Currency Market Monitor - CME Group · 2017-06-27 · Currency Market Monitor 2nd Quarter 2014 JULY...

CURRENCIES

Currency Market Monitor 2nd Quarter 2014

JULY 3, 2014

John W. Labuszewski Sandra Ro Bluford Putnam

Managing Director Executive Director Chief Economist

Fin’l Research & Product Development

312-466-7469

[email protected]

FX Research & Product Development

011 (44) 203-379-3789

[email protected]

Research & Product Development

212-299--2302

[email protected]

http://www.cmegroup.com

2 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP

An ongoing debate has long persisted in the global

currency or FX markets – is FX an “asset class” akin

to stocks and bonds? While practitioners and

academics may debate this point at length, perhaps

the most practical answer is – does it really matter

provided that investors may draw a return from

currency investments?

The performance of the currency or FX markets is

found in the exchange rates and cross-rates

associated with the world’s myriad currencies. Many

fundamental factors, including national economic

conditions, monetary and policies, current and

capital account flows, impact the returns associated

with the world’s currencies.

This document represents a review of these factors

as they played out in the most recently completed

calendar quarter. We include consideration of the

so-called “carry trade” as well as a look at the

theory of “purchasing power parity” as it impacts FX

markets.

While we cover activity in a broad spectrum of

currencies, we focus on the currencies underlying

some of the most liquid of CME Group FX futures.

This includes the U.S. dollar (USD), Euro (EUR),

Japanese yen (JPY), British pound (GBP), Swiss

franc (CHF), Canadian dollar (CAD), Australian dollar

(AUD) and Mexican peso (MXN). We also have

special interest in the currencies of significant

emerging market economies including the Brazilian

real (BRL), Russian ruble (RUB), Indian rupee (INR)

and Chinese yuan or renminbi (CNY).

Growth and Employment

Q2-14 saw a rebounding economy relative to a

weather-dampened 1st quarter performance. The

employment situation continues to improve amidst

concerns about a historically low employment

participation rate. Still, previously upbeat U.S.

economic forecasts for 2014 have largely been

downwardly revised. Although international tensions

in the Crimea and elsewhere have abated

somewhat, risks are still present. Equity markets

have pushed quietly to new all-time highs on

reduced volatility with interest rates on hold.

The Fed summarizes the situation in its June 18th

Press Release, suggesting that “growth in economic

activity has rebounded in recent months. Labor

market indicators generally showed further

improvement. The unemployment rate, though

lower, remains elevated. Household spending

appears to be rising moderately and business fixed

investment resumed its advance, while the recovery

in the housing sector remained slow. Fiscal policy is

restraining economic growth, although the extent of

restraint is diminishing. Inflation has been running

below the Committee’s longer-run objective, but

longer-term inflation expectations have remained

stable.” 1

GDP during Q1-14 was reported at a very

disappointing -2.9%, driven by generally inclement

weather conditions and down from Q4’s +2.6% and

Q3’s even more impressive +4.1%. As a result, the

Fed downgraded its 2014 GDP forecast from 2.8-

3.0% to 2.1-2.3% with a longer-run forecast of 2.1-

2.3%.

Meanwhile, the unemployment rate wound its way

down to 6.3% by May-14 and below the Fed’s

previously targeted level of 6.5%. While past Fed

statements had suggested that this target may be a

significant milestone towards reconsidering its 0-25

basis point target range for the Fed Funds rate, it

had subsequently revised this guidance to focus on a

2% target inflation rate.

In particular, the steady decline in unemployment is

negatively colored by the employment force

participation rate at a scant 62.8% - the lowest rate

seen since March 1978. Still, the labor market

1 Federal Reserve Press Release dated June 18, 2014.

4%

5%

6%

7%

8%

9%

10%

11%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

Q1 0

5

Q4 0

5

Q3 0

6

Q2 0

7

Q1 0

8

Q4 0

8

Q3 0

9

Q2 1

0

Q1 1

1

Q4 1

1

Q3 1

2

Q2 1

3

Q1 1

4

Unem

plo

ym

ent

Rate

Qtr

ly C

hange in G

DP

Growth and Employment

Real GDP (SA) Unemployment Rate

Source: Bureau of Economic Analysis (BEA) & Bureau of Labor Statistics (BLS)


situation is encouraging to the extent that the non-

farm payrolls (NFPs) have now risen above the Jan-

08 peak of 138.36 million recorded at the onset of

the subprime mortgage crisis. It has taken a full 76

months for NFPs to recover to 138.46 million as

seen in May 2014 – the longest recovery in the last

40 years but we can now say that labor force

numbers are at new highs.

