2 January 27 27 Top FX Trades and Themes Global FX Strategy Royal Bank of Canada Europe Limited Monica Fan Global Head of FX Strategy +44 27 29 776 monica.fan@rbccm.com Adam Cole +44 27 29 778 adam.cole@rbccm.com Tania Kotsos +44 27 29 777 tania.kotsos@rbccm.com Royal Bank of Canada, Sydney Branch Sue Trinh +61 2 933 3333 sue.trinh@rbccm.com RBC Dominion Securities Inc. Matthew Strauss +1 416 842 6631 matthew.strauss@rbccm.com George Davis Chief Technical Analyst +1 416 842 6633 george.davis@rbccm.com 27 Macro-Trading Themes Page 2 Global growth will slow further in the first half of 27 but remains de-synchronised as above-trend growth in Eurozone and Asia contrasts with sub-trend growth in the US and Canada. Global interest rates in G1 will converge as rates in North America fall and rates in Scandis, Japan and Switzerland catch up, which will drive FX volatility lower. Low FX risk aversion and volatility, and decade-high yield appetite are constructive for carry trades. Pro-cyclical/equity currencies should outperform defensive/bond currencies in the second half of 27 once the Fed starts cutting rates. Although falling metal prices will hit commodity currencies, this will be partly offset by the continued recovery in gold prices. Top FX Trade Recommendations for 27 Page 5 Buy Scandi Basket (SEK & NOK) & Sell EUR Buy GBP/CHF Buy Basket Equity FX (JPY, BRL, ZAR) & Sell Basket Bond FX (EUR, CZK & CHF) Buy Antipodean Basket (AUD & NZD) & Sell NAFTA Basket (CAD & MXN) in Q1 Sell USD/ZAR in H1 Sell USD/HUF in H1 Buy BRL/MXN in H1 Sell EUR/JPY in H2 Buy JPY/KRW in H2 RBC s 26 Model Performances Page 8 Macro-discretionary Fundamental FX Portfolio: Solid Profit of 9.1% Economic Surprise Indices Model: Down 1.8% G4 Trading Signal Model: Robust Profit of 5.9% Canadian Dollar Hedging Model: Profit of.8% Emerging Market Automated Trading Model: Profit of 1.% FX Forecasts 27 28 Page 1 RBC s Forecast Currency Returns (against the USD) in 27 1. 8. 6. Min Max End y ear 4. The next Currency Report Card will be published on 1 February 27. 2.. -2. -4. -6. -8. Forecast FX returns vs USD, 27, % including carry SEK ZAR BRL NOK JPY HUF SGD KRW EUR PLN MXN CHF GBP CZK CAD AUD NZD, * Maximum and minimum returns are relative to spot and include indicative carry. For pertinent disclosures, please see last page. See RBC s research at www.rbccm.com.
2 January 27 Global FX Strategy: 27 Top FX Trades and Themes FX Valuations, Risk and Yield Appetite Barometers Relative to our fair-valuations, all the major currencies are currently overvalued against the USD except for the ZAR and JPY. Against the EUR; GBP, SEK, CZK and PLN remain modestly overvalued and only NOK is now undervalued. The 2% depreciation in EUR/HUF through December made HUF move from under to overvalued. As the half-life for currencies to revert back towards fair-value is 6-12 months, we use these valuations only as a guide to long-term pressures. Risk and yield appetite are constructive for FX carry trades (see Figures 1 & 2). Our Risk Appetite Thermometer - a barometer of general market risk appetite in equities, FX, credit and emerging debt markets - is currently neutral, but would be in risk seeking mode if it were not for the recent rise in equity volatility. The more important gauge of systemic risk in the FX markets, the ECB s Global Hazard Index, continues to trend lower and remains bullish for carry trades such as AUD/CHF. Our Yield Appetite Thermometer, which tracks the monthly correlation of the average performance of G1 currencies against the USD and EUR, with their respective interest rate carry over the US and eurozone, is at a decade high. The YAT is similarly constructive for high yielding currencies. 1. Risk appetite is neutral 1 5-5 -1 Risk Av ersion Thermometer Adv anced 1 w eek LHS AUD/CHF inverted RHS Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 2. Yield appetite is near decade high.8.6.4.2. -.2 -.4 -.6 Yield Appetite Thermometer, LHS MSCI w orld equities, inv. (6M % ch, adv. 6M), RHS 95 96 97 98 99 1 2 3 4 5 6 7.85.875.9.925.95.975 1. -4-3 -2-1 1 2 3 4 3. FX Forecasts Spot 3M f Forwards 6M f Forwards Majors EUR/USD 1.3189 1.36 1.33 1.37 1.34 USD/JPY 119.7 116 117.49 114 116.15 EUR/GBP.674.675.6764.687.6789 EUR/CHF 1.689 1.61 1.6 1.62 1.59 Scandis EUR/SEK 9.262 8.7 9. 