CURRENCIES Currency Market Monitor 4 th Quarter2013 JANUARY 6, 2014 John W. Labuszewski Sandra Ro Bluford Putnam Managing Director Executive Director Chief Economist Research & Product Development 312-466-7469 [email protected]Research & Product Development 011 (44) 203-379-3789 [email protected]Research & Product Development 212-299--2302 bluford.putnam@cmegroup.com
A Review of the Leading Factors affecting the FX Market in the 4th Quarter 2013. Many fundamental factors, including national economic conditions, monetary policies and current and capital account flows, to name just a few, impact the returns associated with the world’s currencies.
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CURRENCIES
Currency Market Monitor 4th Quarter 2013
JANUARY 6, 2014
John W. Labuszewski Sandra Ro Bluford Putnam
Managing Director Executive Director Chief Economist
billion in 2011 and 2012, respectively, but that still
represents sizable values.
But during the first ten months of 2013 through
October, foreign investors purchased a scant $46
billion of Treasuries on a net basis. Despite this
surprisingly low total, a rather substantial $500
billion in capital has flowed into the U.S. on a net
basis from January through October 2013.
Most of this inflow has come into U.S. equities with
an influx of some $544 billion on a net basis as a
result of strong U.S. equity performance and a
widespread anticipation of rising rates and falling
bond prices.
Mutual Fund Flows
The flow of equity and fixed income investments
may be examined per data published by the
Investment Company Institute (ICI) which tracks
activity in the mutual fund industry. 12
Investors added some $156.5 billion into equity
funds during the first eleven months of 2013
through November. Interestingly, only $27.1 billion
was directed into domestic equity funds, despite
their generally strong performance while another
$129.4 billion was added to foreign equity funds.
12 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.
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 October, some $57.9 billion had
been withdrawn from bond funds on a year-to-date
basis.
USD Price Performance
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
-$40
-$30
-$20
-$10
$0
$10
$20
$30
$40
Jan-1
2
Mar-
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May-1
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Jul-
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Sep-1
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Nov-1
2
Jan-1
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Mar-
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May-1
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Jul-
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Sep-1
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Nov-1
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Equity Fund Cash Flows (Billions USD)
Domestic Equities Foreign EquitiesSource: Investment Company Institute (ICI)
quarter’s ending mark of 1,027.22 and well over the
year-end 2012 figure of 992.19.
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
growth has generally decelerated relative to DM
economies in recent years.
Actual and Forecast GDP Growth
2010 2011 2012 2013
2014
-19
(f)
2020
-25
(f)
Developed Markets (DMs)
Australia 2.6% 2.4% 3.7% 2.7% 2.3% 2.2%
Canada 3.2% 2.6% 1.8% 1.4% 2.0% 1.8%
France 1.7% 2.0% 0.0% 0.2% 1.4% 0.9%
Germany 4.2% 3.0% 0.7% 0.4% 1.6% 1.4%
Japan 4.7% -0.6% 2.0% 0.8% 1.0% 0.6%
UK 1.8% 1.0% 0.3% 0.6% 1.9% 1.1%
US 2.5% 1.8% 2.8% 1.6% 2.4% 1.7%
Emerging Markets (DMs)
Brazil 6.9% 2.7% 0.9% 2.0% 2.9% 2.8%
Mexico 5.3% 3.9% 3.9% 2.5% 2.9% 3.1%
Russia 4.5% 4.3% 3.4% 2.9% 1.8% 1.2%
India 9.3% 6.2% 5.0% 4.2% 4.8% 3.6%
China 10.4% 9.3% 7.7% 7.5% 5.9% 3.5%
Source: The Conference Board Global
Economic Outlook 2014 (November 2013)
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
13 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.
(+1.0%), the United Kingdom (+1.9%) and the
United States (+2.4%). Note that the Euro (EUR)
posted a total return vs. the U.S. dollar (USD) in
2014 of +4.31%; the British pound (GBP) was seen
at +2.36% while the Japanese yen brought up the
rear at -17.52%.