The Fed’s recent statement spoke of moderate

advances in household spending and business fixed

investment along with a slow recovery in the

housing sector.

This is supported by the May-14 retail sales figure of

$184.597 billion, up 1.65% from May-13. Similarly,

light vehicle sales were reported for May-14 at

16.700 million units and up 8.27% from May-13.

The Index of Industrial Production was reported at

103.6585 in May-14, an improvement of 4.7% on a

year-on-year (YOY) basis. Capacity utilization

continued to advance to 79.1% in May-14 and

moderately higher than the 77.9% seen a year

earlier. Note that 80% is often viewed as a

significant mark, above which point production

bottlenecks and inflationary pressures and are

generally thought to emerge.

Corporate profits were reported at $1,879.7 billion

for the 1st quarter, down 1.30% from Q4-13 but an

advance of 5.32% from the Q1-13. Of course, most

analysts would dismiss the Q1 hiccup as a

consequence of poor weather conditions.

The Fed alluded to slow housing market conditions,

noting that building permits fell to 991 thousand

units in May-14, down 1.9% from 1,010 thousand

units a year earlier in May-13. But housing starts

62%

63%

64%

65%

66%

67%

68%

4%

5%

6%

7%

8%

9%

10%

11%

Jan-0

2

Jan-0

3

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

1

Jan-1

2

Jan-1

3

Jan-1

4

Labor

Forc

e P

art

icip

ation

Unem

plo

ym

ent

Rate

Employment Statistics

Unemployment Rate Labor Force Partcipation

Source: Bureau of Labor Statistics (BLS)

93%

94%

95%

96%

97%

98%

99%

100%

101%

1 5 913

17

21

25

29

33

37

41

45

49

53

57

61

65

69

73

NFPs a

s %

of Peak

Months Since Peak NFP

NFP Recovery from Recession

Apr - Dec-80 Aug-81 - Oct-83

Jul-90 - Jan-93 Mar-01 - Jan-05

9

10

11

12

13

14

15

16

17

$155

$160

$165

$170

$175

$180

$185

$190

Jan-0

7

Aug-0

7

Mar-

08

Oct-

08

May-0

9

Dec-0

9

Jul-

10

Feb-1

1

Sep-1

1

Apr-

12

Nov-1

2

Jun-1

3

Jan-1

4

Vehic

le S

ale

s

Reta

il S

ale

s (

Bil $

)

Consumer Sector Activity

Real Retail Sales SA Light Vehicle Sales

Source: U.S. Census Bureau and Dept.of Commerce

66%

68%

70%

72%

74%

76%

78%

80%

82%

80

85

90

95

100

105

Jan-0

7

Aug-0

7

Mar-

08

Oct-

08

May-0

9

Dec-0

9

Jul-

10

Feb-1

1

Sep-1

1

Apr-

12

Nov-1

2

Jun-1

3

Jan-1

4

Capacity U

tilization

Industr

ial Pro

duction I

ndex

Industrial Sector Activity

Index of Industrial Production Capacity Utilization

Source: St. Louis Federal Reserve FRED Database


were up 9.4% while completions were up 24.8%

over the same YOY period.

Inflation

While the Fed recognizes that inflation is “running

below the Committee’s longer-run objective … [and]

… inflation expectations have remained stable … the

Committee recognizes that inflation persistently

below its 2 percent objective could pose risks to

economic performance and it is monitoring

developments carefully for evidence that inflation

will move back towards its objective over the

medium term.” 2

2 Ibid.

Personal Consumption Expenditures (PCE) were

recorded at +1.77% in May-14 on a year-on-year

basis while Core PCE ex-food & energy checked in at

+1.49%. Both of these figures fall short of the Fed’s

target of 2% although the Fed is projecting PCE and

Core PCE to be clocked at 1.6-2.0% and 1.7%-

2.0%, respectively, by 2016.