8.5 8.99 EUR/NOK 8.2364 7.8 8.19 7.7 8.2 Dollar Bloc USD/CAD 1.1654 1.18 1.13 1.21 1.15 AUD/USD.7883.79.79.77.79 NZD/USD.736.69.7.67.69 EMEA USD/ZAR 6.9879 6.9 7. 6.8 7.7 EUR/HUF 251.43 253. 253.8 252. 259.14 EUR/PLN 3.8368 3.78 3.83 3.76 3.84 EUR/CZK 27.522 27.9 27.42 27.85 27.32 Asia USD/CNY 7.81 7.75 7.69 7.7 7.6 USD/HKD 7.78 7.75 7.75 7.75 7.73 USD/SGD 1.53 1.52 1.52 1.51 1.52 USD/KRW 93. 91. 926.9 9. 921.75 Latin America USD/MXN 1.81 11.15 1.84 11.3 1.89 USD/BRL 2.14 2.17 2.16 2.2 2.19 USD/CLP 533.38 535. 531.36 54. 531.66, * Spot as at 29 December 26 4. Spot versus Fair Valuations Spot* Fair Value Valuation Majors EUR/USD 1.3189 1.22 Over-valued USD/JPY 119.7 96. Over-valued EUR/GBP.674.7 Under-valued EUR/CHF 1.689 1.47 Over-valued Scandis EUR/SEK 9.262 9.37 Under-valued EUR/NOK 8.2364 7.73 Over-valued Dollar Bloc USD/CAD 1.1654 1.18 Under-valued AUD/USD.7883.72 Over-valued NZD/USD.736.63 Over-valued EMEA USD/ZAR 6.9879 6.79 Over-valued EUR/HUF 251.43 255.2 Under-valued EUR/PLN 3.8368 4.449 Under-valued EUR/CZK 27.522 28.35 Under-valued, *Spot as at 29 December 26 2
Global FX Strategy: 27 Top FX Trades and Themes 2 January 27 Macro FX Trading Themes Five macro-trends will dominate the FX market in 27. First, the de-synchronisation of global growth; second, the convergence of global interest rates; third, the persistence of low FX volatility will be constructive for carry trades; fourth, pro-cyclical currencies are likely to outperform defensive currencies in the latter half of 27; and finally, cooling metal prices will hit commodity currencies. 1. Global Growth Divergence Global growth will slow but remain de-synchronised in 27 and the divergences in growth between North America, the eurozone and Asia will be stark in the first half of 27. Our economists forecast US and Canadian GDP growth will remain below trend of 3% throughout 27, while Eurozone GDP growth will stay above trend of 2% in the first half of 27 before slipping below trend in the second half of the year (Figure 5). By contrast, growth in the Scandis, Japan and Australia are likely to defy the US slowdown and accelerate over the next six months. RBC s Economic Surprise Indices (Figure 6) highlight the persistent disappointment with US economic activity last quarter and the dissipation of upside surprises in the Eurozone. By contrast, disappointment over the strength of the Japanese recovery is abating. FX Trading Implications: Bearish USD and CAD; and bullish Western European currencies in H1-7. 5. GDP Forecasts %Y/Y Q3-6 Q4-6f Q1-7f Q2-7f Q3-7f Q4-7f 26 27 US 2.2 2.3 2.5 2.7 2.8 2.7 3.4 2.6 Eurozone 2.5 2.5 2.5 2.3 1.9 1.4 2.5 2. UK 2.7 2.7 2.5 1.9 1.7 1.8 2.6 1.9 Canada 1.7 2.7 2.8 2.8 2.7 2.8 2.7 2.7 Australia 2.2 2.3 2.5 2.7 3.1 3.2 2.5 2.9 New Zealand 1.8* 2. 2.2 2.1 2.3 2.1 2. 2.1, *Forecast 6. Economic Surprises highlight growth divergences* 8 6 4 2-2 -4-6 -8 US ESI EU ESI JP ESI Jan 5 Jul 5 Jan 6 Jul 6 2. Global Interest Rate Convergence As a result of the de-synchronisation in business cycles, global interest rates are likely to converge sharply this year. Rate cuts in the more mature business cycles, i.e. US and Canada, are unlikely to get underway until Q3. In the interim, rates in New Zealand are likely to rise further to a peak of 7.5% in Q1 and Australian rates could potentially rise again to 6.5% this quarter. The normalisation of what are still very low rates in the lagging business cycles of Sweden, Norway, Switzerland and Japan, is likely to accelerate in 27. We expect the Scandi central banks will start tightening bi-monthly rather than quarterly. The risks are that Scandi, Swiss and Japanese rates will peak above levels implied in the forward curve (see Figure 7). The steady erosion of the USD s yield advantage through the course of 27 against all currencies, and especially the Scandis and Yen, should contribute to these currencies appreciation over the next 12 months, particularly in late 27 when the Fed starts to cut rates. The growing risk of rate hikes in UK and Australia in Q1 as well as forecast tightening in New Zealand and the Eurozone (not fully discounted in interest rate futures) should be very bullish for these currencies over the next three months. FX Trading Implications: Bullish for high yielding FX. 7. Official Interest Rates End of period Q4-6 Q1-7f Q2-7f Q3-7f Q4-7f US 5.25 5.25 5. 4.75 4.75 Eurozone 3.5 3.75 4. 