fx market monitor - 1st quarter 2013
TRANSCRIPT
CURRENCIES
Currency Market Monitor 1st Quarter 2013
APRIL 6, 2013
John W. Labuszewski Sandra Ro Bluford Putnam
Managing Director Executive Director Chief Economist
Research & Product Development
312-466-7469
Research & Product Development
011 (44) 203-379-3789
Research & Product Development
212-299--2302
1 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
An ongoing debate has long persisted in the global
currency or FX markets – is FX an “asset class” akin
to stocks and bonds? While practitioners and
academics may debate this point at length, perhaps
the most practical answer is – does it really matter
provided that investors may draw a return from
currency investments?
The performance of the currency or FX markets is
found in the exchange rates and cross-rates
associated with the world’s myriad currencies. The
total return associated with a currency is driven by
interest income associated with fixed income
instrument investment in the particular currency; as
well as pure price performance.
Many fundamental factors, including national
economic conditions, monetary and policies, current
and capital account flows, to name just a few,
impact the returns associated with the world’s
currencies.
This document represents a review of these factors
as they played out in the most recently completed
calendar quarter. We include consideration of the
so-called “carry trade” as well as a look at the
theory of “purchasing power parity” as it impacts FX
markets.
While we cover activity in a broad spectrum of
currencies, we focus on the currencies underlying
some of the most liquid of CME Group FX futures.
This includes the U.S. dollar (USD), Euro (EUR),
Japanese yen (JPY), British pound (GBP), Swiss
franc (CHF), Canadian dollar (CAD), Australian dollar
(AUD) and Mexican peso (MXN).
In addition, we have special interest in the
currencies of significant emerging market economies
including the Brazilian real (BRL), Russian ruble
(RUB), Indian rupee (INR) and Chinese yuan or
renminbi (CNY) – the so-called “BRIC” nations.
Finally, we highlight several CME Group FX Indexes
including a USD Index, a Carry Trade Index,
Commodity Country Index and BRIC Index.
Market Fundamentals
As a general rule, FX analysts will evaluate the
fundamental value of any particular currency by
reference to a number of national economic factors.
These factors including growth and inflation
prospects; monetary and fiscal policies; and, current
and capital account balances.
To illustrate, we include a brief discussion of the
economic situation prevailing in the United States as
of the conclusion of the most recently completed
calendar quarter. Of course, the U.S. dollar (USD)
may be just one side of any currency pair that may
be traded using CME Group FX futures.
A brief summary of economic conditions in various
nations, organized along similar lines, is included in
Appendix 1 of our document below. One may
compare and contrast these conditions as they exist
in the two countries whose currency pairing one may
be interested in to draw an appreciation of the
fundamental factors that impact currency markets.
Growth and Employment
Fourth quarter 2012 GDP was most recently
reported at a somewhat disappointing +0.4%. But
the Federal Open Market Committee (FOMC)
attributed this figure, after a rather robust advance
of +3.1% in the 3rd quarter, to “weather-related
disruptions” with an obvious nod to Superstorm
Sandy “and other transitory factors” such as
inventory drawdowns. 1
The FOMC suggested more recently on March 20th
that we are now witnessing a “return to moderate
1 Federal Reserve Press Release dated January 30, 2013.
4%
5%
6%
7%
8%
9%
10%
11%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
Q1 0
5Q
3 0
5Q
1 0
6Q
3 0
6Q
1 0
7Q
3 0
7Q
1 0
8Q
3 0
8Q
1 0
9Q
3 0
9Q
1 1
0Q
3 1
0Q
1 1
1Q
3 1
1Q
1 1
2Q
3 1
2Q
1 1
3
Unem
plo
ym
ent
Rate
Qtr
ly C
hange in G
DP
Growth and Employment
Real GDP (SA) Unemployment Rate
Source: Bureau of Economic Analysis (BEA) & Bureau of Labor Statistics (BLS)
2 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
economic growth following a pause late last year.” 2
The Fed elaborates that while “[l]abor market
conditions have shown signs of improvement in
recent months … the unemployment rate remains
elevated.” 3 Unemployment is winding down,
reported at 7.6% for March 2013. But it does
remain significantly above the Fed’s target of 6-½%.
The Fed does concede that it sees “downside risks to
the economic outlook.” Certainly these risks are
implied by the ongoing decline in labor force
participation, reported at 63.3% for March 2013.
Still, the Fed found solace in the facts that
“[h]ousehold spending and business fixed
investment advanced, and the housing sector has
2 Federal Reserve Press Release dated March 20, 2013. 3 Ibid.
strengthened further but fiscal policy has become
somewhat restrictive.” 4
Consumer confidence has been buoyed in recent
months with the Michigan Index of Consumer
Sentiment reported at 77.6 in February 2013 and up
from 75.3 in February 2012. This sentiment is
reinforced by a decline in the personal savings rate
to 2.4% in January 2013 from 6.4% in December
2012.