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 Chinese yuan or renminbi rallied by
7.07% relative to the USD in 2014. The Indian
rupee (INR) was off 2.51%; the Brazilian real (BRL)
was down some 6.73% while the Russian ruble
(RUB) was off 0.55%. Still, GDP in these nations is
On the negative side of the ledger, the Japanese yen
(JPY) posted a return of -6.66%, the Turkish lira
(TRY) checked in at -4.08% with the Brazilian real
(BRL) at -3.93%, the South African rand (ZAR) at -
3.81% and the Chilean peso (CLP) at -2.80%.
Because the carry trade has become such an
important and widely followed transaction in the
global FX markets, CME Group has developed the
CME FX Carry Index.
This novel index is designed to follow the
performance of a basket of currencies that offer
relatively high interest rates and have, at least on
an historical basis, generated favorable total returns. 14 The CME FX Carry Index closed the 4th quarter at
808.21 and off 4.2% from its 3rd quarter ending
value of 843.70. The Index was further down
12.4% from its ending 2012 value of 922.27. This
reflects the general poor performance of EM
currencies vs. the USD and EUR during 2013.
14 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.
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. 15 The theory is based
upon the assumption that exchange rates are in
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
generally fell a bit on a productive growing season
coupled with moderating global demands.
CME Group has developed the CME FX Commodity
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. 16
16 The CME Commodity Country Index is constructed to be
effectively long Australian dollar (AUD), Brazilian real (BRL), Canadian dollar (CAD), Norwegian krone (NOK),
The CME FX Commodity Country Index fell to 857.91
and off 3.2% from its 3rd quarter value of 886.53.
This represents a decline of 10.0% decline for the
year 2013 from its year-end 2012 value of 953.60.
This performance is a reflection of the generally
tepid performance of commodity markets in 2013.
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),
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.
870.99. This represents a decline of 6.8% from its
year-end 2012 value of 920.65. These negative
results further reflect the general deceleration of
emerging market growth.
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.
dollar).
These products provide facile and liquid vehicles
with which one may express a view on prospective
market movements. Or, to manage the risks
associated with currency holdings or international
investments during turbulent times.
17 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.
Australia’s economy has weakened since the days of the commodity boom. Problems may
persist into 2014 with low gold prices potentially leading to mine closures.
Economic growth may move incrementally higher in 2014. Risks remain due to public
unrest surrounding a lack of perceived progress with many government services
against a backdrop of hosting the World Cup and the Olympics.
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
Short-term interest rates have been lowered to cushion economic growth without fear of
inflation pressures accelerating. Further rate declines could keep the currency on a
weakening path.
The short-term SELIC rate has been raised to help stabilize the currency. Any currency
strength that might emerge in 2014 could be met with rate cuts.
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 was once a favorite for the long-side of the carry trade. With lower rates, China risk, weak-to-stable commodity
prices, and less than favorable comparisons to New Zealand, the bloom may remain off the
Aussie dollar.
Brazil hosts the World Cup in 2014 and the Olympics in 2016. How political uncertainties
are resolved ahead of these high profile events is the major risk factor for the currency.
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
Economic growth in 2013 ran about 7.6% in real GDP terms. China may squeeze out 6.5%
to 7% real GDP growth in 2014, as the economy avoids a hard landing but continues
to face challenges in its transition to a domestic demand growth model.
Europe appears to have stabilized and may even show some incremental economic growth
in 2014. Challenges remain with an under-capitalized banking sector holding back a return to more robust economic activity.
Like China and Brazil, India saw a rapid deceleration of economic growth in 2012 and 2013. To tackle the current account deficit,
tariffs have been raised on gold imports. Large energy and food subsidies, though,
remain a big challenge for the Government.
Monetary
Policy
Monetary policy remains in flux as China tries to curtail past rapid expansion of credit while also pushing for more rapid development of
financial institutions, including derivative markets.
