hsbc jan 2014 usd strength

8/13/2019 Hsbc Jan 2014 USD Strength

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Currency

OUTLOOK

Disclosures and Disclaimer This report must be read with the disclosures and analyst

certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

USD rally to spread its wings

USD strength is set to continue through 2014, and expand in scope.

Currency gains on the Feds exit strategy are only just beginning.Furthermore, the EUR and GBP will no longer be the exceptions to the

USD dominance for the reasons we provide in the following reports.

GBP: mind the trade gap

We question the sustainability of a UK recovery driven by rising house

prices. Moreover, the threat of a rapidly widening UK trade deficit adds

to our concerns regarding GBP. We believe the combination should see

GBP lower, particularly in H2 2014.

EUR: myth-buster

The EURs resilience in the face of a dovish ECB has encouraged a

mistaken belief that the currency is being dominated by factors other

than carry. We explain why this is not convincing and show that the

outlook for monetary policy is still the key driver of the EUR, and one

which should see it lower.
http://www.research.hsbc.com/midas/Res/RDV?p=pdf&ao=20&key=S2FYA8Wkbb&n=399893.HTM


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Summary (pg 3)

Here we summarise our FX views and provide top EM FX trades for 2014.

USD rally to spread its wings (pg 5)

We see the USD rally continuing and expanding in scope in 2014. The pace of tapering and the ability of

the Fed to reassure the market that rate hikes need not swiftly follow the end of tapering will be central to

the USDs fortunes. On both measures, we expect the currency to thrive. Further, the two notable

exceptions to USD dominance in 2013, the EUR and GBP, are likely to succumb in 2014.

GBP: mind the trade gap (pg 13)

We believe that GBP will face renewed downward pressure in H2 14. The GBP has capitalised on the

back of consumption driven recovery that has been fuelled by rising house prices. We have our doubts

over the sustainability of this economic revival. If doubts about the durability of the recovery were to

threaten capital inflows at the same time as concerns about the UKs widening visible trade deficit were

taking hold, the negative impact on GBP would be sizeable.

EUR: myth-buster (pg 20)

The EURs resilience in the face of a dovish ECB has encouraged a mistaken belief that the currency is

being dominated by the improvement in the Eurozones current account balance, and portfolio flows into

recovering Eurozone markets. We are not convinced by either. The reality is that the outlook for

monetary policy is once again the key driver to the EUR. With the Fed heading towards exiting its

emergency accommodation, the EUR bullish run is likely to meet a tragic end.

Precious metals (pg 27)

We lower our 2014, 2015 and long-term gold forecasts in line with our stronger USD view. However, we

see the negative impact of further investor liquidation being partially offset by continued strong emerging

market demand. We also lower our platinum forecasts but leave palladium unchanged.

Dollar Bloc (pg 30)

No love for CAD in the New Year:The CAD has started the year on the defensive and we expect further

weakness going forward. The main factors which will provide additional downward pressure on the CAD

are: the market perceiving a greater chance of BoC easing, the Feds exit strategy, the shift from surplus

to deficit in Canada trade dynamics and diminished USD recycling from EM.

Summary


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AUD: the worst is over: Given the adjustment in the AUD over the last year, we believe the depreciation

in 2014 will moderate. Sluggish domestic growth with little signs of rebalancing and expected USD

dominance are among the main drags on the AUD. However, our view that the RBAs easing cycle is

done is likely to see only a moderate sell off.

NZD: a booming 2014: With the economy booming and the RBNZ expected to be the first central bank

in the G10 space to start raising rates we are looking for a stronger NZD in 2014.

Key events

Date Event

09 January ECB rate announcement09 January BoE rate announcement12 January Central Bank and Regulatory Chiefs meet in Basel15 January Fed releases Beige Book21-22 January BoJ monetary policy meeting22 January BoC rate announcement and Monetary Policy Report29 January FOMC rate announcement30 January RBNZ rate announcement04 February RBA rate announcement06 February BoE rate announcement06 February ECB rate announcement

Source: HSBC

Central Bank policy rate forecasts

Last Q2 2014(f) Q4 2014(f)

USD 0-0.25 0-0.25 0-0.25EUR 0.25 0.25 0.25JPY 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 1.321 1.279JPY 101.9 105.5

GBP 1.594 1.569CAD 1.051 1.066AUD 0.902 0.875NZD 0.816 0.792

Source: Consensus Economics Foreign Exchange Forecasts December 2013


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The rally seen in the USD during much of 2013 is

set to continue this year and expand in scope. Our

greater bullishness on the USD is based on two

principal reasons.

1. The Feds exit will drive USD higher

The USDs gains on the Feds exit strategy are

only just beginning, and are likely to accelerate as

the market questions the gap between the likely

end of QE3 and the first Fed rate hike.

2. GBP and EUR will no longer be the

exception to this USD dominance.

The unbalanced nature of the UK recovery means

the already large trade deficit could become an

even greater concern for GBP. EUR resilience is

being built on specious arguments. The currency

will succumb to lacklustre growth, low inflation

and possible ECB policy easing.

Fed to drive the USD higher

The pace of further USD gains will depend on

how fast the Fed chooses to taper and whether the

market continues to believe there will be a big gap

between the end of QE3 and the first rate hike. On

both aspects, we think the balance of risks favour

USD strength.

Recent surveys suggest the market expects that

the Fed QE3 programme will not end until the

December FOMC meeting. We believe the end

could come sooner, especially if the recent run of

upside surprises on US economic activity persists.The initial USD10bn taper came earlier than the

majority expected, targeted both MBS and

Treasuries, and was described as modest by the

Fed. There is scope for the pace to be increased

subject to the data.

The USD may also benefit should the market

begin to question the Feds message that there is

likely to be a substantial gap between the end of

QE3 and the start of a rate hike cycle. Surveys

suggest that market expectations of this gap

currently stand at 10 months. It may narrow. The

UK provides a useful parallel where the market

has questioned central bank forward guidance,

and bought the currency as a result. A similar

process in the US is likely to drive the

USD stronger.


The UKs unbalanced recovery points to

considerable GBP weakness later in 2014. For

now, GBP may be underpinned by the

acceleration in UK activity and the associated

hawkish shift in rate expectations. However, the

upswing is being driven largely by consumption

supported, not by rising real incomes, but by a

combination of dis-saving, renewed housing

leverage, and wealth effects from a government-

boosted housing market. With little hope for a

marked improvement in exports, this means that

rising import demand will widen the UK visible

trade deficit in goods from an already large 6.5%

of GDP in 2013 to potentially troubling levels.

At the same time, doubts are likely to emerge

about the sustainability of the UK recovery, whichwill undermine the short-term inflows which have

been a crucial element of funding for the trade

Summary


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deficit. GBP would face the double whammy

of questions over the trade deficits

sustainability alongside retreating interest rate

hike expectations.

EUR: myth-busters

We are not convinced by a number of suggestions

offered for the EURs resilience to wider USD

strength. One idea is that EUR is gaining on the

basis of its improving current account balance.

Yet the US deficit has seen an even greater

correction in its imbalance. In addition, the swing

into surplus for the Eurozone reflects economic

weakness or collapsing domestic demand not

strength. The second suggestion is that the EUR is

being supported by portfolio flows, but the

Eurozone is not the only market to see buying of

local equity and bond markets. Furthermore,

portfolio flows are not the dominant aspect of the

Eurozones capital account.

Like the AUD in 2013, which seemed initially

immune to deterioration in many of its macro

drivers, we therefore expect the EUR to belatedly

weaken in response to its economic frailties. The

divergent paths of US and Eurozone monetary

policy and the relative pace of economic growth

point to a much lower EUR during 2014.

