Would you really do it Mr. Ingves?

Transcription

1 Would you really do it Mr. Ingves? Global growth worries have intensified over the past few months. Many problems still confront both developed and emerging economies eight years after the Great Recession. Still, we think market fears dominant so far this year are exaggerated. Global monetary policy remains very loose. Indeed, so far only the Federal Reserve has stated it is considering tightening policy and then only gradually. Growth in both the US and Europe are expected to remain reasonable this year with the latter expanding more rapidly than at any time since 21. Further, the negative implications of the lower oil price connected with declining capex and increasing risk of credit defaults in the commodity sectors, with which the market is currently concerned of, should sooner or later be countered by the potential positive effects of lower energy costs on private consumption. While prospects for the Chinese economy remain central, global markets are focused on the country s currency policy rather than the growth rate. No one expects China to continue to grow by 7-1% indefinitely. Instead, it is the process by which authorities manage a soft landing while concurrently opening up the capital account that generates most uncertainty worldwide. Chinese currency policy (and CNY FX risk) will remain an important swing factor for global risk appetite, and we expect a gradual depreciation of the yuan. Emerging markets remain vulnerable but some currencies are now attractively valued and the USDindebtedness provides an upside flow factor for the greenback. For G1 currencies stabilizing risk appetite and oil prices mean traders can focus on what matters; the growth outlook, monetary policy and valuation. We expect some oversold commodity currencies to partly reverse losses to date. Further, as the ECB has promised to do more the EUR remains a funding currency. The fundamental outlook for SEK remains very strong but Riksbank also seems credible in its threat of FX interventions. Finally, as prospects for NOK improve Norges Bank will need to continue cutting rates to prevent the currency from appreciating too fast. WEDNESDAY 27 JANUARY 216 EDITOR Carl Hammer BUY THE CS BASKET We propose the following currency basket: long SEK (3%), CAD (3%), USD (21%), AUD (11%) and NOK (8%) vs short CHF (3%), EUR (%), JPY (21%) and NZD (2%) and GBP (4%). BUY RANGEBET USD/SEK SEK has been in range for some time vs EUR and USD and we continue to see USD/SEK stuck between 8.3 and 8.9. Buy a 3 month DNT 8. vs 8.9 for 2% of notional payout. Alternatively buy a 3 month NOK/SEK DNT.94/1.2 at 2% of notional payout. SELL EUR/CAD The loonie has weakened substantially on the back of lower oil prices. But the Canadian labour market is holding up well and the sectors outside of petroleum are now very competitive. Bank of Canada also remains firmly on hold whereas ECB will continue to ease monetary policy. SELL NZD/NOK One of our top (valuation) trades for 216 is short NZD/JPY (from Dec 9 th, 215). As an alternative commodity valuation trade we recommend short NZD/NOK which we think is trading at least 1-15% above long-term viable levels. A bare minimum target is 5. in NZD/NOK. You can also find our research materials at our website: This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutional investors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurate or complete. No liability is accepted for any direct or consequential loss resulting from reliance on this document. Changes may be made to opinions or information contained herein without notice.

2 Forecasts and FX Scorecard FX forecasts -Jan Q1 16 Q2 16 Q4 16 Q1 16 Q2 16 Forecasts 2 EUR/USD The big picture 5 EUR/JPY USD 1 EUR/GBP EUR 12 EUR/CHF JPY 14 EUR/SEK GBP 16 EUR/NOK CAD 18 EUR/DKK AUD 2 USD/RUB NZD 22 Cross rates CHF 24 USD/JPY SEK 26 GBP/USD NOK 28 USD/CAD RUB 3 USD/CHF CNY 32 AUD/USD Contacts 34 NZD/USD Disclaimer 35 USD/SEK GBP/SEK JPY/SEK CHF/SEK NOK/SEK USD/NOK USD/CNY *Bloomberg survey FX forecasts., SEB FX G1 Scorecard, Medium Term SEB Consensus* Contents Weights USD EUR JPY GBP CAD AUD NZD CHF SEK NOK Fundamentals.% Carry.% Mon. policy 22.5% Flows 1.% Valuation 15.% Positioning 7.5% Technicals.% Liquidity.% Ec. Surprise 5.% Event risk.% Risk appetite 15.% Total weighted score G1 FX Scorecard - Contributions to total score 2

3 3 Currency Strategy

4 SEB FX EM Scorecard, Medium Term Weights RUB CNY Fundamentals.% -2-1 Carry.% Monetary policy 22.5% -1 Flows 1.% -1 Valuation 15.% -2-5 Positioning 7.5% Technicals.% -3-1 Liquidity.% Ec. Surprise 5.% -1-1 Event risk.% -1 Global cycle 15.% Total weighted score

