CURRENCIES Currency Market Monitor 1 st Quarter2014 APRIL 3, 2014 John W. Labuszewski Sandra Ro Bluford Putnam Managing Director Executive Director Chief Economist Fin’l Research & Product Development 312-466-7469 [email protected]FX Research & Product Development 011 (44) 203-379-3789 [email protected]Research & Product Development 212-299--2302 bluford.putnam@cmegroup.com
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CURRENCIES
Currency Market Monitor 1st Quarter 2014
APRIL 3, 2014
John W. Labuszewski Sandra Ro Bluford Putnam
Managing Director Executive Director Chief Economist
another $142.1 billion was added to foreign equity
funds. This trend continued in January through
February 2014 with another $43.3 flowing into
equity funds.
Funds had generally been flowing into bond funds
through May 2013. But June saw the reversal of
this trend as investors began to believe that interest
rate advances, fueled by economic growth and
expectations of tapering of Fed easing programs. By
the conclusion of 2013, some $80.5 billion had been
withdrawn from bond funds. But some $8.9 billion
flowed back into these markets in January through
February 2014.
Global Economic Performance
Emerging market (EM) economies have been the
stars of the investment world for some years now.
Still, it was the developed market (DM) economies
that provided some of the most positive growth
surprises in 2013. While the EM countries generally
exhibit higher growth rates than DM countries, that
11 These indicators are often highly correlated with price
action as retail investors may “chase” the market by buying in response to a bull trend. Or, they may exhibit a “herd mentality” by liquidating investments in response to significant market breaks.
growth has generally decelerated relative to DM
economies in recent years.
Actual and Forecast GDP Growth
2011 2012 2013
2014
(f)
2014
-19
(f)
2020
-25
(f)
Developed Markets (DMs)
Australia 3.4% 3.7% 2.7% 2.6% 2.3% 2.2%
Canada 2.5% 1.7% 1.4% 2.1% 2.0% 1.8%
France 2.0% 0.0% 0.2% 0.9% 1.4% 0.9%
Germany 3.3% 0.7% 0.4% 1.7% 1.6% 1.4%
Japan -.06% 1.9% 1.8% 1.5% 1.0% 0.6%
UK 1.1% 0.1% 1.3% 1.9% 1.9% 1.1%
US 1.8% 2.8% 1.9% 3.0% 2.4% 1.7%
Emerging Markets (DMs)
Brazil 2.7% 0.9% 2.0% 2.3% 2.9% 2.8%
Mexico 3.9% 3.8% 1.5% 3.1% 2.9% 3.1%
Russia 4.3% 3.4% 1.5% 2.5% 1.8% 1.2%
India 6.2% 5.0% 4.2% 4.4% 4.8% 2.6%
China 9.3% 7.7% 7.5% 7.0% 5.9% 3.5%
Source: The Conference Board Global Economic
Outlook 2014 (February 2014)
NOTE: (f) = forecast data
According to the Conference Board’s Global
Economic Outlook, growth in Germany is expected
to run at a very moderate +1.6% on an annual basis
from 2014-19. Similarly modest growth is expected
in much of the developed world including Japan
(+1.0%), the United Kingdom (+1.9%) and the
United States (+2.4%).
While GDP growth has slowed in many of the
emerging economies, such growth has nonetheless
generally surpassed that of the DMs. This is
expected to continue, according to Conference Board
forecasts, albeit the gaps may narrow.
Note that the trade surpluses that have supported
many emerging market economies are shrinking
along with trade deficits in the U.S. and Europe. As
The factors discussed above exert an obvious impact
upon the price performance of the U.S. dollar vis-à-
vis other world currencies. In order to monitor this
price impact, CME Group has developed the “CME
USD Index” as one in a family of similarly
constructed FX Indexes. 12
The CME USD Index ended calendar year 2013 at a
value of 1,042.66 and remained virtually unchanged
over the course of the 1st quarter to end at
12 The CME USD Index represents a basket of equally
weighted positions (as of December 31, 2010) of the USD vs. the Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar (AUD) and Chinese yuan (CNY). It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.
1,0401.10. As such, the 1st quarter proved to be a
relatively quiet market in terms of price or spot
return performance.
The Euro generated a spot return of +0.25% vs. the
USD; the British pound (GBP) posted a return of
+0.76%; while the Japanese yen (JPY) was seen
+2.04% for the quarter, bouncing back a bit from its
-17.62% plunge during the course of 2013.
Mixed and more dramatic movements were seen
amongst emerging market currencies where the
Brazilian real (BRL) posted a spot return of +6.62%;
historical basis, generated favorable total returns. 13
The CME FX Carry Index closed the 1st quarter at
828.38 and +2.49% from its 2013 ending value of
808.21. This reflects the generally good
performance of the BRL (total return = +6.62%),
AUD (+4.58%), NZD (+6.26%) and TRY (+3.06%)
during the 1st quarter.
