Currency Market Monitor

Transcription

1 CURRENCIES Currency Market Monitor 1 st Quarter 2014 APRIL 3, 2014 John W. Labuszewski Sandra Ro Bluford Putnam Managing Director Executive Director Chief Economist Fin l Research & Product Development jlab@cmegroup.com FX Research & Product Development 011 (44) sandra.ro@cmegroup.com Research & Product Development bluford.putnam@cmegroup.com

2 An ongoing debate has long persisted in the global currency or FX markets is FX an asset class akin to stocks and bonds? While practitioners and academics may debate this point at length, perhaps the most practical answer is does it really matter provided that investors may draw a return from currency investments? The performance of the currency or FX markets is found in the exchange rates and cross-rates associated with the world s myriad currencies. The total return associated with a currency is driven by interest income associated with fixed income instrument investment in the particular currency; as well as pure price performance. Many fundamental factors, including national economic conditions, monetary and policies, current and capital account flows, to name just a few, impact the returns associated with the world s currencies. This document represents a review of these factors as they played out in the most recently completed calendar quarter. We include consideration of the so-called carry trade as well as a look at the theory of purchasing power parity as it impacts FX markets. While we cover activity in a broad spectrum of currencies, we focus on the currencies underlying some of the most liquid of CME Group FX futures. This includes the U.S. dollar (USD), Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar (AUD) and Mexican peso (MXN). In addition, we have special interest in the currencies of significant emerging market economies including the Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese yuan or renminbi (CNY) the so-called BRIC nations. Finally, we highlight several CME Group FX Indexes including a USD Index, a Carry Trade Index, Commodity Country Index and BRIC Index. Market Fundamentals As a general rule, FX analysts will evaluate the fundamental value of any particular currency by reference to a number of national economic factors. These factors including growth and inflation prospects; monetary and fiscal policies; and, current and capital account balances. To illustrate, we include a brief discussion of the economic situation prevailing in the United States as of the conclusion of the most recently completed calendar quarter. Of course, the U.S. dollar (USD) may be just one side of any currency pair that may be traded using CME FX futures. A brief summary of economic conditions in various nations, organized along similar lines, is included in Appendix 1 of our document below. One may compare and contrast these conditions as they exist in the two countries whose currency pairing one may be interested in to draw an appreciation of the fundamental factors that impact currency markets. Growth and Employment The 1 st calendar quarter of 2014 was marked by mixed economic results. On the one hand, economic growth appears to have slowed as a result of seasonally inclement weather. The housing market seems to be in a stall pattern while fiscal policy may be putting on the brakes. On the other hand, labor markets show signs of improvement while consumer spending is reasonably strong. Concerns regarding tensions in the Crimea and a general slowdown in the emerging markets likewise played a role in shaping the character of 1 st quarter results. The Fed summarizes the domestic situation nicely growth in economic activity slowed during the winter months, in part reflecting adverse weather conditions. Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated. Household spending and business fixed investment continued to advance, while the recovery in the housing sector remained slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has been running below the Committee s longer-run objective, but longer-term inflation expectations have remained stable. 1 1 Federal Reserve Press Release dated March 19, Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

3 Qtrly Change in GDP GDP was reported at +2. in the 4 th quarter but slipped from the 3 rd quarter s recent peak at +4.1%. This growth drove the February unemployment rate down to 6.7%, an uptick from January s 6. but a 1% improvement from the 7.7% reported a year earlier in February These levels are approaching the 6.5% rate cited in the Fed s previous forward guidance regarding the trigger for a tighter monetary policy. Unemployment Rate 2% -2% % -1 11% 1 9% 8% 7% 5% Q1 05 Jan-02 Q4 05 Growth and Employment Q3 06 Q2 07 Q1 08 Real GDP (SA) Q4 08 Q % 1 9% 8% 7% 5% While this represents improvement, labor force participation remains at anemic levels of only 63. in February 2014 and at levels not seen since the late 1970s. Further, the total number of employed at million as of February 2014 remains less than the pre-financial crisis peak of million seen in January This means that we have now seen 73 months pass by without recovering to exceed pre-crisis levels. This represents the most extended Q2 10 Q1 11 Q4 11 Q3 12 Q2 13 Q1 14 Unemployment Rate Source:Bureau of Economic Analysis (BEA) & Bureau of Labor Statistics (BLS) Jan-03 Employment Statistics Jan-04 Jan-05 Jan-06 Jan-08 Jan-10 68% 67% 6 65% 6 63% 62% Unemployment Rate Labor Force Partcipation Source: Bureau of Labor Statistics (BLS) Unemployment Rate Labor Force Participation recovery from recession by a wide margin during the past 35 years. Still, the Fed is encouraged and expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate of fostering maximum employment and price stability. 2 The Fed s most recent statement alluded to advances in household spending. However, this is not borne out by an examination of data regarding either retail sales or light vehicle sales. Retail sales slipped 1.2% to $ billion during February 2014 from a November 2013 peak of $ billion. Similarly, sales of cars and light trucks fell 6.3% to million units in February 2014 from the November peak of million units. Still, the longer-term trend has been steadily pushing upwards since the major trough seen in early A general propensity to loosen the purse strings is reflected in the personal savings rate. The rate appears generally to be drifting downwards and was reported at 4.3% in February 2014 after drifting up in the wake of the financial crisis. Note, however, that this does not fully reflect the complete winter 2 NFPs as % of Peak 101% 10 99% 98% 97% 9 95% 9 93% Ibid. NFP Recovery from Recession Months Since Peak NFP Apr - Dec-80 Aug-81 - Oct-83 Jul-90 - Jan-93 Mar-01 - Jan-05 Feb-08-2 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

