Diminishing upside for USD from rising Fed funds rates. Fed funds target rate

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1 1 September 25 Currency Report Card Global FX Strategy Monica Fan Global Head of FX Strategy Adam Cole Senior Currency Strategist Tania Kotsos Senior Emerging Markets Strategist Greg Gibbs Senior Currency Strategist greg.gibbs@rbccm.com T.J. Marta Senior Currency Strategist tj.marta@rbccm.com Jeremy Friesen Senior Currency Strategist jeremy.friesen@rbccm.com Paul Biszko Latin American Debt Analyst paul.biszko@rbccm.com Political risks should shake up FX volatility through September. General elections loom in Germany, Japan, Norway, New Zealand and Poland. These are likely to herald a change of government in Germany, Norway and Poland, while the status quo is expected in Japan and New Zealand. In Germany, a CDU/CSU coalition victory over the SPD is a foregone conclusion. But the market risks being disappointed if the new government backs down on reforms. In Norway, the widely anticipated Red-Green Alliance victory could be NOK bullish. In Poland, current doubts about the sustainability of the incoming expected PO-PIS coalition government is PLN bearish. But the market has now priced in a majority outcome for the coalition and latest opinion polls show the euro-friendly PO party is ahead, easing concerns over a neck-and-neck outcome with the euro-sceptic PiS. In Japan, the LDP-New Komeito coalition looks like it will comfortably retain power. PM Koizumi s approval rating continues to recover from the lows. In New Zealand, Labour PM Helen Clark remains markedly stronger in the polls. We expect small relief rallies in the Yen and Kiwi after these elections. Forecast Revisions USD/CAD: End-Q3 target cut from 1.23 to 1.21 and end-q4 cut from 1.25 to End-26 cut from 1.29 to Revisions reflect changes to RBC economists rate forecasts, with BoC rates now expected to peak of 4.% (previously 3.75%) in Q3 26. USD/ZAR: End-25 revised down to 6.65 from 7. and now seen peaking at 7.1 in Q2 26 before falling back to 6.8 by end-26. EUR/PLN: Q3 25 revised down to 3.87 from 3.98 and Q4 to 3.98 from 4.1 but is seen appreciating back up to 4.1 on fiscal concerns by end-26. EUR/CZK: Q3 25 revised down to 29. from 3.4 and Q4 to from 3.5 but is seen appreciating to 3.1 by end-26 on political risks. EUR/HUF: End-25 revised down to 242 from 25 and is now seen gradually appreciating to 252 (previously 258) by end-26. Diminishing upside for USD from rising Fed funds rates Fed funds target rate Implied rates on eurodollar futures, % RBC Fed funds rate forecasts, % Jun-3 Dec-3 Jun-4 Dec-4 Jun-5 Dec-5 Jun-6 Dec-6 For pertinent disclosures, please see last page. See RBC s research at

2 1 September 25 Global FX Strategy:Currency Report Card Table of Contents FX Focus in September: September Election Blitz to Revive FX Volatility 3 Majors US Dollar 5 Euro 6 Japanese Yen 7 Sterling 8 Swiss Franc 9 Scandis Swedish Krona 1 Norwegian Krone 11 Commodity Currencies Canadian Dollar 12 Australian Dollar 13 New Zealand Dollar 14 South African Rand 15 Central Europe Polish Zloty 16 Hungarian Forint 17 Czech Koruna 18 East-Asia Chinese Yuan 19 Hong Kong Dollar 2 Singaporean Dollar 21 South Korea Won 22 Latin America Mexican Peso 23 Brazilian Real 24 Argentinean Peso 25 Venezuelan Bolivar 26 Currencies 27 EUR Crosses 27 JPY Crosses 28 CAD Crosses 28 2

3 Global FX Strategy: Currency Report Card 1 September 25 September Election Blitz to Revive FX Volatility Monica Fan Political risks will escalate in September as elections take place in five countries: Japan (on the 11th), Norway (12th), New Zealand (17th), Germany (18th) and Poland (25th). Uncertainties about potential changes of governments, or in the recent case of the Eurozone, the failure to ratify the new European Union constitution, have typically triggered a sell-off in these currencies leading up to the plebiscites. But currencies have become increasingly inured to political risks unless the outcome of the election triggers a significant change in macroeconomic policies. Below, we provide a cheat sheet to the upcoming elections: the state of parliament and the latest opinion polls; the key policy issues at stake; and the implications for the currency markets. Please see FX Impact of September s Five General Elections, 31 August, for a more detailed version of this note. September 11 Election: Japan Prime Minister: Mr Junichiro Koizumi (Liberal Democratic Party) Government: LDP-led coalition with New Komeito Clean Government Party and the New Conservative Party. 1. Japan: Lower House of Diet Party Leaning Seats Latest Poll* Liberal Democratic Party (LDP) Socialist % New Komeito (Kt) Buddhist 34 4% Democratic Party of Japan (DPJ) Conservative % Communist Party of Japan (CPJ) Communist 9 3% Social Democrat Party (SDP) Democrats 6 2% Independents Party - 3 1% Vacant - 3 Total 48 Source: *Yomiuri, August 19, 25 (no margin of error provided) Key Policy Issues. A public vote on postal savings reforms is the key reason for the election. Opinion Polls. Since the Upper House rejected the postal savings reform bill on July 5, the approval rating of Koizumi s Cabinet has recovered by 6% points to 49%, according to a Nihon Keizai poll conducted on August 22. An earlier Yomiuri poll (see Figure 1) showed that support for the LDP was 37%, more than double the 16% support for the DPJ. Koizumi said that he would step down in September 26, even if the LDP wins the upcoming election. FX Impact Bullish for the Yen. The return of an LDP-New Komeito government is now widely expected by the market, with potentially a larger majority for the LDP, that would strengthen both the government s commitment and capacity for reform. An earlier Yomiuri poll (see Figure 1) showed that support for the LDP was 37%, more than double the 16% support for the DPJ. Koizumi said that he would step down in September 26, even if the LDP wins the upcoming election. September 12 Election: Norway Prime Minister: Mr Kjell Magne Bondevik (Christian Democratic Party) Government: Conservative Party-led coalition with Christian Democratic Party and Liberals. 2. Norway: Parliament Party Leaning Seats Latest Poll* Labour Party Social Democrats % Conservative Party Right % Progressive Party Right Populist % Socialist Left Party Extreme Left % Christian Democratic Party Christian Democrats % Centre Party Centrist 1 6.3% Liberals Left 2 3.4% Coastal Party Fishermen's Party 1 - Independents Right 2 1.7% Total seats 165 Source: *Norsk Gallup/TV2 from August 24, 25 (margin of error is 3%) Seats in parliament will increase from 165 to 169 on September 12, 25. Key Policy Issues. Immigration; Oil exploration; Privatisation of public companies; Taxation. Opinion Polls: have consistently shown that (1) the Labour Party will probably win the highest proportion of seats, and (2) the Red-Green Alliance comprised of the: Labour Party, Socialist Left and Centre Party; will probably win up to 89 seats of the enlarged 169-seat parliament, and overthrow the current centre right coalition. If this happens, Labour leader Stoltenberg will replace Bondevik as the Prime Minister.. FX Impact Neutral to modestly medium-term bullish for NOK. The market would not be concerned with a reduction in immigration under the Red-Green Alliance, but it would be concerned that the Socialist Left would push for a gradual re-nationalisation of partly privatised public utilities and reduce Norway s oil exports. That said, the Socialist Left have said they would not stand in the way of Statoil and Norsk Hydro s joint venture with Russia s Gazprom to develop the Shtokman gas fields in the Russian Arctic. The Red-Green Alliance s income and tax policies are likely to increase real wages, and lead to tighter monetary policy and easier fiscal policy. Higher interest rates would be marginally bearish EUR/NOK, 3

