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MacroCurrency Strategy

July 2011

GBP: between a rock and a hard place

For now, it is the changing dynamics of the EUR and USD that areimpacting GBP rather than a specific GBP story itself. For GBP to tradeindependently, we need to see a dramatic change in the UK economy,either for the better, or for the worse. Until then, GBP will remain trapped

between a rock and a hard place.

EUR and CHF: Where core EUR might have beenImagine the EUR had been split into two currencies in 2009: EUR-core(EUC) and EUR-periphery (EUP). These currencies would be performingvery differently, with a current EUC-USD around 1.80 and EUP-USD of

perhaps 1.10. Relative competitive positions within the Eurozone would be very different.

Will a new tax holiday boost the USD?There has been discussion of another Homeland Investment Act thatwould involve a tax break that could see US multinationals repatriatefunds from overseas. This could boost the US economy and the USD, atleast temporarily.

Currency

OUTLOOK

Disclosures and Disclaimer This report must be read with the disclosures and analystcertifications in the Disclosure appendix, and with the Disclaimer, which forms part of it


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GBP between a rock and a hard place (pg 3)For now, it is the changing dynamics of the EUR and USD that are impacting GBP rather than a specific

GBP story itself. When Eurozone sovereign risk is dominating market focus, GBP outperforms the EUR

but underperforms the USD. Alternatively, when the market is in the mood to punish the USD, GBPoutperforms the USD but underperforms the EUR. For GBP to trade independently, we need to see a

dramatic change in the UK economy, either for the better, or for the worse. Until then, GBP will remain

trapped between a rock and a hard place.

EUR and CHF: Where core EUR might have been (pg 9)Since the onset of the sovereign debt problems, EUR and CHF have behaved very differently, which has

interesting implications for the Eurozone. Imagine the EUR had been split into two currencies in 2009,EUR-core (EUC) and EUR-periphery (EUP). These currencies would be performing very differently,

with a current EUC-USD around 1.80 and EUP-USD of perhaps 1.10. Relative competitive positions

within the Eurozone would be very different with the EUC area much less competitive.Will a new tax holiday boost the USD? (pg 15)The US economy is slowing, QE is finished and the debt ceiling issue is lingering. In recent months there

has been discussion of another Homeland Investment Act that would involve a tax break that could seeUS multinationals repatriate funds from overseas to promote investment and job creation. This could

boost the US economy and the USD, at least temporarily.

NOK has beauty, but not everyone sees it (pg 22)On all metrics that we consider the NOK is more defensive than the CHF. However, the market has been

buying the CHF in a frenzy of defensive activity whilst ignoring the NOK. We believe this is a

mispricing. Those fleeing from the EUR and the fear of any possible systemic problems would be ill

advised to rush into the CHF. It does not offer safety from a break-up scenario or any systemic problems

owing to its giant-sized banking sector. In this scenario the NOK would be less exposed than the CHF.

Dollar Bloc (pg 28)Canada CAD easily absorbs shifting BoC policy expectations We continue to see the overall

backdrop for the CAD as supportive, given still-healthy growth in emerging market economies and the

associated support that provides to commodity prices, as well as Canadas superior fiscal condition and

modestly better growth trajectory, relative to most other G10 countries. However, we are also hesitant to

view those factors as ones that are likely to drive the CAD measurably higher.

Summary


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Australia AUD still at elevated levels The set-back in RBA rate hike expectations coupled with therecent weakness in global indicators should take its toll on the AUD. The AUD remains above 1.05 for

now, but at such elevated levels we feel that the currency should retrace in the coming months.

New Zealand Recovery in swing The NZD has performed well over the past few months, with the

currency reaching fresh all-time highs on the back of rising rate expectations and positive domestic

developments. However, with the summer months bringing a number of events that could see further risk

off developments we expect a mild retracement.

Key events

Date Event

19 July BoC key policy interest rate announcement20 July BoE publishes minutes of July 6-7 meeting27 July Federal Reserve issues Beige Book28 July RBNZ rate announcement2 August RBA rate announcement4 August BoE rate announcement4 August ECB rate announcement9 August FOMC rate announcement10 August Norges Bank rate announcement10 August BoE publishes quarterly inflation report

Source: HSBC

Central Bank policy rate forecastsLast August 11(f) November 11 (f)

USD 0-0.25 0-0.25 0-0.25EUR 1.50 1.50 1.75JPY 0-0.10 0-0.10 0-0.10GBP 0.50 0.50 0.50

Source: HSBC forecasts for Fed funds, Refi rate, Overnight Call rate and Base rate

Consensus forecasts for key currencies vs USD

3 months 12 months

EUR 1.429 1.405JPY 83.14 87.85

GBP 1.628 1.664CAD 0.968 0.986AUD 1.043 0.988NZD 0.774 0.752

Source: Consensus Economics Foreign Exchange Forecasts June 2011


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GBP stuck in the middle GBP is caught in the crossfire between negative

developments surrounding the EUR and USD.

When Eurozone sovereign risk is dominating

market focus, GBP underperforms the USD but

outperforms the EUR. In this context, GBP-USD

is dragged lower because it is caught in the EURs

orbit as the UK has strong financial and trade

links to the Eurozone.

Alternatively, when the market is in the mood to

punish the USD and Eurozone sovereign risk isless in focus, GBP underperforms the EUR butoutperforms the USD by a small margin. In thissituation, EUR-GBP goes up as the ECB is stillseen trying to normalise monetary policy beforethe BoE. We believe the market has given GBP a

slight advantage versus the USD because the UK

is ahead of the curve in trying to deal with itsfiscal problem and for a period believed the BoEcould raise rates before the Fed.

To us, it is the changing dynamics of EUR andUSD that are impacting GBP rather than aspecific GBP story. For GBP to tradeindependently, we need to see a dramatic changein the UK economy either for the better or for theworse. Although we maintain a relativelypessimistic view on the UK economy, it will also

be the misfortunes of other currencies that willkeep GBP trapped in the ugly contest.

GBP between a rock and ahard place

1. GBP against a broad range of currencies has remained weak since late 2008

70

75

80

85

90

95

100

105

110

Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Mar-09 Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Apr-1170

75

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95

100

105

110BoE GBP trade-weighted (Broad index)

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110

Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Mar-09 Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Apr-1170

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105

110BoE GBP trade-weighted (Broad index)

Source: HSBC, Bloomberg


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Arise Sir Sterling!...Not...A persistent feature since the peak of the globalfinancial crisis is GBPs inability to rally(chart 1). When measuring GBPs performanceagainst a broad basket of currencies, it remainsnearly as weak as it did back in 2008. We havelong been cautious on GBP, believing that thelooming fiscal tightening would keep UK growthsluggish and in turn keep the currency subdued.

The issue for GBP, however, is that its directionalpull for some time has been dictated more bydevelopments in other currencies, in particular theEUR and USD. This is shown in our GBPdiffusion index below.

GBPs diffusion illusionOne way to show whether the market is overlyfocused on GBP is to look at a diffusion index.This measures the breadth of its movementsagainst a host of currencies (chart 2). Our GBP

diffusion index analyses the direction of the dailyGBP movements against 14 currencies andmeasures the proportion that are rising or fallingagainst GBP. Each currency is given an equalweight, as we are looking at the breadth of the riseor fall in GBP rather than the magnitude.

The index is scaled between 0 and 100 such that areading of zero implies that the GBP is falling

against all fourteen currencies, and a reading of

100 implies that GBP is rising against all of the

currencies. In order to extract information from

this index, we take a 20-day moving average.

GBP a sideshow to other currencies

The diffusion index has tended to move in a 35-65

range since the beginning of 2009. When periods

of significant GBP strength have occurred againsta range of currencies, it has usually been very

brief and the index has been associated with a

reading near 65. Likewise, when there have been

periods of extreme GBP weakness, the index has

briefly been below 35.