5 Exaggerated global growth concerns focused on oil and China In our previous Currency Strategy ( Get used to Scandinavian Parity ) we favoured long USD, GBP, SEK and JPY positions vs. commodity currencies and the EUR. Given the recent collapse in both oil prices and risk appetite we are now slightly more optimistic on some commodity currencies given their attractive valuation. We retain our bearish EUR and NZD view and continue to see SEK as one of the stronger G1 currencies 216. SEB EXPECTS COMMODITY PRICES TO STABILISE IN 216. So far this year, the oil price has declined more than we forecast. Meanwhile, concerns regarding global and Chinese growth have intensified. Risk appetite, its correlation to currencies and interdependencies on commodity prices make the short term FX outlook very digital. In the short term, tentative signs of risk appetite and oil price stabilisation clearly have the potential to improve the fortunes of hard hit currencies such as the Loonie and Krone. Simultaneously defensive currencies like the JPY and the EUR are giving back gains won over the past month. Overlooking short-term volatility in oil and risk appetite still leaves the question unresolved: Is the recent improvement the end of the beginning or (as we think more likely from a 3-6 month perspective) the beginning of the end? Our view also reflects our more positive opinion on the outlook for several beleaguered commodity currencies. added uncertainty in terms of Chinese currency risk. For the past 1 years, the renminbi has appreciated against most if not all currencies. However, the (crawling) peg vs. the USD made life tougher for China due to the USD s rapid appreciation once the Fed signalled higher rates to come. A changing currency regime and opening up of the capital account over time (letting markets determine the price of the currency) increases market uncertainty and introduces FX risk to China. Clearly the new currency regime is having a great impact on global risk appetite as suggested below. RORO RETURNING AS A MAJOR CURRENCY DRIVER Each currency has many individual factors affecting their price but generally there have from time to time been some general ones dominating the market. For example, in the aftermath of the financial crisis there was a period where risk appetite clearly was a major driver. Thus is often referred to as a RORO period (risk-off/risk-on). After this period most attention has been given to Monetary Policy outlook indicative through high correlations between currency pairs and their rate spreads. Average absolute currency correlation with risk appetite CHINESE FX POLICY AND OIL PRICES THE DRIVER FOR RISK APPETITE AND CURRENCIES? No doubt China is at the epicentre of attention in global markets. However, players can hardly be surprised by a slowdown in Chinese growth: the debate on sustainable growth in China has been continuing for a very long time. Also, official growth figures remain reassuring (215 GDP +6.9%). Rather the change in FX policy in China has In the graph above we have conducted a specific sensitivity analysis of some currencies versus risk appetite. Looking at the correlation between risk appetite and currencies it has 5

6 FX Ringside increased with the turning point in August 215. Even if average correlation is not at the highs seen during the RORO years the steep rise still shows that this is one of the main drivers of currency markets at the moment. However, the rate spread is still a large driver but the average correlation has fallen sharply since November 215 and it is clearly on the defense with a RORO environment taking over. Average absolute currency correlation with rate spread CAN CHINA HANDLE HUGE CAPITAL OUTFLOWS? The size of the FX market has grown fivefold since 2 according to the BIS Triennial FX survey while the global economy is some way short of doubling its size. Indeed, in some respects, we now have a situation in which the tail wags the dog with financial markets today dictating the real economic developments rather than vice versa. Over the past few decades there has been a clear tendency for increased global USD borrowing as the Fed has slashed interest rates. This time around is no different. Since 28, the BIS reckons that global USD borrowing by emerging markets has grown fourfold to USD 4 bn. Chinese companies have seen the fastest USD debt growth. This story is fairly familiar by now. The US Federal Reserve signal in 214 of increasing borrowing rates encouraged many companies to start decreasing their dependence on USD funding, a process that is still on-going. Repaying debt is probably one of the reasons why the USD has surged and indeed why the renminbi is under pressure. However China continues to generate a large current account surplus and has huge FX reserves. Opening up the Chinese capital account has also happened at a time when the renminbi is fairly valued (according to IMF estimates). Likely Chinese and foreign companies have started to hedge FX exposures (China has a large net liability in FDI). Trying to assess the drain on FX reserves and capital outflows is very hard. We expect continued capital outflows from China in the coming year and ultimately forecast that FX reserves will fall back to around 28 levels, something we think China can handle. China Assets Liabilities FDI 1,38 2,852 Equities Debt securities Financial deriv CCY & Deposits Loans Trade credits Other Reserves 3,59 Total 6,281 4,741 Net 1,54 Percent of GDP 18% There is another dimension to this question seldom cited. The fact that many EM countries and their companies now see a need to repay USD-denominated debt is obviously a result of the surging greenback. However, if the Fed remains very patient and barely hikes rates then the USD is unlikely to surge that much. This may impact the behavior of USD debt repayment. Another factor signaling less pressure is a rebound in commodity prices, which will come as a major relief for several EM countries. Consequently, a more cautious Fed policy outlook and commodity price stabilisation may well alleviate global angst over continued capital outflows from EM countries with China at the epicentre. US GROWTH IS REASONABLY HEALTHY. As shown in the graph below, consensus growth expectations for the US are approaching the level at which most economists set the potential growth rate (also the rate at which the US has grown over the past five years). Q4 215 appears to have been a relatively soft quarter (1% AR). However, for 216 we forecast a rate slightly above consensus driven by consumers taking advantage of higher wages, stronger employment and lower gas prices. The fact that US growth is holding up should help relieve current fears of a more dramatic global growth slowdown but does not really promote the idea yet that the Fed must deliver rate hikes faster than the market is pricing (which would give the USD a further 6