Purchasing Power Parity
The theory of purchasing power parity (PPP) dates to
the 16th century and the School of Salamanca but
was further developed in the early 20th century by
economist Gustav Cassel. 14 The theory is based
upon the assumption that exchange rates are in
13 The CME FX Carry Index represents a basket of equally
weighted positions (as of December 31, 2010) which is effectively long a basket including the Australian dollar (AUD), Brazilian real (BRL), Mexican peso (MXN), New Zealand dollar (NZD), South African rand (ZAR) and Turkish lira (TRY) vs. short positions in the USD and EUR. It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010. The long components of the CME FX Carry Index were selected in light of the high local interest rates that prevailed in those countries during the post-financial crisis era through 2010. The short components of the index were identified because of the low interest rates offered.
14 See Cassel, Gustav, “Abnormal Deviations in International Exchanges” (December 1918).
equilibrium when purchasing power is equivalent in
the two countries.
On a granular level, PPP is based on the “law of one
price” or the notion that identical products should be
priced at the same level in different national markets
adjusted for exchange rates. Typically, this law is
qualified by the absence of significant trade barriers
or other artificial constraints on commerce.
But the theory of PPP expands the application of the
law of one price from any single good or product to
generalized prices in any particular economy as
measured by inflation indexes, e.g., Consumer Price
Index (CPI) or Producer Price Index (PPI). The
implication of this theory is that inflation rates and
exchange rates should exhibit negative correlation.
If inflation increases
� Currency value should decline
If inflation decreases
� Currency value should advance
Thus, if inflation as measured by an inflation index
increases, the value of the currency should generally
decline to maintain price equilibrium. Similarly, if
inflation declines, the value of the currency should
advance.
The theory of PPP is closely related to another
classic theory that addresses exchange rate values
known as the International Fisher Effect (IFE). This
theory suggests that the disparity between nominal
interest rates in two countries drive the future path
of exchange rates.
Per this theory, one might expect that the value of a
currency with a low nominal interest rate might
increase into the future. Or that the value of a
currency with high nominal rate might decline.
IFE further assumes that real interest rates (i.e., the
risk-free interest rate less inflation) should generally
be equal across countries. This implies that nominal
interest rates and inflation are positively correlated.
Country Index to follow the performance of a basket
of currencies from nations that rely heavily upon the
exportation of commodities and other raw materials.
To the extent that commodities have been in great
demand over much of the past decade, these
currencies have, on a historical basis, generated
favorable total returns. 15
The CME FX Commodity Country Index drifted up
2.01% to 875.19 by the conclusion of the 1st quarter
from the year-end 2013 value of 857.91.
CME Group has further developed the CME FX BRIC
Index to follow the performance of select “emerging
market” economies and their national currencies,
namely the Brazilian real (BRL), Russian ruble
(RUB), Indian rupee (INR) and Chinese yuan (CNY),
that have created much of the demand for
commodities in the world today. 16
15 The CME Commodity Country Index is constructed to be
effectively long Australian dollar (AUD), Brazilian real (BRL), Canadian dollar (CAD), Norwegian krone (NOK), New Zealand dollar (NZD) and South African rand (ZAR) vs. a short position in the U.S. dollar (USD). It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.
16 The CME BRIC Index is constructed of equal weightings of long Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese yuan (CNY) vs. a short position in the U.S. dollar (USD). Like other CME FX indexes discussed above, the BRIC Index was equally weighted and calibrated to equal an arbitrary 1,000.00 as of December 31, 2010.
The CME FX BRIC Index ended the 1st quarter at
852.35 and virtually unchanged from the year-end
2013 mark at 858.26.
Conclusion
CME offers a broad array of currency futures and
option contracts covering a wide range of currency
pairings (where one side is the U.S. dollar) and
cross-rate pairings (which do not involve the U.S.
Australia’s economy may suffer from further deceleration of growth in China and by
potential problems in China’s shadow banking system.
Economic growth has been slow in Brazil, but there are signs of incremental improvement.
Water shortages, especially around Sao Paulo, though, may be a risk to growth.
Canada is benefiting from the continued jobs expansion in the US. On the negative side, the domestic oil sector has some challenges
and delays in the US decision on the Keystone pipeline are not helping economic confidence.
Monetary
Policy
Monetary policy now appears to be on hold in Australia. Short-term interest rates offer a small premium to the near-zero rates in the
US, Europe, and Japan.
Short-term interest rates around 10% now provide solid support for the currency. As
emerging market currency pressures abate, there may be room for rate cuts later in 2014.
Canada’s rates are low. There are no inflation pressures. The Bank of Canada seems
comfortable with the current set of policies, at least so long as the US keeps its federal funds
rate near zero.
Special
Factors
The Australian dollar managed a small appreciation in Q1/2014, even with uncertainties relating to China and
commodities prices.
Brazil hosts the World Cup in 2014 and the Olympics in 2016. A successful World Cup
has the potential to give the markets a boost of confidence in the Brazilian real.
Rate differentials with the US are too small to support the Canadian dollar. The big risks are in the energy sector. Weaker oil prices or a US decision against the Keystone pipeline
would probably hurt the currency.