The index is currently at the rise-fall 50 level,

which means GBP has been basically rising and

falling equally against a broad range of currencies. In other words, GBP has been treated

as a sideshow to other currencies, as the market

has been fixated with EUR and USD risks. The

last time that the market was really focused on

GBP, albeit in a negative way, was around the UK

election last year. GBP has not had primacy for

2. GBP has been more of a sideshow but the lesson learned over the past couple of years is the markets focus can change quickly

25 .0

35 .0

45 .0

55 .0

65 .0

75 .0

J a n-0 9 Ma y-09 Se p -09 J an-10 M ay-1 0 S e p -1 0 J an -1 1 M ay -1125.0

35.0

45.0

55.0

65.0

75.0G B P D i ff u s i on I n d e x 2 0 d m a

GBP caught in the middle of Eurozon e

so vereign r isk a nd US debt problems. I t hasbeen m ore about USD and EUR than GBP in

recent m onths

Hung par l iam ent concerns for GBP



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some time, but of course the risk with a weak UK

economy is that the market starts to punish GBP.

For a specific GBP event to happen now, we would

need to see a significant change in the outlook for

the economy, in either direction. However, the

long-term trends in our UK activity and inflation

surprise indices are not as dramatic as those for theUS (charts 3 and 4). The UK economy is slowly

but surely disappointing, while inflation continuesto beat expectations; but these trends are not as

pronounced as those for the US. This has been a

constant theme since April last year.

Flip flopping on UK interest ratesDespite the weak growth and high inflation storythat has been prevalent for some time, the market

has notably changed its view on UK interest rates

(chart 5). Initially it was quick to price in BoE

rates hikes as headline inflationary pressures were

rising. But it steadily became apparent to the

market that as real wages remain negatively

coupled with the disinflation impact from fiscaltightening, rates were not going to rise. In this low

inflation environment, some may consider rising

rate expectations to be associated with a stronger

3. US and UK activity surprise indices trending down 4. US and UK inflation surprises trending up

-50.0

-40.0

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0.0

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20.0

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11-50.0

-40.0

-30.0

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0.0

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20.0US activity surprise UK activity surprise

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-15.0

-10.0

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-1140.0

50.0

60.0

70.0

80.0US inflation surprise (LHS)UK inflation surprise (RHS)

Source: HSBC, Bloomberg Source: HSBC, Bloomberg

5. The market is no longer expecting BoE rate increases this year

0. 5

0. 6

0. 7

0. 8

0. 9

1. 0

1. 1

Jan-11 Jan-11 Feb-11 Mar-11 Apr-11 May-110.5

0.6

0.7

0.8

0.9

1.0

1.1

GBP forward swap Jan 2012 (expected BoE policy rate in Jan 2012)

The interest rate market priced in Bo E ratehikes early this year but has more recentlypriced them out. The interest rate futures

see the BoE keeping interest ratesunchanged this year

Source: HSBC, ICAP, Bloomberg


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GBP, and as these expectations waned, GBP

should have fallen back again.

We have shown previously how relative interestrate differentials were a powerful indicator for

GBP-USD, especially in the pre-crisis

environment. But we have also suggested that inthe post-crisis environment relative interest rates

do not provide as good a guide for GBP-USD

(chart 6).

The relationship between interest rate differentials

and GBP-USD has been breaking down over the

past couple of months, as GBP-USD should havetraded lower as UK rate expectations fell away. In

fact, if the relationship still held, then GBP-USD

should be closer to 1.55. The breakdown in this

relationship illustrates how USD-negative

dynamics dominated more than the negativeheadwinds for GBP. We have long argued that in

the post-crisis world other factors can swamp

interest rate differentials.

Our explanation for this change comes down to therelative fiscal forces at play. After all, the UK is set

to adopt aggressive fiscal tightening while the US

looks set to increase its debt ceiling yet again. Also,

with a US Presidential election next year, the

appetite to deal with the deficit in any meaningful

way is lacking. So one might expect GBP to be

dragged up against the USD, but on the other footsits the EUR, which could drag GBP down.

GBP is not immune to EurozoneconcernsLets not forget that GBP is vulnerable to

developments in the Eurozone. GBP is notimmune when we consider the UK economys

financial and trade links with the Eurozone. The

first mechanism by which problems in the

Eurozone could be negative for GBP is through

the exposure of UK banks to problem Eurozone

sovereign bonds.

According to BIS figures, UK banks hold aboutUSD 170bn of Greek, Portuguese and Irish

sovereign debt, and an additional USD 170bn of

Spanish and Italian sovereign debt (table 7). We

recognise that one needs to be careful drawing too

many conclusions from the BIS data. Nevertheless,

any fallout from Greece that triggers contagion inthe periphery will have a substantive knock-on

impact on the UK financial system.

6. Interest rate differentials suggest GBP-USD should be lower

0.0

0.2

0.4

0.6

0.8

1.0

1.2

Jun-10 Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-111.42

1.47

1.52

1.57

1.62

1.67

1.72Short Sterling spread Dec 2011 (UK-US) (LHS)

GBP-USD (RHS)



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Meanwhile, table 8 shows that a very high

proportion of UK exports are shipped to theEurozone, with over 6% bound for Ireland alone.

With the sovereign debt problems in Europe

testing investors nerves, this does not seem like a

good time to be a trading partner relying on

Eurozone growth.

The fall in the EUR has seen Germany attack the

overseas markets with a volume expansion; this

lowers the unemployment rate and stimulates the

domestic economy. In the next section, we showthat without the peripheral economies in the EUR,

the core EUR would be trading at 1.80 or above.

The main point we are making is that Germany has

been able to capitalise on the weakness of the EUR.

The UKs response to a fall in GBP was not to

increase the volume of goods exported, but to takea value adjustment that boosted profitability.

However, the second-round impact on the

economy is small compared with a volumeexpansion that creates jobs. Perhaps that is

because the UK has not been as successful as

Germany in making and shipping goods to the

buoyant emerging market economies.

The hopes for an export-led recovery based on the

large fall in GBP in the latter half of 2008 has notpanned out. Instead, the UK recovery has been

lacklustre; and with UK exports highly exposed to

developments in the Eurozone, we do not expect a

strong pick-up anytime soon.

7. BIS consolidated foreign claims of reporting banks (USDbn)

Claims vis--vis Greece Ireland Portugal Spain Italy

France 57 30 27 141 393Germany 34 118 36 182 163Spain 1 10 85 - 31Switzerland 3 14 3 18 18UK 14 135 24 107 66USA 7 51 5 47 37Total 146 462 202 709 867

Source: HSBC, BIS

8. UK exports exposed to the Eurozone

Exports by destination 2010 Value (GBPbn) % total

US 38.0 14.3Germany 27.8 10.5Netherlands 21.3 8.0France 19.1 7.2Ireland 16.9 6.4Belgium-Luxembourg 13.6 5.1Spain 9.9 3.7Italy 8.8 3.3China 7.6 2.9Sweden 5.6 2.1Switzerland 5.2 1.9Hong Kong 4.5 1.7UAE 4.0 1.5Japan 4.3 1.6Canada 4.1 1.6

BRICs 17.5 6.6Eurozone 125.4 47.3EU-27 141.8 53.5

Source: ONS


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What could see GBP escape the trap?There are two scenarios that could see GBP move

out of its current trapped state. One is that the UK

economy powers ahead and the fiscal situation

gets resolved this would see the UK as the role

model of how to handle the crisis. Under this

scenario, GBP could easily trade at 1.75 or above

against the USD.

The opposite scenario is the one that seems to be

playing out at present: a fiscal tightening turnsinto a slowdown. In this situation the UK is the

example of how not to do things. Here GBP-USD

could easily trade at 1.45. In the absence of either

of these scenarios playing out, fair value is between

1.55 and 1.65, and there is little reason GBP-USD

should break out on either sides of this range.

ConclusionGBP is currently stuck between a rock and a hard

place, which are negative developmentssurrounding the EUR and USD. In this

environment, GBP is less driven by a UK-specific

story, but is instead dominated by the changing

dynamics of the EUR and USD.

When markets are focused on Eurozone sovereignrisk, GBP underperforms the USD, but

outperforms the EUR. In contrast, when the

markets focus shifts to the US, GBP

underperforms the EUR, but marginallyoutperforms the USD.

Before GBP trades more independently, we

believe that there needs to be a major change in

the outlook for UK economy either for the better

or for the worse. We have a fairly pessimisticview on the UK economy, which the market has

now also come to accept. Should UK growth

deteriorate further, which is a clear risk, we couldsoon see the market paying closer attention to UK

fundamentals than elsewhere. This would not be a

good development for GBP.


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Will the SNB follow the ECB?With the ECB having raised interest rates for a

second time to 1.5% at the July 7 th meeting, marketattention is turning towards the Swiss National

Bank. Former SNB Vice President Niklaus Blattner

has said that price stability is threatened by the

expansion of the money supply and that a rate

increase would be in order also because of signs of

overheating on the property market.