Emerging marketopportunities

Long INR-IDR. Though both currencies are

plagued by current account deficits, the INR is

mainly suffering from a large trade deficit, while

the IDR is being hurt by a widening income

account deficit. The INR has recovered from the

summer sell off, helped by import restrictions and

schemes to attract capital inflows. The IDR still

suffers steady income outflows despite rate hikes

and an improved trade balance. While the RBI has

been trying to curb the INRs volatility, BI hasallowed the IDR to adjust weaker. Valuation also

suggests that at current levels, the INR is still

more undervalued than the IDR. Selling IDR

against the INR rather than against the USD

removes the negative carry aspect.

Short USD-MXN:On a relative basis, the MXN

outperformed all other currencies in LatAm FX in

2013 thanks to the approval of important

structural reforms that are expected to raise the

country's potential growth in the coming years.

And yet, in absolute terms, current USD-MXN

levels do not reflect this structural shift, in ourview. We expect continued support for the MXN

against the USD in 2014, aided by an upgrade by

the rating agencies, increased FDI inflows, and a

rebound in cyclical domestic data. We target

USD-MXN at 12.60/USD in 2014 and find

current levels as attractive entry points. We would

also look to play MXN outperformance against

other currencies in the region, or against the EUR,

echoing our EUR-USD view.

Long USD-RUB: Interestingly, the RUB has

never been categorised in the fragile group of

currencies like the TRY and ZAR. The fact that

Russia displays a current account surplus is

certainly the main explanation. Yet, the RUB has

weakened significantly during the EM sell-off in

H2 2013 and we believe that the adjustment is

likely to extend in 2014. A small current account

surplus in a context of persistent and structural

capital outflows will continue to weigh on the

RUB, particularly given very weak economic

growth and sticky inflation. The diminished

involvement of the Russian central bank in the

FX market and a likely further widening of the

RUB trading band should also contribute to a

weaker currency.


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Dollar dominance

It may not feel like it, but 2013 was a good year

for the USD. Chart 1 shows the performance of

the worlds most actively traded currencies

against the USD during 2013. The skew towards

underperformance is clear, and even those few

that managed to outpace the USD did so only by a

rather small margin.

However, for many in the market, the main points

of reference for the USD are against the EUR,

GBP and JPY. As the USD fell against both the

EUR and GBP during 2013, notably during thesecond half of the year, it may not be remembered

as a dominant year for the USD. But even with the

headwinds from the EUR and GBP, the broad

USD index in 2013 finished close to 4% higher

than it started. Furthermore the USD rose 3% in

2013 against an equally weighted index of EUR,

GBP and JPY.

For 2014, we believe the USD dominance will

continue and indeed expand in scope. This is for

two principal reasons:-

1 The USD gains on the Feds exit strategy are

only just beginning, and will accelerate as the

market questions the gap between the likely

end of QE3 and the first Fed rate hike.

2 GBP and EUR will no longer be the

exceptions to this USD dominance, and will

succumb to vulnerabilities in their respective

economic outlooks.


1. Currency performance vs USD during 2013

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10FX performance against the USD in 2013

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Source: HSBC, Bloomberg


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1) USD gains on Fed policyhave only just begun

There are two aspects as to why we believe USD

gains on the back of Fed policy are still in their

infancy. Essentially, the extent of USD gains will

depend on the following:-

A) Pace of Fed tapering

B) Ability of the Fed to differentiate between QE

ending and rates being raised

A) Setting the pace

In terms of pace, the Fed is already off to a

reasonably aggressive start. It announced the

beginning of its tapering programme at its

December FOMC meeting, sooner than expected

by the majority of forecasters who had generally

anticipated a March 2014 move. The Fed cut back

its purchases of both Treasuries and Mortgage

Backed Securities (MBS), where some had

expected the taper to be confined to Treasuries.

The Fed also described the USD10bn taper as a

modest reduction, suggesting an appetite for a

swifter reduction were the data to warrant it.

The pace will invariably be central to the USDs

fortunes. Within G10, carry considerations

dominate the behaviour of many of the exchange

rates with the possible exception of the JPY and

CHF. If data prompts the Fed to shift to a soft

tapering approach, then EUR-USD would likely

hold onto the bulk of the gains posted during

H2 13. Similarly, GBP-USD would be supported

and emerging market FX would likely

capitalise on the upside from the Feds continued

liquidity largesse.

Of course, this data dependency cuts both ways

and the recent signs are encouraging for the

USD. Our US activity economic surprise

index, shown in Chart 2, has been trending

higher for a number of months now. This signals

that upside surprises have been outstripping

economic disappointments.

If sustained, it could be consistent with a swifter

end to tapering than is currently anticipated by the

market. A Bloomberg survey conducted after the

December 2013 FOMC meeting showed the

median expectation was that QE3 would end in

December 2014. Even if the USD10bn pace

established at the December meeting is

maintained, it would point to a likely exit at the

October meeting. Were data consistently

2. US economic data has been surprising to the upside

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US activ ity surprise index



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surprising to the upside and inflation began to

show some signs of life alongside the activity

pick-up, that could arguably come sooner.

B) Mind the gap

Considering the trauma evident in US Treasuries

and emerging market FX between May and

September 2013 when markets adjusted to the

mere possibility of tapering, the market reaction

to the actual arrival of tapering in December has

been remarkably relaxed. For example, US 10yr

government bond yields rose more than 100bp

between May and September, but have so far risen

only a modest 13bp since tapering was announced

somewhat earlier than expected. Similarly, a

basket of the fragile five (BRL, IDR, INR, TRY

and ZAR) against the USD fell 7% between the

May 22 announcement of likely tapering and the

September FOMC meeting. This understates the

true weakness as between the start of May and the

start of December, the drop was over 13%. The

drop since the December 18 taper has been less

than 1%, with much of this attributable to

heightened political risk rather than

tapering trauma.

Part of this comfort is driven by the Feds success

in convincing markets that the end of QE3 will

not be followed swiftly by a hike in the Fed funds

rate. Chart 3 uses a sequence of Bloomberg

surveys to find when the market expects QE3 to

end, and measure the gap in months between this

date and when Fed funds futures imply the first

hike in the policy rate will occur.

When tapering fears were at their height ahead of

the September 2013 FOMC meeting, the market

anticipated a gap of only 7 months between the

end of QE3 and the first rate hike. A combination

of a September tapering delay and a concerted

communication strategy by the Fed to emphasise

that the end of QE3 was a distinct process from

any rate hike consideration saw that gap widen

out to a sizeable 13 months ahead of the

December 2013 FOMC meeting. The ability of

the Fed to get the market to buy into this message

is all the more remarkable given that US

economic data was generally surprising to the

upside over this period (see Chart 2).

So far, so good; but the problem for the Fed will

be in sustaining this distinction as tapering

progresses and economic data remains consistent

with a normalisation of activity and, in the future,

inflation. It is interesting to note that in the wake

of the December FOMC taper, that gap betweenthe end of QE3 and the first rate hike has already

narrowed back to 10 months.

3. The Fed has convinced markets that end of QE3 will not see rates rise swiftly thereafter

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Gap between ex pected end of tapering and first priced in rate hike (months)

months

months



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Rule Britannia

A useful parallel to the Feds potential difficulty

is the UK where the Bank of England has

struggled to convince markets that interest rates

are not about to rise anytime soon. When Mark

Carney arrived as the new governor of the Bankof England in July 2013, forward guidance was

promoted as a key policy tool. An unemployment

threshold of 7.0% was announced above which

rates would not be raised, while a move below

7.0% was not necessarily a trigger for a rate hike.