Further evidence of retail strength, accounting for
perhaps 70% of domestic economic growth, is found
in strong retail sales activity. The February 2013
retail sales report is the strongest figure on record,
topping numbers recorded in late 2007 before the
full weight of the subprime mortgage crisis was felt.
4 Ibid.
63%
64%
65%
66%
67%
4%
5%
6%
7%
8%
9%
10%
11%
Jan-0
2
Jan-0
3
Jan-0
4
Jan-0
5
Jan-0
6
Jan-0
7
Jan-0
8
Jan-0
9
Jan-1
0
Jan-1
1
Jan-1
2
Jan-1
3
Labor
Forc
e P
art
icip
ation
Unem
plo
ym
ent
Rate
Employment Statistics
Unemployment Rate Labor Force Partcipation
Source: Bureau of Labor Statistics (BLS)
55
60
65
70
75
80
85
90
95
100
1%
2%
3%
4%
5%
6%
7%
8%
9%
Jan-0
7
Jul-
07
Jan-0
8
Jul-
08
Jan-0
9
Jul-
09
Jan-1
0
Jul-
10
Jan-1
1
Jul-
11
Jan-1
2
Jul-
12
Jan-1
3
Consum
er
Confidence
Pers
onal Savin
gs R
ate
Personal Savings & Sentiment
Personal Savings Rate Consumer Sentiment Index
Source: FRED Database
1.20
1.25
1.30
1.35
1.40
1.45
1.50
$150
$155
$160
$165
$170
$175
$180
$185
Jan-0
7
Jul-
07
Jan-0
8
Jul-
08
Jan-0
9
Jul-
09
Jan-1
0
Jul-
10
Jan-1
1
Jul-
11
Jan-1
2
Jul-
12
Jan-1
3
Invento
ry:S
ale
s R
atio
Reta
il S
ale
s (
Bil $
)
Retail Sector Activity
Real Retail Sales & Food Services SATotal Business Inventory:Sales Ratio
Source: U.S. Census Bureau
0
500
1,000
1,500
2,000
2,500
Jan-0
4
Sep-0
4
May-0
5
Jan-0
6
Sep-0
6
May-0
7
Jan-0
8
Sep-0
8
May-0
9
Jan-1
0
Sep-1
0
May-1
1
Jan-1
2
Sep-1
2
000 U
nits
Housing Activity
Building Permits Housing Starts Completions
Source: Dept. of Housing & Urban Development (HUD)
3 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
March housing activity figures were generally quite
upbeat with building permits rising to 946 thousand
units and housing starts up to 917 thousand units
and the highest levels recorded since 2008.
Further signs of growing momentum may be found
in housing values. The S&P/Case-Shiller Composite
Index of 10 U.S. cities was reported for January
2013 as 8.4% above the trough recorded in March
2013 but still 29.9% below the all-time peak from
June 2006.
This consumer optimism spilled over into the
industrial sector as the Index of Industrial
Production was recorded for February 2013 at its
highest level since April 2008. Similarly, capacity
utilization rose to 78.3% in February 2013. Still,
these figures fall a bit short of the peaks observed in
late 2007 and early 2008 just prior to the onset of
the subprime crisis.
Industrial growth was further reflected in strong
corporate profitability. Third quarter 2012 corporate
profits were recorded at $1.74 trillion. This is an
advance of 17.9% over the 2nd quarter 2012 figure
and the highest observed performance yet to be
recorded.
Inflation
The Fed observed that “[i]nflation has been running
somewhat below the Committee’s longer-run
objective, apart from temporary variations that
largely reflect fluctuations in energy prices. Longer-
term inflation expectations have remained stable …
[t]he Committee also anticipates that inflation over
80
120
160
200
240
280
320
Jan-0
0
Nov-0
0
Sep-0
1
Jul-
02
May-0
3
Mar-
04
Jan-0
5
Nov-0
5
Sep-0
6
Jul-
07
May-0
8
Mar-
09
Jan-1
0
Nov-1
0
Sep-1
1
Jul-
12
S&P/Case-Shiller Housing Indexes
Los Angeles San Diego San Francisco
Denver Washington DC Miami
Chicago Boston Las Vegas
New York Comp-10
Source: Standard & Poor's
66%
68%
70%
72%
74%
76%
78%
80%
82%
80
85
90
95
100
105
Jan-0
7
Jul-
07
Jan-0
8
Jul-
08
Jan-0
9
Jul-
09
Jan-1
0
Jul-
10
Jan-1
1
Jul-
11
Jan-1
2
Jul-
12
Jan-1
3
Capacity U
tilization
Industr
ial Pro
duction I
ndex
Industrial Sector Activity
Index of Industrial Production Capacity Utilization
Source: St. Louis Federal Reserve FRED Database
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
120%
Q1 0
4
Q4 0
4
Q3 0
5
Q2 0
6
Q1 0
7
Q4 0
7
Q3 0
8
Q2 0
9
Q1 1
0
Q4 1
0
Q3 1
1
Q2 1
2
Pre
-Tax P
rofits
(Billions)
Annualized C
hange
U.S. Corporate Profitability
Annual Change Corporate Profits (Bil)
Source: Department of Commerce
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
Jan-0
4
Aug-0
4
Mar-
05
Oct-
05
May-0
6
Dec-0
6
Jul-
07
Feb-0
8
Sep-0
8
Apr-
09
Nov-0
9
Jun-1
0
Jan-1
1
Aug-1
1
Mar-
12
Oct-
12
Year-
on-Y
ear
Change
Consumer Price Index (CPI)
CPI - All Urban Consumers SACPI ex-Food & Energy SA
Source: Bureau of Labor Statistics (BLS)
4 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
the medium term will run at or below its 2 percent
objective.” 5
Indeed, both CPI and CPI ex-food and energy prices
were recorded, on a seasonally adjusted (SA) basis,
at 2.0% in February 2013 and precisely equal to the
Fed’s stated objective.