As can be seen in chart 1, Swiss interest rate

policy has mirrored that seen the Eurozone formost of the past ten years. With ECB rates rising

again, it is natural that some expect the SNB to

follow suit at some point.

Relative inflation experience, however, suggests that

historical relationships in monetary policy are nolonger valid. Whilst Swiss CPI is currently 0.6%year on year, Eurozone inflation is currently 2.7%

(chart 2). Core inflation in the Eurozone is lower, at

1.5% year on year, but it is flat in Switzerland.

Currency performance is the keyThe main driving force behind this inflation

divergence is the performance of the currency.

Since the emergence of the sovereign credit

problems in the Eurozone in 2010, the EUR has

lost about 20% against the CHF, having spent

much of the previous 10 years in a 1.45-1.65

range (chart 3).

The new exchange rate environment can be seeneven more clearly in chart 4. This shows the six-

month rolling correlation of daily changes in

EUR-USD and USD-CHF. When the EUR and

EUR and CHF: where core EURmight have been

1. ECB and SNB policies have historically moved together

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5.0

Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-110.0

0.5

1.0

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3.0

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4.5

5.0EUR and CHF Policy Rates% %

Source: Bloomberg, HSBC


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CHF move together, this correlation is very high,

as it was for most of the 1999-2009 period. The

correlation did fall to some extent during the

financial crisis, but it was fully re-established

during the early part of the recovery in 2009,

before falling sharply once the sovereign creditissues emerged.

A further demonstration of the changed

relationship between EUR and CHF can be seen

in implied options volatility. As we argued in

Swiss Franc - the last safe haven, Currency

Weekly 4 th April 2011 , central bank intervention in

USD-JPY has made CHF the only viable safe

haven currency, which makes it more susceptible

to swings in risk on-risk off sentiment and

therefore more volatile. Chart 5 shows implied 3-

month EUR-CHF compared with the average of

other Euro crosses (NOK, SEK, PLN, HUF, andCZK). Until the crisis and again in 2009, EUR-

CHF volatility was below 5%. Since 2010, it has

moved above 10% and is well above the average

as other volatilities have declined.

3. EUR-CHF stability broke down in 2010

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Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-111.00

1.10

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1.80EUR-CHF

Sovereign creditproblems


2. Swiss and Eurozone inflation has diverged

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Swiss and Eurozone Inflation YoY% y-o-y % y-o-y

http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=Yk5BXrYj8n&n=295192.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=Yk5BXrYj8n&n=295192.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=Yk5BXrYj8n&n=295192.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=Yk5BXrYj8n&n=295192.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=Yk5BXrYj8n&n=295192.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=Yk5BXrYj8n&n=295192.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=Yk5BXrYj8n&n=295192.PDF


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For Swiss monetary policy, the implications of

this new CHF behaviour can best be analysed by

using monetary conditions indices.

Monetary Conditions Index

A monetary conditions index (MCI) aims tomeasure the effect of both real interest rate changes

and exchange rate moves on the economy. If theexchange rate is strengthening then, other things

being equal, monetary conditions will be

tightening, and vice versa. An MCI can be used to

gauge whether (relative to some benchmark period)

monetary conditions are boosting or restraining the

economy by combining the effect of interest rate

and exchange rate movements.

Chart 6 shows an MCI for Switzerland using

April 2002 as a benchmark and giving an 80%

rate to changes in real interest rates and a 20%weight to changes in the effective exchange rate.

As can be seen, there was relatively little change

in the MCI between 2002 and 2009, but since then

conditions have tightened by the equivalent of

about 450bp in interest rates. This strongly

suggests that the SNB should be in no hurry to

increase interest rates.

5. EUR-CHF implied volatility is now above the European average

EUR-CHF vol versus EUR-other Europe vol

0

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15

20

25

Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-110

5

10

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Average EUR-Europe vol EUR-CHF vol

% %


4. The correlation between EUR and CHF movements has fallen sharply

30%

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100%

Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-1130%

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100%EUR-USD and USD-CHF - 6m rolling correlation



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Where core EUR might have beenThe behaviour of the EUR and CHF over the past18 months and the tightening of monetaryconditions in Switzerland have interestingimplications for the Eurozone. Imagine that the

EUR had been split into two currencies in 2009,call them EUR-core (EUC) and EUR-periphery(EUP) where EUC members were those that hadno significant public sector funding problems.Given the close association between the behaviourof the Swiss economy and the German economy(chart 7), it would not be unreasonable to suggestthat EUC-CHF would have remained fairly stable.

Assuming EUC-CHF had remained at 2009 EUR-

CHF levels (1.50) this would imply a current

EUC-USD of 1.83(about 28% higher than EUR).

This would also mean EUC-JPY of 144 and EUC-GBP of 1.13.

What would be the value of EUP-USD? There are

several possible ways of estimating this. The two

simplest are shown in table 8. The first column

assumes that the current EUR is just a simple

average of the values of the hypothetical EUC and

EUP. This would mean EUP-USD of about parity.

If the EUR is a weighted average of EUC and

6. Swiss monetary conditions have tightened sharply because of currency appreciation

-2.0%

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0.0%

1.0%

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Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%Switzerland - MCI (Apr 2002= 0)


7. Swiss and German economies tend to move together

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108

113

Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10-2.5

-1.5

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1.5

2.5

3.5IFO (LHS) KOF (RHS)

German IFO and Swiss KOF Indices



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EUP then, based on approximate GDP weights

this would mean EUP-USD of about 0.65.

What would this mean for economicperformance? With a much weaker currency EUParea exports would probably have beenperforming better and fiscal consolidation mayhave been slightly easier if there was the prospectof stronger activity. Inflation in the EUC areawould probably be very subdued and the EUCcentral bank may not have felt the need to raiserates. Inflation in the EUP area would probably behigher but, rather like the UK, the impact wouldbe mostly felt on real incomes and the EUPcentral bank may also have been reluctant totighten. EUC area holder of EUP bonds would, of course, have suffered a big currency loss(assuming they were not hedged) in the same wayEUR holders of gilts did in 2007/08.

Relative competitive positions in the Eurozone

would have been very different. Chart 9 shows theBIS real effective exchange rates for Greece,

Switzerland and Germany. With higher domestic

inflation, Greeces REER has moved steadily

higher, but Germanys has fallen implying a

stronger competitive position. With a split EUR or

a situation where the peripheral Eurozone deflated

internally, Germanys REER would have been

higher and the Greek REER would have been

significantly lower. Although the financial cost of

the sovereign debt problems may be high for thecore countries, they have gained a competitiveness

boost from having a currency much less strong

than it otherwise could have been.

9. German and Greek real effective exchange rates would look very different

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120

Jan-00 Jul-96 Jan-98 Jul-99 Jan-01 Jul-02 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10

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120Greece REER Swiss REER Germany REER (BIS, rebased 95'=100)


8. Alternative estimates for hypothetical EUP exchange rates

Cross Rate Using 50/50 weights Using GDP weights (65% EUC, 35% EUP)

EUP-USD 1.00 0.65EUP-GBP 0.62 0.40EUP-JPY 79.0 51.4EUP-CHF 0.82 0.53EUP-AUD 0.93 0.60EUP-CAD 0.96 0.62

Source: HSBC


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ConclusionThe SNB seems very unlikely to follow the ECB

in raising rates because monetary conditions in

Switzerland have already been tightened

significantly by the strength of the CHF.

The sharp change in behaviour of EUR-CHF sincethe beginning of the Eurozone sovereign debt

problems raises the question of how a split euro

would have performed over the past eighteen

months. Assuming a core euro would haveremained relatively stable against the CHF, then

monetary conditions in the core Eurozone would

also be significantly tighter, and the central bank

would perhaps not have decided to tighten policy.

There seems little doubt that a euro-periphery

currency would by now be significantly weaker

than the EUR.

Would two EURs have been better than one? This is

impossible to say given the counter-factual nature of

the argument. The relationship between the EUR

and the CHF does, however, suggest how things

might have been different for the Eurozone.