In August, the BoE projected that the 7%

threshold would be not be hit with a greater than

50% probability until Q2 16. Chart 4 shows the

progression of UK rate expectations during 2013,

using short sterling futures to indicate when the

first hike was priced in. The market took a muchmore hawkish view than the BoE of the UK

economy, implying that the first rate hike could be

delivered one year earlier during Q2 15.

4. Market expectations for the first BoE hike (measured by short-sterling futures contracts)

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UK first ex pected rate hike, 3M GBP futures

ovs

aw

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Hawkish

Dovish


5. The BoE has shifted its expectations for when the unemployment threshold might be crossed

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BoE unemployment rate forecast (August 2013) BoE unemployment rate forecast (Nov ember 2013)%%

Source: HSBC, BoE


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By November, the markets stance was largely

validated by the Bank of Englands fresh set of

unemployment forecasts in the inflation report.

Chart 5 compares the forecasts made in August

with those made in November, indicating that

they are lower across the board. In addition, that50% probability that the unemployment rate

would be 7.0% or lower is now expected in Q4

2014, matching the markets expectation for when

the first hike may be delivered.

In the UK, the market chose not to believe the

central bank and anticipated swifter policy

tightening than the BoE had in mind. In the US,

the market has so far chosen to believe the Fed

that there will be a reasonable gap between the

end of QE and the start of a rate hiking cycle. The

market also took solace from the Feds insistence

at the December FOMC that it likely will be

appropriate to maintain the current target rangefor the federal funds target rate well past the time

that the unemployment rate declines below 6.5%.

But the UK example shows that the market will

not always take its lead from the central bank. The

fact that US government bond yields are already

inching higher and that the QE3-hike gap is

narrowing following the December taper could be

6. USD FX is increasingly correlated with moves in US government bond yields

Chart Title

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Av g correlation (100D) of USD v s G10 ex change rates w ith US 10Y Treasury y ield


7. US bond yield movements may also be critical to any emerging market FX view

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US 10Y gov t bond y ield % (LHS)Index of USD vs ' fragile fiv e' ex change rates (BRL, IDR, INR, TRY and ZAR), 100=01 May 13 (RHS)



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a sign that markets will increasingly question

quite how long-lasting the Feds commitment

to unchanged rates will last if the data continues

to improve.

In similar fashion to the pace of tapering, this

element of the policy has immediate policy

implications for the USD. Chart 6 shows the

average correlation of the daily changes in various

G10 exchange rates vs the USD against daily

changes in US 10Y government bond yields.Clearly, the relationship has strengthened

markedly during 2013 and will be a key

determinant of USD fortunes in 2014. If the gap

closes between the perceived end of QE3 and the

first rate hike, the USD will capitalise.

An additional angle on this theme relates to

emerging market FX where there has been a

similar hardening of the relationship between US

government bond yields and EM FX movements.

Chart 7, for example, shows an index of the

fragile five plotted against the US 10Y

government bond yield. Assuming you believe

this relationship will hold, then your expectations

for these currencies will be heavily dependent on

your view for US yields.

So we believe that USD gains related to Fed

policy have only just begun. We expect the US

economy to be sufficiently strong to allow the

current pace of tapering to persist through 2014,suggesting an exit at the October meeting. In

addition, the USD should also capitalise were the

market to challenge the Feds message that the

gap between the end of QE3 and the start of a rate

hike cycle will be a long one.

2) GBP and EUR to fall oneconomic vulnerabilities

The second part of the bullish USD view is driven

by our belief that the two principal exceptions toUSD dominance in H2 13, namely the EUR and

GBP, will weaken in 2014. Both will succumb to

economic deficiencies, although these

vulnerabilities are quite different in nature.

GBP: unbalanced

GBP has been a noteworthy exception to USD

strength during H2 13, rallying close to 10%

against the USD. It is a trend we expect to

reverse, and our forecast for GBP-USD at the end

of 2014 is 1.50. The unbalanced nature of the UK

economic recovery is what troubles us most with

regard to GBP. It has relied excessively on aconsumption binge fuelled by rising house prices

which, in turn, may have been fostered by

government support rather than any notable shift

in underlying fundamentals. We outline our

concerns in greater detail elsewhere in this

document (see GBP: mind the trade gap), but in

summary we believe this imbalance in growth

drivers will be echoed in rising concerns

regarding the UKs sizeable visible trade deficit.

These fears are likely to be most prevalent duringH2 14 as doubts about the sustainability of the

recovery begin to undermine the capital inflows

which have so far underpinned GBP despite the

large trade deficit.

With export markets still facing headwinds but

imports supported by the consumer revival, the

visible trade balance is likely to deteriorate in

2014. The UK is starting an economic

expansion with a deficit as a percentage of GDP

of roughly 7%.

The hope, and our economic teams presumption,

is that the drag from net investment income and

net transfers will reverse in 2014 and allow the

headline overall current account deficit to narrow.

However, this was also the hope at the start of

2013, and it never happened. GBP has capitalised

on the boost to interest rate expectations that

better than expected economic data has driven,

but 2014 may be the year where the focus

switches from carry considerations to balance of

payments concerns. If it does, GBP could face a


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similarly traumatic time to that of H1 13, although

for quite different reasons.

EUR = AUD version 2.0

In arriving at a forecast for the EUR, one simple

question is whether we can recommend that

investors continue to buy the EUR at current

levels in anticipation of further gains based on

fundamentals? Our answer is no. We faced a

similar predicament with the AUD when it moved

above parity against the USD. For us, thecurrency then represented poor value relative to a

backdrop of slowing China growth, declining

commodity prices and narrowing carry against the

USD. However, the AUD remained stubbornly

resilient throughout H2 12 and into early 2013

before finally succumbing to those fundamental

pressures in Q2 13. We think the EUR faces a

similar path.

Some after-the-fact rationalisations have been

offered for EUR strength, including the

improvement in the Eurozones current account

balance, and portfolio flows into recovering

Eurozone markets. We are not convinced by

either, and explain why elsewhere in this report in

more detail (seeEUR: myth-buster). To

summarise, the US has seen a greater

improvement in its current account balance than

the Eurozone since the crisis began. In addition,

Europes trade improvement largely reflects

crumbling domestic demand and imports, not

some export revival. Should we really be buying

the currency of countries suffering in this way?

The portfolio flow argument holds some merit as

net inflows have improved, but they are small

when compared to net FDI or other investment

flows. They cannot be the dominant driver to the

EURs resilience.

Instead, the problem for the EUR remains the

divergent paths of monetary policy and the

relative pace of economic growth. The Feds

balance sheet may be still getting bigger even as

they taper, but it is clear that policy is heading

towards the exit from emergency accommodation.

By contrast, we believe that the ECB may choose

to ease policy again this year given the weakness

of activity and associated disinflation. ECB

President Draghi has made it clear that all optionsremain open, including a negative deposit interest

rate or a further LTRO, perhaps linked to a

commitment to boost credit growth. It is rare for

policy within G4 to move in opposite directions,

and the reality of such a divergence rather than the

mere prospect of it, will likely see EUR-USD

head much lower through the year.

8. Divergent monetary policy will put EUR-USD under downward pressure

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EUR-USD Expected Dec'15 3M rate differential (EUR-USD, RHS) %



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Chart 8 shows EUR-USD plotted against relative

rate expectations for the end of 2015. The

relationship has been growing stronger in recent

months. If, as we argued in the previous section,

the market no longer looks for such a big gap

between the end of QE3 and the start of rate hikes

in the US, then this relative interest rate spread

will point towards a lower EUR-USD. In addition,

if policy easing in the Eurozone delays when

markets expect Eurozone rates to ultimately go

higher, then this too will drag EUR-USD lower.