4 1 September 25 Global FX Strategy: Currency Report Card September 17 Election: New Zealand Prime Minister: Ms Helen Clark (Labour Party) Government: Labour Party-led coalition with Progressive Party, with the support of the United Future party. 3. New Zealand: Parliament Party Leaning Seats Latest Poll* Labour Party Centre-left 52 43% National Party Centre-right 27 4% New Zealand First Party Centrist 13 5% ACT Liberal 9 2% Green Party Left-Environmentalist 9 7% United Future Centre-right Christian 8 1% Progressive Party Left 2 - Total 12 Source: *Colmar Brunton/One News, August 25, 25 (margin of error 3.2%) Key Policy Issues. Taxation; Foreign Policy. Opinion Polls: The Labour Party are set to retain power for a third-term, although its victory over the National Party may prove to be surprisingly narrow, and Labour will undoubtedly require the continued support of the Progressive and United Future parties to rule as a minority government. FX Impact Short term neutral to bullish for NZD. The token tax cuts that have been showered on voters will not trigger any significant changes in New Zealand s macroeconomic policies and thus the outcome of the election is likely to be benign for the NZD. September 18 Election: Germany Chancellor: Mr Gerhard Schröder (Social Democratic Party) Government: SDP-Greens coalition 4. Germany: Bundestag Party Leaning Seats Latest Poll* Social Democratic Party (SDP) Centre Left % Christian Democratic Union (CDU) Centre Right 19 **42% Bavarian Christian Social Party (CSU) Centre Right 58 Alliance 9/Green Green 55 7% Free Democratic Party (FDP) Liberal 47 8% Party of Democratic Socialism (PDS) Socialist 2 9% Total 63 Source: Infratest-Dimap from August 24, 25 (margin of error 3.1%) ** Support for CDU/CSU coalition Key Policy Issues. Economic Reforms, Foreign Policy. Opinion Polls. All polls show the SDP-Greens coalition will be resoundingly defeated by the CDU/CSU coalition, with the support of the FDP. FX Impact Risk of short-term sell off in euro. The markets have long been praying for an acceleration of microeconomic reform in Germany. Although Merkel has been hailed as East Germany s version of former British PM Margaret Thatcher, Merkel is at risk of disappointing the market by failing to deliver on her ambitious reform agenda. She has already rolled back some of the more radical reforms that were announced at the start of the election campaign. Large scale strikes may mar the start of her leadership, especially as the planned reforms will hurt East German workers disproportionately, and it could unnerve investors about Merkel s stomach for reforms. That said, the CDU/CSU coalition would have the advantage of a majority in both houses of parliament. More importantly, Merkel has rejected any possibility of forming a grand coalition with the SPD which would have crushed any prospects of significant reforms. Opinion polls show that most Germans, including the powerful German Trade Union Federation (DGB), are willing to suffer the short-term pain of reforms for a chance of boosting economic growth and jobs. We expect the currency markets will be increasingly inured to industrial disputes in Germany in the early days of Merkel s leadership. A CDU/CSU coalition is already priced into EUR/USD and the only risk after the German election is a watering down of the government s reform agenda. September 25 Election: Poland Prime Minister: Care-taker prime minister Marek Belka (joined Democratic Party in May 25) Government: SLD-UP minority coalition 5. Poland: Parliament Party Leaning Seats Latest Poll* Civic Platform (PO) Centre-right 56 27% Law and Justice (PiS) Right 44 23% Self Defence (SO) Populist 31 8% League of Polish Families (LPR) Catholic-right 25 7% Democratic Left Alliance (SLD) Left 158 8% Peasants Party (PSL) Protectionist 4 4% Social Democrats & Labour Union (SDPL-UP) Left 48 7% Democratic Party (PD) Centrist 3% Independent & Others 58 - Total 42 Source: *TNS OBOP, August 8, 25 (no margin of error provided) Key Policy Issues. Timing of the adoption of the euro; PLN appreciation; independence of the National Bank of Poland. Opinion Polls. Polls have consistently shown that the PO-PiS coalition will defeat the SLD-led coalition government in a landslide. FX Impact Short term bearish for PLN. Although a victory for the PO-PiS coalition would be no surprise to the markets, there would be concerns about the viability of their coalition given the conflicting policies between the pro-euro PO and the euro-sceptic PiS. Consequently, we expect the political landscape to be PLN bearish but now see this concern as a medium-term rather than near-term factor. A majority victory for a PO-PiS coalition at the September 25 general election appears to be priced in and opinion polls have begun to suggest that the euro-friendly PO party is garnering more support, diminishing the risk of a neck-and-neck outcome with the PiS. 4

5 Global FX Strategy: Currency Report Card 1 September 25 US Dollar Monica Fan After a flat July, the DXY Index fell 1.9% in August, as the USD underperformed the CAD by 1.8% and the EUR by 1.5%. Hawkish comments by Chicago Federal Reserve President Moskow that core inflation is at the upper end of price stability (CPI ex-food and energy accelerated to 2.1%y/y in June) and policy accommodation would continue to be reduced, but with a notable omission of the phrase measured pace, did not give the USD any support, which is not surprising given implied rates on Eurodollar futures have been discounting a 4.25% peak in Fed funds rate in 26 since July. RBC economists revised up their peak in Fed funds rates from 4% to 4.25% in Q2 26. We remain bearish on the USD in the short-term, as rising Fed funds rates are likely to flatten the Treasury curve further (2/1 are currently 19bp) before the curve resumes steepening. The flattening of the curve, in tandem with high oil prices (spot WTI crude in excess of $69/b) will probably stoke fears of recession in the US. The elimination of political risks in Japan and Germany, after general elections on September 11 and 17, respectively, are likely to trigger a short-term rally in the euro and Yen against the USD. These factors will be partly offset by the potential for the much lauded repatriation of foreign earnings by US companies - estimated to be worth up to US$3bn, half of which are derived in euro-denominated markets to give a one-off boost to the USD at the end of this year. RBC economists forecast the US current account deficit is now at, or near, its peak, at 6.4% of GDP. Although the bulk of the USD s depreciation has occurred, our forecast of a 4% depreciation in the Fed Major Dollar Index (primarily due to a depreciation in USD/JPY to 1) in the second half of 25, is consistent with the USD s tendency to depreciate for at least 18 months after the US current account deficit has peaked. Further, the risk is that the USD will weaken more significantly, as the improvement in the US budget deficit has so far been overwhelmingly cyclical, while the structural component of the deficit has actually deteriorated. A deterioration in the cyclical budget deficit triggered by a slowdown in US growth and tax revenues and continued deterioration in private savings will hit the US deficit from both sides.. Official cash rate 3.5% (3.25%) Trend interest rates (1yr average) 4.2% Rising Core PCE Inflation %Y/Y Q2 (Q1) 1.99% (2.16%) Inflation target Price stability Budget balance % GDP FY4 (FY3) -4.9% (-4.6%) Budget balance target % GDP - GDP Growth %Y/Y Q2p (Q1) 3.6% (3.6%) Trend GDP %y/y 3-3.5% Purchasing Power Parity Value - Spot - PPP Valuation - Current account balance % GDP Q1 (Q4) -6.4% (-6.3%) Trend current account balance % GDP -3.% Moody's Foreign Currency Rating Aaa 1. RBC s US Economic Surprise Index has peaked Jan 4 Apr 4 Jul 4 Oct 4 Jan 5 Apr 5 Jul 5 Source: RBC Capital Markets, Bloomberg US ESI - 4 WMA 12 WMA 2. Diminishing upside for USD from rising Fed funds rates Implied rates on eurodollar futures, % RBC Fed funds rate forecasts, % Jun-3 Dec-3 Jun-4 Dec-4 Jun-5 Dec-5 Jun-6 Dec-6 Source: RBC Capital Markets, Bloomberg EUR/USD USD/JPY USD/CAD