7 FX Ringside boost). Inflation remains too subdued for that to happen in H Therefore, monetary policy is no longer as supportive of the USD as it was previously. expected range: we would be surprised to see an additional move to and above.8 unless the UK votes to leave the European Union. Currently, the BOE is sending few signals they are about to hike rates anytime soon, but when that situation changes we would retune our neutral ranking to something more positive again. WEAKER EURO RATHER THAN A STRONGER USD? Ever since the ECB meeting on Dec 3, EUR/USD has traded in a very tight range of 1.7/1.1, while shortdated FX volatilities have sunk as a result. It is highly plausible that this development will continue for some time (albeit in a slightly wider range, say ): indeed our scorecard now gives the USD small positive grading differential vs. the EUR. The growth outlook in Europe appears reasonably positive compared to previously. However, we repeat our view of the EUR: the common currency is not as undervalued as most models suggest (our estimate of fair value for the trade-weighted euro is only 1% above current level) and with low commodity prices the ECB will remain currency sensitive. At its Jan 21 meeting Mr Draghi spelled out a case for more policy easing in March this year when new staff projections will be published, which are likely to show very subdued inflation until 218. At present SEB has not formalised what form this easing will take but a combination of a rate cut and more rapid asset purchases seems likely. The effectiveness of this policy is questionable. Indeed, we think weakening the EUR is the best policy. Consequently, the ECB will be happy to see EUR/USD down to 1.5 or lower. STERLING HAS LOST ITS SHINE? One of our top trades for 216 is short Cable. We have been positively surprised by how quickly this trade has delivered. The currency is slightly overvalued. Its strength is holding down inflation making the case for rate hikes distant once again. Although the trade balance has improved the UK still runs a fairly large current account deficit. Also, with declining global FX reserves, central banks may have begun to downscale previous strong purchases of gilts as the risk of a Brexit is increasing. This is also likely the main factor why the pound fell heavily at the start of the year as bets on the upcoming referendum were added. Regarding EUR/GBP, the pair has traded above our SCANDI DIVERGENCE RUNNING LATE? For a very long time we have expressed a bias toward the SEK over the NOK contrary to the views of many in the market. Earlier in January, NOK/SEK reached our bearish six month target at.95 and has since recovered slightly. The dovish economic implications for Norway of dealing with and living with a low oil price will take time to evaluate. As such, although NOK/SEK is now trading below our estimate of long-term fair value ( ) we still think it premature to buy NOK/SEK. Once the oil price stabilises and recovers part of the fairly severe losses it has incurred, the market will immediately buy the NOK as a favoured currency. Also, Norway has ample resources to stimulate the economy should it prove necessary. Increasing government spending will result in an even higher rate of NOK purchases by Norges Bank on behalf of the Government Pension Fund Global (expected buying NOK 5-6m daily in 216). Further, it looks fairly likely that at some stage long-term real money investors will look at the NOK s attractive valuation and sell FX/NOK. Avoiding recession (but entering a very prolonged economic slowdown) coupled with a positive flow outlook means that Norges Bank will face pressure to limit this development and maintain a weak currency for longer. While SEB only expects one more rate cut, there is clearly a risk that the policy rate will end up closer to zero in 216. We expect a fairly sharp rally by the NOK once the oil price stabilises and Norges Bank nears the end of cutting rates. In Sweden, the Riksbank remains very focused on the exchange rate and the outlook for EUR/SEK is fairly straightforward: FX interventions will occur if EUR/SEK falls towards 9. before CPIF has been established at or above 1.5% y/y. At the same time we think that investors and companies will use weaker SEK 7

8 FX Ringside levels to increase their FX hedges making range-trading the expected outcome in EUR/SEK (9.-9.4). Without previous firm Riksbank interventions through a negative repo rate, the QE programme and verbal threats of FX interventions, the SEK would clearly be stronger than it is at present. The more robust growth outlook for 216 together with our expectation that the Riksbank will need to address its inflation target more flexibly (a view bolstered by the recent Riksbank monetary policy evaluation by Mervyn King and Marvin Goodfriend) make us believe that the hurdle that must be cleared before further easing takes place is becoming higher (at the same time as the inflation outlook has deteriorated again due to lower commodity prices making the Riksbank more sensitive to the SEK). This means FX interventions are as likely as any other policy option to boost inflation near-term. Eventually however, the Riksbank will lose the battle to contain the SEK and the currency itself will become the factor tightening Swedish financial conditions. The biggest risk (apart from FX interventions) is continued risk aversion, which may force foreign investors to reduce their remaining high ownership of Swedish equities. We expect EUR/SEK at or below 9. in H FX SCORECARD PERFORMANCE SINCE SEPTEMBER Once again our core view on further upside potential for the USD and EUR weakness because of the prospects for further divergence in monetary policy was key for the outcome expressed in our last scorecard in September 215. Then, the USD was once again at the top, this time sharing the lead with the SEK. Other currencies supposed to outperform according to our framework were the JPY and GBP. On the other side of the portfolio were currencies that suffered from high valuations and exposures towards the commodity sector (AUD, NZD and NOK). Since Sep 9, when we last rebalanced the scorecard basket, it has remained almost unchanged (Jan 2) including carry. Performance was extremely weak following the Fed s decision to leave rates unchanged at the Sep 17 policy meeting. We had expected the first hike that very month. In just a few weeks between Sep 24 and Oct 15 the Scorecard portfolio index lost more than 4% as commodity-related currencies rallied substantially on the back of the dovish Fed decision. However, this was only a temporary reaction and signals that the first rate hike would take place in December triggered a reversal. The positive return since September has been due to the continued weakness of the NOK and CAD as a result of the lower oil price, a slightly stronger dollar and appreciation by the JPY. Basically, there are two sources of negative return. Firstly, there was a large short NZD exposure as we believed the RBNZ would continue to ease policy with inflation virtually at zero. However, it still appears substantially overvalued based on our models. The NZD recovered sharply in early October and although it has weakened again it is still stronger than in early September. Secondly, we have maintained a long exposure in GBP. Since the September report when we expected the BOE to be the first central bank to follow the Fed in tightening policy, which we thought would be GBP positive, conditions have changed substantially. Today, it seems it will take a lot longer before rising inflation and increased domestic cost pressure will cause the BOE to tighten policy. In September last year we expected the first BOE rate hike at its meeting this February. Currently it appears it will not happen at all this year. THE UPDATED FX SCORECARD The FX Scorecard takes into account the relative importance of various categories reflected by the weight we attach to each category. For a long time monetary policy has been the key factor for exchange rates. We still believe relative monetary policy and the outlook for growth will remain important factors for the currency market over the coming 3-6 months. The weight attached to monetary policy expectations is 22.5 (%). One reason monetary policy receives a slightly lower weight than has been the case for several years is that it has reached its outer bound (as set by the ECB, BOJ and Riksbank) and further policy easing by these institutions is unlikely to have any material impact on currencies going forward. Additionally, the growth outlook captured by Fundamentals receives a fairly high weight of % as we expect growth and to some extent the terms of trade to be important drivers for currencies in the present environment. Due to falling oil prices and the general sell-off in commodities the valuations of some currencies with commodity exposures have become stretched, which in the long term is unsustainable. When the present rout in oil prices and commodities ends, which it will eventually, these currencies are set to recover substantially simply because of their valuation. Valuation receives a 15% weight. Finally, the weight attaching to risk appetite has increased to 15%. This is because the correlation 8