Monetary Policy
The Fed suggests that “a highly accommodative
stance of monetary policy will remain appropriate for
a considerable time after the asset purchase
program ends and the economic recovery
strengthens … [thus, it is maintaining] … the target
range for the federal funds rate at 0 to ¼ percent
and currently anticipates that this exceptionally low
range … will be appropriate at least as long as the
unemployment rate remains above 6-½ percent,
inflation between one and two years ahead is
projected to be no more than a half percentage
point above the Committee’s 2 percent longer-run
goal, and longer-term inflation expectations continue
to be well anchored.” 6
While Fed policy on the very shortest end of the
curve remains fixed, they nonetheless “decided to
continue purchasing additional agency mortgage-
based securities at a pace of $40 billion per month
and longer-term Treasury securities at a pace of $45
billion per month … Taken together, these actions
should maintain downward pressure on longer-term
5 Ibid. 6 Ibid.
interest rates, support mortgage markets, and help
to make broader financial conditions more
accommodative.” 7
Fiscal Policy
The Fed comments that “fiscal policy has become
somewhat restrictive.” 8 Certainly this restrictive
stance is reflected in a decline the Federal deficit for
2012 of $10.1 trillion. While this is a considerable
figure and far in excess of all previous deficits prior
to the onset of the subprime crisis, it nonetheless
represents some improvement over the deficits of
2009, 2010 and 2011.
Still, the budget battle in Washington is not over as
the gap between the Democratic and Republican
fiscal visions are far apart. This battle may reach
crisis proportions around May 19th when the next
debt limit crisis is projected to come to a head.
Entitlement spending, income and estate taxes and
the size of government remain controversial issues.
Current & Capital Account Flows
Just as incremental progress is achieved with
respect to the Federal spending deficit, we also see
some improvement with respect to the U.S. current
account or trade deficit. The 4th quarter 2012 deficit
was reported at $100.4 billion. While not altogether
cheerful, it represents a significant improvement on
the $133.8 billion deficit from the 1st quarter 2012
7 Ibid. 8 Ibid.
0%
1%
2%
3%
4%
5%
6%
7%
Jan-0
1
Jan-0
2
Jan-0
3
Jan-0
4
Jan-0
5
Jan-0
6
Jan-0
7
Jan-0
8
Jan-0
9
Jan-1
0
Jan-1
1
Jan-1
2
Jan-1
3
Benchmark U.S. Rates
Target Fed Funds 2-Yr Treasury
5-Yr Treasury 10-Yr Treasury
30-Yr Treasury
-$1,600
-$1,400
-$1,200
-$1,000
-$800
-$600
-$400
-$200
$0
$200
$400
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Federal Surplus/Deficit(Billions USD)
Source: Office of Management and Budget (OMB)
5 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
and is running at roughly half of the pre-crisis
deficits which peaked in 2006.
Another interesting source of flow of funds data may
be found in the U.S. Treasury Department’s
Treasury International Capital (or “TIC”) database.
This database tracks flows into and out of the U.S.
The data is broken into foreign stocks, foreign
bonds, U.S. stocks, U.S. corporate bonds, U.S.
government agencies and U.S. Treasuries.
Capital flowing out of the U.S. by domestic or
foreign investors was rather negligible during the
entirety of 2012. Some $105.2 billion, on a net
basis, flowed into the U.S. equity markets from
overseas in 2012. But the major story was the
continued inflow of funds into the U.S. Treasury
markets as overseas investors bought some $391.6
billion of Treasuries, on a net basis, in 2012.
Still, this represents a significant decline from the
$703.7 billion flowing into Treasuries in 2010.