4 weather experience, which has certainly diminished or possibly just deferred consumer spending. Retail Sales (Bil $) While consumer spirits seem to have been dampened by unseasonably cold weather, the industrial sector has shown further advances. The Index of Industrial Production was reported at in February This is 2.8% above the February 2013 mark and represents a new peak, advancing above pre-crisis levels. % of Disposable Income $190 $185 $180 $175 $170 $165 $160 $155 9% 8% 7% 5% 3% 2% 1% Aug-07 Consumer Sector Activity Mar-08 Oct-08 May-09 Dec-09 Real Retail Sales SA Jul-10 Similarly, capacity utilization is on the upswing, reported at 78.8% in February This is just a bit off of the 78.9% from November 2013 but decidedly above the 78.2% reported a year earlier in February The figure is rising but remains a bit below the key 8 mark at which point many economists believe that inflationary pressures may be expected to be observed. Feb-11 Sep-11 Apr-12 Nov-12 Jun Light Vehicle Sales Source: U.S. Census Bureau and Dept.of Commerce Jul-07 Jan-08 Personal Savings Rate Jul-08 Jul-09 Jan-10 Jul-10 Jul-11 Jul-12 Source: St. Louis Federal Reserve FRED Database Jul-13 Vehicle Sales Industrial Production Index This activity is reflected in domestic corporate profitability which is deep into all-time high territory. The Department of Commerce reported $1,904.5 billion in 4 th quarter profitability or +6. on a year-on-year basis. Some analysts suggest that this profitability is primarily responsible for the new alltime highs recorded in equities while others point to low rates held in place by QE programs. Annualized Change Industrial Sector Activity Aug-07 Mar-08 Oct-08 May-09 Dec-09 Jul-10 82% 8 78% % 7 68% 6 The Fed further remarked upon slowness in the housing markets. This is underscored by slight dips in housing values in Chicago, Boston and Los Angeles in January 2014 from the prior month. Still, gains were shown in Miami, Washington and San Francisco. Further, the S&P/Case-Shiller 10-City Composite index held its ground in January and as advanced 13.5 on a year-on-year basis and 22.9 since the trough of March Feb-11 Index of Industrial Production Sep-11 Apr-12 Nov-12 Jun-13 Capacity Utilization Capacity Utilization Source: St. Louis Federal Reserve FRED Database U.S. Corporate Profitability Q1 04 Q4 04 Q3 05 Q2 06 Q1 07 Q4 07 Q3 08 Q2 09 Q1 10 Q4 10 Q3 11 Q2 12 Q1 13 Q4 13 Annual Change $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 Corporate Profits (Bil) Source: Department of Commerce Pre-Tax Profits (Billions) 3 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

5 But building permits, housing starts and housing completions continue to hover in the vicinity of 900 thousand to 1 million units. This is a little less than half of the peak pre-crisis era figures near 2.2 million units. Inflation The Fed concedes that inflation is well below their long-term objectives. It further recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term Year-on-Year Change Jan-00 5% 3% 2% 1% -1% -2% -3% Ibid. S&P/Case-Shiller Housing Indexes Dec-00 Nov-01 Oct-02 Sep-03 Aug-04 Jul-05 Jun-06 May-07 Apr-08 Mar-09 Feb-10 Dec-11 Nov-12 Oct-13 Los Angeles San Diego San Francisco Denver Washington DC Miami Chicago Boston Las Vegas New York Comp-10 Source: Standard & Poor's Jan-04 Jan-05 Consumer Price Index (CPI) Jan-06 Jan-08 CPI - All Urban Consumers SA Jan-10 Source: Bureau of Labor Statistics (BLS) CPI ex-food & Energy SA The seasonally adjusted read of the Consumer Price Index (CPI) from February 2014 was at only 1.1% with the CPI ex-food and energy holding up at 1. on an annualized basis. These figures have generally trended down over the past few years, raising some concerns of deflation. Still, capacity utilization at 78.8% and starting to challenge that key 8 mark seems to support the Fed s attitude towards these risks. Monetary Policy The Fed s quantitative easing (QE) programs called for the purchase of some $85 billion of Treasuries, agency debt and agency mortgage backed securities (MBS) on a monthly basis, in an innovative attempt to keep intermediate- to long-term rates at modest levels. But the 4 th quarter saw the Fed begin to scale back or taper the program by $10 billion per month. Consistent with its judgment that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions [and] in light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Fed announced another $10 billion round of tapering. Specifically, beginning in April, the Committee will add to its holdings of agency mortgage-backed securities a a pace of $25 billion per month rather than $30 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $30 billion per month rather than $35 billion per month. 4 Further tapering may be expected contingent upon the pace of economic recovery. Tapering was further supported by updated Fed projections of % unemployment in 2014, down to % in 2015 and in Of course, the target Fed Funds rate has long been the primary monetary policy tool. But the Fed reaffirmed its view that a highly accommodative 4 5 Ibid. See Summary of Economic Projections of Board of Governors of the Federal Reserve System, (March 2014). 4 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