9 FX Ringside between changes in market risk sentiment and currencies appears to have increased in recent periods of increased stress in financial markets following the sharp fall in oil prices and increased uncertainty related to the Chinese growth outlook. Based on the individual scores for each currency and the new set of category weights the SEK and the CAD receive the highest scores, each with a 3% weight in our new Scorecard portfolio. Next comes the USD (for which we have a fairly positive view) with a 21% weight. The scorecard also recommends being long the NOK and the AUD. Currencies with the largest short exposures include the CHF (3%), EUR (%), JPY (21%) and NZD (2%). Finally, the FX basket is basically neutral in GBP. The following portfolio represents the FX Scorecard Currency Strategy update: 9

10 US dollar Although the year has started poorly we expect the US economy to perform fairly well this year with household spending the key driver for US growth. Weakness in the second half of last year is partly related to lower inventories. Further rate hikes from the Fed later this year and easing by other central banks should sufficiently support the USD to finally push it through the recent EUR/USD lows at 1.5. However, the valuation of the dollar is becoming stretched limiting further upside potential. ECONOMIC FUNDAMENTALS The slump in oil prices in 214 and 215 did not fully translate into increased spending. Instead US households increased savings almost equally as gains from lower fuel prices. We expect this to change in 216 with household spending set to rise by 3.2% this year, slightly faster than in 215. The US labour market is strong. On average 22, new jobs were created each month in 215 and unemployment dropped to 5.%, which should lead to faster wage growth this year. Capital spending has so far failed to recover in a similar way. Business sentiment indicators show a marked contrast between the manufacturing sector (ISM 48.2) and the service sector (ISM 55.3). Nevertheless a composite index based on these would suggest GDP growth of around 2.5%. Part of the weakness in the manufacturing sector is probably related to a stronger dollar and reduced inventories in H Although current market sentiment seems to suggest that US growth could disappoint this year, we believe fundamentals are set for another year of stable US economic expansion. +2 MONETARY POLICY Expectations that the Fed would begin to tighten monetary policy while the ECB and other central banks would move in the opposite direction have helped the dollar. Although the Fed is likely to continue to slowly tighten policy later this year subdued inflation from lower fuel prices and below average wage growth allow it to remain on hold until June. Subsequently, we expect one hike each quarter with the Fed fund target rate reaching % by the end of 216. This is more than is currently discounted in market prices. Although we view monetary policy as a positive factor for the dollar given our Fed forecast,] it will probably be less important than what happens to monetary policy outside the US. +1 FLOWS Relatively strong US growth and a stronger dollar have increased the US current account deficit since 213. In Q3 it widened to 2.% of GDP. Most likely the trade deficit will continue to increase going forward as we expect US domestic demand to remain the key driver for US growth. Capital flows related to long-term securities (TIC-flows) have been fairly volatile since 213. Overall, these show net inflows of capital to US long-term securities, although more recently inflows have been related to US investors scaling back on holdings of foreign securities. Amongst those from overseas, there is a marked difference between official and private investors. While foreign official accounts have net sold US long-term securities over the last 12 months private investors have instead increased their purchases. Currently, capital flows are probably neutral to the dollar. Fundamentals Mon. policy Valuation Positioning Technicals Ec. Surprise Event risk Risk appetite USD Weighted score:.3 Carry Flows Liquidity U SD/C AD EUR/U SD