4. 4. Japan.25.5.75 1. 1.5 UK 5. 5.25 5.25 5.25 5. Switzerland 2. 2.25 2.5 2.25 2.75 Sweden 3. 3.25 3.75 4. 4.25 Norway 3.5 4. 4.25 4.5 4.75 Canada 4.25 4.25 4.25 4. 4. Australia 6.25 6.25 6.25 6.25 6.25 New Zealand 7.25 7.5 7.5 7.5 7.5 South Africa 9. 9.5 9.5 9.5 9. Hungary 8. 8.25 8.25 8.25 8.25 Poland 4. 4. 4.25 4.25 4.5 Czech Republic 2.5 2.5 2.75 2.75 2.75 China* 6.12 6.66 6.93 6.93 6.93 Hong Kong** 3.97 3.9 3.9 4.1 4.2 Singapore** 3.38 3.2 3.2 3.4 3.4 Korea 4.5 4.5 4.5 4.25 4. Mexico 7. 7. 7. 6.75 6.5 Brazil 13.25 12.75 12.25 12. 12. Chile 5.25 5.25 5.25 5. 5. * 1 Year lending rate ** 2 Year IRS, * ESIs are diffusion indices of economic activity relative to Bloomberg consensus forecasts. ESIs range from +1 (net balance of all positive surprises) to 1 (net balance of all negative surprises). 3
2 January 27 Global FX Strategy: 27 Top FX Trades and Themes 3. FX Volatility will Stay Low Equity and bond volatility are countercyclical, i.e., they rise as global growth slows, but FX volatility is not. The close correlation between FX, bond and equity volatility over the past four years has broken down. A key driver of G3 FX volatility is the divergence, rather than the average level, of rates in the G1 (reflected in the standard deviation of rates within these markets). Since 1998, average G3 FX volatility has fallen from 13. to 7. as the standard deviation between G1 rates has fallen from 2.7 to 2.1. Our forecast changes in interest rates in 27 imply a further fall in the standard deviation of G1 rates from 2.1 to 1.6 along with further declines in the volatility of the major currencies. FX Trading Implications: Persistently low FX volatility is constructive for carry trades. 8. FX volatility should stay low as G1 rates converge 14 13 12 11 1 9 8 7 6 G3 Av erage 3M implied v olatility % LHS Std dev iation of G1 policy rates % RHS 95 96 97 98 99 1 2 3 4 5 6 7 4. Equities to Outperform Bonds Our chief Equity Strategist forecasts the S&P will rise by 5% over the next 12 months. In the event of a global strategic switch out of bonds into equities, we expect pro-cyclical currencies that are positively correlated to global equities and negatively correlated to global bonds, will outperform defensive currencies that are positively correlated to bonds and negatively correlated to equities. The cross correlation of 2 currencies (on a trade weighted basis) with the MSCI All Countries Equities Index and the JP Morgan Global Bond Index since 2 is shown in Figure 9. The vertical axis shows the currency s correlation with bonds and the horizontal axis shows their correlation with equities. FX Trading Implications: A global asset reallocation out of bonds into equities, ceteris paribus, is bullish for JPY, GBP, CAD, ZAR and BRL; and bearish for CHF, EUR, NOK, CZK and HUF. 3. 2.5 2. 1.5 9. Currency correlations with bonds and equities Bonds Prices CZKHUF EUR CHF NZD NOK 1. AUD.5 KRW. SEK PLN -1. -.5..5 ZAR 1. -.5 5. Commodities Cool Down SGD US -1. Equities Prices MX GB CAD TRY CLP JPY BRL Our Commodities analysts expect precious and base metal prices to fall sharply in 27, albeit from extremely high levels, with declines in platinum (-25%), nickel (-17%) and copper (-7%). Moreover, the Consensus forecasts suggest the risks to our metal forecasts are biased to the downside. Gold, however, is expected to buck the downtrend in metal prices, due to supply constraints and is expected to rebound by 9% towards US$685/oz. But this would still leave gold prices well below the 26 high of US$73.4/oz. Energy prices should stabilise this year, with oil prices expected to remain in a US$55-65/b range (currently US$61.5/b) and natural gas prices to stay in a US$6.-8./MMBtu (spot: US$6.29/MMBtu). FX Trading Implications: By itself, our bearish outlook for base metals is bearish for commodity currencies, in particular the CAD, AUD and ZAR (prominent platinum and nickel producers) and the CLP (copper producer). The CAD will be hit by the double whammy of flat-declining oil and natural gas prices, which will leave Canada s trade surplus extremely vulnerable to lower export volumes to the US, that had been masked by rising energy prices. Part of the commodity price hit on the CAD, AUD and ZAR, however, should be ameliorated by the continued recovery in gold prices. 1. Commodities End of period Q4-6 Q1-7f Q2-7f Q3-7f Q4-7f 27f Mkt** Platinum, US$/oz 1136 11 1 1 9 1 149 Silver, US$/oz 13.7 11.7 11.85 11.95 12.5 12. 12.4 Copper, US$/lb 2.8 3. 3. 3. 3. 3. 2.61 Nickel, US$lb 15.11 12.5 12.5 12.5 12.5 12.5 9.49 Gold, US$/oz 64 655 67 67 685 67 678 Oil, US$/b 61.5 62.5 62.5 62.5 62.5 62.5 62.4 Natural Gas, 6.29 7.5 6.5 7.5 7.5 7.25 7.81 US$/MMBtu. * Spot as at 8 December 26. ** Bloomberg Consensus for 27 year average. 4