6 stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to ¼ percent target range for the federal funds rate, the Committee will assess progress both realized and expected toward its objectives of maximum employment and 2 percent inflation The Committee continues to anticipate that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. 6 5% 3% 2% 1% Jul-07 Jan-08 Benchmark U.S. Rates Jul-08 Jul-09 Target Fed Funds 5-Yr Treasury 30-Yr Treasury Jan-10 Jul-10 Note that the Fed s longer-run projection for PCE inflation is reported at It is further noteworthy that the Fed has backed away from previous suggestions that it would consider more aggressive action when unemployment reached 6.5% [w]ith the unemployment rate nearing 6-1/2 percent, the Committee has updated its forward guidance. 8 Still, this is consistent with the Fed s indications from December 2013 to the effect that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that unemployment rate declines to 6-1/2 percent, especially if projected inflation continues to run below the Committee s 2 percent longer-term goal. 9 Jul-11 Jul-12 6 Op. cit., Fed Statement of March 19, Op. cit., Summary of Economic Projections. 8 Op. cit., Fed Statement of March 19, Ibid. Jul-13 2-Yr Treasury 10-Yr Treasury Fiscal Policy Once more, the Fed acknowledges that [f]iscal policy is restraining economic growth, although the extent of restraint is diminishing. 10 This is underscored when we consider that Federal fiscal deficits of $1.4, $1.3, $1.3 and $1.1 trillion in , respectively, shrunk to just $680 billion Washington was able to avert another in a string of chronic debt ceiling crises. Specifically, the Senate approved a House measure on February 12 th that provides funding for Federal activities through March It was hailed by President Obama who was pleased that Republicans and Democrats in Congress have come together to pay for what they ve already spent, and remove the threat of default form our economy once and for all. He further expressed hope that this puts an end to politics by brinkmanship. But this represented something of a blow to fiscal conservatives including the Tea Party. House Speaker John Boehner criticized the measure, suggesting that [i]t s the President driving up the debt and the President wanted to do nothing about the debt that s occurring so, let his party give him the debt ceiling increase that he wants. In further fiscal news, the deadline for signing up for Obamacare was marked on Monday, March 31, An extension into April has been granted to those who have experienced difficulty accessing the 10 $400 $200 $0 -$200 -$400 -$600 -$800 -$1,000 -$1,200 -$1,400 -$1,600 Ibid. Federal Surplus/Deficit (Billions USD) Source: Office of Management and Budget (OMB) 5 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

7 websites and signing up. Still, a reported 6 million Americas have acquired health insurance since October 1 st through the Federal and State exchanges. Still, we may expect debate on this issue to be ongoing. Current & Capital Account Flows billion in 2011 and 2012, respectively, but that still represents sizable values. $1,200 $800 Net US/Foreign Capital Flows (Billions USD) The 4 th quarter 2013 current account deficit improved further, reported at only $81.1 billion and 15.9% less than the $96.4 billion reported in the 3 rd quarter. This is less than the $ billion deficit reported in the 2 nd quarter 2009 at the height of the sub-prime crisis. Billions $0 -$100 -$200 -$300 -$400 -$500 -$600 -$700 -$800 -$900 US Current Account Balance US Current Account % % % % % 2. The total 2013 current account balance was reported at only $360.7 billion and 2.2% of estimated 2013 GDP of $16.72 trillion. This is the most optimistic figure seen for well over a decade. Another interesting source of flow of funds data may be found in the U.S. Treasury Department s Treasury International Capital (or TIC ) database. This database tracks flows into and out of the U.S. The data is broken into foreign stocks, foreign bonds, U.S. stocks, U.S. corporate bonds, U.S. government agencies and U.S. Treasuries. U.S. vs. overseas capital flows have generally been characterized over the past decade by substantial influx of funds into U.S. Treasuries. This phenomenon peaked in 2010 as overseas investors purchased some $704 billion in U.S. Treasuries on a net basis. The figure tailed off to $433 and $ % of GDP % of GDP $400 $0 -$400 -$ But net inflows in U.S. Treasuries slowed to only $42.88 billion in January 2014 actually saw a net outflow of $0.57 billion. Interest in Treasuries was replaced by large scale interest in U.S. equities where foreign investors directed a net $ billion into domestic markets. This remarkable shift was obviously driven by fears of rising rates alongside a continued strong surge in U.S. stocks. Mutual Fund Flows US Treasuries US Gov't Agencies US Corporates US Stocks Foreign Bonds Foreign Stocks $40 $30 $20 $10 $0 -$10 -$20 -$30 -$40 Mar-12 The flow of equity and fixed income investments may be examined per data published by the Source: U.S. Treasury TIC Database May Equity Fund Cash Flows (Billions USD) Jul-12 Sep-12 Nov-12 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Domestic Equities Foreign Equities Source: Investment Company Institute (ICI) Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