11 US dollar VALUATION Our internal long-term fair value model, SEBEER, indicates the USD probably has been undervalued in trade weighted terms since 23. It appears the general dollar weakness coincided with the introduction of the euro in 22 and its reputation as an alternative global reserve currency. However, superior US growth and expectations of widening rate differentials have triggered a recovery for the USD since May 214. Our internal valuation model as well as the real effective exchange rate, indicate the USD now trades on the rich side of its long-term fair value. Although it is approaching stretched territory where valuation would become a drag on the USD it is too early to argue for a weaker dollar just on the back of its valuation. Based on the real effective exchange rate the dollar is still substantially below valuations in previous dollar peaks in 1985 and POSITIONING Speculative accounts are long USD and have so been since May 214. The general trend in 215 was downscaling as the strong USD trend faltered when a Fed hike was pushed further out in time. However beginning at the end of October, when a rate hike in December became increasingly probable, the net long USD position was added again. Positioning peaked at an all-time net long the week ECB had their (to the market disappointing rate decision) and has since then, in a classical buy the rumour (Fed hike) and sell the fact manner, fallen back to more normal levels. Current positioning is only.2 standard deviations above the three year average position but the sharp trend lower, representing a negative USD sentiment, provides the current positioning score of -1. Also note the building divergence between a rising USD index and falling positioning. Such deviations occurred also in 215 and then the USD index tended to eventually fall in accordance with the negative sentiment indicated by positioning. -1 LIQUIDITY, EVENT RISK AND GLOBAL CYCLE With its superior liquidity the USD has traditionally been seen as a typical safe haven currency which is negatively correlated with risk appetite. However since 212 these relationships between currencies and risk appetite have disappeared and that goes for the USD as well. More recently it has actually been the other way around and currently the USD seems to be punished against funding currencies like the EUR and the JPY when financial markets come under increased stress. Another reason is probably that the outlook for the USD is closely related to monetary policy and the timing and pace of coming rate hikes by the Fed, which probably enforces the positive relationship between the dollar and risk appetite. Based on the rate differential between the euro area and the US the EUR/USD exchange rate seems to be fairly accurate slightly below the 1.1-level U SD/C AD EUR/U SD

12 The euro The euro continues holding up very well but new downside risks are on the horizon. The ECB signalled its willingness to ease its monetary policy even further in March due to a worsening of the inflation outlook. On the other hand, a high current account surplus and falling budget deficits are supporting the currency. However, additional ECB easing measures may be required before too long. Moreover, the crisis is far from over and latest political developments indicate that additional steps to more integration look distant. ECONOMIC FUNDAMENTALS The composite purchasing manager index (PMI) as well as the Economic Sentiment Indicator (ESI) of the EU Commission were stronger than expected in December showing that the economic recovery strengthened at the end of last year. Looking ahead, real GDP is expected to expand by 2.% and 2.1% this year and next, but downside risks are mounting. On a political level, its handling of the refugee crisis shows the EU is in bad shape. Still, recent general elections in some member states saw anti-euro parties strengthen their position. In future it will be even more difficult to reach agreement on further integration, leaving the framework of the monetary union very fragile. +2 MONETARY POLICY Times remain very challenging for the ECB. Falling oil prices indicate that the ECB will miss its inflation target in 216 and in 217 despite the additional measures announced in December 215. After the January meeting, the ECB signaled to review and possibly reconsider its monetary policy stance at its next meeting in March, due to the fact that the outlook for inflation has worsened significantly. Downward revised March ECB staff inflation projections for 217 and disappointingly low ones for 218 could be a trigger to act. After having extended the lifetime of its QE program in December, the focus could now lie on increasing monthly asset purchases by 1bn or 2bn. Furthermore, another cut in the deposit rate to -.4% or even -.5% cannot be excluded. Additional monetary easing in March could lead to renewed downward pressure on the euro.-2 Fundamentals Mon. policy Positioning Technicals Ec. Surprise Risk appetite EUR Weighted score: -.1 Carry Flows Valuation Liquidity Event risk U SD/C AD EUR/U SD FLOWS In the 12 month period ending in October 215, the 12-month cumulated current account surplus rose to 299.9bn or 2.9% of GDP, compared with a surplus of 237.5bn during the 12 months to June 215. In the same period, combined direct and portfolio investments of euro area-based investors totalled 819bn, surpassing similar investments by foreigners in the euro area by 267bn. Looking ahead, without a major rebound in oil prices no change in trend in the current account will occur in the foreseeable future. It therefore looks increasingly likely that the surplus will rise beyond 3% of GDP towards the end of 216, indicating that the euro is already undervalued at current levels

13 The euro VALUATION When the euro began to depreciate in 214 it was clearly overvalued in trade weighted terms according to the SEBEER long-term fair value model. The common currency began to weaken after the ECB had announced further policy easing including rate cuts and eventually an extensive asset purchase program. Today, the valuation of the euro is quite close to its estimated long-term fair value in trade weighted terms. However, the sharp drop in the euro was not only related to euro weakness but a broad based dollar appreciation contributed as well. The euro appears slightly undervalued according to other valuation measures as the real effective exchange rate or in nominal trade weighted terms. Altogether valuation should be slightly positive for the euro going forward. +1 POSITIONING Speculators are net short EUR vs. USD and has been so since May 214. However, current positioning is more bearish than usual situated.9 standard deviations below its three year average. The net short position peaked early December when the ECB disappointed speculators far reaching expectations on further easing. Since the beginning of the year speculators have been quite inactive in the EUR but last week they reduced their net short substantially. After the ECB once again seemed more dovish at the Jan 21 rate decision there is scoop for a similar development as after their meeting in Oct, which would weigh in EUR/USD. However, increased uncertainty and risk-off mood also diminish the speed, by which Fed is expected to hike rates which could partially balance the downside potential due to dovish ECB. All in all, the lack of an extreme positioning or sharp trend in positioning renders a neutral positioning score for EUR in this report. LIQUIDITY, EVENT RISKS, GLOBAL CYCLE ECB bond purchases will continue at a monthly rate of 6bn or more at least until March 217 and longer if necessary. Early tapering of such purchases looks unlikely at present. We expect markets to refocus on fundamental economic data but at the same time downside risks have increased due to slower growth in many emerging markets and China in particular U SD/C AD EUR/U SD