In addition, the starting point for this adjustment

may already suggest that EUR-USD is a little high

relative to current rate expectations. We look for

EUR-USD to finish 2014 at 1.28.

The exceptional JPY

If there is to be an exception to USD dominance,

we suspect it may be the JPY. The consensus

persists with its view that USD-JPY will continue

to climb higher during 2014. But as much of H213 demonstrated, ongoing monetary easing by the

Bank of Japan does not mean the currency has to

persistently weaken. Much is already in the price,

most likely including some additional BoJ easing

later this year. In addition, we start 2014 with the

market once again anticipating a wave of Japanese

money to flood out, causing the JPY to weaken.

They may be right this time around, but 2013

showed that such presumptions can be wide of the

mark. Finally, 2014 will be the year where the

market will have to deliver its verdict on

Abenomics. If all we witness is a currency-

induced temporary spike in inflation rather than a

wage-led revival in inflation expectations, then

how much has really changed, especially if

structural reforms continue to underwhelm in their

scope and pace of delivery. We forecast USD-JPY

to finish the year at 101.

ConclusionUSD strength is set to continue through 2014, and

expand in scope. Both the EUR and GBP, which

were the notable exceptions to the rule of USD

dominance in 2013, are likely to weaken. The

EUR will succumb to the reality of economic

underperformance against the US, and the

divergence in monetary policy. GBP, buoyed so

far by the pick-up in UK economic indicators and

associated carry considerations, is vulnerable to a

shift in the markets focus to the UKs

problematic trade deficit. All of which clears a

path for a powerful USD this coming year. Its

only just begun.


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GBPs carry dominance tofade

We believe currencies fall into three main

groupings or buckets, namely the carry-sensitive

G10 pairings, the diminished safe-havens of the

JPY and CHF, and finally the balance of

payments club dominated by emerging market FX

category (see Currency Outlook: The new FX

paradigm,October 2013). In general, GBP has

happily belonged in the first bucket. Chart 1

shows GBP-USD in red plotted against

expectations for how wide the market believes the

gap will be between UK and US interest 3M rates

by the end of 2015. The currency has closely

tracked the shifts in relative rate expectations. For

H2 13, this has driven a stronger GBP against the

USD as the market consistently brought forward it

expectation of when the Bank of England (BoE)

might first hike interest rates. In addition, a delay

to the Feds tapering in September 2013 and a

successful effort by the Fed to emphasise that

US rates are unlikely to rise soon after QE3

ends further contributed to the gap moving inGBPs favour.

This all makes perfect sense in a carry world and,

for now at least, should help provide some

underpinning to GBP. However, for GBP-USD in

particular, carry considerations may begin to

move in the opposite direction during 2014. In

addition, GBP may find itself more in focus for its

balance of payments fundamentals, a process that

points to considerable downside for the currency.

Quantity not quality

The principal problem for GBP is that the driver

to the UK economic upswing may be impressive

in terms of quantity, but less so in terms of

quality. The recovery in the UK economy has

been heavily dependent on the improvement in the

housing market and the increase in consumption


1. GBP has taken its cue from relative rate expectations

-0.50

-0.30

-0.10

0.10

0.30

0.50

0.70

Jan-12 Mar-12 May -12 Jul-12 Sep-12 Nov -12 Jan-13 Mar-13 May -13 Jul-13 Sep-13 Nov -13 Jan-14

1.48

1.51

1.54

1.57

1.60

1.63

1.66

1.69

Expected Dec15 3M rate differentials (UK-US) GBP-USD (RHS)%

https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=jTCtrPCWvs&n=389866.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=jTCtrPCWvs&n=389866.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=jTCtrPCWvs&n=389866.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=jTCtrPCWvs&n=389866.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=jTCtrPCWvs&n=389866.PDF


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that a more active housing market induces. The

housing market has been helped by continued low

mortgage rates (and assurances that rates will stay

low for some time) plus government incentive

such as the help to buy schemes.

Chart 2 shows the monthly rate of mortgage

approvals. Before the crisis, these were running at

over 100,000 per month. Between 2010 and 2012

the rate was about 50,000 per month, but it has

recently accelerated to about 70,000 per month.

There would still seem to be some scope for this

to increase further, which would imply that

further strength in UK consumption spending may

be seen in early 2014.

At the same time, the increase in housing market

activity has seen housing construction pick up

from a low base (chart 3), and there would again

seem to be scope for this to accelerate further.

So this has been a consumption driven recovery

that has been funded either by improved access to

credit or a draw-down in savings as consumers

grow in confidence on the back of rising house

prices and falling unemployment. This creates

two problems for GBP:-

2. Housing activity being fuelled by low mortgage rates and government incentives

20

40

60

80

100

120

140

Sep-02 J ul-03 M ay -04 Mar-05 J an-06 N ov -06 Sep-07 J ul-08 M ay -09 M ar-10 J an-11 N ov -11 Sep-12 J ul-13

20

40

60

80

100

120

140

UK mortgage approv als (000)


3. Still scope for housing construction to rise

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

55,000Starts Completions

House Building in England, quarterly,

Source: Bloomberg, HSBC


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1 Questions over the sustainability of the

UK recovery

2 Likely deterioration in the visible

trade balance

Ultimately, strong consumption spending cannotbe sustained without growing incomes. As chart 4

clearly shows, real earnings growth has been

negative for much of the period since 2009, so

consumption spending will eventually falter. Once

consumption starts to falter, the UK economy will

start to look weak again, and the markets

perception of sterling will quickly change. The

December 2014 hike currently priced into the

market would likely be postponed into 2015, and

GBP would weaken in tandem.

However, it is the second vulnerability of external

imbalance that may prove the greater threat to

GBP, and see it move from the carry bucket into

the balance of payments club.

4. Negative real income growth will eventually bite

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

UK Real weekly earnings y-o-y% %


5. UK current account deficit could be more than 5% of GDP in 2015

-7.0%

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

101

102

103

104

105

106

107

108

109UK Current Account (% GDP 4Q ma, LHS inverted)

Relative domestic demand (RHS)

Forecast relative domestic demand

UK Current Account and relativ e domestic demand Index

Source: HSBC, Datastream


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Welcome to the balance ofpayments club

It is understandable that policymakers are less

concerned about the quality of growth, and are

simply relieved to see the UK emerge from

recession and in fact lead the way in terms of

European growth. However, for currency

investors, the nature of growth is likely to

become increasingly important and more

threatening to GBP.

More worryingly, this time around, the starting

point for the visible trade deficit is already larger

than in the late 1980s. Chart 6 shows the UK

visible trade balance as a percentage of GDP. If

domestic demand is outstripping peers by the

magnitudes expressed in chart 5, there is a

substantial risk that the visible trade deficit will

take a further lurch deeper into the red.

Certain idiosyncrasies of the UKs overall current

account balance may help limit the damage. Much

of the deterioration in the deficit over the last two

years has been due to two less closely followed

components of the current account, namely the

6. The starting point for the trade deficit is already at a worrying level

-8.0%

-7.0%

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

-8.0%

-7.0%

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%UK visible trade balance, % GDP

Source: HSBC, ONS

7. The UK overseas income balance has turned negative

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

UK Income balance (% of GDP 4Q sum)



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balance on overseas income and the balance on

transfers (such as worker remittances, overseas

aid, EU payments and receipts).

Both of these elements have moved towards a

larger deficit in the past two years. Chart 7 shows

the balance on overseas income as a per cent of

GDP on a 4 quarter sum basis. While this was

strongly in surplus until 2008, it has since moved

to a deficit approaching 1% of GDP. This

deterioration has been driven by lower earnings

on UK assets held abroad and increased profit

repatriation by overseas owned businesses in the

UK. Chart 8 shows the balance on transfer

payments. The widening deficit here has been

due mostly to an increase in the deficit on

government transfers which were running at about

GBP 2.5bn per quarter in 2009 and are now about

GBP 5bn per quarter.