8 Investment Company Institute (ICI) which tracks activity in the mutual fund industry. 11 Investors added some $159.8 billion into equity funds during the But only a scant $17.7 billion was directed into domestic equity funds, despite their generally strong performance while another $142.1 billion was added to foreign equity funds. This trend continued in January through February 2014 with another $43.3 flowing into equity funds. Funds had generally been flowing into bond funds through May But June saw the reversal of this trend as investors began to believe that interest rate advances, fueled by economic growth and expectations of tapering of Fed easing programs. By the conclusion of 2013, some $80.5 billion had been withdrawn from bond funds. But some $8.9 billion flowed back into these markets in January through February Global Economic Performance Emerging market (EM) economies have been the stars of the investment world for some years now. Still, it was the developed market (DM) economies that provided some of the most positive growth surprises in While the EM countries generally exhibit higher growth rates than DM countries, that 11 $40 $20 $0 -$20 -$40 -$60 -$80 Mar-12 Equity & Bond Fund Cash Flows (Billions USD) May-12 Jul-12 Sep-12 Nov-12 These indicators are often highly correlated with price action as retail investors may chase the market by buying in response to a bull trend. Or, they may exhibit a herd mentality by liquidating investments in response to significant market breaks. Mar-13 May-13 Jul-13 Sep-13 Equity Funds Bond Funds Source: Investment Company Institute (ICI) Nov-13 growth has generally decelerated relative to DM economies in recent years. Actual and Forecast GDP Growth (f) (f) (f) Developed Markets (DMs) Australia % 2.7% % 2.2% Canada 2.5% 1.7% % % France % 0.9% % Germany 3.3% 0.7% % Japan % 1.8% 1.5% UK 1.1% 0.1% 1.3% 1.9% 1.9% 1.1% US 1.8% 2.8% 1.9% % Emerging Markets (DMs) Brazil 2.7% 0.9% % 2.9% 2.8% Mexico 3.9% 3.8% 1.5% 3.1% 2.9% 3.1% Russia 4.3% % 2.5% 1.8% 1.2% India 6.2% % % 2. China 9.3% 7.7% 7.5% % 3.5% Source: The Conference Board Global Economic Outlook 2014 (February 2014) NOTE: (f) = forecast data According to the Conference Board s Global Economic Outlook, growth in Germany is expected to run at a very moderate +1. on an annual basis from Similarly modest growth is expected in much of the developed world including Japan (+1.), the United Kingdom (+1.9%) and the United States (+2.). While GDP growth has slowed in many of the emerging economies, such growth has nonetheless generally surpassed that of the DMs. This is expected to continue, according to Conference Board forecasts, albeit the gaps may narrow. Note that the trade surpluses that have supported many emerging market economies are shrinking along with trade deficits in the U.S. and Europe. As discussed above, the U.S. current account deficit shrank to 2.2% of GDP in 2013 from a peak deficit of 5.7 in The Chinese trade surplus similarly shrank from a peak of 11.0 of GDP in 2007 to 2.3 in Arguably, these trade imbalances have been a fundamental driving engine behind much emerging market growth over the past several decades. 7 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

9 5% Annual GDP Growth (Mature Economies) 12% Annual GDP Growth (BRIC Economies) 1 3% 8% 2% 1% 2% -1% Germany Japan UK US Source: The Conference Board Brazil Russia India China Source: The Conference Board Current Acct Balance (% GDP) (Mature Economies) 12% Current Acct Balance (% GDP) (BRIC Economies) 1 8% 2% 2% -2% - -2% US Euro Area UK Japan Brazil Russia India China Price Performance The factors discussed above exert an obvious impact upon the price performance of the U.S. dollar vis-àvis other world currencies. In order to monitor this price impact, CME Group has developed the CME USD Index as one in a family of similarly constructed FX Indexes. 12 The CME USD Index ended calendar year 2013 at a value of 1, and remained virtually unchanged over the course of the 1 st quarter to end at 12 The CME USD Index represents a basket of equally weighted positions (as of December 31, 2010) of the USD vs. the Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar (AUD) and Chinese yuan (CNY). It is (arbitrarily) established at a value of 1, as of December 31, , As such, the 1 st quarter proved to be a relatively quiet market in terms of price or spot return performance. The Euro generated a spot return of +0.25% vs. the USD; the British pound (GBP) posted a return of +0.7; while the Japanese yen (JPY) was seen +2.0 for the quarter, bouncing back a bit from its % plunge during the course of Mixed and more dramatic movements were seen amongst emerging market currencies where the Brazilian real (BRL) posted a spot return of +6.62%; the Russian ruble weighed down by tensions in the Crimea saw a spot return of -4.8; the Indian rupee (INR) was seen +9.25%; while the onshore Chinese yuan or renminbi (CNY) posted a spot return of -2.62%. 1 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