Global FX Strategy: 27 Top FX Trades and Themes 2 January 27 Top Trade Recommendations Trade 1: Sell EUR/SEK and EUR/NOK Basket Rationale: Objective measures of the stance of monetary policy in the G1 such as Taylor Rule estimates of neutral interest rates (see Figure 11, pale blue bars, bottom scale) imply that monetary policy in Norway and Sweden is the most and second most accommodative respectively in the G1. The Norges Bank has signalled it may increase the pace it will raise rates from quarterly to bi-monthly and we expect rates will peak above the market s expectation. The cyclical positions of Norway and Sweden are similar. Core inflation in Sweden has risen to three-year highs and the Riksbank is also likely to step up its pace of tightening beyond market expectations. There is significant diversification benefit in selling a Scandi basket against the EUR, compared to selling EUR/SEK or EUR/NOK individually. The combined volatility of the EUR/Scandi basket is 3.7%, which is lower than the volatility on EUR/NOK of 5.9% and EUR/SEK of 4.2%. 11. Sweden and Norway have the loosest policy stance New Zealand UK Australia Eurozone Japan Sw eden Sw itzerland Canada Norway US 6 4 Cash rate minus Taylor Rule neutral rate, %, bottom scale 1y r-1m market rates (inv erted), bp, top scale 2-2 -4-3. -2. -1.. 1. 2., OECD Trade 2: Buy GBP/CHF in H1 Rationale: GBP is trading almost entirely based on the outlook for UK interest rates. Over the past year, EUR/GBP has an 82% correlation with the Dec-7 Euribor-short Sterling spread and GBP/CHF has a 9% correlation with the short Sterling-Euroswiss spread (see Figure 12). In early 27, a robust UK housing market, rising inflation expectations and upside risks to wages growth in the key months of the UK pay negotiations, all suggest that the MPC will maintain a tightening bias, beyond the 25bp rate hike at the 3338-9 February MPC meeting. We expect GBP to remain well bid on the crosses in the first half of 27 but prefer to express our bullish GBP view through GBP/CHF than through EUR/GBP. Both the ECB and SNB are likely to continue raising rates in early 27, but CHF is more vulnerable to its outright low level of rates and hence the persistent use of CHF as a funding currency in carry trades. Trade 3: Buy Equities & Sell Bond FX Proxies in H2 Rationale: In the second half of 27, solid growth in Asia and a rebound in US growth should offset a slowdown in the Eurozone. Global rates will converge as the FOMC starts to ease monetary policy in Q3 and most other G1 rates remain stable. The combination of falling US rates and strong global growth is a highly positive background for global equity markets. There should be opportunities to position for a shift out of bonds into equities by buying the most cyclical currencies (those positively correlated with equities) and selling the defensives (those correlated with bond returns). We recommend clients watch for opportunities in the second half of 27 to buy a basket of JPY, BRL and ZAR, against a basket of EUR, CZK and CHF (see Figure 13). 12. GBP/CHF rallying with UK inflation expectations 3.3 3.1 UK 228 breakev en inflation, LHS GBP/CHF, RHS 2.9 2.7 2.5 2.3 Jan-3 Jan-4 Jan-5 Jan-6 13. FX equity proxy mirrors S&P 16 15 14 13 12 11 1 9 S&P5, LHS 8 7 FX equity prox y /FX bond prox y, 2=1, RHS Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 2.45 2.4 2.35 2.3 2.25 2.2 2.15 2.1 12 11 1 9 8 7 6 5