6 1 September 25 Global FX Strategy: Currency Report Card Euro Monica Fan EUR/USD gained 1.5% in August, on top of the.3% increase in July, despite more hawkish Fed rhetoric and the surge in oil prices to new highs above US$7/b. EUR/USD is on track to reach our end-september target of We remain modestly bullish about the euro outlook over the next three-months due to both USD weakness and the recovery in Eurozone economy and sentiment. Further increases in US Fed funds rates (up to a peak of 4.25% in 26) have been fully discounted in Eurodollar interest rate futures and the USD is becoming increasingly immune to expectations of higher US rates. Sino-US trade tensions could increase, amidst demands for further USD/CNY revaluation, during Chinese President Hu Jintao s visit to the US on September 5 and implicit threats to name China as a currency manipulator in the US Treasury s semi-annual report on currency manipulation (due in October). By contrast, EUR/USD sentiment is being boosted by polls showing that pro-business Christian Democrats leader Angela Merkel is on track to win the September 17 general election. The lowering of the USD/CNY peg from 8.28 to 8.11 has not led to a collapse in EUR/USD and the PBoC s comment that their reserves will continue to grow rapidly, is consistent with our view that burgeoning Asian foreign exchange reserves will keep the euro above 1.2, even in the absence of increases in the strategic allocation to euros. The 6% drop in the trade weighted euro this year has increased the chances that Euribor interest rate futures will start to price in rate hikes in Q4 (with headline CPI at 2.1%y/y in July) even though RBC economists do not expect the ECB to start raising rates until Q1 of 26 at the earliest (as core CPI is still below target at 1.4%y/y). Two bearish risks to our short-term EUR/USD view are the continued deterioration in the Eurozone basic balance (the current account balance plus net foreign direct investment) deficit to EUR27.6bn in Q1, and the risk that Merkel s failure to deliver on reforms will trigger a buy the rumour, sell the fact fall in EUR/USD. EUR/USD is likely to peak at the end of this year as further depreciation of USD/CNY reduces the amount of official support for the euro in preference to the Asian currencies. Official cash rate 2.% (2.%) Trend interest rates 1y average 4.1% Rising HICP Inflation %Y/Y Jul (Jun) 2.2% (2.1%) Inflation target Below, but close to, 2.% Budget balance % GDP FY3 (FY2) -2.6% (-1.9%) Budget balance target % GDP 3% of GDP-Unless special circumstances GDP Growth %Y/Y Q2 (Q1) 1.2% (1.4%) Trend GDP %y/y 2.2% Purchasing Power Parity Jul (Jun) (1.1499) Spot PPP Valuation EUR/USD is over-valued Current account % GDP Q1 (Q4).% (.3%) Trend current account balance % GDP.2% Moody's Foreign Currency Rating Aaa (Germany) 1. Risk of earlier than expected ECB tightening cycle EUR/USD LHS Dec-5 Eurodollar-Euribor futures (bp) RHS Jan-4 Mar-4 Jun-4 Sep-4 Dec-4 Mar-5 Jun-5 Source: RBC Capital Markets, Bloomberg 2. But FDI outflows are weighing on EUR/USD Narrow basic balance EURbn 12m rolling sum LHS EUR RHS EUR/USD EUR/JPY EUR/CAD

7 Global FX Strategy: Currency Report Card 1 September 25 Japanese Yen Adam Cole JPY has given back some of its recent gains against USD, but remains firm on the crosses. Recent MoF capital flows data have shown renewed strength in inflows into Japanese equities (Figure 1) with net purchases averaging JPY5bn in the four weeks to August 19 the highest since April 24. This is despite the overhang of political uncertainty after PM Koizumi called a general election for September 11 after losing an upper house vote on privatisation of Japan Post. Offsetting these flows, however, and potentially limiting the scope for JPY gains, have been heavy flows into overseas bonds on the part of Japanese investors. Anecdotal evidence suggests a significantly larger proportion of these flows may have been unhedged than in recent years. Higher US short term interest rates have increased the cost of hedging US bond purchase to the point where hedged US Treasuries now yield less than JGBs (figure 2). The initial impact of this crossover appears to have been a reduction in the hedge ratio on overseas bond purchases, increasing outright JPY sales by Japanese investors. Interviews with the largest life insurers, however, suggest the remainder of the fiscal year is likely to be dominated by increased purchases of JGBs, and hence a more positive JPY environment. Although political uncertainty will remain a near term constraint on JPY performance heading into the September 11 lower house election, we see USD/JPY rallies as opportunities to establish short positions. In the longer term, we continue to see USD/JPY as one of the principal routes through which USD-weakness will manifest itself. Japan s large current account surplus (3.6% of GDP in the 12 months to June), combined with growing demand for Japanese equities from abroad and falling purchases of overseas bonds by Japanese investors should ensure the supply/demand balance favours a stronger JPY in the medium term. Our end-25 forecast for USD/JPY remains at 1 with a further fall to 95 expected through 26. Official cash rate % since 21 Trend interest rates 1yr average.5% Rising Core CPI Inflation %Y/Y Jul (Jun) -.2% (-.2%) Inflation target Positive %Y/Y before interest rates rise Budget balance % GDP FY4 (FY3) -6.9% (-8.2%) Budget balance target % GDP Primary budget surplus by early 21 GDP Growth %Y/Y Q2 (Q1) 1.4% (1.3%) Trend GDP %Y/Y 1.2% Purchasing Power Parity Value 95.3 (95.84) Spot 11.7 Valuation USD/JPY is over valued Current account balance %GDP Q2 (Q1) 3.6% (3.6%) Trend current account balance % GDP 2.5% Moody's Foreign Currency Rating Aaa 1. Strong overseas interest in Japanese equities Ov erseas purchases of Japanese equities, JPY tbn, 4 w eek av erage Jan 2 Jul 2 Jan 3 Jul 3 Jan 4 Jul 4 Jan 5 Jul 5 Source: RBC Capital Markets, Bloomberg 2. but Japanese buying more unhedged bonds? y ear JGB y ield 1 y ear UST y ield, FX hedged for three months Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Source: RBC Capital Markets, Bloomberg USD/JPY EUR/JPY CAD/JPY

8 1 September 25 Global FX Strategy: Currency Report Card Sterling Adam Cole GBP was the best performing G1 currency in the last month in a classic buy the rumour, sell the fact move around the MPC s August 4 25bp rate cut. Having gone into the meeting convinced the cut would be the first of a series of cuts, subsequent news has pushed markets closer to RBC s view that the cut was an insurance move and a further rate cut is unlikely until next year. As figure 1 shows, although longer term rate expectations in the UK have continued to fall (Dec 26 short sterling yield 11bp over the last month), near term expectations have risen (Dec 25 yield +5bp). Although this takes the curve closer to pricing in no change in rates this year, we see scope for a further sell-off in front end UK rate futures which should be GBP-supportive. Not only did the minutes of the August MPC meeting show four of the nine members of the committee, including Governor King, opposing the cut, the discussion seemed to suggest those that voted for it saw no case for further reductions on the evidence as it stood at the time. Subsequent to the meeting, every activity indicator released (including IP, unemployment and retail sales), has beaten expectations, taking RBC s UK Economic surprise Index to +1 for the first time in 18 months. Moreover, July CPI inflation (2.3% y/y) rose to its highest level since BoE independence in Yet markets still attach around a 5% probability to a further 25bp rate cut by December. We expect the unwinding of this expectation to support GBP short term. Longer term trends in GBP are also likely to be driven by the evolution of rate expectations which again look set to be supportive. Evidence continues to grow that the UK housing market is stabilising, with the volume of mortgage commitments (97K in July) now consistent with small rises in house prices in the coming months (Figure 2). In the absence of renewed weakness in the housing market, RBC economists forecast UK rates ending 26 at their current level of 4.5%, albeit with a temporary dip to 4.% in the interim, above the market implied level of just below 4.25%. Official cash rate 4.5% (4.75%) Trend interest rates 1y average 5.5% Falling CPI Inflation %Y/Y Jul (Jun) 2.3% (2.%) Inflation target (HICP) 2.% Budget balance % GDP FY4 (FY3) -3.% (-3.4%) Budget balance target % GDP Balanced current budget over the cycle GDP Growth %Y/Y Q2 (Q1) 1.8% (2.1%) Trend GDP %Y/Y 2.5% Purchasing Power Parity Value (1.623) Spot 1.87 PPP Valuation GBP/USD is over-valued Current a/c balance % GDP Q1 (Q4) -2.% (-2.%) Trend current account balance % GDP -1.5% Moody's Foreign Currency Rating Aaa 1. Markets starting to push rate cuts further out Short sterling implied three month rates, % Current Month ago Sep 5 Mar 6 Sep 6 Mat 7 Seo 7 Source: RBC Capital Markets, Bloomberg 2. as housing market stabilises Mortgage commitments, 's, LHS Halifax house prices, RHS, %Y/Y Source: RBC Capital Markets, Bloomberg GBP/USD EUR/GBP GBP/JPY GBP/CAD