10 Note that we may distinguish the spot return of a currency, or the outright price movements, from the total return inclusive of price movements plus interest accrual considerations, as discussed in more detail below. 1,250 1,200 1,150 1,100 1,050 1, Jul-07 Total Return Jan-08 Jul-08 One of the most popular long-term FX trading strategies over the past decade is known simply as the carry trade. This practice simply suggests that one might exploit cost of carry by borrowing in countries with low nominal interest rates to invest in countries with high nominal interest rates. Thus, one might sell the low-rate currency and buy the high-rate currency. Carry trade CME USD Index Jul-09 Jan-10 Sell low-rate currency & buy high-rate currency By so doing, one hopes to capitalize on discrepant interest rates, and by implication, divergent investment opportunities, in the two countries. This strategy further recognizes that total currency return consists of 2 components, specifically, exchange rate or price movement plus the accrual of interest. The implicit assumption is that these interest rate relationships will endure. As such, carry traders implicitly discount classical exchange rate theories by assuming that the interest rate relationships may endure over extended periods of time. This suggests that low-yielding currencies that are sold will not advance; and, that high-yielding currencies that are purchased will not decline. Jul-10 Long Short 14.3% EUR 10 USD 14.3% JPY 14.3% GBP 14.3% CHF 14.3% CAD 14.3% AUD 14.3% CNY Jul-11 Jul-12 Jul-13 Total Currency Return = Price Movement + Interest Historically, such relationships have been known to endure for extended periods of time, reinforcing interest in the carry trade. In particular, vast sums of money totaling in the trillions of U.S. dollars were invested in the carry trade prior to the outbreak of the subprime crisis, specifically by shorting the Japanese yen (JPY) and investing in other currencies including the Icelandic krona (ISK). USD-BRL NZD-USD USD-INR AUD-USD USD-ISK USD-TRY USD-JPY USD-CHF GBP-USD USD-ZAR USD-MXN EUR-USD USD USD-KRW USD-COP USD-TWD USD-CNY USD-CLP USD-CAD USD-RUB USD-ARS -8% Appendix 2 depicts the total return associated with various currencies, relative to the U.S. dollar, during the most recently completed calendar quarter. Amongst the mature economies, the EUR generated a total return of +0.25% for the quarter; the GBP at +0.7; and, the JPY was at To the extent that interest rates remain at near zero levels in these mature economies, the total returns are not much different than spot returns as reported above. But interest accruals may exert a much greater influence in less mature economies. The BRL posted a total return of +6.62% for the 1 st quarter; the RUB was seen at -4.8; the INR at +5.57%; and, the CNY at -2.33%. Carry Return (Q1 2014) % The Argentine peso (ARS) generated a spot return of % for the quarter. But the total return was much more muted at -7.57% as a result of the extremely high prevailing 3-month rate of Because the carry trade has become such an important and widely followed transaction in the 2% 8% 2 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

11 global FX markets, CME Group has developed the CME FX Carry Index. This novel index is designed to follow the performance of a basket of currencies that offer relatively high interest rates and have, on an historical basis, generated favorable total returns. 13 1,050 1, Jul-07 Jan-08 Jul-08 The CME FX Carry Index closed the 1 st quarter at and +2.49% from its 2013 ending value of This reflects the generally good performance of the BRL (total return = +6.62%), AUD (+4.58%), NZD (+6.2) and TRY (+3.0) during the 1 st quarter. Purchasing Power Parity CME FX Carry Index Jul-09 Jan-10 Long Short 16.7% BRL 5 USD 16.7% AUD 5 EUR 16.7% ZAR 16.7% NZD 16.7% TRY 16.7% MXN The theory of purchasing power parity (PPP) dates to the 16 th century and the School of Salamanca but was further developed in the early 20 th century by economist Gustav Cassel. 14 The theory is based upon the assumption that exchange rates are in Jul-10 Jul-11 Jul-12 Jul-13 equilibrium when purchasing power is equivalent in the two countries. On a granular level, PPP is based on the law of one price or the notion that identical products should be priced at the same level in different national markets adjusted for exchange rates. Typically, this law is qualified by the absence of significant trade barriers or other artificial constraints on commerce. But the theory of PPP expands the application of the law of one price from any single good or product to generalized prices in any particular economy as measured by inflation indexes, e.g., Consumer Price Index (CPI) or Producer Price Index (PPI). The implication of this theory is that inflation rates and exchange rates should exhibit negative correlation. If inflation increases If inflation decreases Currency value should decline Currency value should advance Thus, if inflation as measured by an inflation index increases, the value of the currency should generally decline to maintain price equilibrium. Similarly, if inflation declines, the value of the currency should advance. The theory of PPP is closely related to another classic theory that addresses exchange rate values known as the International Fisher Effect (IFE). This theory suggests that the disparity between nominal interest rates in two countries drive the future path of exchange rates. Per this theory, one might expect that the value of a currency with a low nominal interest rate might increase into the future. Or that the value of a currency with high nominal rate might decline. 13 The CME FX Carry Index represents a basket of equally weighted positions (as of December 31, 2010) which is effectively long a basket including the Australian dollar (AUD), Brazilian real (BRL), Mexican peso (MXN), New Zealand dollar (NZD), South African rand (ZAR) and Turkish lira (TRY) vs. short positions in the USD and EUR. It is (arbitrarily) established at a value of 1, as of December 31, The long components of the CME FX Carry Index were selected in light of the high local interest rates that prevailed in those countries during the post-financial crisis era through The short components of the index were identified because of the low interest rates offered. 14 See Cassel, Gustav, Abnormal Deviations in International Exchanges (December 1918). IFE further assumes that real interest rates (i.e., the risk-free interest rate less inflation) should generally be equal across countries. This implies that nominal interest rates and inflation are positively correlated. If inflation increases If inflation decreases Rates increase Rates decrease Currency value should decline Currency value should advance 3 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