2 January 27 Global FX Strategy: 27 Top FX Trades and Themes Trade 4. Buy Antipodeans & Sell NAFTA Proxy in Q1 Rationale: Buy an Antipodean basket comprised equally of AUD and NZD, against a NAFTA proxy comprised equally of CAD and MXN (to minimise the effects of broad based USD moves) in Q1. The US economic slowdown will hit the CAD and MXN harder than the AUD and NZD, since over 8% of Canadian and Mexican exports are destined for the US, compared with less than a quarter of exports from Australia and New Zealand. This trade has positive, and potentially, rising carry as we expect New Zealand rates will rise from 7.25% to 7.5% in Q1, and there is a strong chance that Australian rates will also increase by 25bp to 6.5% (to average 7.%). Relative interest rates have reasserted their influence on this basket trade since mid-26 as Canada s M&A boom waned (Figure 14). By contrast, we anticipate Canadian and Mexican rates will stay at 4.25% and 7% (average of 5.63%) for the next six months. The stabilisation of oil prices between US$55-65/b this year will favour oil importing Australia and New Zealand, and eliminate marginal price gains to Canadian and Mexican oil exporters. 14. Antipodean/NAFTA rates reassert their influence 3 25 NAFTA less Antipodean 3Y y ields bp LHS 2 NAFTA/Antipodean Basket RHS 15 1 5-5 -1 Canadian M&A Boom Jan-3 Jan-4 Jan-5 Jan-6.75.7.65.6.55.5 Trade 5. Sell USD/ZAR in H1 15. Widening SA-US real rates are bearish for USD/ZAR Rationale: Sell USD/ZAR in H1 with a target of 6.7 with the potential for further downside to 6.5. Our bearish USD/ZAR outlook partly reflects our expectation that carry trades will outperform over the next six months; that SA-US interest rate differentials will widen in favour of the ZAR (see Figure 15); that investors have underestimated the potential magnitude of SARB rate hikes in 27 and an ongoing recovery in gold prices. The SARB hiked rates by 5bp to 9% in December and we expect at least another 5bp rate hike in Q1, which is less than 5% discounted by the market. The pro-cyclical ZAR should also benefit from stronger global equities on expectations of Fed rate cuts in H2. South Africa s current account deficit has peaked, albeit still a risk, and the strong rebound in net portfolio inflows should comfortably fund this deficit. Trade 6. Sell USD/HUF in H1 Rationale: Sell USD/HUF in the first half of 27 and buy it back in the second half if carry trades start to be unwound. We forecast USD/HUF will fall to 183.9 over the next six months as the USD extends its broad-based losses and the HUF retains its appeal as a carry trade with the highest rates in CEMA. We expect Hungarian rates will rise from 8% to 8.25% in Q1. Even if the HUF's strength prevents the NBH from tightening policy again, current outright interest rates of 8% should be sufficient to sustain further HUF gains in the first half of 27. But in the second half of 27, a short USD/HUF position will be vulnerable to a rally in global equity markets after the Fed starts to cut rates. Consequently, we look for opportunities to buy USD/HUF in the second half of the year, and target an appreciation back up to 194.7 by year-end. 12 1 8 6 4 2-2 S.A.-U.S. real rate differential % LHS USD/ZAR inverted RHS Gold Effect Jan-2 Dec-2 Nov -3 Oct-4 Sep-5 Aug-6 16. USD/HUF is falling amidst strong yield appetite.8.6.4.2. -.2 -.4 -.6 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Yield Appetite Thermometer LHS USD/HUF inv erted LHS 5. 6. 7. 8. 9. 1. 11. 12. 16 17 18 19 2 21 22 23 6
Global FX Strategy: 27 Top FX Trades and Themes 2 January 27 Trade 7. Buy BRL/MXN in H1-7 Rationale: We expect BRL/MXN will appreciate from 5.6 to 5.14 over the next six months as equities strengthen by 5% this year (see Figure 17). This trade benefits from high positive carry of 55bp. Our bullish BRL/MXN view is supported by the fact that Mexico (8% of exports are destined for the US) is more vulnerable to the US economic slowdown than Brazil (2%). Accordingly, Mexico s current account deficit is forecast to widen from.4% to 1.% of GDP this year as US manufacturing slows, while Brazil s current account is expected to remain in a small surplus of.5% of GDP. We expect FX volatility will remain low in 27 and this should be conducive to persistent demand for high yielding currencies such as the BRL. Even if FX risk aversion increases sharply, Brazil s high outright rates of 13.% and its current account surplus should see BRL/MXN strengthen in the event of a broad based sell-off in emerging market currencies. Trade 8. Sell EUR/JPY in H2-7 17. BRL/MXN and equities grind higher 115 MSCI World (local ccy ) LHS 15 BRL/MXN RHS RBC F 95 85 75 65 55 Jan-1 Mar-2 May -3 Jul-4 Sep-5 Nov -6 5.5 5. 4.5 4. 3.5 3. 