9 Global FX Strategy: Currency Report Card 1 September 25 Swiss Franc Adam Cole With investor risk aversion remaining close to neutral levels in recent weeks, EURCHF continues to be driven primarily by expected interest rate spreads. The yield on the June 26 Euroswiss interest rate future has risen by 24bp from its mid- July low of.86% to stand at 1.11% currently. The latest leg up in Swiss rate expectations was driven by SNB board member Blattner commenting on August 17 that rates cannot stay at the current low level for very long and the SNB did not anticipate revising growth forecasts lower again. Subsequent economic news has pointed to better, though still unspectacular, economic growth. Retail sales growth rebounded to 3.2% y/y in June, but Q2 as a whole is still only flat y/y. The KOF leading indicator rose to.71 in July from.64 previously, but is still well down from the.83 reading a year earlier. Official cash rate % ( %) Trend interest rates 1y average 1.7% Unchanged CPI Inflation %Y/Y Jul (Jun) 1.2% (.7%) Inflation target less than 2.% Budget balance % GDP FY4 (FY3) -2.5% (-1.9%) Budget balance target % GDP Balanced over the business cycle GDP Growth %Y/Y Q1 (Q4).8% (1.2%) Trend GDP %Y/Y 1.2% EUR Purchasing Power Parity Value (1.4544) Spot PPP Valuation EUR/CHF is over-valued Current a/c balance % GDP Q4 (Q3) 12.% (13.2%) Trend current account balance % GDP 9.7% Moody's Foreign Currency Rating Aaa 1. Rate spreads driving EUR/CHF The rise in CHF rate expectations, which has not been matched in the Eurozone, has helped EUR/CHF fall around 1.% from the 14 month high of seen in late July. We do not see the recent run of indicators as being sufficiently strong to justify a policy tightening at the September 15 SNB policy review. The market already attaches a 75% probability to a 25bp rise in the LIBOR target (currently.75%) at the December meeting. While we argued a month ago that CHF was oversold and EUR/CHF was due to correct lower, the move over the last month has largely taken the cross back to fair value on the basis of rate spreads (Figure 1) and, baring a material change in investor risk appetite EUR/CHF is likely to be range-bound for the remainder of the year Jan 4 Apr 4 Jul 4 Oct 4 Jan 5 Apr 5 Jul 5 Source: RBC Capital Markets, Bloomberg 2. CHF rallies in equity bear markets Dec 25 euribor-eurosw iss implied rate differential, LHS EUR/CHF, RHS CHF has the strongest negative correlation with equity returns amongst the G1 and also the third strongest positive correlation with bond returns. The 1.9% fall in the S&P 5 in August and the simultaneous 23bp fall in US 1 year yields is a very bullish combination for CHF. In the medium term, this positive background is unlikely to remain in place as US long term rates lead global bond yields higher and on-going robust economic activity supports global equities. Our medium term expectation remains that EUR/CHF will grind higher FX trade w eighted indices, fiv e y ear correlation w ith global equity capital returns CHF NOK CZK** HUF** EUR NZD AUD THB SEK KRW GBP USD SGD MXN PLN** ZAR TWD CAD* JPY CLP BRL Source: RBC Capital Markets, Bloomberg USD/CHF EUR/CHF CHF/JPY CAD/CHF

10 1 September 25 Global FX Strategy: Currency Report Card Swedish Krona Adam Cole SEK was the third best performing G1 in August (after GBP and CHF) with EUR/SEK touching a two month low of In part, this reflects upside surprises in Swedish activity indicators which continue to question the necessity of the Riksbank s 5bp June 21 rate cut. In particular, Q2 GDP data showed growth rising to 2.2% y/y and Q1 was simultaneously revised to 1.7% (from 1.4%), leaving growth close to trend (2.5%). Monthly indicators released in August have also been much better than expected, with June industrial production growth accelerating to 2.6% y/y (consensus.5%) and July retail sales growth slipping only slightly at a still-robust 8.6% y/y (consensus 6.5%). As growth has returned to trend and core inflation risen (unchanged at.7% y/y in July, but up from a recent low of.2% in May), our estimate of neutral interest rates has started to rise. As Figure 1 shows, a Taylor rule estimate of neutral rates, based on current inflation and the estimated output gap, is around 4.1% compared to the Riksbank s policy rate of 1.5%. Growing expectations that the central bank will begin to remove monetary stimulus in the early months of 26 is likely to continue to see SEK well supported. Fundamental valuation models suggest EUR/SEK is still significantly overbought, even taking account of SEK s negative carry vs EUR. RBC s medium term fair value model for EUR/SEK, which takes the three month rate spread, relative equity market performance and relative unemployment rates as independent variables, puts fair value at 8.99 currently. SEK weakness through June and July is difficult to rationalise as the model suggests the strong performance of Swedish stocks (OMX +15% year-to-date) should have more than offset the impact of lower Swedish rates. Possibly, SEK undervaluation is a result of adverse seasonal effects (Figure 2), which tend to turn much more positive through September and October. We maintain our medium term view that SEK will out-perform EUR with a 12 month target level of 8.5. Official cash rate 1.5% (1.5%) Trend interest rates 1y average 4.5% Unchanged CPI Inflation %Y/Y Jul (Jun).7% (.2%) Inflation target (UND1X) 2.% Budget balance % GDP FY4 (FY3).3% (.5%) Budget balance target % GDP Cyclical average surplus of 2% GDP Growth %Y/Y Q1 (Q4) 3.2% (.6%) Trend GDP %Y/Y 2.5% EUR Purchasing Power Parity Value (8.4728) Spot PPP Valuation EUR/SEK is over-valued Current a/c balance % GDP Q1 (Q4) 3.4% (3.3%) Trend current account balance % GDP 2.% Moody's Foreign Currency Rating Aaa 1. Neutral rate starting to rise Source: RBC Capital Markets Sw eden 3m interest rate, % Tay lor rule implied rate, % 2. summer weakness the norm for SEK EUR/SEK m/m % change Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: RBC Capital Markets, Bloomberg USD/SEK EUR/SEK SEK/JPY CAD/SEK