In its official projections for the current account

deficit for 2014, the Office for Budget

Responsibility (OBR) has assumed that these two

deteriorating elements will simply reverse in a

mean-reversion exercise. Whether this happens or

not is open to question as a similar misplaced

assumption was made at the start of 2013. In any

event, we believe the troubling picture from the

8. The deficit on transfers has widened further

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

UK Transfers balance (% of GDP)


9. The UKs substantial visible trade deficit may become a greater concern in 2014

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

Net investment income balanceTransfers balanceTrade in servic es balanceTrade in goods balance

Current account balance

UK Current account balance as % of GDP

Source: HSBC, ONS


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more fashionable parts of the current account, the

visible trade deficit in particular, will be sufficient

to trip up GBP.

Chart 9 shows the various constituents of the UK

current account deficit. The prominent deficiency

is the sizeable deficit in the trade in goods balance(visible trade balance). For 2014, the combination

of rising UK domestic demand and lacklustre

growth in the UKs major export markets point to

further deterioration in this part of the overall

deficit. If net income and transfers do not improve

as forecast, then things could be very grim indeed.

Financing the current account deficit

The fact that the UK has a troublesome trade

balance does not necessarily imply that sterlingwill be under downward pressure. Ex ante

demand for sterling denominated assets may be

more than strong enough to finance the deficit,

which will result in upward pressure on the

currency (as has been happening in recent

months). The nature of the current account

financing will, however, show whether the

currency is becoming more vulnerable, and an

analysis of the UK data does not give

encouraging results.

Current account financing can come from

three sources:

1 Direct investment inflows: the purchase of

UK fixed assets and businesses by

overseas investors.

2 Portfolio flows: the purchase of UK bonds

and equities by overseas investors.

3 Short-term financing: short-term loans or the

purchase of money market instruments by

overseas investors.

Of course, the financing element for the current

account is the net of inflows and outflows for each

of these categories.

Chart 10 shows the balance on direct investment

and portfolio balance on a 4 quarter sum basis.

Large portfolio inflows during the crisis have

become large outflows in recent quarters. For the

most part, portfolio outflows have been larger

than direct investment inflows, which means short

term financing flows must be large enough to

cover this capital flow deficit as well as the wider

current account deficit. Chart 11 shows the

short-term financing flows that have been

required to ensure that the balance of payments

does, in fact, balance.

10. Direct investment has turned positive, but portfolio flows have been strongly negative

-200

-100

0

100

200

300

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

-200

-100

0

100

200

300

Direct Investment Portfolio

UK Direct Inv estment and Portfolio flows (4Q sum)

GBP bnGBP bn



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During the crisis, the fall in the current account

deficit and the portfolio inflow implied that short-

term funding flows were negative. The rush to

safe havens during the crisis saw investors

moving funds out of sterling and into the yen and

the dollar. Since 2011, however, the impliedshort-term financial flow has been positive,

suggesting that investors have been building up

large holdings of UK short-term assets.

Conclusion: The doublewhammy

The importance of short-term financial flows has

put sterling firmly in the carry candidate bucket

where expected moves in short term rates are

crucial to the fortunes of the currency. As long asthe market continues to perceive sterling in terms

of carry, and as long as the economy continues to

improve, then recent sterling strength can remain

in place. However, as we noted earlier, we have

our doubts over the sustainability of this economic

revival without a productivity-driven rise in

wages growth that could put the economy on a

firmer footing. If doubts about the durability of

the recovery were to threaten capital inflows at

the same time as concerns about the UKswidening visible trade deficit were taking hold,

the negative impact on GBP would be sizeable.

We believe this time will come in H2 14, and we

look for GBP-USD to fall to 1.50 by year end.

11. Short term inflows into the UK have become substantial

-200

-100

0

100

200

300

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

-200

-100

0

100

200

300

Implied short term funding flows (4Q sum) GBP bnGBP bn



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The EUR myths emerge

The EURs relentless rise, even as the ECB has

cut interest rates and flagged the possibility of

negative interest rates, has encouraged the

markets to look for other explanations for the

currencys on-going rise. There are two

popular suggestions:-

Suggestion 1: The EUR is rising

because of Europes improving

current account balance

The logic offered is that the EUR is capitalising

on the improving current account balance whichhas seen it swing from a deficit in the early part of

the crisis to a surplus currently (see chart 1).

Suggestion 2: Flows into Eurozone

peripheral asset markets are driving

the EUR higherIn addition, not only is the current account side of

the balance of payments improving, but capital

inflows are also likely to be benefitting from the

renewed strength in Eurozone equities and

peripheral bond markets. For example, since

Draghi announced in mid-2012 his willingness to

do whatever it takes to protect the Euro project,

the broad European equity market has risen by

roughly 25% and 10Y Spanish government bond

spreads have narrowed roughly 400bp against

their German equivalent (see chart 2).

Both these developments are, of course,

potentially currency positive. However, we have

our doubts that they are the most pertinent driver

of the EUR. We examine both lines of logic in the

coming sections.

EUR: myth-buster

1. Eurozone current account has moved into surplus

-20

-15

-10

-5

0

5

10

15

20

25

30

Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

-20

-15

-10

-5

0

5

10

15

20

25

30

Eurozone C/A balance, 3M MA (EUR billions)



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The EUR rise is due to theimproving currentaccountwrong

The US has delivered the biggest

improvement

The red columns in Chart 3 shows the change in

the current account balances of developed nations

in USD terms since the start of the crisis in 2007.

The first notable point is that the biggest

improvement has been delivered by the US, yet

few people seem to argue that the USD should be

stronger as a result. In addition, it is worth noting

that the improvement in the Eurozones balance

can be accounted for by the swing in the

peripheral country balances, a point we will

revisit below.

Furthermore, the black line shows the spot return

of the respective currencies against the USD from

the end of 2006 until the end of 2012, the same

period used for the current account balance shift.

The best performing currency was in fact the JPY,

strengthening despite the deterioration in its

current account balance. The CHF came a close

second despite a virtually unchanged external

balance. Their role as safe havens during the crisis

explains this apparent anomaly, but it also

2. European equities and peripheral bond markets have performed well

210

230

250

270

290

310

330

Jan-11 May -11 Sep-11 Jan-12 May -12 Sep-12 Jan-13 May -13 Sep-13 Jan-14

1.5

2.5

3.5

4.5

5.5

6.5

EuroStoxx 600 Index Germany v s Spain bond yield spread, % (RHS, inverted)


3. Currency performance has not been driven by current account balance developments during this crisis

-200

-100

0

100

200

300

400

Japan

Canada

France

U

K

Austra

lia

Swede

n

New

Zealand

Switzerland

Italy

Norwa

y

Ireland

Portgual

Greece

German

y

Spa

in

Periphery

Eurozone

U

S

-30

-20

-10

0

10

20

30

40

50

60

C/A change, 2006-12 (1000 million USD) Currency performance against the USD since 2006, % change

Source: HSBC, IMF, Bloomberg


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illustrates that current account balances have not

been at the heart of G10 FX. If you were investing

in FX on the basis of the current account, you

would have bought USD-JPY over this period, not

sold it.

Admittedly, what drives a currency market can

change with time. External balances gained

sudden prominence in emerging market FX earlier

in 2013 when the market became nervous about

what US tapering of QE would mean for capital

flows to deficit nations. Have they simply become

equally fashionable in G10 FX, and so explain the

ongoing rally in the EUR?