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A new tax holiday on US

corporate earnings heldabroad?With the US economy weak, politicians are under

increasing pressure to take additional measures to

stimulate job growth. Those already-difficult

efforts are severely complicated by the more

immediate negotiations on raising the debt-ceilinglimit, due both to the time it diverts from other

matters, as well as the associated fiscal

constraints. Nonetheless, in an effort to address

the countrys economic troubles, some members

of Congress are once again advocating a tax

holiday that would allow US corporations torepatriate overseas earnings at a reduced tax rate.

This type of legislation and the associated flows

had a profound impact on the USD in 2005 as can

be seen by the circled area in chart 1.

US Representative Kevin Brady (R., Texas)introduced legislation that would allow companiesto repatriate foreign earnings at a 5.25% tax rateinstead of the current 35% rate. Not surprisingly,the legislation has strong support in the businesscommunity, and some previous politicalopponents to the proposal have recently appearedto soften their position. Hence, the FX market hasunderstandably focused in on the possibility of acorporate tax holiday and the associatedrepatriation as a potential support for the USD.

Nonetheless, as senior congressional leaders andthe White House progress in their negotiations onthe debt ceiling and the broader debt and deficitproblem, it appears that more items and proposalsare being put on the table, and we cannotcompletely discount the possibility that proposalssuch as the Brady bill will be given more seriousconsideration. Hence, some review of its detailand the potential FX implications is useful.

Will a new tax holidayboost the USD?

1. USD gains during the 2005 HIA program have peaked interest in new proposals

65

75

85

95

105

115

125

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201165

75

85

95

105

115

125Dollar Index (DXY)

2005 USD rally

DXY Index DXY Index



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Sizeable amounts of USD repatriationare estimatedAs noted, the Brady bill (H.R. 1834, titled the

Freedom to Invest Act of 2011) calls for a one-

time 85% relief in the tax burden on repatriated

foreign earnings of US corporations. There arevarying estimates on the amount of repatriation

potentially stemming from the program, ranging

from USD500bn up to USD1trln. For purposes of

comparison, we will focus on figures provided by

the bi-partisan congressional JCT, which

estimates total repatriation associated with theprogram at USD700bn. Importantly, the JCT

estimate, as well as the broader range of

USD500bn to USD1trln, are greater than the total

repatriation which stemmed from 2004 HomelandInvestment Act (HIA), also known as the

American Jobs Creation Act (AJCA). A 2008report authored by Melissa Redmiles, an

economist at the Internal Revenue Service (IRS),

estimates that total repatriation from HIA was

USD362bn, the bulk of which occurred in 2005.

This moved the USD substantially in 2005 and the

fear is it will have the same impact. We look at

this below.

USD repatriation would likely be larger today

than under the 2004-2005 HIA program

Higher estimates of repatriation for the current

proposal relative to the original HIA stem from

several factors. The Bureau of Economic Analysisreports that the foreign operations of US

corporations generate 24% of profits from overseas

operations, compared with 21% in the 2000-2009

period, and 14% in the 1990-1999 period. Both the

current level of foreign earnings and the upwardtrend in the series suggest a notably higher amountof accumulated earnings abroad relative to 2004.

2. Weak labour market pressures Washington to act

4

5

6

7

8

9

10

11

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-114

5

6

7

8

9

10

11US Unemployment Rate %%


3. 2005 HIA Repatriation by Industry

Industry USD bn

Manufacturing 289.4- Computer/Electronic 68.6 - Pharmaceutical 105.5 Wholesale and retail trade 14.7

Information 14.6Finance, insurance, real estate 13.3All others 29.8Total 361.8

Source: Redmiles (IRS), 2008


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Beyond that, the economy is roughly 23% larger

today than at the end of 2004 (using nominal GDP

measures), with correspondingly larger corporate

earnings. And anecdotally, following the 2004-2005

HIA experience, there may well now be sometendency for corporations to accumulate earnings

overseas in anticipation of another tax holiday.

In order to assess the potential impact of those

flows on the FX market, we should consider them

in the context of the change in total FX volumes

between 2004 and the present. According to the

2004 BIS Triennial Central Bank Survey, the totaldaily volume of spot and outright forward

transactions combined was USD840bn at that

time. The same survey in 2010 showed the total

daily volume of spot and outright forwards wasUSD1.965trn, some 2.3 times greater than in 2004.

The working assumption on the potential

repatriation in the new proposal of USD700bn is

1.93 times greater than the USD362 of actualrepatriation in 2005 cited in the Redmiles IRS

report, leaving it roughly near the change in

overall FX volumes that has occurred over the

same time. Hence, some may conclude the spot

impact of repatriation coming into the FX marketnow could well be similar to that in 2005. And

while we are primarily referencing the JCT

estimate of potential repatriation, the wider rangeof estimates (USD500bn to USD1trn) leave some

level of uncertainty in this process.

The geographic distribution of 2005

repatriation is instructive

The Redmiles IRS report also breaks downgeographically the primary sources of the funds

repatriated under the HIA program, accounting for

roughly three-quarters of the total flows. Among

those, Eurozone countries dominate the list (the

Netherlands, Ireland and Luxembourg are

specifically cited), accounting for 40.7% of thetotal USD362bn in flows. Other key sources were

Switzerland at 9.9%, Canada at 7.1% and the UK

at 6.2% (chart 4). While shifting dynamics in the

global economy and, in some cases, changes inlocal tax structures may have resulted in some

changes today relative to 2004, those figures

provide some reasonable basis for estimating the

sources of repatriation going forward.

Overseas earnings most likely to be held in

local currencies

There is also the potential that some portion of the

accumulated earnings being held abroad may

already be in USD. This is difficult to estimate andthe data is not readily available. However, assessing

the matter from an accounting perspective, we think

4. 2005 HIA Repatriation by country, as a percent of total repatriation

26.1

9.9 9.77.6 7.1 7.0 6.2

0

5

10

15

20

25

30

Netherlands Switzerland Bermuda Ireland Canada Luxembourg UK0

5

10

15

20

25

302005 HIA Repatriation by Country, percent of total% %



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that most foreign subsidiaries of US corporations are

local currency functional (that is, their books are not

in USD); holding USD would create income

statement volatility at the local level, which would

be undesirable. Hedging these USD balances via FX

derivative contracts introduces hedging costs, alongwith the additional administrative demands of

managing a hedging program (rolling hedges, risk

reporting, disclosure, etc.). Hence, US multinationals

are more likely to hold the local currency, where the

yields locally will likely be higher than those of

USD paper. There are some corporations which have

global USD functional subsidiaries, but they are in

the minority. Viewed in that manner, it suggests that

a majority of these holdings are in local currency and

not in USD.Estimating potential future repatriationUsing the 2004-05 HIA example, and

extrapolating that out into current estimates,

generates some reasonably sized USD

purchases/foreign currency sales, including:

USD 285bn in EUR-USD

USD 70bn in USD-CHF

USD 50bn in USD-CAD

USD 43bn in GBP-USD

On the surface, those figures appear to be fairly

small compared with total volumes in the FX

market. Not only are those sums a fraction of the

~USD 2trn in daily volumes in the FX market

(spot and forward outright transactions), but the

potential repatriation flows would be spread outover a period of time, further diluting their impact

on exchange rates. Moreover, some may want to

make a modest downward adjustment to these

figures to account for some portion being held in

USD notwithstanding that we think the bulk of

the funds are held in foreign currencies.

The 2005 USD rally had severalsourcesRecall during the 2005 HIA experience, forecasts

for total USD purchases relative to the size of the

FX market were fairly small, and the estimated

impact on the USD was also thought to be limited.

But as it happened, the USD performed well

during 2005, generating a strong counter-trend in

the midst of its broader 2002-2008 decline. There

were several factors supporting the USD in 2005,

a key development being stronger-than-expectedUS growth, accompanied by a more aggressive

Fed tightening trajectory. In addition, with the

USD having fallen sharply and fairly consistently

in the 2002-2004 period, corrective forces within

5. 2005 HIA Repatriation by country, and estimates for the newly proposed tax holiday

0

50

100

150

200

Netherlands Sw itzerland Bermuda Ireland Canada Luxembourg UK

0

50

100

150

200

2005 HIAPotential Repatriation From New Tax Holiday

USD bn USD bn



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the broader downtrend also worked to the

currencys advantage. And within that broaderdynamic, additional HIA-related inflows also

contributed to the USDs gains.