11 Global FX Strategy: Currency Report Card 1 September 25 Norwegian Krone Adam Cole EUR/NOK has traded in a broad range for the last three months, with little clear direction. Although economic news in Norway has generally remained upbeat and oil prices remain close to record highs (Oct NYMEX currently USD69.5/bl), political uncertainty ahead of the September 12 election have been weighing on NOK. Opinion polls have consistently shown that (1) the Labour Party will probably win the highest proportion of seats, and (2) the Red-Green Alliance comprised of the: Labour Party, Socialist Left and Centre Party; will probably win up to 89 seats of the enlarged 169-seat parliament, and overthrow the current centre right coalition. If this happens, Labour leader Stoltenberg will replace Bondevik as the Prime Minister. The market may be concerned that the Socialist Left would push for a gradual re-nationalisation of partly privatised public utilities and reduce Norway s oil exports. That said, the Socialist Left have said they would not stand in the way of Statoil and Norsk Hydro s joint venture with Russia s Gazprom to develop the Shtokman gas fields in the Russian Arctic. Moreover, the Red-Green Alliance s income and tax policies are likely to increase real wages, and lead to tighter monetary policy and easier fiscal policy and therefore support NOK. We therefore see political jitters as a relatively short term concern for NOK. Shifting rate expectations are likely to be the main medium term driver for NOK, once the September 12 election is behind us. As Figure 2 shows, the stance of monetary policy in Norway is not just loose, but has actually been eased significantly over the last year, despite the June rate hike, as spare capacity in the economy has been eroded and inflation risen. Our estimate of the Taylor Rule neutral rate for Norway currently stands at 4.4%. We continue to believe that the market significantly underestimates the scope for Norges Bank tightening going forward, with only three further 25bp tightenings discounted by June 26. We expect EUR/NOK to fall to 7.7 over the next 12 months, with the risks to the downside if Norges Bank steps up the pace of tightening. Official cash rate 2.% (2.%) Trend interest rates 1y average 5.% Rising CPI (ex energy and taxes) %Y/Y Jul (Jun) 1.1% (1.1%) Inflation target % 2.5% Budget balance % GDP FY4 (FY3) 6.6% (8.3%) Budget balance target % GDP Structural, non-oil deficit < 4% GDP Growth %Y/Y Q1 (Q4) 1.9% (2.6%) Trend GDP %Y/Y 3.4% EUR Purchasing Power Parity Value (8.148) Spot PPP Valuation EUR/NOK is over-valued Current a/c balance % GDP Q1 (Q4) 11.3% (11.5%) Trend current account balance % GDP 8.4% Moody's Foreign Currency Rating Aaa 1. Rate spreads leading EUR/NOK lower Three month change in 3m rate spread, LHS, inv erted EUR/NOK, RHS Source: RBC Capital Markets, Bloomberg 2. Neutral rates in Norway still rising Source: RBC Capital Markets Norw ay 3m interest rate, % Tay lor rule implied rate USD/NOK EUR/NOK NOK/JPY CAD/NOK

12 1 September 25 Global FX Strategy: Currency Report Card Canadian Dollar Jeremy Friesen RBC has revised down its end-q3 USD/CAD forecast to 1.21 from 1.23 and its end-q4 forecast to 1.23 from 1.25 based on our upward revised interest rate forecast and the current sentiment on energy prices. RBC economists now expect Canadian rates to rise to 4% by Q2 26 from 3.75% previously. In contrast, the market has only fully priced in a September 7 25bp rate hike to 2.75% and BA futures are showing official cash rats at less than 3.% by Q2 26. In their last rate statement on July 12 the BoC signalled that they would begin tightening on September 7, stating rates needed to increase in the near term. Q2 GDP grew faster than the BoC s estimate (3.2% q/q saar vs.2.3%) and may be enough to worry the BoC about future capacity pressures. However, Q2 growth showed a deceleration in final domestic demand with only a rebound in net exports offsetting this (see Figure 2). The BoC will have to weigh the risks that net exports will continue to be healthy and energy prices will not slow global growth. The main risk to our bullish USD/CAD view from current levels is the continued market perception of CAD as a petro currency which has caused USD/CAD to be oversold despite nonenergy price weakness and higher U.S. interest rates. Figure 1 shows that USD/CAD price action in 25 has reflected the steady increase in energy prices while abandoning its stronger non-energy prices relationship. In the short run, USD/CAD could be weighed down by sustained higher global oil prices. In the longer term, despite the rise in global oil prices since 2, energy remains only one of Canada s main export sectors. Despite the 2.5 fold increase in crude oil prices since January 2, energy s nominal goods export share is still only 17.4% (albeit up from 9.3%) compared to 19.2% for the auto sector. Only if the oil industry were to be convinced that oil will remain above $6/b over the next few years would Canada s oil sands live up to their current hype. However, the risk is that oil prices will correct down in the next few years towards a U$4-5/b range making Canadian energy equities expensive, notwithstanding the higher CAD, as their stock prices currently reflect a stable U$55/b oil assumption. RBC s long-term model suggests USD/CAD is fairly priced above 1.25 with a 12- month adjustment towards this level. Official cash rate 2.5% (2.5%) Trend (1y) interest rates 4.% Rising Core CPI Inflation %Y/Y July (June) 1.4%(1.5%) CPI Inflation target range %Y/Y 1-3% Budget balance % GDP FY3 (FY2) 1.2% (.8%) Budget balance target % GDP Balanced over the business cycle GDP Growth %Y/Y Q1 (Q4) 3.2% (2.1%) Trend (1y) GDP %Y/Y 3.3% Purchasing Power Parity Value July(June) (1.3913) Spot PPP Valuation USD/CAD is under-valued Current account balance % GDP Q2 (Q1) 1.4% (1.%) Trend (5y) current account balance % GDP 2.% Moody's Foreign Currency Rating Aaa 1. Energy prices continue to lead USD/CAD Jan-5 Mar-5 May -5 Jul-5 Source: Statistics Canada BoC's energy commodity price index LHS BoC's non-energy commodity price index LHS USD/CAD (inv erted) RHS 2. Domestic demand seems to be peaking 1% 8% 6% 4% 2% % Consumer spending (q/q saar) Gov ernment (q/q saar) Business investment (q/q saar) Q2-4 Q3-4 Q4-4 Q1-5 Q2-5 Source: Statistics Canada and Bloomberg USD/CAD EUR/CAD CAD/JPY

13 Global FX Strategy: Currency Report Card 1 September 25 Australian Dollar Greg Gibbs The AUD has been in a gradual and choppy down trend against the USD since March. It has had a mixed performance against other major currencies, but is generally weaker over the last month. This reflects relative interest rate trends with the rate outlook shifting from neutral to a modest chance of a rate cut over the next year in Australia, while yields have generally recovered from mid-year declines in Europe and rate hike expectations have increased in North America. NZD bonds have also made greater inroads into AUD s dominance in the Japanese Uridashi bond market (see Figure 1 on the NZD page). The sharp rise in oil prices over the last few months is again dampening confidence in the global economy. This threatens to reduce global investor risk appetite and represents a downside risk for the high yielding AUD in the near term. However, the US Federal Reserve is showing little additional concern over inflation, and still appears more focussed on targeting full employment, underpinning US and global demand. As such we doubt there will be a sustained further decline in the AUD. Official cash rate 5.5% (5.5%) Trend interest rates 1yr average 5.6% Neutral CPI Inflation %Y/Y Q2 (Q1) 2.5% (2.4%) Inflation target 2.-3.% Budget balance % GDP FY4 (FY3).7% (1.2%) Budget balance target % GDP Balanced over the business cycle GDP Growth %Y/Y Q1 (Q4) 1.9% (1.5%) Trend GDP %Y/Y % Purchasing Power Parity Value.6616 (.6615) Spot.757 Valuation AUD/USD is over-valued Current account balance % GDP Q1 (Q4) -6.7% (-6.5%) Trend current account balance % GDP 4.5% Moody's Foreign Currency Rating Aaa 1. AUD/USD and the AU-US 2 year govt yield spread Domestic demand is on a more moderate path (2-3%) as households consolidate their finances following the housing boom, which peaked at end-23. However, this is offset by a strong labour market (unemployment at a 3 year low of 5.%) and strong national real income growth (3.5% y/y in Q1, above 1.9% y/y growth in real expenditure based GDP) reflecting the highest terms of trade in over 3 years. The RBA will be reluctant to cut rates with strong growth impetus from abroad and happy to encourage household debt consolidation. While the AUD is vulnerable to a significant down turn in the global economy, over the longer term we anticipate a weaker USD, more so against Asian currencies, and sustained high levels of commodity prices to keep the AUD around its long term cyclical highs over the next year..67 AUD/USD LHS AU-US 2 y r y ield spread % RHS.62 May -4 Aug-4 Dec-4 Mar-5 Jun-5 Source: Bloomberg, RBC Capital Markets 2. Domestic demand out-stripping GDP (% y/y) 1 Domestic Demand GDP Sep-82 Sep-86 Sep-9 Sep-94 Sep-98 Sep Source: Econdata, ABS, RBC Capital Markets AUD/USD EUR/AUD AUD/JPY AUD/CAD