Still, with Capacity Utilization straining up towards

the key 80% mark, inflation could perhaps become a

cause for some concern on the part of the Fed

sooner than anticipated.

Monetary Policy

The Fed’s quantitative easing (QE) programs

historically called for the monthly purchase of $85

billion of Treasuries, agency debt and agency

mortgage backed securities (MBS), in an attempt to

keep intermediate- to long-term rates at modest

levels. But the Q4-13 saw the Fed begin to taper

the program by $10 billion per month.

In what has become a predictable move, and “[i]n

light of the cumulative progress toward maximum

employment and the improvement in the outlook for

labor market conditions … the Committee decided to

make a further measured reduction in the pace of its

asset purchases. Beginning in July, the Committee

will add to its holdings of agency mortgage-backed

securities at a pace of $15 billion per month rather

than $20 billion per month, and will add to its

holdings of longer-term Treasury securities at a pace

of $20 billion per month rather than $25 billion per

month.” 3

The Committee reiterated its intent to “closely

monitor incoming information on economic and

financial developments in coming months and will

continue its purchases of Treasury and agency

mortgage-backed securities, and employ its other

policy tools as appropriate, until the outlook for the

labor market has improved substantially in the

context of price stability. If incoming information

broadly supports the Committee’s expectation of

ongoing improvement in labor market conditions and

inflation moving back (up) toward its longer-run

3 Ibid.

0

500

1,000

1,500

2,000

2,500

Jan-0

4

Sep-0

4

May-0

5

Jan-0

6

Sep-0

6

May-0

7

Jan-0

8

Sep-0

8

May-0

9

Jan-1

0

Sep-1

0

May-1

1

Jan-1

2

Sep-1

2

May-1

3

Jan-1

4

000 U

nits

Housing Activity

Building Permits Housing Starts Completions

Source: Dept. of Housing & Urban Development (HUD)

-2%

-1%

0%

1%

2%

3%

4%

5%

Jan-0

4

Jan-0

5

Jan-0

6

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

1

Jan-1

2

Jan-1

3

Jan-1

4

Year-

on-Y

ear

Change

Personal Consumption Expenditures

PCE Core PCESource: Bureau of Economic Analysis (BEA)


objective, the Committee will likely reduce the pace

of asset purchases in further measured steps.” 4

But the Fed remains intent on holding target Fed

Funds, historically, its primary monetary policy tool,

steady at current levels. Thus, the Fed “reaffirmed

its view that a highly accommodative stance of

monetary policy remains appropriate. In

determining how long to maintain the current 0 to ¼

percent target range for the federal funds rate, the

Committee will assess progress—both realized and

expected—toward its objectives of maximum

employment and 2 percent. This assessment will

take into account … measures of labor market

conditions, indications of inflation pressures and

inflation expectations, and readings on financial

developments … [and is likely to] … maintain the

current target range for the federal funds rate for a

considerable time after the asset purchase program

ends.” 5 Thus, we remain in a long-term holding

pattern in this regard.

Fiscal Policy

The Fed continues to suggest that “[f]iscal policy is

restraining economic growth although the extent of

restraint is diminishing.” 6

Total expenditures on the part of the Federal

government on a seasonally adjusted and

annualized basis were at $3.887 trillion during the

Q1-14, down from the peak of $4.004 trillion seen

4 Ibid. 5 Ibid. 6 Ibid.

during Q1-11. But Federal total receipts rose to

$3.112 trillion in Q1-14 from $2.516 trillion in Q1-

11. Thus, net borrowing contracted to $775.3 billion

on a seasonally adjusted and annualized basis in Q1-

14 from $1,378.2 billion in Q1-11.

Current & Capital Account Flows

The current account deficit had been improving

nicely before falling back to $111.156 billion in Q1-

14 from $87.317 billion in Q4-13. Still, the figure is

less than the $123.962 billion deficit seen in Q1-12

and much less than the >$200 billion deficits

witnessed in the pre-crisis era in 2005-06.

Another source of flow of funds data is the U.S.