Eurozone improvement reflects

weakness not strength

Part of the answer to this depends on what is

driving the improvement in the current account

deficit. A stronger external balance driven by

accelerating export growth has a different feel toone fostered by a collapse in domestic demand

and the associated drop in imports. In our opinion,

this distinction once again argues against the

current account story being a dominant driver to

the EUR rally.

4. Export growth has decelerated less in the US than elsewhere

-14.0

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

Japan UK Greece Germany Ireland Spain Periphery Italy Eurozone Portugal France US

-14.0

-12.0

-10.0

-8.0

-6.0

-4.0

-2.0

0.0

Change in export grow th rate 2007-12 vs 2001-06, %

Source: HSBC, Bloomberg, Eurostat, BEA

5. Collapsing import demand has driven the Eurozone's improving current account

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Japan US Spain Greece Periphery Eurozone Ireland UK France Germany Italy Portugal

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Import grow th 2001-2006 (CAGR) Import grow th 2007-2012 (CAGR)% %

Source: HSBC , Bloomberg, Eurostat, BEA


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Chart 4 looks at export growth before and during

the crisis. The red columns show what the average

growth rate was of exports of goods and services

during the crisis compared to what it was in the

years leading up to the global financial crisis. Not

surprisingly, given the global recession, export

growth decelerated across the board. However,the slowdown in export growth in the US has

proven rather more modest than in the Eurozone,

and considerably better than the experience of

Japan or the UK.

Given the drop in export growth, any

improvement in the current account balance in the

Eurozone has been driven by a marked drop in

import demand. The red columns in Chart 5 show

import growth before the crisis, the black columns

import growth during the crisis. The improvement

in the peripheral current account balance, whichdrove the swing in the overall Eurozone balance,

has clearly been driven by the collapse in

import demand.

6. Cumulative flows into European asset markets

-40

-30

-20

-10

0

10

20

30

-110

-90

-70

-50

-30

-10

10

30

Jul-07 Oct-08 Feb-10 May-11 Sep-12 Dec-13

Cumulativeflow,

USDbn

Cumulative flow, USD bn

Europe ex UK Equity Europe ex UK bond (rhs)

Source: HSBC, EPFR

7. Cumulative flows into US and European asset markets

-150

-50

50

150

250

350

450

550

-150

-50

50

150

250

350

450

550

Jul-07 Oct-08 Feb-10 May-11 Sep-12 Dec-13

Cumulativeflow,

USDbn

Cumulative flow, USD bn

Europe ex UK bond Europe ex UK Equity US Equity US bond (rhs)

Source: HSBC, EPFR


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Buying the EUR on the basis of the current

account improvement in the Eurozone faces two

problems. Firstly, there has been a more marked

improvement in the US current account balance

than in the Eurozone, and G10 FX performance

has not been closely tied to deficit developments

during the crisis. Secondly, the source of

improvement in the Eurozones current account

balance has been much lower import demand.

Buying the EUR because of this would suggest

the winners in global FX should be those

currencies where domestic demand is collapsing

a rather counter-intuitive strategy.

EUR strength reflects strongerportfolio inflowswrong

So we are doubtful that the current account story

in the Eurozone really is a key point of support for

the EUR. We have rather more sympathy for the

suggestion that the renewed appeal of Eurozone

asset markets may still be inducing capital inflows

that will continue to drive the EUR higher. But

even here, we remain doubtful that it is the key

element in the EUR story.

Chart 6 shows cumulative investment flows into

European equity markets (in black) and European

bond markets (in red) since the global financial

crisis took hold. Initially, both bonds and equity

holdings were reduced, with flows back into

bonds picking up in 2009. The pick-up in equity

market flows took much longer to arrive,

coinciding with ECB President Draghis

underpinning of the EUR in mid-2012. Recent

months have seen a particularly sharp acceleration

in equity market holdings, and yet they still

remain below levels seen at the start of the crisis.

EUR bulls would argue there is further upside on

this front.

Europe is not the only market seeing

equity inflows

The challenge to this logic comes on two fronts.

Firstly, Europe is not along in seeing renewed

flows into equity markets. Chart 7 repeats the data

for Europe from Chart 6, but adds the equivalentnumbers for the US market. The flow in US

equities started earlier than in Europe and has also

been more sizeable. For EUR-USD, it is not

immediately apparent therefore that the fashion

for buying European equities was driven by this

relative story of US and European equity flows.

8. Eurozone capital account breakdown. Portfolio flows are not dominant

-60

-40

-20

0

20

40

60

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

-60

-40

-20

0

20

40

60

Di rect inv es tm ents Portfolio flow balance F inancial deriv ativ es Other inv es tm ent Reserv e ass ets

(EURbn) (EURbn)

Source: HSBC, Eurostat, Bloomberg


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Eurozone portfolio inflows are not the

dominant part of the capital account

The second problem is that currency markets tend

to place too much emphasis on what is happening

to portfolio flows. This is understandable. After

all, their impact is evident each day in themovement of share, bond and currency prices.

However, this does not mean they are the

dominant capital flow. Chart 8 shows a

breakdown of the Eurozones capital account.

Portfolio flows have been positive, but it is also

clear that they have been dwarfed by movements

in the net balances for other investments and

direct investments. If the EUR is being whipped

about by the capital account part of the balance of

payments, the decisive factor is not flows into andout of European financial assets.

This is not to say flows into European financial

markets are irrelevant to the EUR. Chart 9 returns

to an observation we have made in the past that

EUR-USD is being partly driven by fear, or an

absence of it. In the early stages of the crisis, this

was reflected in peripheral bond spreads over safe

haven bunds. With the introduction of the ECBs

OMT, the threat to peripheral bonds passed and

the link between bond spreads and EUR-USD

weakened. However, the Cyprus crisis ensured

that the fear merely changed in nature from a

peripheral bond market fear to a banking system

fear. Since then, EUR-USD has tracked the

relative performance of European Banks

compared to equities overall. If banks are

outperforming, the EUR has typically beenstronger, and vice-versa.

9. EUR-USD fares better when the market is less nervous about banks

1.20

1.22

1.24

1.26

1.28

1.30

1.32

1.34

1.36

1.38

1.40

Jan-12 Mar-12 May -12 Jul-12 Sep-12 Nov -12 Jan-13 Mar-13 May -13 Jul-13 Sep-13 Nov -13 Jan-14

77

82

87

92

97

102

107

112

EUR-USD (LHS) Europe banks and financial services performance relative to Euro Stoxx (RHS) Index

2007=100



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Conclusion: rating the EUR

The current account improvement in the Eurozone

may have helped the EUR, but it is hard to

demonstrate that it has been the key driver to EUR

fortunes. The USD should be the winner in this

particular battle. Similarly, while Eurozonefinancial markets are enjoying support, so too

have other markets, and in any event portfolio

flows are not the dominant element of the capital

account in the Eurozone.

So in the end, the EUR continues to be a carry

trade where currency movements are largely

determined by movements in relative rate

expectations. Chart 10, for example, shows

EUR-USD in black plotted against the expected

gap between Eurozone and US 3M interest rates

by the end of 2015. The link may not be perfect,

but it is strong. The EUR-USD exchange rate will

be determined by the policies of the ECB and Fed,

a data-determined evolution, and one we continue

to believe will see EUR-USD much lower over

the coming year.

10. Rate expectations are at the heart of EUR fortunes

1.26

1.28

1.30

1.32

1.34

1.36

1.38

1.40

03-Jun 18-Jun 03-Jul 18-Jul 02-Aug 17-Aug 01-Sep 16-Sep 01-Oct 16-Oct 31-Oct 15-Nov 30-Nov 15-Dec 30-Dec

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

EUR-USD Expected Dec'15 3M rate differential (EUR-USD, RHS)%



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Gold to recover modestly

We are lowering our average gold price forecasts

across the board and introduce a 2016 forecast, as

shown in the table below. We estimate a wide

trading range of USD1,390/oz to USD1,105/oz

for 2014.