Clearly, U.S. Treasuries continue to be regarded as a
“safe haven” investment that is highly valued by
foreign investors, despite generally low yields.
In any event, the weight of these structural U.S.
fiscal and trade deficits appears likely to exert
influence on the future course of the USD for many
years to come
European Sovereign Debt Crisis
In addition to developments specific to the U.S.
economy, the currency markets continue to be
colored by a number of fundamental news events
including the ongoing European sovereign debt
crisis. The 1st quarter was heavily colored by
developments in Italy, Cyprus and on the
unemployment front.
Deadlock surrounding Italy’s elections held on
February 24-25th elevated concerns that it would not
hold firm on economic austerity measures.
President Giorgio Napolitano continues attempts to
facilitate negotiations aimed at forming a new
government.
Meanwhile, Cyprus concluded an accord to impose
losses on uninsured depositors in the Bank of Cyprus
and Cyprus Popular in return for some €10 billion in
bailout funds from the IMF, ECB and EU. These
loans carry a 2.5% rate over 22 years.
Finally, Eurostat reported record 12.0%
unemployment in the 17-nation Eurozone bloc by
-$250
-$200
-$150
-$100
-$50
$0
Q1 0
4
Q3 0
4
Q1 0
5
Q3 0
5
Q1 0
6
Q3 0
6
Q1 0
7
Q3 0
7
Q1 0
8
Q3 0
8
Q1 0
9
Q3 0
9
Q1 1
0
Q3 1
0
Q1 1
1
Q3 1
1
Q1 1
2
Q3 1
2
U.S. Current Account Deficit(Billions USD)
Source: Bureau of Economic Analysis (BEA)
-$800
-$300
$200
$700
$1,200
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Net US/Foreign Capital Flows (Billions USD)
US Treasuries US Gov't Agencies US Corporates
US Stocks Foreign Bonds Foreign Stocks
Source: U.S. Treasury TIC Database
1.10
1.20
1.30
1.40
1.50
1.60
1.70
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
EUR/USD Exchange Rate
6 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
Feb-13. This rate is up from 10.9% in Feb-12 and
includes some 19.1 million unemployed persons.
The highest rates were recorded in Greece (26.4%);
Spain (26.3%); Portugal (17.5); Ireland (14.2%);
and, Cyprus (14.0%). The lowest unemployment
rates were recorded in Austria (4.8%); Germany
(5.4%); Luxembourg (5.5%); and, the Netherlands
(6.2%).
These ongoing uncertainties in the Eurozone
weighed heavily on the value of the Euro currency
which declined below $1.30/Euro.
Emerging Economy Performance
Emerging market economies including those in the
so-called BRIC nations of Brazil, Russia, India and
China, have played the most prominent role in
global economic expansion in recent years.
However, this growth has slowed in recent years
from its previous arduous pace.
BRIC Nation GDP Growth
2009 2010 2011 2012
Brazil -0.33% +7.53% +2.73% +0.87%
Russia -7.80% +4.03% +4.34% +1.96%
India +6.40% +9.80% +7.30% +5.10%
China +9.20% +10.40% +9.30% +7.80%
NOTES
2012 figures based on early indications and subject to further revisions.
These slow-downs have been driven, in some cases,
by policies aimed at slowing down inflation and the
possibility of asset bubbles. Note that the four BRIC
nations experienced (estimated) inflation of 5.4%,
5.12%, 9.5% and 2.6%, respectively, in 2012. Still,
growth is generally expected to re-accelerate in the
emerging markets moving forward.
Policy-Driven JPY Movement
One of the more dramatic stories in the FX markets
surrounds the movement in the Japanese yen (JPY).
A stellar performer a couple of years ago, the JPY
has reversed downward some 24% since its peak in
October 2011.
This decline may be attributed to pressure applied
on the Bank of Japan (BOJ) to adopt a more
expansionary monetary policy and to address the
ongoing threat of deflation. As such, the BOJ
adopted its own version of quantitative easing (QE)
and has increased its target for inflation to 2%. This
has prompted large scale capital outflows from
Japan.
Price Performance
These factors 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. 9
9 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.
75
80
85
90
95
100
105
110
115
120
125
130
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
USD/JPY Exchange Rate
900
950
1,000
1,050
1,100
1,150
1,200
1,250
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
CME USD Index
Long Short16.7% EUR 100% USD16.7% JPY16.7% GBP 16.7% CHF 16.7% CAD16.7% CNY
7 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
The CME USD Index generally advanced during the
1st quarter 2013 on signs of a consumer-driven
economic recovery in the U.S. along with increased
tensions in Europe and tepid conditions in emerging
economies. Thus, investors have been moving
funds into USD-denominated investments. Thus,
our USD Index remains rallied from 992.19 to
1,027.16 during the 1st quarter 2012.