2005 vs. today: some similarities, butmore differencesThere are some similarities, but seemingly more

differences, in the FX market and the global

economy today relative to six years ago. Oneimportant similarity is that the USD is trading at

relatively weak levels. The Dollar Index is

currently trading near three-year lows, albeit near

the bottom of the three-year range, rather than

having essentially moved straight down for the

past three years, as was the case from 2002 to2004. Another similarity is that the expected USD

repatriation from a new tax holiday on foreign

earnings would be small relative to total FX

market volumes. That was the case in 2005, butthe USD still performed well.

The differences now are most glaring in terms of US

and global growth, and as well as in the role that risk

appetite has on the FX market. Clearly, economic

growth rates in the US and other developedeconomies are well below those which prevailed six

years ago, i.e., pre-crisis. And because of factors

such as the severe debt overhang and clogged credit

channels, the prospect of a US-growth-led boost tothe USD seems very low at this stage. The

importance of risk appetite and the risk on-risk off

(RORO) dynamic, which remains a key feature in

financial markets, is a further complicating

condition. In essence, the ongoing shifts in risk

appetite have and can continue to overwhelmtraditional fundamentals as drivers for currencies.

Repatriated funds as economicstimulusBut importantly as well, there is also the concept

that capital inflows stemming from the proposedtax holiday could act as stimulus for the broader

economy. Indeed, that is the primary rationalesupporting the proposal. Along those same lines,

some analysts are even likening it to another

round of Fed quantitative easing, with potentially

even greater benefits as the repatriated fundswould go directly to corporations and theoretically

trickle down to the rest of the economy, rather than

remain concentrated as excess liquidity in the

banking and financial system.

Those are issues for economists to debate. But if itwere to actually develop in that manner and

support US growth, this would theoretically be

6. Cyclical forces were big factors in the USDs 2005 rally

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-0780

82

84

86

88

90

92

94

96Fed Funds Target Rate (LHS) USD Index, DXY (RHS)% DXY Index



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USD supportive. But there are several good

reasons to be sceptical of such rationale. First, in a

RORO world, better US economic growth is

positive for risk appetite in a manner that tends to

work against, rather than for, the USD. Similarly,if the effects were similar to those of Fed QE, the

added liquidity and boost to risk appetite have

proven to be USD-bearish in recent years. Finally,

because the original HIA program was generallynot deemed as having generated broad economic

benefit (it primarily was seen as helping

individual corporations and their shareholders),

the notion that a new tax holiday will support

growth now is far from assured.

Balancing those factors against one another, we

are sceptical that a new tax holiday on foreign

earnings would provide sustained support for the

USD. That does not preclude the potential for

some temporary gains in the currency, as markets

may anticipate the flows and/or as they actually

occur. But the limited size of the flows in relation

to the FX market, the weak cyclical position of

the US and associated accommodative Fed policystance, and the exceedingly poor fiscal backdrop

in the US, are factors that suggest to us that a

repatriation-related boost to the USD will be

difficult indeed.

Congressional passage appearsunlikely for nowOf course, key to all of this is getting the current

bill moved into law, and that appears to face someserious headwinds. In general terms, Democrats in

Congress tend to oppose the bill because they feel

it will primarily support large corporations and

their shareholders, with few obvious benefits for

the middle class and/or broader economy. They

cite the lack of trickle down effects from the

2004-2005 HIA program as evidence of such.

Moreover, with the JCT estimating the cost of thecurrent legislation at USD78bn over 10 years,

both Democrats and Republicans will have aseriously difficult time supporting the legislation

during a period when fiscal considerations and

constraints are so severe.

It is also the case that the immediate and

overwhelming focus in Washington is on the debt-

ceiling negotiations, and that issue is precluding

debate and consideration of most other items. Inaddition, any discussion of changes in the broader

tax regime taking place in the context of the debt-

ceiling negotiations are focused more on

7. Congress under pressure to improve the economy

0102030405060708090

100

J a n - 0 9

A p r - 0

9

J u l - 0 9

O c t - 0

9

J a n - 1 0

A p r - 1

0

J u l - 1 0

O c t - 1

0

J a n - 1 1

A p r - 1

1

J u l - 1 1

0102030405060708090100

Congressional Job Disapproval

Congressional Job Approval

% %

Source: HSBC, Gallup


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comprehensive tax reform, which would entailboth individual and corporate tax policies. The

Brady bill, a one-time tax holiday, is not

consistent with those efforts (it essentially creates

another tax loophole), which also creates

impediments to its passage.

Bill sponsors understand these hurdles andcurrently remain focused on the more immediate

debt ceiling issue. They will attempt to garner

more support for the legislation in the comingmonths and make a stronger push for it in the

autumn. There are a few factors that maintain

some scope for this bill to move forward,including the dire state of the economy/labor

market and the ensuing need for politicians to be

seen as addressing it, as well as the notion that

all things are on the table in the current debt-

ceiling negotiations. But, based on current

priorities in Washington, and the increasing

importance of fiscal consolidation to both parties,it seems very unlikely that this bill will become

law in the immediate future, and its prospects for

passing at a later date also appear limited.

Conclusion Not a slam dunk for theUSDEfforts to implement a tax holiday for US

corporations to repatriate foreign earnings havepicked up some momentum recently as Congress

feels pressured to respond to ongoing weakness in

the economy. The FX market has understandably

taken interest in these proceedings, given the

potential for the USD to benefit from repatriation

flows. While the overall amount of expectedrepatriation stemming from the proposal is small

relative to total flows in the FX market, that was

also the case during the 2004-2005 HIA episode,

and the USD appreciated notably during the period.

However, current conditions in the US and globaleconomy, as well as the drivers in the FX market,

are different now, making it more difficult for the

USD to benefit from repatriation flows in the same

way it did in 2005. Moreover, the current legislationfaces fairly stiff resistance in Congress at this stage,

and appears unlikely to progress into law. Still, with

many items being considered in the current debt-

ceiling negotiations, and pressure on Congress to

address ongoing economic weakness, efforts to

promote the tax holiday will continue on CapitolHill, and in so doing they will continue to garner the

attention of the FX market.


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Why CHF and not the NOK?The markets love affair with the CHF continues.

As the Arab spring and the Eurozone crisis

intensified, it made sense that the ultra-defensive

CHF would do well. In fact, when the G7

intervened in the JPY, we assumed that by

limiting the upside on the other defensivecurrency, the JPY, further upward pressure would

be exerted on the CHF. Closing the door on the

JPY meant that the much less liquid CHF wouldhave to bear most of the defensive flows.

Now we find ourselves asking why this squeeze

into CHF has not spilt over to what we would see

as an even better defensive play, namely theNOK. We look at a host of defensive indicators

and try to ascertain why the market has not

pushed some of the excess liquidity into the NOK.

It seems strange to us that since the beginning of the year the NOK has been trading as a proxy for

the EUR, with EUR-NOK trading in a tight 3%

range (chart 1). However, the NOK and the

Eurozone have little in common, and in our view

the NOK looks very undervalued versus the CHF.

We would advise switching out of CHF into NOK.

Inflation and rates a score drawOn the rates and inflation front there is barely a

cigarette paper between the two economies. In an

environment of nominal returns the NOK justabout pips the CHF. The Norges Bank started

raising rates at the tail end of 2009 and they

currently stand at 2.25%, whereas CHF rates are

stuck at a mere 0.25%. Even in real terms the

NOK comes out on top. CHF inflation is 0.4%

giving a negative real return of 0.15%, whereas

NOK has beauty, but noteveryone sees it

1. Since the beginning of the year EUR-NOK has traded in a tight range

7.65

7.70

7.75

7.80

7.85

7.90

7.95

8.00

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-117.65

7.70

7.75

7.80

7.85

7.90

7.95

8.00EUR-NOK

3.2 %

EUR-NOK EUR-NOK



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NOK has a real positive return of 0.65%. So, if

one were to hold the currency in a real deposit

account, the NOK pips the CHF.

Of course, if one wants to move into local equities

then the CHF offers more liquidity. TheNorwegian equity market, the OBX, has a marketcap of a mere ~EUR 163bn (NOK1.27trn) versusthe SMI Swiss equity market of ~EUR 675bn(CHF800bn), some four times larger. In terms of performance, they are both down around 5% thisyear. Having said that, this does raise thequestion: if you are going into the CHF fordefensive reasons why buy an asset class that

counteracts those defensive qualities? Thus therelative size of the equity markets does notexplain the rally in the CHF relative to the NOK.