2.5 Rationale: EUR/JPY has been forging fresh highs to over 157 as carry trades have remained dominant and the interest rate carry on the EUR over the JPY has increased by 125bp over the past 12 months. But we expect the ECB s tightening cycle will end in Q2. A trade to watch in the second half of 27 is to sell EUR/JPY after EUR/USD has peaked in Q2 above its alltime high of 1.3666 and eurozone refi rates have peaked at 4% and Euribor interest rate futures start to discount the ECB s easing cycle in 28. By then, Japanese interest rates will still be in the process of being normalised at a pace of at least 25bp per quarter. Further, the outperformance of global equities over global bonds in late 27, should see the pro-cyclical JPY correct lower to 11 against the USD, as both Japanese and non-japanese investors reduce their underweight positions in Japanese equities. These factors together with a moderation in EUR/USD to 1.33 by the end of 27, should see EUR/JPY fall from 157 towards 146. 18. EUR/JPY will correct lower after ECB tightening ends 155 15 EUR/JPY LHS Bunds-JBG 1Y Yield RHS 3. 145 2.5 14 135 2. 13 125 1.5 Jan-4 Jul-4 Jan-5 Jul-5 Jan-6 Jul-6 Jan-7 Jul-7 Trade 9. Buy JPY/KRW in H2 Rationale: Further depreciation in JPY/KRW appears limited as the cross breached 7.8. There are growing risks of jawboning by the BoK. The BoK has ended its tightening cycle after a cumulative 125 bps of rate hikes in this cycle. Core CPI of 2.3%y/y in November remains below the BoK s 2.5%-3.5% target range, so in order to contain strong house price inflation, the BoK has raised the required reserve ratio on demand deposits for commercial banks from 5% to 7%. By contrast, the BoJ is only at the start of its interest rate normalisation process. The correlation between the Japanese and Korean leading economic indicators and the JPY/KRW broke down in 25 as Japanese-Korean rates spreads widened in favour of the KRW. But now that Korean rates have peaked and Japanese rates will be normalised, we expect the JPY/KRW cross to play catch up towards 8.3 in H2. 19. JPY/KRW reaching the BoK comfort level of 8. 14 13 12 11 1 9 8 JPY/KRW, LHS JN-KRW Leading Economic Index, %Y/Y, Adv anced 3M RHS Jan-98 Jan- Jan-2 Jan-4 Jan-6 8 6 4 2-2 -4-6 -8 7
2 January 27 Global FX Strategy: 27 Top FX Trades and Themes 26 FX Trading Performance Our macro discretionary Fundamental FX Portfolio was up a solid 9.1% in 26, despite difficult trading conditions in the second half of this year. Moreover, five of the eight 26 Top FX Trades (we recommended in December 25) were profitable. The performances of our systematic trading models were more variable in these range-bound markets. In 26,, our G4 FX Trading Signal is up an impressive 6.4%, while our Emerging Markets Automated Trader is up 2.4% and our CAD Monthly Hedging Model is up.8%. Our Economic Surprise Indices (ESI) trading model is down 1.1%, as currency movements were dominated by relative interest rates, rather than growth surprises. Review of Top FX Trade Recommendations for 26 In 25, we recommended eight macro FX trades for 26 (see Figure 2). Of these, five trades would have been profitable if they had been held through 26. Our most profitable recommendation was to buy GBP against a basket of ZAR and CAD (+18.7%, including carry) and buying BRL/MXN (+18.4%). Our least profitable recommendation was to sell CHF/JPY (-8.9%). We lost the premium on a 6M USD/CAD double-no-touch just one month before the option expired as the downside barrier at 1.15 was broken. 2. Indicative Returns: 26 Top FX Trades Trade Return 1. Buy a 6M USD/CAD DNT, barriers at 1.15 and 1.185 Cost Premium 2. Buy USD/CAD if it gaps temporarily to 1.12.2% 3. Buy AUD/NZD 4.9% 4. Sell CHF/JPY -8.9% 5. Buy GBP against a Basket of ZAR and CAD 18.7% 6. Buy HUF against a Basket of CZK and PLN -.8% 7. Buy SEK against a Basket of EUR and NOK 4.8% 8. Buy BRL/MXN 18.4% Fundamental FX Portfolio Our macro-discretionary Fundamental FX Portfolio made a healthy 9.1% profit in 26 (see Figure 21). We had 24 trades, most (15) of which were initiated in the first half of the year and we lightened our positions in the second half (9 trades) as currencies became more range bound. Our win rate in 26 was 5% and Sharpe ratio was.7. The average gain was 1.5% per profitable trade compared to an average.7% loss per unprofitable trade. Our most profitable trade was selling NOK/SEK in January (+4.6%) and our largest loss was selling USD/ZAR in July (-1.3%). 