Total Return
One of the most popular long-term FX trading
strategies over the past decade is known simply as
the “carry trade.” This practice simply suggests
that one might exploit “cost of carry” by borrowing
in countries with low nominal interest rates to invest
in countries with high nominal interest rates. Thus,
one might sell the “low-rate” currency and buy the
“high-rate” currency.
Carry trade � Sell low-rate currency &
buy high-rate currency
By so doing, one hopes to capitalize on discrepant
interest rates, and by implication, divergent
investment opportunities, in the two countries. This
strategy further recognizes that total currency return
consists of 2 components, specifically, exchange rate
or price movement plus the accrual of interest.
Total Currency
Return =
Price Movement +
Interest
The implicit assumption is that these interest rate
relationships will endure. As such, carry traders
implicitly discount classical exchange rate theories
by assuming that the interest rate relationships may
endure over extended periods of time. This
suggests that low-yielding currencies that are sold
will not advance; and, that high-yielding currencies
that are purchased will not decline.
Historically, such relationships have been known to
endure for extended periods of time, reinforcing
interest in the carry trade. In particular, vast sums
of money totaling in the trillions of U.S. dollars were
invested in the carry trade, specifically by shorting
the Japanese yen (JPY) and investing in other
currencies including the Icelandic krona (ISK).
Appendix 2 below depicts the total return associated
with various currencies, relative to the U.S. dollar,
during the most recently completed calendar
quarter. Note the Mexican peso (MXN) led the pack
with a quarterly return of +5.20%; followed by the
Icelandic krona (+4.92%); Argentine peso
(+4.65%); and, Indian rupee (+3.65%).
The Japanese yen continued its downward skid
during the 1st quarter 2013, posting a total return of
-7.90%). Other currencies turning in a weak
performance during the quarter included the South
African rand (-7.67%); British pound (-6.39%); and,
the South Korean won (-3.67%).
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. 10 The CME FX Carry Index closed the 1st quarter at
10 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
-8%
-6%
-4%
-2%
0%
2%
4%
6%
USD-JPYUSD-ZARGBP-USDUSD-KRWUSD-CHFEUR-USDUSD-TWDUSD-COPUSD-CADUSD-RUBUSD-TRY
USDAUD-USDUSD-CNYNZD-USDUSD-BRLUSD-CLPUSD-INRUSD-ARSUSD-ISK
USD-MXN
Carry Return (Q1 2013)
8 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
934.15 and up 1.3% from its 4th quarter value of
922.27.
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. 11 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
short components of the index were identified because of the low interest rates offered.
11 See Cassel, Gustav, “Abnormal Deviations in International Exchanges” (December 1918).
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.
If inflation
increases �
Rates
increase �
Currency value
should decline
If inflation
decreases �
Rates
decrease �
Currency value
should advance
The IFE suggests interest rates and exchange
negatively correlated. Similarly, PPP suggests
inflation and exchange rates negatively correlated.
As such, the IFE theory is generally consistent with
the PPP theory.
Putting the classic theory of purchasing power parity
into practice requires a measurement of inflation in
order to calculate the proportion by which any
particular currency is (theoretically) over- or under-
valued relative to the norm. There are three popular
methodologies that have been referenced in this
regard.
• OECD - The Organization for Economic Co-
operation and Development (OECD) provides data
that is useful in this regard by comparing price
changes in a representative basket of goods in
various countries.
• Bloomberg - Bloomberg offers an analytical tool
that is grounded in a very long-term assessment
of inflation, as measured by either CPI or PPI in
700
750
800
850
900
950
1,000
1,050
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
CME FX Carry Index
Long Short16.7% BRL 50% USD16.7% AUD 50% EUR16.7% ZAR 16.7% NZD16.7% TRY16.7% MXN
9 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
various countries extending from January 1982
through June 2000.
• Big Mac - Finally, the Economist’s “Big Mac PPP”
methodology compares the price of a (almost)
universally available product with verifiable pricing
in the form of the McDonald’s Big Mac hamburger
in various countries.
Actually, all three methodologies may readily be
referenced on Bloomberg quotation devices.
Appendix 3 below provides data from all three
methods. Further, we have taken the average of
the three assessments (where available) for a
variety of national currencies and rank-ordered the
set from most over-valued to most under-valued.
Note that the most over-valued currency, per our
methodology, remains the Norwegian krone (NOK)
at +39.83% relative to the USD. Other highly
valued currencies include the Swiss franc (CHF) at
29.84; the Brazilian real (BRL) at +29.66%; the
Australian dollar (AUD) at +27.27%; and, the
Swedish krona (SEK) at +23.13%.
Under-valued currencies, per our analysis, include
the South African rand (ZAR) down at -55.60%; the
Polish zloty (PLN) at -53.71%; the Hong Kong dollar
(HKD) at -49.95%; and, the Hungarian forint (HUF)
at -49.00%.