The ECB may become more aggressive in supervising banks in 2014 as it is pushed into taking the lead in EU-wide financial reform. Rates are likely to remain on hold. Liquidity will be made available to banks as needed.
India has installed a new head of the central bank with a mission to reform the financial
sector. Only time will tell, but the new direction is a welcome change for the currency
markets.
Special
Factors
China’s new leadership has moved to relax the one-child policy and make moving from the
rural to the urban sector easier. For 2014 and 2015, China may speed up the pace toward
normalizing the currency.
Leadership in the European Union is weak. Germany held elections in September, but it
took three months for Chancellor Merkel to put together a coalition Government. France’s
President ranks extremely low in the opinion polls. The Euro carries considerable political
risk going into 2014.
The Indian rupee was very weak in the second and third quarters of 2013, before stabilizing in the fourth quarter. With the trade balance
potentially narrowing a little and financial reforms on the way, the rupee has a chance to
reverse course and appreciate, but only if global markets embrace greater risk taking.
Appendix 1: Summary of World Economic Conditions, cont.
Japan Mexico Russia
Growth,
Inflation
& Fiscal
Policy
Japan faces a big hike in its national sales tax in April 2014. This is expected to lead to
anticipatory spending in the January-March 2014 quarter, and then negative real GDP
afterwards.
With economic growth in the US economy continuing at a healthy pace, Mexico should
benefit from increased trade with its partner to the north.
Elevated crude oil prices have benefitted Russia’s economy, but an aging population and a difficult
environment for foreign investment suggest slower economic growth in the years to come. There are key recent signs, though, of Russia
attempting to become friendlier to foreign investment.
Monetary
Policy
The Bank of Japan is pursuing the largest quantitative easing (asset purchase) program
relative to GDP ever attempted to raise inflation and economic growth. Inflation is
ticking upward, mostly in response to past yen weakness.
Currency strength in 2012 helped to reduce inflation pressures. Recent currency weakness in 2013, however, threatens the progress on inflation. Central bank policy is probably on
hold for now.
Russia has accumulated a large quantity of foreign reserves giving the authorities some firepower to counter any ruble weakness, if they so choose,
during periods of oil market weakness.
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. Nothing moves
in a straight line, though, and the coming sales tax hike adds considerable risks to the timing
of any scenario.
Mexico’s currency emerged as one of the favorites for the long-side of the carry trade
versus the Japanese yen, but only in “risk-on” markets. Conditions in 2014 suggest the
possibility for a peso rebound if a “risk-on” climate returns to global markets.
Russia’s energy supply dominance of Europe is being challenged by increased oil and natural gas supplies around the globe. If the link in Europe
between natural gas pricing and Brent oil is broken, this could hit Russian government
revenues quite hard.
Switzerland United Kingdom United States
Growth,
Inflation
& Fiscal
Policy
Switzerland will benefit in 2014 from Europe’s stabilization. Moreover, stronger growth in the
US may also help exports.
The UK has a very strong housing market and prospects for solid economic growth in 2014. Fiscal policy is less restrictive than in the past few years as the Government looks ahead to
elections in 2015.
The US economy appears poised for robust growth in 2014 as the post-crisis deleveraging fades into history and fiscal stability is achieved faster than expected. The Federal budget deficit may decline below 3% of GDP in FY2014 and 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 and some emerging
inflation pressure could change that guidance during 2014.
The Federal Reserve has announced that the US economy no longer needs emergency life support, and the tapering of QE has begun. Even with a
declining unemployment rate, the Fed has made it clear it will keep its zero federal funds rate policy in place until it sees some inflation pressure, and
there is none in sight yet.
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.
Tensions between the UK and the European Union are likely to intensify, especially over
the push by the EU to impose financial transaction taxes. As the UK outperforms the Euro-zone economically, the possible scenario for pound strength versus the euro may come
into play in 2014.
The US dollar is not a strong currency, but other major currencies are challenged as well. Markets may start to focus as 2014 progresses on which country might raise rates first in 2015. For now,
the UK is the leading contender, the US and Eurozone in the middle, with little probability of
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