21. Returns: 26 Fundamental FX Portfolio Returns Hit Rate Sharpe Ratio 24 15.4%.36 1.2 25-15.%.3-1.3 26 9.1%.5.7 Systematic Trading Models 1 1. Economic Surprise Indices (ESI) Our ESI trading model generates weekly buy, sell or neutral signals for EUR/USD, GBP/USD, USD/JPY, USD/CAD and AUD/USD. The ESI was down 1.8% in 26 (assuming no leverage nor interest on uninvested capital) as currency movements were dominated by relative interest rates, rather than surprises in economic activity data (see Figure 22). Nevertheless, the win rate was 49%. The ESI performed the best for trading USD/CAD (+3.1%) and least well for EUR/USD (-5.4%). The ESI generated 238 trading signals, of which 137 were long/short positions, and the remaining 11 signals were neutral. 22. Returns: Economic Surprise Indices Model Returns Hit Rate Sharpe Ratio 24 1.9%.55.4 25-3.6%.48 -.8 26-1.8%.49 -.3 2. G4 FX Trading Model Our G4 FX trading model generates weekly buy, sell or neutral signals for GBP/USD, EUR/USD and USD/CAD based on a series of financial market variables. The G4 FX Trading Model generated a robust 5.9% in 26 (see Figure 23). The win rate was even more impressive at 6% and the Sharpe ratio was 1.8. The G4 FX trading model generated 15 long/short positions and 11 neutral positions. The G4 FX Trading Signal worked most effectively for GBP/USD. In particular, trading GBP/USD against the UK and US short rate box spread generated 9.3% in 26, with a win rate of 55.1%. 23. Returns: G4 FX Trading Signals Model Returns Hit Rate Sharpe Ratio 24 2.7%.6 1.3 25 1.9%.52 1.2 26 5.9%.6 2.1 1 Details of the Fundamental FX Portfolio and our systematic FX trading models are in our FX Strategy ToolKit. 8
Global FX Strategy: 27 Top FX Trades and Themes 2 January 27 3. CAD Hedging Model Our CAD Hedging model capitalises on the tendency for Canadian equity managers to hedge their USD/CAD exposure at the end of each month depending on the magnitude of the monthly change in the S&P. By its nature, the model trades infrequently and any long/short USD/CAD positions are held for only one day preceding the last trading day of the month. In 26, the model generated four signals, all of which were short USD/CAD, and of these signals three positions were profitable and yielded a cumulative return of.8% (see Figure 24). 24. Returns: CAD Monthly Hedging Model Returns Hit Rate 24 -.1%.5 25 1.3% 1. 26.8%.75 4. Emerging Market Automated Trader (EMAT) Our EMAT is a technical trading model. The EMAT was up 1.% in 26 based on an equally weighted USD/ZAR and EUR/PLN portfolio (including carry but no leverage nor interest on un-invested capital). The win rate was 51% and high volatility depressed the Sharpe ratio to.2 (see Figure 25). There were 67 trades in 26, of which 43 were in USD/ZAR and 24 in EUR/PLN. The USD/ZAR trades generated 9.1% with a win rate of 54% and a Sharpe ratio of 1.. The EUR/PLN trades lost 7.1% with a win rate of 48%. 25. Returns: Emerging Market Automated Trader Returns Hit Rate Sharpe Ratio 24 32.%.66 1.9 25 14.%.62 1. 26 2.4%.52.3 9
2 January 27 Global FX Strategy: 27 Top FX Trades and Themes Forecasts FX Forecasts 26 27 28 Q4 Q1f Q2f Q3f Q4f Q1p Q2p Q3p Q4p EUR/USD 1.319 1.36 1.37 1.35 1.33 1.32 1.31 1.3 1.29 USD/JPY 119.1 116. 114. 112. 11. 111. 111. 112. 112. GBP/USD 1.957 2.15 1.994 1.942 1.9 1.886 1.879 1.871 1.861 USD/CHF 1.22 1.184 1.182 1.178 1.188 1.197 1.26 1.28 1.217 USD/SEK 6.844 6.397 6.24 6.222 6.316 6.364 6.412 6.538 6.589 USD/NOK 6.245 5.735 5.62 5.63 5.865 5.99 5.954 6.77 6.124 USD/CAD 1.165 1.18 1.21 1.2 1.19 1.2 1.18 1.16 1.15 AUD/USD.788.79.77.75.74.74.73.72.72 NZD/USD.74.69.67.65.63.62.6.58.56 USD/ZAR 6.988 6.9 6.8 6.7 6.85 6.9 6.75 6.5 6.45 USD/HUF 19.7 186. 183.9 189.6 194.7 197. 2. 22.3 24.7 USD/PLN 2.99 2.779 2.745 2.815 2.895 2.955 2.992 3.31 3.62 USD/CZK 2.87 2.51 2.33 2.74 21.24 21.44 21.62 21.81 21.99 USD/CNY 7.85 7.75 7.7 7.65 7.5 7.5 7.4 7.3 7.3 USD/HKD 7.779 7.75 7.75 7.7 7.7 7.7 7.65 7.65 7.6 USD/SGD 1.534 1.52 1.51 1.5 1.5 1.49 1.49 1.48 1.48 USD/KRW 93. 91. 9. 9. 91. 915. 915. 92. 92. USD/MXN 1.81 11.15 11.3 11.27 11.25 11.3 11.4 11.5 11.55 USD/BRL 2.136 2.17 2.2 2.21 2.22 2.25 2.28 2.32 2.35 USD/CLP 533.4 535. 54. 55. 55. 556. 56. 564. 568. EUR Crosses 26 27 28 Q4 Q1f Q2f Q3f Q4f Q1p Q2p Q3p Q4p EUR/USD 1.319 1.36 1.37 1.35 1.33 1.32 1.31 1.3 1.29 EUR/JPY 157. 