China European Union India
Growth,
Inflation
& Fiscal
Policy
China may decelerate further to around 6.5% to 7% real GDP growth in 2014. The
economy is likely to avoid a hard landing but continues to face challenges in its shadow
banking system.
Europe is likely to post some small gains in economic growth in 2014. The rise in the
euro over the past 12 months of a little more than 7%, however, appears to be contributing to a risk of slipping into deflationary territory.
India’s economy is growing at only about half the pace it once did. At the same time,
monetary policy was tightened to defend the currency in 2013.
Monetary
Policy
Monetary policy remains in flux. The central bank has to decide how much support to give a struggling shadow banking system. Also,
the weaker RMB means that China is unlikely to be a buyer of US Treasuries, as it was in periods of upward pressure on the currency.
The ECB faces two big policy challenges (a) supervising banks and completing a round of
stress tests, and (b) deciding how to deal with deflationary pressures. Some form of
expanded policy accommodation is possible.
Short-term interest rates above 8% worked to stabilize the currency in Q1/2014. A
prolonged period of currency stability could potentially allow for rate cuts down the road.
Special
Factors
China has widened the bands for currency volatility, and the RMB weakened during
Q1/2014, joining the ranks of other emerging market currencies that had previously
experienced weakness.
The EU Parliamentary elections in May 2014 could prove very interesting. Fringe parties appear to be gaining ground, such as the UK Independence Party and the National Front in
France.
The India has parliamentary election in 2014 that could bring a shift of power. Despite
election uncertainties, though, stability at the central bank is likely to mitigate any market
Appendix 1: Summary of World Economic Conditions, cont.
Japan Mexico Russia
Growth,
Inflation
& Fiscal
Policy
Japan’s hike in its national sales tax is expected to lead to weaker real GDP for a few quarters. There is possibility of Prime Minister
Abe bringing forward more fiscal stimulus if economic growth is too depressed by the sales
tax hike.
Mexico is benefiting from improved growth in the United States. Mexico has also increased its imports of relatively inexpensive natural
gas through its pipeline link with Texas.
Russia’s annexation of the Crimea will come at a price of expanded spending and potential
sanctions. Slower economic growth and even possibly a recession seem quite possible.
Monetary
Policy
The Bank of Japan may also consider expanding its quantitative easing (asset
purchase) program if real GDP shrinks in the April-June quarter.
The Bank of Mexico has been able to allow for small rate reductions as the currency has
stabilized.
The political uncertainties over the Crimea takeover have led to a weaker Ruble and higher
interest rates.
Special
Factors
A 2% inflation target by the Bank of Japan is not likely to be achieved in a short time frame unless there is further yen depreciation toward
the 120-140 yen/dollar rate. There is the possibility the government and central bank
would welcome another round of yen weakness.
In the emerging market currency sell-off in 2013, the Mexican peso did not lose as much ground as many of its peers. And now that pressures have abated, the peso is poised to
regain some lost ground.
Russia’s annexation of the Crimea has dominated the headlines in Q1/2014. And, Russia is likely to put more pressure on the Ukraine through higher
natural gas prices.
Switzerland United Kingdom United States
Growth,
Inflation
& Fiscal
Policy
Switzerland is seeing some benefits from Europe’s stabilization. Moreover, stronger growth in the US may also help exports.
The UK’s growth prospects are steadily improving. The budget deficit as a percent of
GDP is also declining.
The US economy suffered through a tough winter in midwest and northeast, but a bounce back seems in progress as spring has arrived. And,
surprising to many, the Federal budget deficit is on track to be balanced on an operating basis in
FY2015.
Monetary
Policy
As the EU debt crisis has morphed into a long-term banking capital adequacy problem, the
Swiss have little flexibility, and they are likely continue to keep a lid on the Swiss franc
relative to the euro.
The Bank of England has indicated it plans to keep rates low and focus its efforts on financial
supervision. A stronger economy than expected by the BoE could change that
guidance later in 2014.
The Yellen-led Federal Reserve immediately moved to alter its forward guidance process at its first FOMC meeting after Bernanke’s retirement. Indicator-based guidance is out, replaced by a
more nuanced view of labor market conditions and potential inflation pressures. QE is on track to
end in Q4/2014.
Special
Factors
The post-2008 financial crisis has led to increased regulation of financial institutions all
over the world. On net, this increased regulation poses additional challenges for the
traditional model of Swiss secrecy and the overall role of Switzerland in the world’s
financial system.
The vote in Scotland on independence in September is starting to cast a shadow over the British pound. The outcome will depend on the tug of war between the pocket book
and the heart strings. Economics says independence would hurt Scotland and the UK. But Scots can achieve at the ballot box what
eluded Robert Bruce and William Wallace.
The US dollar may hold the key to whether inflation pressures emerge in the US. The 1970s
saw a weak dollar and rising inflation, and the early 1980s saw dramatic declines in inflation with
a strong dollar. During 2013, a weak yen and weak emerging market currencies contributed to
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