One might recommend creating “baskets” of several
currencies to buy and sell on the basis of this
analysis in order to diversify risks to a certain
extent. However, it is important to recognize that
currencies might remain in apparent states of over-
or under-valuation for extended periods of time. In
fact, the carry trade as discussed above, takes a
completely opposite approach to the classic PPP
theory by buying high-rate currencies and shorting
low-rate currencies.
Impact of Commodities
As a general rule, the nations whose currencies have
remained top performers over the past decade may
be identified as those whose national income is tied
heavily to commodity production.
Commodity prices have advanced rather sharply
over the past decade as seen in the rise in the value
of energy, grain, livestock, precious metals and
industrial metals. These price advances have largely
been driven by emerging market demand in nations
including China and India.
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. 12
The 1st quarter 2012 saw modest advances in
energy prices with mixed grain prices but gold
declined approximately $50 on growing economic
12 The CME Commodity Country Index is constructed to be
effectively long AUD, BRL, CAD, Norwegian krone (NOK), NZD and ZAR vs. a short position in USD. It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
$2,000
$0
$20
$40
$60
$80
$100
$120
$140
$160
Jan-0
7
Aug-0
7
Mar-
08
Oct-
08
May-0
9
Dec-0
9
Jul-
10
Feb-1
1
Sep-1
1
Apr-
12
Nov-1
2
Gold
($ p
er
troy o
z)
Cru
de O
il (
$ p
er
Bbl
Crude Oil & Gold
Crude Oil Gold
Source: Bloomberg
650
700
750
800
850
900
950
1,000
1,050
1,100
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
CME FX Commodity Country Index
Long Short16.7% AUD 100% USD16.7% BRL 16.7% CAD 16.7% NOK16.7% NZD16.7% ZAR
10 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
optimism. Thus, the CME FX Commodity Country
Index declined 2.0% from 953.60 to 934.32 over
the course of the 1st quarter 2012. This decline
might be more aptly attributed to USD strength on
modest economic momentum more so than any
movements in commodity values.
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. 13
The CME FX BRIC Index ended the 1st quarter at
921.56 and essentially unchanged from the 4th
quarter value of 920.65.
Conclusion
CME Group 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
13 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 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.
market movements. Or, to manage the risks
associated with currency holdings or international
investments during turbulent times.
800
850
900
950
1,000
1,050
1,100
1,150
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
CME FX BRIC Index
Long Short25% BRL 100% USD25% RUB 25% INR 25% CNY
11 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
Appendix 1: Summary of World Economic Conditions
Australia Brazil Canada
Growth,
Inflation
& Fiscal
Policy
China avoided a hard-landing but China risk still weighs on the Australian economy.
Economic growth slowed in 2011, and remained sluggishness in 2012. Lower rates and fiscal stimulus provided in the past year are likely to see their impact in higher real
GDP growth rates in 2013.
Canada’s is benefiting from the continued jobs expansion in the US economy. Domestically,
the oil sector has some challenges.
Monetary
Policy
Short-term interest rates were lowered in 2012 to cushion economic growth without fear
of inflation pressures accelerating. Further rate declines in 2013 are unlikely unless significant currency strength emerges.
The short-term SELIC rate was brought down in 2012 narrowing the premium over the
prevailing inflation rate. Further rate reductions may occur in 2013 if the central bank decides to lean against the wind of
potential currency appreciation.
Canada’ rate policy is on hold. There are no inflation pressures. The former Governor of
the Bank of Canada has been exported to the UK to run the Bank of England.
Special
Factors
The Australian dollar was once a favorite for the long-side of the carry trade versus the
Japanese yen. With Japan adopting a “weaken the yen” approach to policy, the
Australian dollar may again receive inflows from this source.
The major factor impacting the Brazilian real in 2013 is likely to revolve around the zero
interest rate policies of the US, UK, Europe, and Japan, as currency traders expand their
risk appetites for higher rate currencies.
Rate differentials with the US are too small to support the Canadian dollar, even if markets
shift to risk-on trading.
China European Union India
Growth,
Inflation
& Fiscal
Policy
Economic growth in 2012 decelerated faster than many had projected or hoped. With new
leadership and a brighter global outlook for 2013, China’s real GDP growth is likely to
stabilize in the 6% to 7% range.
The fiscal austerity related to the sovereign debt crisis will continue to be a major drag on
economies within the EU in 2013. Europe faces rising unemployment and the possibility of another year of negative real GDP growth.
Like China and Brazil, India saw a rapid deceleration of economic growth in 2012. India has taken a number of steps in the
direction of policy reform, especially regarding foreign investment, that should work to help
the economy regain its balance in 2013.
Monetary
Policy
Expanded bank lending and a push toward more rapid development of financial
institutions is likely. This may include more debt issuance by the Government to fund
health care and pollution reforms.