12 The IFE suggests interest rates and exchange negatively correlated. Similarly, PPP suggests inflation and exchange rates are negatively correlated. As such, the IFE theory is generally consistent with the PPP theory. Putting the classic theory of purchasing power parity into practice requires a measurement of inflation in order to calculate the proportion by which any particular currency is (theoretically) over- or undervalued relative to the norm. There are three popular methodologies that have been referenced in this regard. OECD - The Organization for Economic Cooperation and Development (OECD) provides data that is useful in this regard by comparing price changes in a representative basket of goods in various countries. Bloomberg - Bloomberg offers an analytical tool that is grounded in a very long-term assessment of inflation, as measured by either CPI or PPI in various countries extending from January 1982 through June Big Mac - Finally, the Economist s Big Mac PPP methodology compares the price of a (almost) universally available product with verifiable pricing in the form of the McDonald s Big Mac hamburger in various countries. All three methodologies may readily be referenced on Bloomberg quotation devices. Appendix 3 below provides data from all three methods. Further, we have taken the average of the three assessments (where available) for a variety of national currencies and rank-ordered the set from most over-valued to most under-valued. The Norwegian krone (NOK) stands out as the most over-valued currency per this analysis at %. The NOK is followed by the Swiss franc (CHF) at %; the New Zealand dollar (NZD) at +23.3; the Danish krone (DKK) at %; and, the Icelandic krona (ISK) at %. Under-valued currencies, per our analysis, include the Turkish lira (TRY) at %; the Polish zloty (PLN) at -53.0; the Malaysian ringgit (MYR) at %; the Mexican peso (MXN) at %; and, the Hong Kong dollar (HKD) at %. One might generally recommend creating baskets of several currencies to buy and sell on the basis of this analysis in order to diversify risks to a certain extent. However, it is important to recognize that currencies might remain in apparent states of overor under-valuation for extended periods of time. In fact, the carry trade, as discussed above, takes a completely opposite approach to the classic PPP theory by buying high-rate currencies and shorting low-rate currencies. Impact of Commodities As a general rule, the nations whose currencies have remained top performers over the past decade may be identified as those whose national income is tied heavily to commodity production. Commodity prices have generally advanced, often sharply, over the past decade as seen in the rise in the value of energy, grain, livestock, precious metals and industrial metals. These price advances have largely been driven by emerging market demand in nations including China and India. Crude Oil ($ per Bbl $160 $140 $120 $100 $80 $60 $40 $20 Sep-07 May-08 Crude Oil & Gold Sep-09 May-10 $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 But those trends have corrected over the past year. Gold values fell sharply during 2013 to the extent that economic recovery in the developed economies led to much reduced economic anxiety. West Texas Intermediate (WTI) crude oil drifted a bit higher during the 1 st quarter following a moderately buoyant Grain values including corn, soybeans and wheat were off a bit on a productive growing season coupled with moderating global demands. Sep-11 May-12 Crude Oil Source: Bloomberg Sep-13 Gold Gold ($ per troy oz) 4 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

13 CME Group has developed the CME FX Commodity Country Index to follow the performance of a basket of currencies from nations that rely heavily upon the exportation of commodities and other raw materials. To the extent that commodities have been in great demand over much of the past decade, these currencies have, on a historical basis, generated favorable total returns. 15 $ per Bushel $18 $16 $14 $12 $10 $8 $6 $4 $2 Jul-07 Jan-08 Jul-08 Jul-09 Grains Jan-10 The CME FX Commodity Country Index drifted up 2.01% to by the conclusion of the 1 st quarter from the year-end 2013 value of CME Group has further developed the CME FX BRIC Index to follow the performance of select emerging market economies and their national currencies, namely the Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese yuan (CNY), that have created much of the demand for commodities in the world today. 16 Jul-10 Jul-11 Jul-12 Jul-13 Corn Soybeans Wheat Source: Bloomberg 1,100 1,050 1, The CME FX BRIC Index ended the 1 st quarter at and virtually unchanged from the year-end 2013 mark at ,120 1,080 1,040 1, Jul-07 Conclusion CME FX Commodity Country Index Jul-07 Jan-08 Jan-08 Jul-08 Jul-08 Jul-09 Jan-10 Jul-10 Long Short 16.7% AUD 10 USD 16.7% BRL 16.7% CAD 16.7% NOK 16.7% NZD 16.7% ZAR Jul-11 CME FX BRIC Index Jul-09 Long Short 25% BRL 10 USD 25% RUB 25% INR 25% CNY Jan-10 Jul-10 Jul-11 Jul-12 Jul-12 Jul-13 Jul The CME Commodity Country Index is constructed to be effectively long Australian dollar (AUD), Brazilian real (BRL), Canadian dollar (CAD), Norwegian krone (NOK), New Zealand dollar (NZD) and South African rand (ZAR) vs. a short position in the U.S. dollar (USD). It is (arbitrarily) established at a value of 1, as of December 31, The CME BRIC Index is constructed of equal weightings of long Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese yuan (CNY) vs. a short position in the U.S. dollar (USD). Like other CME FX indexes discussed above, the BRIC Index was equally weighted and calibrated to equal an arbitrary 1, as of December 31, CME offers a broad array of currency futures and option contracts covering a wide range of currency pairings (where one side is the U.S. dollar) and cross-rate pairings (which do not involve the U.S. dollar). These products provide facile and liquid vehicles with which one may express a view on prospective market movements. Or, to manage the risks associated with currency holdings or international investments during turbulent times. For more information please visit our website at 5 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