Golds bull run, which lasted more than a decade,

ended last year as the investment demand that

fuelled the long-running rally sharply contracted.

Reduced demand for safe havens and expectations

of US monetary policy shifts triggered a rush out

of gold-exchange traded funds (ETFs) and greatly

reduced net long positions on the Comex. A chart

illustrating the decline in ETF holdings is located

on the following page.

We expect monetary policy especially as it

influences the USD will be key in helping to

shape and determine gold prices this year.

Tapering expectations helped trigger a near

stampede out of gold in 2013 and it is reasonable

to say that some form of tapering has already been

factored into prices. That said, it is likely that

further tapering would have a second-round

negative impact on gold prices. These declines

should be much more restrained than the plunge

in prices in the first half of 2013.

Much will depend on the pace and timing of the

tapering the Fed decides on and economic

conditions going forward. If, as HSBC foreign

exchange research anticipates, the Fed tapers

decisively this year, in the midst of a solid

Precious Metals

We lower our 2014, 2015 and long-term gold forecasts based on

expected tapering in line with economic recovery and a stronger

USD; we introduce a 2016 forecast for all the precious metals

The negative impact on gold of further investor liquidation should

be partially offset by continued strong emerging market demand,

reduced scrap supplies and stagnant mine output

We lower our platinum forecasts but leave palladium unchanged;

the PGMs should be supported by robust auto demand and

sluggish mine output; we also expect them to decouple from gold

HSBC gold price forecast (USD/oz)

__________2014f____________ ___________ 2015f ___________ __________ 2016f ___________ _______ Long term ________Old New Old New Old New Old New

1,435 1,292 1,395 1,310 1,345 1,500 1,350

Source: HSBC

James SteelAnalystHSBC Securities (USA) Inc+1 212 525 [email protected]

Howard WenAnalystHSBC Securities (USA) Inc+1 212 525 [email protected]


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PGMs decoupling from gold

We are lowering our platinum price forecasts

across the board but leave our palladium forecasts

unchanged with the exception of our long-term

forecast, as shown in the table on the next page.

We also introduce 2016 forecasts for the PGMs.

We expect a wide trading range this year for

platinum of USD1,360/oz to USD1,725/oz and for

palladium of USD680/oz to USD900/oz.

With both the platinum and palladium markets

forecast to run steep production /consumption

deficits in 2014 (Platinum Group Metals

Outlook: Decoupling from gold,22 November

2013), we expect both metals to decouple frompotentially weak gold prices and trade higher.

Prospects for limited mine output and growing

auto and other industrial demand in 2014 will

provide support to the PGMs regardless of gold

direction, we believe. Platinum may be supported

more directly by labor tensions in South Africa.

Palladium is likely to benefit from waning exports

from Russian stockpiles.

HSBC PGMs price forecasts (USD/oz)

________ 2014f __________ _________ 2015f _________ _________2016f__________ ______Long term_______ Old New Old New Old New Old New

Platinum 1,625 1,595 1,875 1,850 1,925 1,825 1,800Palladium 825 825 900 900 925 950 900

Source: HSBC
https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=wYiJrbsTlu&n=394931.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=wYiJrbsTlu&n=394931.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=wYiJrbsTlu&n=394931.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=wYiJrbsTlu&n=394931.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=wYiJrbsTlu&n=394931.PDF


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No love for CAD in the

New Year

The CAD remains on the defensive early in the

New Year, after weakening notably against theUSD through 2013 and registering even more

sizeable declines versus some other G10

currencies. A dovish shift from the Bank of

Canada and deterioration in some

previously-supportive CAD fundamentals

continue to weigh on the currency, encouraging

speculators to continue to build short positions.

Broad based CAD declines

Following several years of trading at historically

strong levels, the CAD weakened through most of

2013, pushing to its lowest levels against the USD

since 2010. The decline in the CAD has been

gradual rather than abrupt (USD-CAD implied

volatility is still among the lowest of other G10

currencies against the USD) but it is nonetheless

pronounced, with the CAD losing over 6% versus

the USD last year. But importantly as well, the

CAD registered even larger declines on some of

the crosses in 2013, falling 7.5% against the SEK,

8.3% against GBP, 8.9% against the CHF and

10.3% against the EUR. Although the CAD is

traditionally measured and still mostly traded against the USD, the broader nature of the selloff

and the more sizeable movements in the CAD

crosses versus USD-CAD has attracted more

speculative sales of the currency, exacerbating the

loonies declines. Indeed, CFTC data shows

speculative sales in the CAD increased sharply in

the latter part of 2013, putting net short positions

at their highest levels since the Spring of 2013,

which themselves were the largest short positions

run in the currency since the CFTC beganpublishing the data.

BoC impact

One obvious change in the CADs dynamics came

from the Bank of Canada, where Gov. Stephen

Poloz, taking over for Mark Carney at mid-year,

dropped the Banks tightening bias and adopted a

neutral one instead. In truth, that might not seem

Dollar Bloc

1. 2013 CAD performance

2013 CAD performance v s G10 (% change)

-10.35-8.9 -8.32

-7.54 -6.61-5.77

1.89

8.86

13.37

-15

-10

-5

0

5

10

15

EUR CHF GBP SEK USD NZD NOK AUD JPY

-15

-10

-5

0

5

10

15



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to be such a momentous shift, given that the Bank

had steadily diluted the tightening bias previously,

to the point where very few market participants

expected any monetary policy tightening in the

foreseeable future. However, additional changes

have followed both in the Canada backdrop and in

the BoCs policy emphasis. In particular,

inflation has remained low, at times lower than

the bottom of the BoCs 1%-3% target range (it

was most recently reported at 0.9% y/y). And

with core inflation also subdued holding between

1.0% and 1.4% throughout 2013 the outlook for

future headline inflation remains low as well.

Against that backdrop, the BoC acknowledged in

its December policy statement that the, downside

risks to inflation appear to be greater than it

assessed in the October Monetary Policy Report,

and that factors weighing on core inflation look

to be more persistent than anticipated. Dropping

the tightening bias in an environment of steady,

near-target inflation is one thing. But doing so

against a backdrop of too-low and/or falling

inflation is a different matter, and one that will

lead to at least some speculation of possible

easing in monetary policy.

Our Canada economist does not expect the BoC tocut the overnight target rate from its current level

of 1%. But markets will certainly be sensitive to

upcoming data (employment and inflation will

likely stand out) as well as BoC meetings and

commentary (the next BoC policy statement is

due January 22) and the extent to which they

increase the perceived risk for a further dovish

shift in policy. The shift in policy emphasis to

date has already weighed on the CAD, but the

currency would still be at further risk if markets

perceive some greater chance of actual

BoC easing.

Relative spreads have shifted in

USD-CADs favour

Also on the interest rate front, the shift in the US

backdrop following the announcement of Fed

tapering in December is clearly an important

development for the USD generally, includingUSD-CAD. On balance, with the Fed now

beginning to exit QE while the Bank of Canada

has sounded more dovish, the relative central

bank stance is potentially more USD-CAD

supportive. That said, the fallout of central bank

expectations on currencies, particularly Fed policy

expectations, has often been inconsistent for much

of the past year. But more tangibly, we would

highlight that US-Canada two-year interest rate

spreads have shifted in USD-CADs favor,

narrowing from near -102 bp in late-November to

-89 bp at present, with most of that move

2. CAD weakness more pronounced on crosses versus the USD since mid-year

88

92

96

100

104

Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13

88

92

96

100

104

EUR GBP CHF USD

Index , 8 July 13=100Index, 8 July 13=100

CAD perfromance against other G10 currencies, Index



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ConclusionLooking ahead, we expect further CAD weakness

going forward. The conditions we have

highlighted above, both in Canada and abroad, are

likely to prevail for the foreseeable future, and

should be consistent with additional downward

pressure on the CAD. With the currency already

at its lowest levels against the USD in nearly four

years, and given the notable depreciation in recent

months and over the past year, more pronounced

near-term gains in USD-CAD will become more

difficult. But buying strategies remain favoured,

and we would continue to view corrective

declines in the currency pair opportunistically to

establish long positions.


