in living memory effectively unscathed - but also planted the seeds of today’s weakness.

2015 Outlook Fundamental outcomes should continue to converge across the Asia Pacific region through the year ahead. Bound to one another, the Chinese and Australian economies are both expected to face severe headwinds, while Japan and India are both poised to gain from lower commodity prices and an easing in inflationary pressures. As this occurs, long-standing investment assumptions will be overturned, leading to rough conditions in the currency markets. In short, for those sailing on the Pacific in the year to come, it is important to remember that calm seas never made for a skilled mariner…

As iron, coal, copper, and agricultural exports soared, the lucky country outperformed its peers, but became vulnerable to changes in some of the world’s most overheated economies – and to changing conditions in the world’s most speculative commodity markets. By encouraging consumers to continue spending, economic outperformance also meant that the post-crisis deleveraging that occurred across much of the developed world did not occur in Australia. According to experts from the Bank for International Settlements and the International Monetary Fund, Australia now possesses one of the world’s most overvalued housing markets.

In the year to come, tertiary effects of last year’s commodity price crash will continue to spread throughout the business sector, weighing on labor markets. Housing investment will likely continue to weaken, driving growth forecasts lower, while putting pressure on the Reserve Bank of Australia to slash rates. Taken in sum, these factors will keep the Australian dollar on the defensive for the foreseeable future – but signs of Chinese stimulus will keep currency traders on their toes.

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CURRENCY INSIGHTS January 2015

EUROPE & THE UK Ongoing Anemic Growth to Pressure Currencies David Starkey, Options Dealer and Senior Market Analyst As we look forward into 2015 the landscape for both the Euro and Sterling has changed drastically from this time last year; at that time both currencies enjoyed the favor of markets. Relief that peripheral nation indebtedness hadn’t triggered a deep recession and revived confidence in the common currency saw the Euro riding high. Meanwhile, Sterling benefitted from a sudden decline in the unemployment rate and a corresponding boost in GDP growth, which had many speculating about interest rate hikes.

How much a year can change!

The year ahead is fraught with downside risks for both currencies.

The specter of full blown Quantitative Easing (QE) in the Eurozone driven by persistent ultralow inflation and general economic weakness sets the stage for continued pressure on the common currency. Additionally, widening periphery member nation yield spreads versus Germany hints at renewed concerns about stability.

Across the English Channel, a sharp downturn in inflation, weak wage growth, and lingering concerns about both domestic and foreign (particularly from the EU) economic shocks has lead the Bank of England (BoE) to hit the brakes on any possible monetary policy tightening. This has put the British Pound on its back foot. Further Sterling risk can be found in the uncertainty of this May’s general election and how its result may frame the UK’s relationship with mainland Europe.

PRESSURES ON THE EURO & STERLING Relative Exchange Rate Performance USD = Federal Reserve Board Trade-Weighted Index Rebased, January 01, 2014 – December 31, 2014

110

105

100

CHF EUR

95

GBP USD Source: Federal Reserve 2015

12

90

85

Jan 2 Feb 2

Mar 2 Apr 2

May 2 Jun 2 Jul 2 Aug 2 Sept 2 Oct 2 Nov 2

Dec 2

CURRENCY INSIGHTS January 2015

Euro: QE, The Defining Factor All eyes are on European Central Bank (ECB) President Mario Draghi and whether or not he will roll out a full-blown QE program, involving the purchase of sovereign debt, in 2015. The ECB has traditionally avoided direct sovereign debt purchases due to the inherent argument that it may indirectly prop up a member government, which is beyond the scope of its mandate.

The risk of a deflationary spiral looms over the Eurozone. Last year saw the Consumer Price Index (CPI), the ECB’s favored measure of inflation, trend convincingly lower. Q4 saw CPI settle in at an anemic +0.3%, its worst result in nearly 5-years and well below the ECB’s official 2.0% target. Unfortunately there is little expectation of this reversing in the near term. The recent capitulation in oil prices as well as domestic risk factors (unemployment near record highs and a lurking recession) are the foundation of a rather bleak outlook for prices growth.

The deteriorating economic data led Draghi to commit to a significant expansion of the ECB’s balance sheet in 2014 as a means to encourage price stability and stimulate the regional economy.

Elements of that commitment includes private asset-backed security purchases, termed QElite, and Long-Term Refinancing Operations (LTRO); whereby the ECB lends directly to European banks at extremely favorable rates.

While there are signs that existing ECB policies are starting to have a positive effect via increases in money growth and real lending, there has been enough time to conclude that the impact does not appear significant enough to “right the ship” so to speak. Additionally, below expectation LTRO uptake has renewed pressure on the ECB to find another channel for achieving its balance sheet promise. This has led to speculation that in early 2015 Draghi will announce the inclusion of sovereign debt in the ECB’s asset purchase program.

Given the ongoing economic concerns, the expectation of further ECB action in Q1 seems reasonable and forms the base case of the 2015 outlook. The monetary policy outlook for the EU is a sharp contrast to the likes of the USA and neighboring UK, and lays the foundation for a weaker Euro in the coming year. Assuming the base case, weakness in the common currency is likely to be most pronounced against the American Dollar, due to the expectation that the Fed will seek to tighten its belt in 2015. Against the Sterling, where local authorities look to have flinched, weakness could be less pronounced.

that while the outlook for the Euro remains negative, the bulk of FX rate expectations could already be priced in. In fact, bets against the Euro are already starting to look overcrowded and should the ECB hold off on further liquidity past Q1, there is elevated risk of a short-squeeze, pushing Euro values temporarily higher.

One other key concern for the Euro this year is the risk to the currency union itself. The protracted period of low inflation and stagnating growth has once again quietly raised concerns about fiscal stability. Europe’s most indebted nations continue to struggle with the tightrope of austerity versus economic stimulus (spending), and maintaining their obligations to the EU for membership in the currency union are proving to be a growing burden. This has led yield spreads against regional benchmark Germany to widen back out and financial markets to discount the risk of crisis. So far it has not drawn much in the way of headlines, but it presents yet another risk factor for the common currency in 2015.

It is worth keeping in mind that the expectation of additional liquidity was a key contributor to Euro weakness in the second half of 2014. Interestingly, this suggests

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CURRENCY INSIGHTS January 2015

British Pound: Rate Hikes on Hold & General Election Burden Material disinflation and soft wage growth took their toll in 2014, suggesting that the UK recovery was not robust enough to be taken off the life support of loose monetary policy. This ultimately signaled the end of a significant Sterling rally as currency markets re-priced the interest rate expectations that had initially been the catalyst for gains.

Hammering the last coffin nail, in November of 2014 the BoE published its regular Quarterly

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Inflation Report and confirmed market fears. The report highlighted that disinflation would continue to overshoot and that this has led the GDP outlook to be revised materially lower. As such the BoE was pushing back its guidance for rate hikes in the near term. Since the report, British economic data has deteriorated as forecasted, validating the BoE’s stance and confirming a bleak outlook for the British Pound.

2015 looks to be a story about the monetary policy tightening that wasn’t. Sensitive both to domestic data and external risks, specifically in Europe, BoE governor Mark Carney seems very comfortable with maintaining loose policy, a concept that is positioned to arrest buying interest in Sterling this year.

Looking particularly at risk is Cable, where the expectation of rate hikes from the Fed could drive further weakness in the pair.

CURRENCY INSIGHTS January 2015

UK INFLATION REMAINS TAME Consumer Price Index, Annualised Percantage Change January 2000 – December 2014

Source: Reuters 2015

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CURRENCY CURRENCY INSIGHTS INSIGHTS January January2015 2013

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