14 Appendix 1: Summary of World Economic Conditions Growth, Inflation & Fiscal Policy Monetary Policy Special Factors Growth, Inflation & Fiscal Policy Monetary Policy Special Factors Australia Brazil Canada Australia s economy may suffer from further deceleration of growth in China and by potential problems in China s shadow banking system. Monetary policy now appears to be on hold in Australia. Short-term interest rates offer a small premium to the near-zero rates in the US, Europe, and Japan. The Australian dollar managed a small appreciation in Q1/2014, even with uncertainties relating to China and commodities prices. China may decelerate further to around 6.5% to 7% real GDP growth in The economy is likely to avoid a hard landing but continues to face challenges in its shadow banking system. Monetary policy remains in flux. The central bank has to decide how much support to give a struggling shadow banking system. Also, the weaker RMB means that China is unlikely to be a buyer of US Treasuries, as it was in periods of upward pressure on the currency. China has widened the bands for currency volatility, and the RMB weakened during Q1/2014, joining the ranks of other emerging market currencies that had previously experienced weakness. Economic growth has been slow in Brazil, but there are signs of incremental improvement. Water shortages, especially around Sao Paulo, though, may be a risk to growth. Short-term interest rates around 1 now provide solid support for the currency. As emerging market currency pressures abate, there may be room for rate cuts later in Brazil hosts the World Cup in 2014 and the Olympics in A successful World Cup has the potential to give the markets a boost of confidence in the Brazilian real. Canada is benefiting from the continued jobs expansion in the US. On the negative side, the domestic oil sector has some challenges and delays in the US decision on the Keystone pipeline are not helping economic confidence. Canada s rates are low. There are no inflation pressures. The Bank of Canada seems comfortable with the current set of policies, at least so long as the US keeps its federal funds rate near zero. Rate differentials with the US are too small to support the Canadian dollar. The big risks are in the energy sector. Weaker oil prices or a US decision against the Keystone pipeline would probably hurt the currency. China European Union India Europe is likely to post some small gains in economic growth in The rise in the euro over the past 12 months of a little more than 7%, however, appears to be contributing to a risk of slipping into deflationary territory. The ECB faces two big policy challenges (a) supervising banks and completing a round of stress tests, and (b) deciding how to deal with deflationary pressures. Some form of expanded policy accommodation is possible. The EU Parliamentary elections in May 2014 could prove very interesting. Fringe parties appear to be gaining ground, such as the UK Independence Party and the National Front in France. India s economy is growing at only about half the pace it once did. At the same time, monetary policy was tightened to defend the currency in Short-term interest rates above 8% worked to stabilize the currency in Q1/2014. A prolonged period of currency stability could potentially allow for rate cuts down the road. The India has parliamentary election in 2014 that could bring a shift of power. Despite election uncertainties, though, stability at the central bank is likely to mitigate any market concerns. 6 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

15 Appendix 1: Summary of World Economic Conditions, cont. Growth, Inflation & Fiscal Policy Monetary Policy Special Factors Growth, Inflation & Fiscal Policy Monetary Policy Special Factors Japan Mexico Russia Japan s hike in its national sales tax is expected to lead to weaker real GDP for a few quarters. There is possibility of Prime Minister Abe bringing forward more fiscal stimulus if economic growth is too depressed by the sales tax hike. The Bank of Japan may also consider expanding its quantitative easing (asset purchase) program if real GDP shrinks in the April-June quarter. A 2% inflation target by the Bank of Japan is not likely to be achieved in a short time frame unless there is further yen depreciation toward the yen/dollar rate. There is the possibility the government and central bank would welcome another round of yen weakness. Mexico is benefiting from improved growth in the United States. Mexico has also increased its imports of relatively inexpensive natural gas through its pipeline link with Texas. The Bank of Mexico has been able to allow for small rate reductions as the currency has stabilized. In the emerging market currency sell-off in 2013, the Mexican peso did not lose as much ground as many of its peers. And now that pressures have abated, the peso is poised to regain some lost ground. Russia s annexation of the Crimea will come at a price of expanded spending and potential sanctions. Slower economic growth and even possibly a recession seem quite possible. The political uncertainties over the Crimea takeover have led to a weaker Ruble and higher interest rates. Russia s annexation of the Crimea has dominated the headlines in Q1/2014. And, Russia is likely to put more pressure on the Ukraine through higher natural gas prices. Switzerland United Kingdom United States Switzerland is seeing some benefits from Europe s stabilization. Moreover, stronger growth in the US may also help exports. As the EU debt crisis has morphed into a longterm banking capital adequacy problem, the Swiss have little flexibility, and they are likely continue to keep a lid on the Swiss franc relative to the euro. The post-2008 financial crisis has led to increased regulation of financial institutions all over the world. On net, this increased regulation poses additional challenges for the traditional model of Swiss secrecy and the overall role of Switzerland in the world s financial system. The UK s growth prospects are steadily improving. The budget deficit as a percent of GDP is also declining. The Bank of England has indicated it plans to keep rates low and focus its efforts on financial supervision. A stronger economy than expected by the BoE could change that guidance later in The vote in Scotland on independence in September is starting to cast a shadow over the British pound. The outcome will depend on the tug of war between the pocket book and the heart strings. Economics says independence would hurt Scotland and the UK. But Scots can achieve at the ballot box what eluded Robert Bruce and William Wallace. The US economy suffered through a tough winter in midwest and northeast, but a bounce back seems in progress as spring has arrived. And, surprising to many, the Federal budget deficit is on track to be balanced on an operating basis in FY2015. The Yellen-led Federal Reserve immediately moved to alter its forward guidance process at its first FOMC meeting after Bernanke s retirement. Indicator-based guidance is out, replaced by a more nuanced view of labor market conditions and potential inflation pressures. QE is on track to end in Q4/2014. The US dollar may hold the key to whether inflation pressures emerge in the US. The 1970s saw a weak dollar and rising inflation, and the early 1980s saw dramatic declines in inflation with a strong dollar. During 2013, a weak yen and weak emerging market currencies contributed to deflationary pressures in the US. 7 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