14 Japanese yen The JPY is stuck in the range. We expect JPY weakness to continue vs USD but we would need to see another round of QE by Bank of Japan or continued Fed rate hikes to break out of current range. The economy remains too weak to increase inflation and BoJ will sooner or later have to act. A Fed and/or BoJ event will act as a catalyst to break 1 and reach 13. ECONOMIC FUNDAMENTALS The economic recovery post the VAT tax hike in April 214 has been disappointing. The economy has only recovered to.6% growth in 215 after a recession in 214. The outlook for 216 is a small bounce to 1.1%. Weakness in exports to US, Europe and China are weighing on growth. Domestic activity in investment and consumption is increasing but many are reluctant to spend aggressively in fear of another recession in 217 from the second round of planned VAT tax hike to 1% from 8%. Prime Minister Abe will announce some positive economic plan going into the July Upper House election but reaction will be limited with a tax hike looming over. +1 MONETARY POLICY BoJ is facing difficulties in reaching the 2% inflation in 2 years promise. Due to 3 rounds of QQE, BoJ has gained credibility from markets that it will react to any adverse effect. However, market patience is running low as BoJ is nowhere close to its 2% target and lower commodity prices and a weaker China are acting as major headwinds to inflation. We think markets may test BoJ s resolve in early 216 by pushing down the equity market and strengthening JPY towards 115. We think BoJ will react in Q3 to a stronger JPY and weaker equity market where they will likely quadruple the size of the monetary base. It will also add purchases of local government bonds as JGB purchases reach a limit. A possible trigger for an earlier than expected easing is if April annual wage negotiations disappoint. -1 FLOWS The current account surplus is growing as nuclear power plants are restarting and energy import volumes and prices decline. Capital outflows led by equity are still putting weakening pressures on the JPY. 6 months currency movements will be driven by capital flows and we are worried that Fed tightening will lead to capital flows returning to Japan and strengthen Yen. However, over the 12 months horizon, we think capital flows will turn outward as markets become accustomed to Fed hikes and emerging markets stabilize, which will lead to Japan hunting for yields abroad Fundamentals Carry Mon. policy Flows Valuation Positioning Technicals Liquidity Ec. Surprise Event risk Risk appetite JPY Weighted score: EUR -.6 speculative positions U-.4 SD/C-.2 AD EUR/U SD 1 Real GDP 1.3 % y/y Forecast % yoy ex VAT CPI ex fresh food BoJ Import Price %yoy (RHS) Forecast Japan BOP 12 month rollin sum as % of GDP Current Account FDI Equity Inv Debt Inv -6 Other Inv

15 Japanese yen VALUATION The rapid depreciation since Q4 212 has moved JPY valuation into a stretch on the downside. From previously being substantially overvalued according to virtually all measures the SEBEER long-term fair value model now places the JPY among the cheapest G1 currencies. Similarly the long-term real effective exchange rate is currently far below the historical average (more than 2 standard deviations), and so is the JPY in nominal trade weighted terms if the long-term trend is removed. Altogether it is difficult to come to any other conclusion than the yen currently is substantially undervalued and likely to move higher if the weak economy improves and the BOJ indicates they will end bond purchases. +3 POSITIONING Speculative accounts are net long JPY vs. USD a position they haven t had since Oct 212. Positioning is highly excessive 3.3 standard deviations above its three year average level. Downscaling of the net short position begun already in the middle of November 215 and was especially aggressive the week that Fed hike the rate. However with falling risk appetite at the beginning of 216 the change in the net JPY position has changed from being driven by speculators scaling down on short JPY contracts to being driven by speculators adding long JPY contracts. Given the excessively positive JPY position normalization is expected which renders the negative positioning score of -3 in this report. -3 LIQUIDITY, EVENT RISK AND GLOBAL CYCLE There are several risks to Japan in this category. On liquidity, too much liquidity has made short term yields in Japan turn negative and mass BoJ purchases of JGBs are reducing activity. These conditions are fine in normal markets but in times of shock, it leads to sudden movements that can be negative for Japan. Next, Japan has an upper house election in July. A big win for Prime Minister Abe s party will be negative Yen and a loss will be positive Yen. We are leaning towards the risk that Yen can strengthen. PM Abe s popularity has been falling due to his stance on a more active military and he may lose a couple of seats in the election which will dent confidence in Abenomics, the equity market and ability to reflate the economy U SD/C AD EUR/U SD