14 1 September 25 Global FX Strategy: Currency Report Card New Zealand Dollar Greg Gibbs The NZD rose in August against the USD after making its low for the year in July. It also recovered two thirds of its fall against the AUD between May and early August. Its firmer tone largely reflected increased investor interest from Japan and other high yield investors; NZD Uridashi bond issuance in the Japanese market rose to a record $US1.5 bn in August, detracting mainly from AUD issuance (Figure 1). While rates appear to have peaked in New Zealand, they remain significantly higher than other developed nations. Even when they begin to fall (as we forecast in Q1 next year), New Zealand is likely to maintain a significant yield advantage through the coming down cycle in the economy. The near term outlook for the NZD will continue to depend on global appetite for high yield product. This has ebbed on occasion this year, but by and large it remains at very high levels judging by relatively tight high yield corporate and emerging market credit spreads. The sharp rise in oil prices over the last few months is again dampening confidence in the global economy. This threatens to reduce global investor risk appetite and represents a downside risk for the high yielding NZD in the near term. However, the US Federal Reserve is showing little additional concern over inflation, and still appears more focussed on targeting full employment, underpinning global demand. As such we doubt there will be a sustained decline in the NZD. We have forecast the NZD/USD to remain around its historic highs, reflecting an expectation that the USD will tend to weaken to address its current account deficit and a robust global economy will ensure commodity prices and risk appetite remain relatively elevated. While still maintaining this view, the inflationary pressure arising from rising commodity prices as the US, in particular, approaches full employment, is pushing up US interest rates. This both tends to dampen global growth expectations and underpin the USD. As such we see more risk that the NZD under-shoots our forecast profile at times over the next year, while still sensing the most likely outcome is that the NZD will rise modestly over the medium term. Official cash rate 6.75% (6.75%) Trend interest rates 1yr average 6.25/6.75% Neutral CPI Inflation %Y/Y Q2 (Q1) 2.8% (2.8%) Inflation target 1.-3.% Budget balance % GDP FY4 (FY3) 3.% (2.3%) Budget balance target % GDP Balanced over the business cycle GDP Growth %Y/Y Q1 (Q4) 2.5% (3.8%) Trend GDP %Y/Y 3./3.5% Purchasing Power Parity Value.5882 (.5897) Spot.698 Valuation NZD/USD is over-valued Current account balance % GDP Q1 (Q4) -7.% (-6.4%) Trend current account balance % GDP 4.6% Moody's Foreign Currency Rating Aaa 1. Uridashi issuance in the Japanese bond market May -4 Aug-4 Nov -4 Feb-5 May -5 Aug-5 Source: Bloomberg, RBC Capital Markets NZD AUD USD ZAR JPY Other 2. Two year government yield spreads over the USA New Zealand Australia UK Canada Eurozone May -4 Aug-4 Nov -4 Feb-5 May -5 Source: Bloomberg, RBC Capital Markets FORECASTS NZD/USD EUR/NZD NZD/JPY NZD/CAD

15 Global FX Strategy: Currency Report Card 1 September 25 South African Rand Tania Kotsos Despite its 2.7% appreciation in August, ZAR is the secondworst performing currency so far this year, down 11% against USD (spot: 6.36). Although we expect further ZAR weakness, we have revised down our USD/ZAR forecasts to reflect our view that the repo rate has now troughed (unchanged at 7.% on August 11) and renewed USD weakness (RBC EUR/USD end-25 forecast is 1.27). We now forecast USD/ZAR to appreciate to 6.65 by end-25 (previously 7.). Although CPIX remains well within the SARB s 3-6% inflation target, it surprised to the upside of expectations for the first time in four months at 4.2%y/y in July (the first 4%-plus reading this year) while July PPI at 3.6%y/y was the highest since April 23. On August 11, SARB Governor Mboweni said the inflation outlook remains favourable and CPIX is expected to remain on target to end-27, peaking at around 5.5% in Q1 26. Mboweni highlighted that rising global oil prices (then at U$64/b versus U$69/b currently) have yet to be reflected in inflation and is the main risk to its favourable outlook. Although we acknowledge that USD/ZAR direction is largely a function of USD sentiment, we retain our bullish USD/ZAR view based on the expected narrowing of the real interest rate differential between U.S. and S.A. to 275bp by end-26 (35bp currently). The inflationary impact of higher oil prices on CPI could narrow the real rate differential by more than expected. Our medium-term bullish USD/ZAR view is largely premised on the aforementioned diminishing real rate differential forecast, as well as the deterioration of the current account deficit (3.8% of GDP in Q1 compared to the trend deficit of ~.9%) and RBC s view that the USD should rebound in 26 (albeit moderately). The current account deficit is currently easily financed by portfolio and interest rate driven short-term flows. However, with the attractiveness of South African assets set to deteriorate, the privatisation initiative shelved and import growth expected to remain strong over the next 12 months, we forecast a weaker ZAR in 26. We now expect USD/ZAR to peak at around 7.1 in Q2 next year before falling back to 6.7 by end-26 in line with our view the SARB should begin hiking rates in H2 26. Official cash rate Aug (Jul) 7.% (7.%) Trend interest rates (average since 1998) 11.95% Lower CPIX Inflation %Y/Y Jul (Jun) 4.2% (3.5%) CPIX Inflation target 3.-6.% Annual Budget balance % GDP FY4/5-1.6% (-2.4%) (FY3/4) Budget balance target % GDP Non-official 3.% of GDP ceiling GDP Growth %Y/Y Q2 (Q1) 4.8% (3.5%) Trend GDP %Y/Y 3.1% Purchasing Power Parity Value Jul (Jun) 7.16 (7.14) Spot 6.36 Valuation USD/ZAR is under-valued Current account balance % GDP Q1 (Q4) -3.8% (-4.%) Trend current account balance % GDP -1.% Moody's Foreign Currency Rating Baa1 1. RBC s USD/ZAR Fair Value Regression Model Jan- Jan-2 Jan-4 Jan-6 Source: Bloomberg; RBC Capital Markets USD/ZAR spot Fitted +/- 1STD USD/ZAR Fitted 2. USD/ZAR versus SA-US Real Rate Differential S.A.-U.S. real rate differential % LHS 4 USD/ZAR inverted RHS RBC end-5 F 275bp Jan-99 Jan-1 Jan-3 Jan-5 USD/ZAR EUR/ZAR ZAR/JPY GBP/ZAR Source: RBC Capital Markets 15