Budgets and Current Account NOK

winsOn the budget and current account front there islittle contest. The Swiss budgetary position hasimproved, and they are expecting a surplus in2011, which in a global context is quite the result.Compared to many of their G10 counterparts, thisputs the CHF in an excellent position. However,when comparing this with the Norwegian

3. Norways excellent budgetary position outshines the strong Swiss position

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08-5.0

0.0

5.0

10.0

15.0

20.0

25.0Swis s bugetary pos ition Norway budgetary position% GDP % GDP


2. CHF and NOK policy rates since 2008

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-110.0

1.0

2.0

3.0

4.0

5.0

6.0Norway Switzerland% %



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budgetary position, an embarrassment of richesbecomes apparent Norway, helped by oil, has anexcellent budget surplus.

So, from this perspective, it is not difficult tounderstand why the CHF has been one of the bestperforming currencies this year. However, it ishard to explain why the NOK has lagged theCHF. It is even harder to explain why the NOKhas been so closely tied in with the EUR (seechart 1). From a budgetary situation Norway andthe Eurozone are like chalk and cheese.

Looking at gross debt to GDP ratios, which theIMF defines as all liabilities that require paymentor payments of interest and/or principal by thedebtor to the creditor at a date or dates in thefuture, Switzerland and Norway appear equals.

Both countries have gross debt to GDP ratios of around 50%; this is very positive and is half thelevel of many countries and a quarter of the sizeof Japans (chart 4). However, if we take intoaccount net debt to GDP, which the IMFcalculates as gross debt minus financial assetscorresponding to debt instruments 1, Norway is theclear outperformer.

1 These financial assets are: monetary gold and SDRs,currency and deposits, debt securities, loans, insurance,

pension, and standardized guarantee schemes, and other accounts receivable.

While Switzerland maintains its strong position,

Norway is in a league of its own as its net debt to

GDP is a surplus of over 150% (chart 5). Thereason that Norways net debt to GDP ratio is so

much better than its gross level is largely due to

the Norwegian Government Pension Fund

(discussed later).

This is absolutely incredible and shows why the

NOK should not be trading in a tight range

against the EUR. Lastly, when we look at current

accounts, both Switzerland and Norway have

fantastic surpluses (chart 6).

CHF is marvellous but NOK is spectacular

So there is no doubt that the budgetary position,

debt to GDP, and current accounts of Switzerland

put it in a fantastic position relative to many

countries in the world. These statistics underlie

the defensive stability of the CHF. For this reasonsome are still happy to buy the CHF, despite it

being one of the most over-valued currencies in

the world on an OECD PPP basis.

In particular, those looking for protection from

any break-up scenario, or any other possible

disaster scenario that may befall the EUR, are

obviously looking for value preservation and are

therefore still happy to buy the CHF despite thesomewhat tenuous FX valuation metrics.

4. Switzerland and Norway as equals... 5. but Norways net debt to GDP ratio is a clear winner

0

50

100

150

200

250

J a p a n

E u r o a r e a

U n i t e d

K i n g d o m

S w i t z e r l a n d

N o r w a y

0

50

100

150

200

250% %Gross debt to GDP

-200

-100

0

100

200

J a p a n

U n i t e d

K i n g d o m

E u r o a r e a

S w i t z e r l a n d

N o r w a y

-200

-100

0

100

200Net debt to GDP% %

Source: HSBC, IMF Source: HSBC, IMF


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On an OECD PPP basis the NOK is not that far

behind the CHF as both are equally over-valuedcurrencies ~+40%. However, with the metrics

shown above, we would far prefer to hold the

NOK than the CHF. Meanwhile, these metrics

also beg the question of why the AUD is as

equally overvalued. On this basis we would rather

own either NOK or CHF rather than the AUD.

Liquidity argument cuts both ways

One often cited reason why the NOK has not

performed as well as the CHF is that the CHF

offers greater liquidity. However, we would turn

the argument on its head. We would argue that, in

a world of excess liquidity that is looking for a

defensive home, the less the liquidity the greaterthe move. We used this argument to justify why

post the JPY intervention the CHF would be

squeezed higher. That is, when the G7 shut the

door on the USD300bn a day spot yen market, thedefensive money would have to squeeze into the

USD92bn a day CHF spot market. This argument

seemed to work well. However, the spot NOK

market according to the BIS is ~USD12bn a day.

Hence it would take a lot less money flowing into

the NOK to push the currency higher. Thus, withthe market looking for a defensive home it caused

the CHF to rise and this has indeed been the case;

but it should have also seen the even less liquid

NOK rise at even faster pace. This has not been

the case as the NOK has underperformed the CHF

over recent months (chart 7). This then continues

to raise the question as to why the market shunned

the defensive properties of the NOK in favour of

the CHF.

CHF Banks versus Petroleum fundsholding of EUR assetsThe size of the two biggest Swiss banks relative to

GDP is some 300%. The Swiss problems with

their banking system during the crisis led some tobelieve that the CHF was losing its safe-haven

status. For a while this seemed true. However, it

would seem the memories of that particular issueremain in the Eurozone but not in Switzerland.

Swiss exposure to Eurozone

According to the BIS data Swiss banks exposure

to Greece, for example, are a mere USD3bn; and

to Greece, Ireland, Portugal, Spain and Italycombined is USD56bn, about the same size as

French banking exposure to Greece alone. Of the

USD56bn about 50% of claims are against banks

and the private sector and roughly 20% of claimsagainst sovereigns are secured with guarantees

and collateral. Nevertheless, if one is buying CHF

6. Swiss and Norwegian current accounts both show large surpluses

0

4

8

12

16

20

Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-100

4

8

12

16

20Switzerland C/A Norway C/A% of GDP % of GDP



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for protection against a disaster scenario of a

banking crisis or a Eurozone break up, one has toask how the CHF banks could remain immune to

systemic contagion.

According to the SNB stability report, at the end of 2010 the total assets of the Swiss banking sector

amounted to CHF 3,582 billion, which is more than

six times the annual gross domestic product (GDP)

of Switzerland. Furthermore they say the two bigbanks UBS and Credit Suisse account for two-

thirds of total assets, which is roughly four times

Swiss GDP. Compared with the other G10

countries, the ratio of the two biggest banks assets

to GDP is highest in Switzerland.

Although the direct exposure to the periphery is

small, the Swiss authorities continue to worry

about contagion effects. In fact, they believecredit and market risk, amplified by potential

contagion effects from the sovereign debt crisis in

the peripheral euro area, would constitute the

most important source of risk for these banks

under the adverse scenario. In fact, they say: The

potential losses under this scenario would besubstantial. It should be noted, however, that a

resurgence of problems in the euro area periphery

is exactly one of the potential triggers for the

adverse scenario. Therefore, the impact of direct

exposures to the peripheral euro area must be

considered in a broader sense, where the two big

banks would also be affected by credit and marketlosses caused by an overall deterioration of the

economic and financial market situation.

This raises the question of why buy the CHF if

one is worried about a major problem in the

Eurozone and the associated problems this would

cause in the banking system. On this front the

CHF does not offer protection at all.

So, from a pure currency perspective, it seems to

make sense to buy and own NOK. Here one wouldhave a currency that would be immune from both a

banking crisis and a euro break-up scenario.

Norway owns a lot of Eurozone assets as well

Although there are some concerns about the links

of Swiss banks exposure to the Eurozone, whatabout Norways Government Pension Fund

(GPF), which owns a lot of Eurozone assets? It

makes sense to look at the GPF given Norwegian

banks are comparatively small compared to Swiss

banks. As background, the GPF has

approximately USD600bn (NOK3.1trn) assetsunder management, which is nearly 50% larger

than Norways economy.

7 The NOK has underperformed the CHF over the past couple of months as Greece becomes a worry again

5.70

5.90

6.10

6.30

6.50

6.70

Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-115.70

5.90

6.10

6.30

6.50

6.70CHF-NOK



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Just like Switzerland, whose banks are a multiple

of GDP, the GPF is a multiple of GDP, albeit

smaller. From a currency perspective, around 80%

of the GPFs assets are denominated in EUR,

GBP, JPY and USD.

The funds asset mix is about 60% equities and

between 35 and 40% in fixed income. Nearly 30%of the equity holdings are held in Europe whilst

nearly 60% of the fixed income investments are

European paper. So, the exposure to Europe viaits assets holdings is substantial.