16 British pound sterling The outlook for the GBP is closely related to the probability of monetary policy tightening by the BOE. However, both low inflation and signs it will be some time before inflation rises towards the BOE target have clearly postponed any action from the BOE until 217. This could potentially contribute to further GBP weakness in coming months. The referendum on EU membership has also created political uncertainty and is negative for the currency. However, a positive outcome could trigger a recovery for sterling. ECONOMIC FUNDAMENTALS In 215, the UK economy was growing by around.5% q/q with household spending the key contributor, as it has been since the recovery began in 213. Household expenditure is supported by rising employment and there are signs of faster wage growth, even if it has slowed in recent months. However, household spending is related to lower household savings, the level of which has fallen sharply from nearly 12% in 21 to 4.7%, which is below previous lows. Therefore, going forward wage growth probably needs to pick up to support further spending increases. Sentiment in the manufacturing sector has dropped to just above 5 with its moderate growth confirmed by production data. Although PMI services has also declined, it still remains fairly strong at around 55 indicating that activity in the service sector is expanding. Various measures show annual growth in house prices at between 5-1%, which supports household wealth and spending. +1 MONETARY POLICY The BOE has kept its policy rate unchanged at.5% since 29. Like the rest of the world lower fuel and food prices and subdued global export prices have exerted significant downward pressure on inflation which stands far below the bank s target: headline inflation was.1% in Nov while core inflation was 1.2%. The expected base effect from the previous fall in fuel prices which was supposed to lift inflation at the beginning of this year will be much smaller than expected. Although inflation is likely to grind higher we now expect the BOE to revise its forecast lower in its Feb inflation report. Wage growth has slowed in recent months showing that present low domestic cost pressures look set to continue. Given the current inflation and growth outlook, the BOE is likely to leave its key rate unchanged in 216, as shown by current market pricing. FLOWS While the UK trade balance has improved slightly since 213, it has proved insufficient to improve the current account balance, which posted a record deficit of nearly 6% of GDP in Q1 last year. Much of this increase was attributable to the income balance, which has switched from a surplus to a deficit in the last few years, due to sharply lower net income from FDI. Fundamentals Mon. policy Valuation Positioning Technicals Ec. Surprise Event risk Risk appetite GBP Weighted score:.1 Carry Flows Liquidity U SD/C AD EUR/U SD

17 British pound sterling VALUATION In just a few months the GBP has depreciated substantially in trade weighted terms after it became clear that low inflation will delay the expected monetary policy tightening by the BOE. In addition increased political uncertainty related to the referendum on the British EU-membership has probably also contributed to GBP weakness. Before its recent depreciation the sterling was slightly overvalued in trade weighted terms according to the SEBEER long-term fair value model. However, the correction lower has brought it back towards a neutral valuation. The nominal trade weighted index is also quite close to the long-term average confirming this view. In contrast the real effective exchange rate for the GBP remains substantially above its historical average as relatively high UK inflation in the years following the financial crisis wasn t offset by a nominal depreciation. Altogether the GBP seems to be close to its fair value but still on the expensive side. -1 POSITIONING Speculators are net short GBP versus USD and have so been for most of 215. However most of 215 was signified by downscaling of the net short position which culminated with a small net long position at the end of October. After the ECB and Fed meetings in October however the sentiment turned negative GBP again. End of 215 and beginning 216 speculators have been adding to their net short GBP position rendering a small negative score for the slope but this is not enough to render a total positioning score of anything but neutral. Current positioning is.6 standard deviations below the three year average level and thus somewhat more GBP bearish than usual. Looking at the development in GBP/USD the increase in the net short GBP position seems small. One interpretation of the forming divergence is that GBP/USD approaches levels from where a correction should be expected as specs seems increasingly hesitant to add to their net short position. EVENT RISK, LIQUIDITY AND GLOBAL CYCLE The outlook for the GBP is closely related to the outlook for the UK economy and the probability for monetary policy tightening by the BOE. However, low inflation has clearly delayed any action from the BOE until 217 at the earliest. With domestic demand being the main driver for growth one obvious risk related to our outlook for the GBP would be another shift in expectations on the BOE policy, which could lead to a stronger GBP than what we currently expect. One additional risk is the uncertainty related to a potential referendum on British EUmembership already this year. The outcome will of course depend on what PM Cameron can achieve in negotiations with other member states. Currently expectations probably reflect a situation where the UK will remain an EU-member following the referendum. Increased likelihood for and adverse outcome would put renewed downward pressure on the GPB. a U SD/C AD EUR/U SD

18 Canadian dollar After having cut the key rate twice last year, surprisingly the Canadian central bank (BOC) maintained the target rate at.5% at its most recent policy meeting. While GDP growth likely stalled in the fourth quarter last year and with the renewed decline in prices for oil and other commodities having adverse effects on the economy, the slowdown is probably temporary. Indeed, above-trend growth rates should return before long. Certainly, the supercharged loonie is already enabling Canada to recoup lost shares of employment and production. We expect the CAD to outperform other commodity currencies due to its present valuation and extensive connections to the comparatively strong US economy. ECONOMIC FUNDAMENTALS Canadian real GDP growth was weak last year but is expected to rebound, due to the weak loonie, the pickup in the US economy and a stabilisation and subsequent turnaround in oil prices. Moreover a process of reorientation towards nonresource activity is well underway; outside the resource sector the economy continues to grow and real consumer spending is advancing at around 2% annually. The extremely rapid CAD depreciation since mid-214 is helping Canada s competiveness; in particular, employment growth has recently been strong in the manufacturing sector. Over the past 12 months, employment in manufacturing rose 2.1%, its first increase since 212. In recent months, Canada s manufacturing sector has been creating jobs almost four times as fast as the US, despite the economy being one-tenth the size of its huge southern neighbour. Going forward and with the output gap still open, we expect economic growth to rebound to above-trend rates. +1 MONETARY POLICY After keeping its policy rate at 1% for over four years, the BOC cut rates twice last year (January and July). Since the oil price is one of the factors that are most closely watched by the central bank, it was surprising to see that it left the target rate unchanged at the January meeting. Back in December, Governor Poloz suggested that negative interest rates were a definite possibility. However, given the present optimistic tone that is hardly the current baseline. Insofar as the bank wanted to talk down the CAD, it has been very successful as the loonie now trades well below its fair value. That the new Liberal government has unveiled plans for shovel ready infrastructure spending projects arguably means less pressure on the BOC to do all the heavy-lifting going forward too. So if oil prices stabilise as we forecast the cheap loonie will continue to exert positive pressure on production and employment. As such, the BOC will probably remain on hold at least for a time rather than cut rates or initiate large-scale bond purchases. +1 FLOWS The current account deficit has shrunk slightly in recent quarters despite still sluggish US demand for Canadian exports. However, trends in the broad basic balance and basic balance are negative. -2 Fundamentals Carry Mon. policy Flows Valuation Positioning Technicals Liquidity Ec. Surprise Event risk Risk appetite CAD Weighted score: U SD/C AD EUR/U SD