16 1 September 25 Global FX Strategy: Currency Report Card Polish Zloty Tania Kotsos EUR/PLN fell to a multi-month low of on September 1. We largely attribute the PLN s rally to the outperformance of the Polish equity market over global equities. The benchmark WIG2 Index appreciated 4% in August compared to just.6% for the MSCI EM Free Index. The 15% weighting of petroleum refinery giant PKN and the 12.4% weighting of copper giant KGHM in the WIG2 Index is bullish PLN amid higher global oil and copper prices. PKN rallied more than 6% in August and KGHM 8% thanks to the rally in oil and copper to new record highs of U$7.85/b (1M Nymex contract) and U$3,654/mT (3M contract) respectively in late August. With global oil prices likely to be pressured higher on the back of Hurricane Katrina s extensive damage to the Gulf of Mexico and copper prices also likely to hit new highs on the back of continued strong demand from China, we would expect Polish equities to continue to outperform their global counterparts and hence PLN to rally in the next 1-3 months. RBC s EUR/PLN fair value regression model concludes that relative equity performance (MSCI Poland to MSCI EM Free) is the third most important driver of EUR/PLN. When adjusting our model to incorporate continued Polish equity outperformance, the model forecasts EUR/PLN at 3.89 by end-q3. RBC has revised down its forecasts to reflect this view. We now expect EUR/PLN to depreciate to 3.87 by end-q3 (previously 3.98) before ending the year back up at 3.98 (previously 4.1). The slight year-end appreciation in EUR/PLN is based on the expected narrowing of the PLN- EUR carry (currently 25bp) as we forecast the NBP to cut rates by a further 25bp to 4.25% by end-25. We have shifted our political and fiscal concerns from a nearterm to a medium-term factor as a majority victory for a PO-PiS coalition at the September 25 general election appears to be priced in. The August OBOP opinion poll shows support for the euro-friendly PO Party (33% from 28% in the early August poll) has overtaken that for the eurosceptic PiS Party (27% from 28%) and combined (6%) is enough to ensure a comfortable majority. Our medium-term concerns include the PiS Party s reluctance to adopt the euro by 21 and to push ahead with painful spending cuts and both parties express desire for a weaker PLN. Official cash rate Aug (Jul) 4.5% (4.75%) Trend interest rates (average since 1998) 11.75% Lower CPI Inflation %Y/Y Jul (Jun) 1.3% (1.4%) Headline Inflation target 2.5% (+/- 1%) Annual Budget balance % GDP 24 (23) 5.6% (4.5%) Budget balance target % GDP Below 3.% of GDP by 27 GDP Growth %Y/Y Q2 (Q1) 2.8% (2.1%) Trend GDP %Y/Y 4.4% EUR Purchasing Power Parity Value Jul (Jun) 4.52 (4.53) EUR/PLN Spot EUR/PLN Valuation EUR/PLN is under-valued Current account balance % GDP Q2 (Q1) -.9% (-1.6%) Trend current account balance % GDP -3.% Moody's Foreign Currency Rating A2 1. RBC EUR/PLN Fair Value Model to end EUR/PLN Actual EUR/PLN Fitted Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Source: Bloomberg; RBC Capital Markets out of sample 2. Linked fortunes of EUR/PLN to WIG2 Performance 3. WIG2 Index %w /w 3mma LHS 3.9 EUR/PLN Inverted RHS Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Source: Datastream; RBC Capital Markets USD/PLN EUR/PLN PLN/HUF PLN/CZK Source: RBC Capital Markets 16

17 Global FX Strategy: Currency Report Card 1 September 25 Hungarian Forint Tania Kotsos We continue to expect EUR/HUF to trade as low as 242 in the next 1-3 months. The NBH cut interest rates by a surprise 5bp (consensus: 25bp) in August to a record low 6.25% bringing the total easing to 525bp since August 24. The accompanying statement and Quarterly Inflation Report was extremely dovish stating that inflation is expected to fall sharply in 26 thanks largely to a VAT cut but that even without the tax reduction, CPI is expected to stay in the lower half of the NBH s 4% (+/-1%) target range. The NBH significantly cut its 26 year-average CPI forecast to 1.6% from 3.4% three months previously and set its medium-term inflation target to 3% (+/-1%) from 27 onwards consistent with price stability. RBC expects the NBH to cut rates by a further 5bp by yearend to 5.75%, leaving the HUF-EUR carry at 375bp but still the most attractive in the region. Rate cut expectations are bullish for bonds and hence HUF with net foreign purchases of HGBs at HUF75bn in July (3mma) compared to a year-to-date average of HUF41bn. Our EUR/HUF fair value model concludes that Hungarian-Eurozone inflation differentials are the number one driver of EUR/HUF. In light of the benign inflation outlook, we have revised down our end-25 EUR/HUF forecast to 242. from 25. previously. Official cash rate Aug (Jul) 6.25% (6.75%) Trend interest rates (average since 1997) 16.2% Falling CPI Inflation %Y/Y Jul (Jun) 3.7% (3.8%) Inflation target 4.% end-25 (+/- 1%) Annual Budget balance % GDP 24 (23) 5.3% (5.6%) Budget balance target % GDP Below 3.% of GDP by 28 GDP Growth %Y/Y Q1 (Q4) 2.9% (4.1%) Trend GDP %Y/Y 3.8% EUR Purchasing Power Parity Value May (Apr) (35.66) EUR/HUF Spot EUR/HUF Valuation EUR/HUF is under-valued Current account balance % GDP Q1 (Q4) -7.6% (-7.7%) Trend current account balance % GDP -7.7% Moody's Foreign Currency Rating A1 1. RBC s EUR/HUF Fair Value Regression Model EUR/HUF Actual EUR/HUF Fitted 24 Our medium-term, moderately bullish EUR/HUF outlook is largely premised on the deterioration of the fiscal situation. We expect the government to overshoot its 25 budget deficit forecast of 4.7% (RBC forecast: 5.2%) - well above the 4.1% target in the initial euro convergence programme. The budget deficit hit 97% of the full-year target in H1 and is likely to overshoot it by September. Until now, Finance Minister Veres has said there is no need for further corrective measures to keep the 25 deficit in check. The 26 general election raises more concerns over the fiscal outlook as we could see a reluctance to cut spending in order to shore up support, thereby threatening the goal of meeting the 3% of GDP Maastricht criterion in 28 and delaying euro adoption beyond 21. We retain our medium-term bullish EUR/HUF outlook and but now only look for gradual appreciation up to 252 by end-26 from 258 previously. 23 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Source: RBC Capital Markets; Bloomberg 2. Net Foreign Purchases of HGBs versus EUR/HUF Net purchases of HGBs by foreigners 3mma HUF bn LHS 27 EUR/HUF inverted RHS Jan-2 Jan-3 Jan-4 Jan-5 Source: Datastream; RBC Capital Markets USD/HUF EUR/HUF PLN/HUF CZK/HUF Source: RBC Capital Markets 17