ECB rate policy is on hold after the fall-out from the messy bail-out of Cyprus. The ECB
will continue to provide bank’s with liquidity as needed.
The monetary authorities have less scope to lower short-term rates than other emerging
market countries, because of elevated inflation. Nevertheless, rate cuts are possible in 2013, especially if the currency takes a turn
toward appreciation and inflation declines a bit.
Special
Factors
An end to economic deceleration portends a more balanced supply and demand for the RMB, and this may allow for a faster pace toward normalizing the currency in 2013.
Elections in Germany in September may add significant political volatility to the path of the
euro. Chancellor Merkel is not popular enough to win an outright majority and new
collation partners may constrain her power to act.
India has shown some signs of becoming friendlier toward foreign investment. This is likely to help the rupee to appreciate along
with other high-rate currencies in response to the very low rates from the US, UK, Europe,
and Japan.
12 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
Appendix 1: Summary of World Economic Conditions, cont.
Japan Mexico Russia
Growth,
Inflation
& Fiscal
Policy
Japan’s new Prime Minister is totally focused on expansionary policies to raise both the real GDP growth rate and to ignite some inflation
pressures.
With brighter prospects for economic growth in the US economy and with the worst of the
fiscal cliff being avoided, Mexico should benefit from increased trade with its partner to the
north.
Elevated crude oil prices are benefitting Russia’s economy, but an aging population and a difficult
environment for foreign investment suggest slower economic growth in the years to come.
Monetary
Policy
The Bank of Japan has a new leader and his first act has been to expand purchases of
Japanese Government Bonds.
Currency strength in 2012 may have the lagged effect of helping to reduce inflation
pressures in 2013. The central bank may be able to make further modest reductions in
short-term interest rates.
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
The Bank of Japan’s new commitment to quantitative easing is likely to support a
weaker yen. A 2% inflation target by the BoJ would suggest a 110-120 yen/dollar rate.
Mexico’s currency has emerged as one of the favorites for the long-side of the carry trade, funded by zero-rate short-term US dollars.
Russia’s energy supply dominance of Europe may be challenged by alternative supplies. The ruble
may be the casualty.
Switzerland United Kingdom United States
Growth,
Inflation
& Fiscal
Policy
Switzerland is not immune to the ramifications of the long-term debt problems facing the European Union. Economic growth will be
constrained for another year.
The UK’s fiscal austerity has constrained economic growth. As we start to look toward
future elections, even well down the road, fiscal policy may get a little less restrictive.
US economic growth in 2013 faces some increased fiscal austerity. We see just enough economic growth to keep the unemployment rate on a
declining path.
Monetary
Policy
As the EU debt crisis has morphed into a long-term problem, the Swiss have little flexibility and are likely continue to keep a lid on the
Swiss franc relative to the euro.
The Bank of England, now led by a Canadian, is likely keep rates very low and focus its
efforts on financial supervision.
The Federal Reserve may end its asset purchase programs in 2013 or early 2014. Even with a
declining unemployment rate, the Fed is unlikely to consider abandoning its zero federal funds rate policy until it sees some inflation pressure, and
there is none.
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 only likely to intensify. Any push by the EU to impose financial transaction taxes will only worsen tensions. UK politics may lead to a non-binding referendum on EU
membership around 2015.
The US dollar is not a strong currency. The US dollar is exhibiting strength against the pound, euro, and yen because they are all even weaker currencies with even bigger long-run problems.