157.8 156.2 151.2 146.3 146.5 145.4 145.6 144.5 EUR/GBP.674.675.687.695.7.7.697.695.693 EUR/CHF 1.69 1.61 1.62 1.59 1.58 1.58 1.58 1.57 1.57 EUR/SEK 9.26 8.7 8.5 8.4 8.4 8.4 8.4 8.5 8.5 EUR/NOK 8.236 7.8 7.7 7.6 7.8 7.8 7.8 7.9 7.9 EUR/CAD 1.537 1.65 1.658 1.62 1.583 1.584 1.546 1.58 1.484 EUR/AUD 1.673 1.722 1.779 1.8 1.797 1.784 1.795 1.86 1.792 EUR/NZD 1.875 1.971 2.45 2.77 2.111 2.129 2.183 2.241 2.34 EUR/ZAR 9.216 9.384 9.316 9.45 9.111 9.18 8.843 8.45 8.321 EUR/HUF 251.4 253. 252. 256. 259. 26. 262. 263. 264. EUR/PLN 4.972 3.78 3.76 3.8 3.85 3.9 3.92 3.94 3.95 EUR/CZK 27.52 27.9 27.85 28. 28.25 28.3 28.32 28.35 28.37 EUR/CNY 1.294 1.54 1.549 1.328 9.975 9.9 9.694 9.49 9.417 EUR/HKD 1.26 1.54 1.618 1.395 1.241 1.164 1.22 9.945 9.84 EUR/SGD 2.24 2.67 2.69 2.25 1.995 1.967 1.952 1.924 1.99 EUR/KRW 1227 1238 1233 1215 121 128 1199 1196 1187 EUR/MXN 14.26 15.16 15.48 15.21 14.96 14.92 14.93 14.95 14.9 EUR/BRL 2.817 2.951 3.14 2.984 2.953 2.97 2.987 3.16 3.32 EUR/CLP 73.5 727.6 739.8 742.5 731.5 733.9 733.6 733.2 732.7 1
Global FX Strategy: 27 Top FX Trades and Themes 2 January 27 JPY Crosses 26 27 28 Q4 Q1f Q2f Q3f Q4f Q1p Q2p Q3p Q4p USD/JPY 119.1 116. 114. 112. 11. 111. 111. 112. 112. EUR/JPY 157. 157.8 156.2 151.2 146.3 146.5 145.4 145.6 144.5 GBP/JPY 233. 233.7 227.3 217.6 29. 29.3 28.6 29.5 28.5 CHF/JPY 97.61 97.99 96.41 95.9 92.59 92.73 92.3 92.74 92.3 SEK/JPY 17.4 18.13 18.37 18. 17.42 17.44 17.31 17.13 17. NOK/JPY 19.7 2.23 2.28 19.89 18.76 18.78 18.64 18.43 18.29 CAD/JPY 12.2 98.3 94.2 93.3 92.4 92.5 94.1 96.6 97.4 AUD/JPY 93.86 91.64 87.78 84. 81.4 82.14 81.3 8.64 8.64 NZD/JPY 83.78 8.4 76.38 72.8 69.3 68.82 66.6 64.96 62.72 ZAR/JPY 17.4 16.81 16.76 16.72 16.6 16.9 16.44 17.23 17.36 HUF/JPY.625.624.62.591.565.564.555.554.547 PLN/JPY 4.94 41.74 41.54 39.79 38. 37.57 37.9 36.95 36.58 CZK/JPY 5.76 5.654 5.68 5.4 5.179 5.177 5.135 5.136 5.93 CNY/JPY 15.26 14.97 14.81 14.64 14.67 14.8 15. 15.34 15.34 HKD/JPY 15.31 14.97 14.71 14.55 14.29 14.42 14.51 14.64 14.74 SGD/JPY 77.6 76.32 75.5 74.67 73.33 74.5 74.5 75.68 75.68 JPY/KRW 7.811 7.845 7.895 8.36 8.273 8.243 8.243 8.214 8.214 MXN/JPY 11.2 1.4 1.9 9.94 9.78 9.82 9.74 9.74 9.7 BRL/JPY 55.75 53.46 51.82 5.68 49.55 49.33 48.68 48.28 47.66 JPY/CLP 4.48 4.612 4.737 4.911 5. 5.9 5.45 5.36 5.71 CAD Crosses 26 27 28 Q4 Q1f Q2f Q3f Q4f Q1p Q2p Q3p Q4p USD/CAD 1.165 1.18 1.21 1.2 1.19 1.2 1.18 1.16 1.15 CAD/JPY 12.2 98.3 94.2 93.3 92.4 92.5 94.1 96.6 97.4 EUR/CAD 1.537 1.65 1.658 1.62 1.583 1.584 1.546 1.58 1.484 GBP/CAD 2.281 2.377 2.413 2.331 2.261 2.263 2.218 2.17 2.141 CAD/CHF 1.47 1.3.977.981.998.997 1.22 1.41 1.58 CAD/SEK 5.872 5.421 5.128 5.185 5.37 5.33 5.434 5.637 5.73 CAD/NOK 5.359 4.86 4.645 4.691 4.928 4.924 5.46 5.239 5.325 AUD/CAD.919.932.932.9.881.888.861.835.828 NZD/CAD.82.814.811.78.75.744.78.673.644 CAD/ZAR 5.996 5.847 5.62 5.583 5.756 5.75 5.72 5.63 5.69 CAD/HUF 163.6 157.7 152. 158. 163.6 164.1 169.5 174.4 178. CAD/PLN 2.496 2.355 2.268 2.346 2.433 2.462 2.536 2.613 2.663 CAD/CZK 17.91 17.39 16.8 17.28 17.85 17.87 18.32 18.8 19.12 CAD/CNY 6.697 6.568 6.364 6.375 6.33 6.25 6.271 6.293 6.348 CAD/HKD 9.66 9.145 9.378 9.24 9.163 9.24 9.27 8.874 8.74 CAD/SGD 1.317 1.288 1.248 1.25 1.261 1.242 1.263 1.276 1.287 CAD/KRW 798. 771.2 743.8 75. 764.7 762.5 775.4 793.1 8. CAD/MXN 9.275 9.449 9.339 9.392 9.454 9.417 9.661 9.914 1.43 CAD/BRL 1.833 1.839 1.818 1.842 1.866 1.875 1.932 2. 2.43 CAD/CLP 457.7 453.4 446.3 458.3 462.2 463.3 474.6 486.2 493.9 11
Global FX Strategy Monica Fan Global Head of FX Strategy Royal Bank of Canada Europe Limited +44 27 29 776 Matthew Strauss RBC Dominion Securities Inc. +1 416 842 6631 Adam Cole Royal Bank of Canada Europe Limited +44 27 29 778 Tania Kotsos Royal Bank of Canada Europe Limited +44 27 29 777 Sue Trinh Royal Bank of Canada, Sydney Branch +61 2 933 3333 George Davis Chief Technical Analyst RBC Dominion Securities Inc. +1 416 842 6633 All of the views expressed in this report accurately reflect the personal views of the responsible analyst(s) about any and all of the subject securities or issuers. No part of the compensation of the responsible analyst(s) named herein is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the responsible analyst(s) in this report. 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