18 1 September 25 Global FX Strategy: Currency Report Card Czech Koruna Tania Kotsos RBC s EUR/CZK fair value model forecasts EUR/CZK should depreciate to over the next 1-3 month period. On this basis, we sold EUR/CZK at 29.8 on August 25 with a target of and stop loss at 3.1. Our fair value model supports our view that CZK-EUR interest rate differentials are not a significant driver of EUR/CZK but instead highlights Czech equity performance relative to global equities as the most important driver. This relationship is enhanced by the 33% weighting of power utility giant CEZ (majority state-owned) in the PX5 Index. CEZ has rallied a massive 72% (local currency terms) year-to-date thanks largely to higher domestic power prices. The PX5 Index has rallied 27% year-to-date, more than double the performance of the MSCI Emerging Market Free Index (up 12% ytd). CEZ s strong performance should continue in the near to medium term after it raised its 25 full-year net profit forecast by around CZK.5bn to CZK16.1bn (CZK13.1bn in 25) citing higher domestic power prices. On August 23, CEZ booked a 14.3%y/y increase in electricity prices in a wholesale auction of power supplies for 26 and the company maintains that although prices are rising fast, they are still well below their Western European counterparts. Based on our fair value model and expectations for the continued outperformance of the PX5 index, we have revised down our EUR/CZK forecasts to 29. (previously 3.4) by end-q3 and to by end-q4 this year. In the medium-term we expect EUR/CZK to trade in a trading range. Although we believe Czech equity outperformance and our expectation that the CNB will begin to raise rates (current 1.75%) in H1 26, should support CZK in the medium-term, we highlight political risks next year. The general election is scheduled in mid-26 and deep divisions still persist between the coalition partners. We fear a reluctance to push through with painful reforms in order to muster support. Encouragingly, the July 28 CVVM opinion poll showed support for the Socialist-led coalition government increased to 28.7% (from 25%) and fell for the opposition, euro-sceptic Civic Democrat Party to 27.5% (below 3% for the first time in months). Official cash rate Aug (Jul) 1.75% (1.75%) Trend interest rates (average since 1995) 6.85% Unchanged / Higher CPI Inflation %Y/Y Jul (Jun) 1.7% (1.8%) Headline Inflation target 2.-4.% Annual Budget balance % GDP 24 (23) 5.2% (12.9%) Budget balance target % GDP Below 3% of GDP in 28 GDP Growth %Y/Y Q1 (Q4) 4.4% (4.6%) Trend GDP %Y/Y 2.6% EUR Purchasing Power Parity Value Jul (Jun) (36.39) EUR/CZK Spot EUR/CZK Valuation EUR/CZK is under-valued Current account balance % GDP Q1 (Q4) -4.1% (-5.1%) Trend current account balance % GDP -4.6% Moody's Foreign Currency Rating A1 1. RBC s EUR/CZK Fair Value Regression Model EUR/CZK Actual EUR/CZK Fitted Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Source: Bloomberg; RBC Capital Markets out of sample 2. PX5 heavyweight CEZ rallies on global oil prices CEZ (pow er utility 33% PX5 w eight) Lev el LHS Ny mex near-month contract U$/b RHS Jan-3 Jul-3 Jan-4 Jul-4 Jan-5 Jul-5 Source: Datastream; RBC Capital Markets USD/CZK EUR/CZK PLN/CZK CZK/HUF Source: RBC Capital Markets 18

19 Global FX Strategy: Currency Report Card 1 September 25 Chinese Yuan Greg Gibbs PBoC Governor Zhou said that the CNY reference basket is weighted mostly in USD, EUR, JPY and KRW, and that the SGD, GBP, MYR, AUD, RUB, THB and CAD were also important. In a later statement, a senior official said there were more than 2 currencies in the basket. Zhou said that the basket includes currencies of trading partners with annual trade with China of $1 bn, and that currencies of trading partners of $5 bn were also important; implying they may be also included or were influential in determining weights. Two of the largest trading partner currencies, HKD and TWD were notably absent from specific mention, suggesting they may not be included. Zhou also said that China s Foreign debt ($228.6 bn outstanding at end-24) and Foreign Direct Investment (6.6 bn net inflow in 24, or a cumulative total of around $56 bn over 2 years) were also considered in the basket. This still leaves a lot of unanswered questions on the make-up of the basket, such as the relative importance of trade (around $1.3 tn annual value in the year to July), FDI and debt in determining weights, and the impact of excluding TWD and HKD on other weights. However, the broad nature of the basket suggests that there has been a substantial shift away from a 1% reference to the USD, which should allow for significant variability in the USD/CNY exchange rate. It appears that the PBoC has preferred to keep the USD/CNY relatively steady to date, and assume greater volatility in its CNY/basket index, as illustrated by figure 1, which shows a comparison of the USD/CNY with a CNY basket based on trade weights. But since there has been little overall shift in the USD against majors since the regime change (21 July), the stable USD/CNY is not inconsistent with the new basket regime; if anything it suggests the USD/CNY might rise, to offset appreciation in the CNY against other currencies recently. The real test will occur if and when there is a significant broad shift in the USD. We anticipate broad strength in Asian currencies will both facilitate and be supported by a significant fall in the USD against the CNY over the next year. Base lending rates 1 yr 5.58% (5.31%) Trend interest rates 1yr average 7.5% Neutral CPI Inflation %Y/Y Jul (Jun) 1.8% (1.6%) Inflation target - Budget balance % GDP FY4 (FY3) -2.3% (-2.8%) Budget balance target % GDP - GDP Growth %Y/Y Q2 (Q1) 9.5% (9.4%) Trend GDP %Y/Y 9.% Purchasing Power Parity Value 7.89 (7.91) Spot 8.1 Valuation USD/CNY is over-valued Current account balance % GDP CY4 (CY3) 4.% (3.1%) Trend current account balance % GDP 2.% Moody's Foreign Currency Rating A2 1. CNY index against USD and TWI basket USD Jun-4 Sep-4 Dec-4 Mar-5 Jun-5 Source: CEIC, Bloomberg, RBC Capital Markets TWI 2. Chinese industrial production and fixed asset inv Value added industry RMB v al %y /y 3mma Fix ed asset inv. y td %y /y May-96 May-98 May- May-2 May-4 Source: CEIC, RBC Capital Markets USD/CNY EUR/CNY CNY/JPY CAD/CNY

20 1 September 25 Global FX Strategy: Currency Report Card Hong Kong Dollar Greg Gibbs The HKD remains comfortably within the official target 7.75/85 band established in May. The 12 month forward HKD premium has narrowed over the last month, suggesting little pressure for the HKD to move outside the band in the next year; although there remains a modest bias towards expecting a stronger HKD. GDP rose 6.8% y/y in Q2/5, above the government forecast for % this year. Unemployment remained at its lowest level since 21 at 5.7% in May-July. Retail sales growth recently moderated from 7.1% y/y in May to 6.2% y/y in June, as tourist inflows moderated from their peak. But these are expected to pick up again with the opening of Disneyland in September. Inflation rose from 1.2% to 1.3% y/y in July, a new high since Cash rate % As required to peg USD/HKD Trend interest rates 1yr average same as the USD Rising CPI Inflation %Y/Y Jul (Jun) 1.3% (1.2%) Inflation target - Budget balance % GDP FY4 (FY3) -4.% (-4.9%) Budget balance target % GDP - GDP Growth %Y/Y Q2 (Q1) 6.8% (6.2%) Trend GDP %Y/Y % Purchasing Power Parity Value 6.36 (6.375) Spot 7.77 Valuation USD/HKD is over-valued Current account balance % GDP Q1 (Q4) 11.2% (1.%) Trend current account balance % GDP 8.% Moody's Foreign Currency Rating A1 1. HKD spot and 12 month forward HKMA head, Joseph Yam said that there is little doubt that what economists call the 'real effective exchange rate' of the renminbi will appreciate over time." However, there are no plans to change the HKD regime which was adjusted to be managed in a 1.3% band around 7.8 in May Spot 12 month fw d It is evident that Hong Kong is increasingly becoming integrated with the mainland. At some point in its future it will become appropriate for the HKD to link to the CNY. Pressure for this to occur will increase when the level of the USD/CNY falls to similar levels as the USD/HKD, which may occur next year. Strength in the Hong Kong economy, generated from strong trade and tourist links with the mainland, is not sufficient to pressure the HKD from its current regime, although it will tend to see it trade on the firm side of the band. 7.6 Mar-4 Jun-4 Sep-4 Dec-4 Mar-5 Jun-5 Source: Bloomberg, RBC Capital Markets 2. Retail sales and tourist arrivals 2.5 Tourist arriv als millions LHS 2. Retail sales %y/y RHS Jan-96 Jan-98 Jan- Jan-2 Jan Source: Bloomberg, CEIC USD/HKD EUR/HKD HKD/JPY CAD/HKD