That said, the direct holdings of sovereign

government bonds in the peripheral part of Europe

are small. For instance, the holdings of Spain,

Greece, Ireland and Portugal government bonds

are a little over USD6bn or a mere 1% of its

portfolio. The GPF also holds a substantial

portion of Eurozone banks bonds and equities,

which would feel the strain from contagion. Do

we have the same potential problem as Switzerland

where the direct exposure is small but the indirect

exposure is large? We would argue no.

The difference is that one is a fund where it can

absorb losses without a material impact on the

economy and the banking system. The same

cannot be said for Switzerland. Those worriedabout a European break-up and systemic banking

problems that rushed into the CHF should, for all

intents and purposes, have their holdings in NOK.

Conclusion Switch out of CHF andinto NOKThe market has fled into the CHF as the key

defensive currency of choice. We too have

advocated the CHF, especially following thecoordinated intervention against the JPY in

March. But we believe the market is overlookingsome key risks for the CHF if significant stress

emerges from the Eurozone. The reason being that

Switzerlands indirect exposure to the Eurozone is

very high. The SNB alluded to the problems for

Swiss banks from the Eurozone under a very

adverse scenario.

When we look at a range of measures, we find the

CHF is a fantastic currency versus the USD, EUR,GBP and JPY. But on all these metrics the NOK

is in an even sounder position and should be

considered in a league of its own. Moreover, the

NOK has traded in a narrow range versus the

EUR and should be making substantive headway.

Those that have sought solace in the CHF shouldtake a closer look at the NOK.

.

8. Switzerland has an outstandingly large banking sector

Size of the banking sector (ratio of totalassets to annual GDP)

Size of the largest banks (ratio of totalassets to annual GDP)

Belgium* 3.2 2.6Canada 2.2 0.8France* 3.2 1.9Germany* 3.4 1.1Italy* 1.6 1.0Japan 2.0 0.6Netherlands* 4.4 3.3Sweden* 3.5 2.2Switzerland 6.6 4.3United Kingdom* 7.0 2.5United States 1.1 0.3

* Banking sector figures as at end of June 2010

Source: SNB


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CAD easily absorbs shiftingBoC policy expectationsWhile there have been further developments and

changes in Canadas economy and the centralbank policy outlook, USD-CAD continues to hold

in the approximate 5-cent range in which it has

trade since the beginning of this year. We

continue to see the overall backdrop for the CAD

as supportive, given still-healthy growth in

emerging market economies and the associatedsupport that provides to commodity prices, as well

as Canadas superior fiscal condition and

modestly better growth trajectory, relative to most

other G10 countries. But we are also hesitant to

view those factors, or more recent cyclical

developments, as ones that are likely to drive the

CAD measurably higher.

On May 31, the Bank of Canada altered thelanguage in its policy statement, signaling that

some of the considerable policy stimulus

currently in place will eventually be withdrawn.

Even so, we observed at the time that despite the

seeming increase in the scope for a summer rate

hike by the BOC, the CAD would have troublebenefitting from such an event, partly because

some amount of tightening was already priced

into the curve, but more because the currency was

already trading at relatively high levels.

Challenging backdrop

In the weeks that followed, the Canadian data

flow was reasonably good, better readings on

indicators such as employment and the PMI were

countered by disappointing outcomes ininternational trade and labor productivity. But

more importantly, the international backdrop

deteriorated in a manner that clearly got theattention of Canadas policy makers. The most

dramatic events stemmed from the Eurozone

sovereign debt crisis, and the ripple effects that

could have on the global economy.

In addition, the soft patch which had developed in

the US economy since the spring persisted and

threatened to evolve into an outright slowdown.Most obvious in that regard was, and continues to

be, the deterioration in the labor market, with job

growth remaining anemic, and the unemployment

rate rising from 8.8% in March up to 9.2% in June.

More dovish BoC

Against that backdrop, BoC Gov. Carney, incomments on June 24, observed that Canadas

economy faced substantial headwinds and thatmonetary policy may still need to be stimulative

in order to close the output gap and in order to get

inflation back on target. So while the signal in

the May 31 policy statement was presumably

designed to prepare the market for the eventual

normalization in policy, Carneys subsequent

comments in late-June were notably more dovish.

As it happened, front-end Canadian yields hadalready been falling in the run-up to Carneys

June 24 remarks, as markets became increasinglyaware of the downside risks to growth. The

implied yield on the March 2012 BA future fell 25

bp between May 21 and June 24, and that was part

of the broader 68bp decline from the April peak

2.23% to the low in late June of 1.55%.

That helped US-Canada yield spreads narrow

roughly 50 bp since April, reducing some of thecarry appeal of the CAD. On balance, USD-

CAD has correlated reasonably well with

Dollar Bloc


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developments in the yield spread over the past

year, although the larger magnitude of the rise in

the spread in the past few months might have beenexpected to see the exchange rate rise more than it

did, if recent history was any guide. But in that

regard, we would make several observations.First, there were several periods over the past year

where the volatility in the spread exceeded that in

the exchange rate, and that has developed againmore recently. Second, even with the spread

narrowing, Canadian yields are still roughly a full

percentage point higher at that term (3-month

rates in March 2012), keeping some carry in

place for the CAD.

Several sources of support

Beyond the yield-related considerations, there are

other, mostly familiar, factors that are also

favoring the CAD. While commodity prices have

pulled back from their recent highs, many remain

at elevated levels. Although growth in somedeveloped economies has stumbled, growth in

emerging market economies continues to hold up

well, suggesting that EM-led demand for

commodities will persist, maintaining a source of

support for the CAD.

Also on the EM theme, reserve managers continue

to intervene to limit appreciation in their own

currencies, accumulating USD in the process. And

that supports the cycle of reserve manager USD

diversification, which continues to weigh on the

greenback more broadly, and support currencies

such as the CAD.

Developments in US growth specifically continue

to be important for the CAD, given the Canadian

economys sensitivity to that in the US. Hence, if

the current soft patch in US growth were to

persist or intensify, it could present moreimmediate risks to Canadian growth. Indeed, this

is one factor we think will keep the Bank of

Canada sidelined at the July policy

announcement. And it may also present more

direct risks to the CAD, particularly if markets

begin to see more pronounced weakness in theCanadian economic data. That said, we would

note that the US economic soft patch from last

summer through the autumn was generally

accompanied by an appreciating CAD versus the

USD. Of course, the fact that the Bank of Canada

was tightening policy during part of that period

did not hurt either. But the CADs resilience in

the face of US economic weakness in the recent

past was notable.

1. Shift in US-Canada yield spreads reduces the CADs interest rate cushion

-1.5

-1.3

-1.1

-0.9

-0.7

-0.5

Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-110.94

0.98

1.02

1.06

US-Canada Yield Spread (March 2012 Eurodollar, BA futures) (LHS) USD-CAD (RHS)



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ConclusionIn the more immediate term, scheduled key events

for the CAD are the aforementioned BoC policy

statement on July, followed by readings on

inflation, retail sales, monthly GDP and

employment in the days and weeks afterwards.

And unscheduled events, such as the type that

influence risk appetite, could be equallyimportant, if not more so. But amid all of that, our

outlook for the CAD remains pretty consistent.

Essentially, we see limited additional upside for

the CAD versus the USD, primarily because with

USD-CAD approaching 0.9500, there is already a

lot of good news priced into the loonie. That does

not preclude the CAD from remaining strong if

the favorable conditions cited above persist (or

falling if they dont), but we remain skeptical that

the currency can register further gains from here.


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AUD still at elevated levelsThe AUD has remained resilient despite a number

of threats that could have harmed the currency,

including the recent downgrade of some

Australian banks and fears of a China slowdown.

However, the shocking US non-farm payrolls

print that has already weighed on the AUD, may

just be the first of a series of risk off events that

could cause the currency to retrace. To call the US

labour market statistics disappointing is anunderstatement, and the report has not only

continued the trend of weaker US activity data in

recent months, but suggests an intensification of

the economic "soft patch" in a manner that could

well lead to additional calls on the Fed to takemore action. As the AUD remains exposed to

global events as a result of the ongoing risk on

risk off phenomenon, the AUD looks vulnerable.