16 Appendix 2: Select Currency Performance (1 st Quarter 2014) Currency Ticker 1 st Quarter Year-to-Date Spot Quote Quote 3-Mth Rates Total Spot Interest Total Spot Interest (3/31/14) Convention (3/31/14) Return 1 Return 2 Return 3 Return 1 Return 2 Return 3 Argentine Peso USD-ARS USD per 1 ARS % % % % 13.4 Australian Dollar AUD-USD AUD per 1 USD % 3.89% 0.67% 4.58% 3.89% 0.67% Brazilian Real USD-BRL USD per 1 BRL 6.62% 3.97% 2.55% 6.62% 3.97% 2.55% British Pound GBP-USD GBP per 1 USD % 0.12% % 0.12% Canadian Dollar USD-CAD USD per 1 CAD 1.08% -3.59% % -3.59% % Chilean Peso USD-CLP USD per 1 CLP -3.39% -4.37% 1.02% -3.39% -4.37% 1.02% China Renminbi USD-CNY USD per 1 CNY 4.75% -2.33% -2.62% 0.29% -2.33% -2.62% 0.29% Colombian Peso USD-COP 1, USD per 1 COP -1.43% -2.11% % -2.11% 0.7 Euro EUR-USD EUR per 1 USD % 0.19% % 0.19% 0.0 Icelandic Krona USD-ISK USD per 1 ISK 5.85% 3.62% 2.12% 1.47% 3.62% 2.12% 1.47% Indian Rupee USD-INR USD per 1 INR 9.25% 5.57% 3.19% 2.31% 5.57% 3.19% 2.31% Japanese Yen USD-JPY USD per 100 JPY % 0.02% % 0.02% Mexico Peso USD-MXN USD per 1 MXN 3.81% 0.58% % New Zealand Dollar NZD-USD NZD per 1 USD 3.19% % 0.75% % 0.75% Russian Ruble USD-RUB USD per 1 RUB 8.38% % 1.81% % 1.81% South Africa Rand USD-ZAR USD per 1 ZAR 6.05% 0.61% -0.37% 0.99% 0.61% -0.37% 0.99% South Korean Won USD-KRW 1, USD per 1 KRW -0.82% % -0.82% % Swiss Franc USD-CHF USD per 1 CHF -0.05% 0.93% % 0.93% % Taiwanese Dollar USD-TWD USD per 1 TWN 0.87% -2.02% -2.23% 0.21% -2.02% -2.23% 0.21% Turkish Lira USD-TRY USD per 1 TRY 11.48% % % 2.7 United States Dollar USD USD 0.23% Notes (1) Return from price movement and interest (2) Return from currency price movement vs. USD as base currency (3) Return from interest at prevailing 3-month rates or implied NDF rate Source: Bloomberg 8 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

17 Appendix 3: Purchasing Power Parity ( PPP ) Analysis (as of 3/31/14) % Over/Under Valued Currency ISO Bloomberg Bloomberg Average OECD Code (CPI) (PPI) Big Mac Norwegian Krone NOK 31.79% 31.98% 10.58% 52.8 Swiss Franc CHF 31.22% 35.45% 24.58% 10.88% 53.95% New Zealand Dollar NZD % 33.57% % Danish Krone DKK 19.57% % Icelandic Krona ISK 18.23% 18.23% Australian Dollar AUD 15.57% 26.71% % Swedish Krona SEK % -5.08% -3.35% 35.3 Euro EUR 11.15% 6.02% British Pound GBP 7.11% % % Canadian Dollar CAD % % 3.62% Brazilian Real BRL 3.59% 3.59% Colombian Peso COP Japanese Yen JPY % % Singapore Dollar SGD % % South Korean Won KRW % Chilean Peso CLP % % Czech Koruna CZK % % Thai Baht THB % % South African Rand ZAR % % Chinese Renminbi CNY % % Hungarian Forint HUF % % % Phillipines Peso PHP % % Argentina Peso ARS Indonesian Rupiah IDR % % Russian Ruble RUB % % Hong Kong Dollar HKD % % Mexican Peso MXN % % % Malaysian Ringgit MYR % % Polish Zloty PLN Turkish Lira TRY % % % Notes Please note that data regarding all countries is not generally available. Source: Bloomberg 9 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP

18 Futures and options trading is not suitable for all investors, and involves the risk of loss. Futures are leveraged investments, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money initially deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME rules. Current rules should be consulted in all cases concerning contract specifications. The information within this presentation has been compiled by CME Group for general purposes only. Although every attempt has been made to ensure the accuracy of the information within this presentation, CME Group assumes no responsibility for any errors or omissions. All data is sourced by CME Group unless otherwise stated. CME Group is a trademark of CME Group Inc. The Globe logo, E-mini, E-micro, Globex, CME and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. All other trademarks are the property of their respective owners. Copyright 2014 CME Group. All rights reserved. 10 Currency Market Monitor 1 st Quarter 2014 April 3, 2014 CME GROUP