19 Canadian dollar VALUATION The Canadian dollar traded at rich levels for a long time, which indisputably was negative for Canadian competitiveness. The sharp decline in commodity prices and in particular the oil price slump have weakened the currency significantly in trade weighted terms since 214. The CAD continued to fall in 215 and currently it trades almost as much below its long-term fair value as it used to do on the upside. According to our fair value estimate the CAD is more than 15% undervalued in trade weighted terms. In fact the Canadian currency is undervalued in trade weighted terms according to all three valuation measures used in this report. This is usually a strong sign that things have moved too far. However in real trade weighted terms valuation is not as extreme as one might think given where the currency trades in nominal terms. Valuation has clearly turned into a positive factor for the CAD. +4 POSITIONING Speculative accounts are net short CAD as has been the norm since 214. However, currently the net short is far larger than normal; to be exact it is 1.2 standard deviations below the three year average, which is the second most extreme position in this report. However, the net short is not large enough to render positive CAD score that would indicate high probability of a correction. But the trend with speculators adding to their net short position, which began in November 215, has corrected slightly the past two weeks and therefore is not strong enough to render a negative slope score. All in all the positioning score for CAD is neutral in this report. EVENT RISK, LIQUIDITY AND GLOBAL CYCLE Historically the Canadian dollar has correlated positively with general risk appetite and the performance of the US equity market. Lately however it is foremost the oil price that dictates the development of CAD. RBA s favoured fair value model for AUD seems to work well for also the CAD which isn t very surprising as the both are commodity related currencies. The fair-value is based on terms of trade, relative real rate spread versus US, Europe and Japan. Terms of trade and CAD have generally fallen since 211 but the pace increased greatly from mid-214 when oil prices tumbled. March to May oil prices corrected, USD generally weakened and the model as well as CAD headed higher. However, oil prices has fallen in June and July and BOC has cut the rate July making both CAD and its fair value falling sharply again in July U SD/C AD EUR/U SD

20 Australian dollar Lower commodity prices and uncertainty related to the Chinese economy have weakened the Australian dollar. The economy is mixed with falling investments in the mining sector being one drag. The labour market has improved again from previous weakness and in recent months growing employment has reduced unemployment rate. Being exposed to China the situation is uncertain and would things in China worsen it is not unlikely that the central bank could ease policy further. This would most likely weigh on the AUD. The AUD has reached a more reasonable valuation as it currently trades around its long-term fair value. ECONOMIC FUNDAMENTALS The Australian economy suffers from sharp falls in mining related investments while non-mining investments so far have failed to pick up according to surveys. One exception is the housing market where dwelling investments have remained strong on the back of rising house prices in some of the major cities. However, there were signs that price growth had started to ease as supply of housing has increased. Mining investments have boosted exports and in Q3 the contribution to GDP growth was almost 1 percentage point. Labour market has improved in recent months and despite rising participation rate unemployment has decreased sharply since summer although wage growth remains muted. Altogether, the situation for households has improved, which is reflected in rising consumer confidence. Considering that household savings increased significantly following the financial crisis and has remained firm there is a case for being positive on household spending going forward. +1 MONETARY POLICY The RBA reduced the cash rate by bps in Feb and then again in May and currently the cash rate is 2.%. Headline inflation was only 1.5% in Q3, partly due to falling fuel prices and well contained domestic cost pressure as wage growth still was abating. Although core inflation is somewhat higher it was still in the lower part of the target range at 2.%. The depreciation of the AUD probably contributes to some upward pressure from import prices but it is unlikely to be enough to push inflation higher near-term given the recent drop in energy prices. Although the RBA has been on hold since May 215 expectations still reflect at least one additional rate cut in 216, which isn t unlikely if the situation in China would deteriorate further having a negative impact on demand for Australian exports. -1 FLOWS The current account deficit has increased dramatically in recent quarters exceeding 4% of GDP in Q2 and Q3 last year. Still the deficit is partly compensated for by net portfolio inflows related to equity securities and direct investments. However, in Q3 broad basic balance, which is the current account balance and net portfolio flows, amounted to -2% of GDP bond related outflows indicating substantial outflows. Fundamentals Mon. policy Positioning Technicals Ec. Surprise Risk appetite AUD Weighted score:.2 Carry Flows Valuation Liquidity Event risk U SD/C AD EUR/U SD