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AUD: The worst is overIn 2013 the AUD depreciated over 14% against

the USD, which put it among worst performers in

the G10 space. Only the JPY faired worse (-16%).

Given the adjustment in the currency, we believe,

the depreciation in 2014 will moderate. Sluggish

domestic growth with little signs of rebalancing

and expected USD dominance, as we outlined in

USD rally to spread its wings(page 5), are

among the main drags on the AUD in 2014.

However, our view that the RBAs easing cycle is

done and prospects of the greater openness of

Chinese financial system could pose some upside

risks for the currency.

Below-trend growth, rebalancing needed

Australias Q3 GDP release showed that the

economy grew 2.3% YoY in (2.6% expected)

remaining sluggish and below trend. On net,

mining investment was still a positive contributor

to growth, despite having slowed down. However,we expect it to fall, as fewer new projects are

getting started, and, particularly from H2 2014

investment in the mining sector is expected to be a

significant drag on growth. So, the economy

needs to rebalance. Disappointingly, there were a

few signs that growth was rebalancing as of Q3.

Household consumption remained subdued, rising

by only 0.4% QoQ, while the saving rate

remained stubbornly high climbing to 11.1% (vs

prior 10.2%). With the timing and success of

rebalancing remaining unclear but signs of a

slowdown in mining investment already in place

we see uncertainty having a negative effect on

the AUD.

Carry still dominates the behaviour of the AUD

The Federal Reserve announced the beginning of

its tapering programme at 18 December meeting,

but also presented a dovish forward guidance

noting that the end of QE3 will not be followedswiftly by a rate hike. Nevertheless, as we

mentioned on page 7, the first rate hike might

come earlier than expected if economic data

continues to bring positive surprises. Chart 1

shows that there is a strong relationship between

AUD-USD and relative interest rate expectations.

Therefore, if market expectations for US rates

rise, while uncertainty surrounding growth

prospects keep Australian rate expectations low,

then this spread will point towards a lowerAUD-USD.

The RBAs easing phase is likely to be over

In testimony to a parliamentary committee on

18 December the RBAs governor Stevens noted

that, while the Board has had an 'open mind' about

cutting rates further, there are 'few serious claims

that the cost of borrowing per se is holding back

growth'. He also highlighted that 'confidence'

matters more, at this stage, not borrowing rates.

1. Divergence in rate expectation will bring AUD-USD lower 2. Recent timely indicators point toward more rebalancing

1.80

2.00

2.20

2.40

2.60

2.80

3.00

01-May 01-Jul 01-Sep 01-Nov 01-Jan

0.85

0.88

0.91

0.94

0.97

1.00

1.03

Ex pected Dec'15 3M rate differential (AUD-USD, RHS)

AUD-USD

%

-12

-8

-4

0

4

8

12

Jan-12 May-12 Sep-12 Jan-13 May-13 Sep-13

90

95

100

105

110

115

NAB business confidence, Index (LHS)

Westpac consumer confidence, Index, Sep 1974=100

Source: HSBC, Bloomberg Source: HSBC, Bloomberg


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Consumer and business sentiment have picked up

recently and retail sales have also shown

improvements in the past four months (chart 2).

These timely indicators suggest that the problem

highlighted by the RBA is already improving as

well as growth may be rebalancing more in the

coming quarters. We think that this can play an

important role in supporting investor sentiment

and is the main reason we only expect the AUD to

sell off moderately against the USD in 2014. We

forecast AUD-USD at 0.86 at the year-end.

Advantages of greater China openness

According to estimates from the Heritage

Foundation, Australia has been the world's largest

recipient of capital investment from China over

the past eight years. As further financial market

reforms announced at the Chinas Third Plenum

in November should provide boost to financial

flows in 2014, Australia is in a favourable

position to take advantage of this opening up ofChinas financial sector (see Downunder digest:

Australias financial ties to China set to grow,

18 December 2013). This could give Australian

businesses greater opportunities in attracting

offshore investment for expansion and thus could

add to domestic growth and rebalancing. This

process is, however, a long term structural

possibility, and thus we dont expect direct impact

on growth this year. Nevertheless, it might help to

boost business and consumer confidence, which inturn should lift overall sentiment and bring some

support for the AUD against the resurgent USD.
https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=UWGVAlINiL&n=398608.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=UWGVAlINiL&n=398608.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=UWGVAlINiL&n=398608.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=UWGVAlINiL&n=398608.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=UWGVAlINiL&n=398608.PDF


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NZD: a booming 2014Unlike its Australian peer, the NZD held its own

against the USD in 2013. Post-earthquake

reconstruction, rapidly rising house prices and

improving terms of trade significantly boosted

domestic demand last year. We expect these

factors to persist and timely indicators point to

further solid growth in 2014. Domestic inflation

has picked up and with the economy already

reaching capacity, we expect the RBNZ to lift

rates soon to keep a lid on inflation. The

combination of these factors will see a stronger

NZD in 2014.

New Zealands boom begins

New Zealand's economy is booming. GDP

increased strongly in Q3, rising by 3.5% YoY

(3.3% expected). The main factors providing the

boost to growth are:

1 Post-earthquake reconstruction in Canterbury.

Here residential investment picked up 18.7%

over the past year.

2 For the country in general, the latest data

showed that house prices rose 9.2% YoY, the

highest since December 2007 (chart 1).

3 Substantial rise in export prices. A rapid run-

up in prices of diary products, the countrys

biggest export earner, saw terms of trade

reaching a 40-year high in Q3 13. This has

supported income growth which saw

domestic demand rising by a whopping

6.2% YoY in Q3.

Looking ahead, these key drivers are likely to

persist and rapidly expanding economy should see

the NZD edging higher.

A rate hike is expected soon

At its latest meeting on December 2013, the

RBNZ noted that they 'will increase the OCR as

needed in order to meet the 2 % inflation target.

According to their profile for the rate outlook, rate

rises are expected to begin from Q2 2014.

However, in our view, the RBNZ may need to

raise rates as soon as Q1 2014, due to greater

cost-pressure than the RBNZ is currently

factoring in (chart 2). In either case, the RBNZ

would be the first central bank in the G10 space to

start raising rates. This should grant support to the

currency in 2014 and we forecast NZD-USD at

0.87 by year-end.

1. New Zealand housing market is booming 2. We expect inflation to be higher than the RBNZ forecast

-10

-7

-4

-1

2

5

8

11

Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12

-10

-7

-4

-1

2

5

8

11New Zealand QV house prices, % YoY

0.5

1.0

1.5

2.0

2.5

3.0

Mar-12 Sep-12 Mar-13 Sep-13 Mar-14 Sep-14

0.5

1.0

1.5

2.0

2.5

3.0

RBNZ CPI inflation projections, YoYHSBC forecast

Current Projections

%%

Source: HSBC, Bloomberg Source: HSBC, Statistics New Zealand, RBNZ estimates


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G10 at a glanceCHF Switzerland: Risk appetite is still a driver

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

0.6

0.8

1.0

1.2

1.4

1.6

1.8

EUR- C

hsbc jan 2014 usd strength

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