13 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
Appendix 2: Select Currency Performance (1st Quarter 2013)
Currency Ticker Spot Quote
(3/29/13) Quote
Convention 3-Mth Rates
(3/29/13)
1st Quarter 2013 2013 Year-to-Date
Total
Return1
Spot
Return2
Interest
Return3
Total
Return1
Spot
Return2
Interest
Return3
Argentine Peso USD-ARS 5.1231 USD per 1 ARS 18.25% 4.65% -4.02% 8.95% 4.65% -4.02% 8.95%
Australian Dollar AUD-USD 1.0419 AUD per 1 USD 2.95% 1.00% 0.23% 0.69% 1.00% 0.23% 0.69%
Brazilian Real USD-BRL 2.0200 USD per 1 BRL 2.69% 1.47% 1.12% 2.69% 1.47% 1.12%
British Pound GBP-USD 1.5198 GBP per 1 USD 0.47% -6.39% -6.50% 0.04% -6.39% -6.50% 0.04%
Canadian Dollar USD-CAD 1.0174 USD per 1 CAD 1.11% -2.22% -2.49% 0.20% -2.22% -2.49% 0.20%
Chilean Peso USD-CLP 472.15 USD per 1 CLP 2.82% 1.49% 1.23% 2.82% 1.49% 1.23%
China Renminbi USD-CNY 6.2102 USD per 1 CNY 3.55% 1.42% 0.33% 1.02% 1.42% 0.33% 1.02%
Colombian Peso USD-COP 1,825.00 USD per 1 COP -2.35% -3.18% 0.79% -2.35% -3.18% 0.79%
Euro EUR-USD 1.2819 EUR per 1 USD 0.11% -2.80% -2.83% -0.04% -2.80% -2.83% -0.04%
Icelandic Krona USD-ISK 128.07 USD per 1 ISK 5.90% 4.92% 3.53% 1.26% 4.92% 3.53% 1.26%
Indian Rupee USD-INR 54.2800 USD per 1 INR 8.25% 3.56% 1.32% 2.14% 3.56% 1.32% 2.14%
Japanese Yen USD-JPY 94.2202 USD per 100 JPY 0.09% -7.90% -7.93% -0.04% -7.90% -7.93% -0.04%
Mexico Peso USD-MXN 12.3312 USD per 1 MXN 4.34% 5.20% 4.23% 0.85% 5.20% 4.23% 0.85%
New Zealand Dollar NZD-USD 0.8371 NZD per 1 USD 2.65% 1.71% 1.01% 0.62% 1.71% 1.01% 0.62%
Russian Ruble USD-RUB 31.0564 USD per 1 RUB 7.40% -0.03% -1.71% 1.64% -0.03% -1.71% 1.64%
South Africa Rand USD-ZAR 9.2362 USD per 1 ZAR 5.07% -7.67% -8.26% 0.57% -7.67% -8.26% 0.57%
South Korean Won USD-KRW 1,111.35 USD per 1 KRW 2.54% -3.67% -4.22% 0.51% -3.67% -4.22% 0.51%
Swiss Franc USD-CHF 0.9492 USD per 1 CHF 0.00% -3.57% -3.56% -0.08% -3.57% -3.56% -0.08%
Taiwanese Dollar USD-TWD 29.033 USD per 1 TWN 0.85% -2.45% -2.66% 0.14% -2.45% -2.66% 0.14%
Turkish Lira USD-TRY 1.8103 USD per 1 TRY 6.38% 0.07% -1.47% 0.01% 0.07% -1.47% 0.01%
United States Dollar USD 1.0000 USD 0.28% 0.07% 0.00% 0.07% 0.07% 0.00% 0.07%
Notes
(1) Return from price movement and interest (2) Return from currency price movement vs. USD as “base currency”
(3) Return from interest at prevailing 3-month rates or implied NDF rate
Source: Bloomberg
14 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
Appendix 3: Purchasing Power Parity (“PPP”) Analysis (as of 3/29/13)
% Over/Under Valued
Currency Ticker Average OECD Bloomberg
(CPI)
Bloomberg
(PPI) Big Mac
Norwegian Krone NOK 39.83% 36.86% 11.59% 71.03%
Swiss Franc CHF 29.84% 33.52% 20.31% 6.46% 59.06%
Brazilian Real BRL 29.66% 29.66%
Australian Dollar AUD 27.27% 37.09% 33.24% 27.42% 11.34%
Swedish Krona SEK 23.13% 26.50% -4.72% -2.78% 73.52%
New Zealand Dollar NZD 21.89% 21.88% 30.47% 36.35% -1.14%
Danish Krone DKK 17.57% 26.25% 14.17% 15.26% 14.61%
Canadian Dollar CAD 14.02% 16.91% 14.76% 4.11% 20.31%
Icelandic Krona ISK 13.23% 13.23%
Euro EUR 8.94% 3.50% 13.14% 11.24% 7.88%
Colombian Peso COP 7.88% 7.88%
British Pound GBP 0.59% 3.52% 8.10% -2.01% -7.26%
Chilean Peso CLP -4.86% -4.86%
Japanese Yen JPY -5.87% 10.28% -7.06% -3.54% -23.16%
Argentina Peso ARS -15.58% -15.58%
Singapore Dollar SGD -17.50% -17.50%
Czech Koruna CZK -18.52% -18.52%
Turkish Lira TRY -29.54% -66.38% 7.30%
South Korean Won KRW -30.95% -36.56% -25.33%
Thai Baht THB -31.47% -31.47%
Phillipines Peso PHP -33.51% -33.51%
Indonesian Rupiah IDR -34.98% -34.98%
Mexican Peso MXN -39.88% -47.90% -31.85%
Chinese Renminbi CNY -41.02% -41.02%
Malaysian Ringgit MYR -41.87% -41.87%
Russian Ruble RUB -45.90% -45.90%
Hungarian Forint HUF -49.00% -79.55% -18.44%
Hong Kong Dollar HKD -49.95% -49.95%
Polish Zloty PLN -53.71% -71.83% -35.58%
South African Rand ZAR -55.60% -55.60%
Notes
Please note that data regarding all countries is not generally available.
Source: Bloomberg
15 | Currency Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
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percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they
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