Tightening cycle to be more elongated

On the domestic front, the strength of the AUD also

looks overdone as the RBA are likely to keep rates

on hold for longer than previously thought. While

Australian employment has continued to rise

modestly, as have retail sales, the Australian

consumer and business confidence indices havefallen. Indeed, consumer confidence is now at its

lowest level since June 2009 (chart 1). Our

Australian economist, Paul Bloxham, believes this

weakness is temporary partly due to the much

maligned carbon tax and also unrest in Greece,which was prominent in the media in Australia.

Nonetheless, the RBA are likely to continue with

their wait and see approach. With the Australian

activity surprise index also trending down (chart 2)an August tightening seems far less likely.

Markets have responded to recent developments

by pricing in easing by the RBA. We think this is

overdone and partly reflects global investors using

the Australian bond market to buy insuranceagainst the possibility of a large negative global

financial event triggered by European

developments. We think the chance of an RBAcut is very small.

We continue to expect the next RBA move to be

up, but are pushing back the timing of our call

from August to Q4, with a more elongated

tightening cycle of another 50bp to follow through

2012. We expect the cash rate to reach 5.50% by

Q4 2012.

The bottom line is that even with an elevated CPI

print on 27th July we still expect a 0.8% rise the RBA will probably need more time to let the

smoke clear before they respond. The fragile

global financial situation and weak local

confidence will keep them sitting on their hands.

1. Consumer sentiment takes a tumble 2. Australia activity surprise index trending down

70

80

90

100

110

120

130

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-1070

80

90

100

110

120

130Consumer sentimentIndex Index

65

70

75

80

85

Jan-10 Apr-10 Jul-10 Oct -10 Jan-11 Apr-11 Jul-1165

70

75

80

85

Source: HSBC, Bloomberg Source: HSBC, Bloomberg


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AUD game changerThe set-back in RBA rate-hike expectations,

coupled with the recent weakness in global

indicators, should also take its toll on the AUD.

The US non-farm payrolls release may prove to

be a tipping point as risk off makes a strong

comeback. The AUD fell aggressively in the

aftermath of the report and, while the RBA had

hoped that the downturn in global growth wastemporary, this report will start to raise questions

about whether global weakness could persist. TheAUD remains above 1.05 for now, but at such

elevated levels we feel that the currency should

retrace in the coming months.

New Zealand Recovery in full swing

The New Zealand economy is finally recovering,

after a long period of economic malaise and some

false starts. The economy has been weak since

early 2008, so its well overdue for a pick-up.

Prospects for growth in H2 are strong on the back

of high meat and dairy prices, which are boosting

incomes and rural investment; the Rugby World

Cup, with 85,000 visitors expected in September

and October; and the rebuilding and repair of the

quake-damaged Canterbury region, with 8% of

GDP to be spent over coming years. We havelong thought the quakes impact would be

geographically contained and that H2 2011 would

be strong, so our GDP forecasts were alreadyquite high the highest in the consensus survey

so we have left them unchanged this quarter. We

still expect GDP growth of 1.7% in 2011 and

4.3% in 2012.

Inflation pressures are expected to build and,

somewhat worryingly, inflation expectations have

already risen to the top of the RBNZs comfort

zone. We continue to expect inflation to hold

above the RBNZs target band well into 2012(chart 3).

Time to tighten

Time will tell if Marchs rate cut in response tothe quake was a policy error we think it mayhave been. While the RBNZ kept the cash rate onhold at 2.50% in their latest meeting, the post-meeting statement was more hawkish than themarket expected, with the Governor shifting histone from rates on hold for some time to rates

are on hold for now. The more hawkish tonesent NZD-USD as high as 0.83 (chart 4). Themore upbeat tone from the Governor and risinginflation expectations suggests a policy reversal isto come sooner rather than later.

We continue to expect the next hike to come in

Q4 this year, but the risk is for an earlier move.

Over a longer time frame, we still expect 175bp

by end 2012, but see upside risks to inflation that

3. Inflation continues on upward path 4. NZD-USD hitting highs

0.0

1.0

2.0

3.0

4.0

5.0

6.0

Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-110.0

1.0

2.0

3.0

4.0

5.0

6.0New Zealand CPI% %

RBNZ targetband

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-110.3

0.4

0.5

0.6

0.7

0.8

0.9NZD-USD

Source: Bloomberg, HSBC Source: Bloomberg, HSBC


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could see more aggressive rate hikes needednext year.

Risk off to weigh on the Kiwi

The NZD has performed well over the last few

months, with the currency reaching fresh all-time

highs on the back of rising rate expectations and

positive domestic developments. The recent talk of the potential for more QE by the Fed has also

pushed the currency higher. However, as the

dominant driver of the currency continues to bethe fluctuations between risk on and risk off,

and while QE3 in the US may be a temporary

support, the fact that the US economy isperforming so poorly is likely to weigh on risk

and harm the NZD. Therefore, in the medium

term we continue to expect the currency to

retrace. The summer months also bring a number

of events that could see further risk off

developments. In particular, focus will be on the

US debt-ceiling issue; but with troubles in theEurozone periphery still lingering and contagion

fears spreading to the likes of Italy, the markets

appetite for risk is likely to be curtailed and thiswill weigh on the NZD in the months to come.


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EUR-CHF Switzerland: The markets love affair with CHF continues

1.10

1.201.30

1.40

1.50

1.601.70

J a n - 0 2

J a n - 0 3

J a n - 0 4

J a n - 0 5

J a n - 0 6

J a n - 0 7

J a n - 0 8

J a n - 0 9

J a n - 1 0

J a n - 1 1

0.70

0.901.10

1.30

1.50

1.70

EUR-CHF (LHS) USD-CHF (RHS)

The ongoing Eurozone crisis keeps sending CHF to new recordhighs against the EUR as the market rushes to the perceivedsafety of the ultra-defensive currency. We expect the CHF tocontinue to appreciate in the current environment, and considerCHF as a fantastic currency versus the G4 currencies.However, it seems the market is overlooking key risks for theCHF if the Eurozone crisis deteriorates. It makes little sense tobuy CHF if fleeing from fears of systemic problems or a breakup scenario, due to Switzerlands giant sized banking sector. The SNB kept rates on hold at 0.25% in June and madeseveral dovish remarks regarding the Swiss economic outlook.The CHF ascent is perceived as a key threat to exports andgrowth. Inflationary pressures remain benign, and we do notexpect a rate hike until Q1 2012. While we believe the CHF willstay strong for now, our preferred call in a risk-off environmentis the NOK.

Source: Thomson Financial Datastream

EUR-NOK Norway: NOK has beauty, but not everyone sees it

7.00

7.50

8.00

8.50

9.00

9.5010.00

10.50

J a n - 0 2

J a n - 0 3

J a n - 0 4

J a n - 0 5

J a n - 0 6

J a n - 0 7

J a n - 0 8

J a n - 0 9

J a n - 1 0

J a n - 1 1

7.00

7.50

8.00

8.50

9.00

9.5010.00

10.50

See pages 22 28.


EUR-SEK Sweden: Sensitive to risk off but fundamentally sound

8.408.809.209.60

10.0010.4010.8011.2011.6012.00

J a n - 0 2

J a n - 0 3

J a n - 0 4

J a n - 0 5

J a n - 0 6

J a n - 0 7

J a n - 0 8

J a n - 0 9

J a n - 1 0

J a n - 1 1

8.408.809.209.6010.0010.4010.8011.2011.6012.00

The SEK has stabilised versus the EUR in recent weeks, butwe maintain there is room for the currency to strengthen,especially if global risk appetite improves. Recent economicindicators still point to robust growth in the Swedish economy,implying the need for additional rate hikes by the Riksbank. The Riksbank last raised its policy rate to 2.00% on 5 July, butthe policy rate remains low by historical standards. We expectthe key rate to be increased by another 50bps this year.However, this is contingent on labour-market conditionsremaining strong and on external conditions, in particularwhether sovereign risk within the Eurozone intensifies. Further rate increases should support the SEK but the positivestory for the currency is broader than just expected rateincreases. Like the NOK, the SEK also stands to benefit frombeing a country with relatively sound fiscal and current accountbalances. Key events released in the coming weeks include Q2GDP on 29 July and CPI on 11 August.


Europe at a glance


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Relatively more attractiveWe continue to believe that Asian currencies offer

good value over the medium-term. However, with

debt issues in the developed world continuing tofester and ove

hsbc euro break

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