Treasury Department’s Treasury International

Capital (or “TIC”) database. This database tracks

flows into and out of the U.S. The data is broken

0%

1%

2%

3%

4%

5%

6%

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Jan-1

3

Jul-

13

Jan-1

4

Benchmark U.S. Rates

Target Fed Funds 2-Yr Treasury5-Yr Treasury 10-Yr Treasury30-Yr Treasury

-$4,000

-$3,000

-$2,000

-$1,000

$0

$1,000

$2,000

$3,000

$4,000

Q1 0

4

Q4 0

4

Q3 0

5

Q2 0

6

Q1 0

7

Q4 0

7

Q3 0

8

Q2 0

9

Q1 1

0

Q4 1

0

Q3 1

1

Q2 1

2

Q1 1

3

Q4 1

3

Federal Receipts vs. Expenditures(Annualized in Billions)

Fed Total Recepits Fed Total Expenditures

Net Lending/BorrowingSource: Bureau of Economic Analysis (BEA)

-$250

-$200

-$150

-$100

-$50

$0

Q1 0

4

Q4 0

4

Q3 0

5

Q2 0

6

Q1 0

7

Q4 0

7

Q3 0

8

Q2 0

9

Q1 1

0

Q4 1

0

Q3 1

1

Q2 1

2

Q1 1

3

Q4 1

3

Balance on Current Account(Billions USD)

Source: Bureau of Economic Analysis (BEA)


into foreign stocks, foreign bonds, U.S. stocks, U.S.

corporate bonds, U.S. government agencies and

U.S. Treasuries.

U.S. vs. overseas capital flows have generally been

characterized over the past decade by substantial

influx of funds into U.S. Treasuries. This trend

peaked in 2010, as overseas investors net purchases

totaled $704 billion in U.S. Treasuries, but tailed off

to $433, $417 and $43 billion in 2011, 2012 and

2013, respectively.

Foreign investors turned their attentions to the U.S.

equity marketplace in 2013 as a net $522 billion

flowed into stocks on the strength of a sustained bull

market continuing through Q2-14. But despite the

gains realized in equities in the first half of 2014,

foreign investors withdrew some $11 billion from

equities in factor of pushing $104 billion into U.S.

Treasuries. This was likely driven by concerns over

a possible correction given that the S&P 500 and

other key indicators have risen to new all-time

highs.

Mutual Fund Flows

The flow of equity and fixed income investments

may be examined per data published by the

Investment Company Institute (ICI) which tracks

activity in the mutual fund industry. 7

7 These indicators are often highly correlated with price

action as retail investors may “chase” the market by buying in response to a bull trend. Or, they may

Some $159.8 billion was invested into equity funds

during 2013. However, only $17.7 billion of this

total was focused on U.S. equity funds despite the

strong performance. During the first 4 months of

2014 through April, some $58.6 billion flowed into

equity funds of which $17.5 came into domestic

equity funds.

Bond funds experienced net withdrawals in 2013

totaling some $80.5 billion, in anticipation of rising

rates and declining values. But interest rates have

generally not advanced in 2014 and bond prices

have not fallen. Thus, some $28.9 billion has come

back into bond mutual funds in 2014 through the

month of April.

exhibit a “herd mentality” by liquidating investments in response to significant market breaks.

-$800

-$400

$0

$400

$800

$1,200

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Thru

Apr-

14

Net US/Foreign Capital Flows (Billions USD)

US Treasuries US Gov't Agencies US Corporates

US Stocks Foreign Bonds Foreign Stocks

Source: U.S. Treasury TIC Database

-$40

-$30

-$20

-$10

$0

$10

$20

$30

$40

Jan-1

2

Mar-

12

May-1

2

Jul-

12

Sep-1

2

Nov-1

2

Jan-1

3

Mar-

13

May-1

3

Jul-

13

Sep-1

3

Nov-1

3

Jan-1

4

Mar-

14

Equity Fund Cash Flows (Billions USD)

Domestic Equities Foreign EquitiesSource: Investment Company Institute (ICI)

-$80

-$60

-$40

-$20

$0

$20

$40

Jan-1

2

Mar-

12

May-1

2

Jul-

12

Sep-1

2

Nov-1

2

Jan-1

3

Mar-

13

May-1

3

Jul-

13

Sep-1

3

Nov-1

3

Jan-1

4

Mar-

14

Equity & Bond Fund Cash Flows (Billions USD)

Equity Funds Bond Funds

Source: Investment Company Institute (ICI)


Global Economic Performance

Emerging market (EM) economies grew quickly even

in the wake of the subprime crisis. But growth in

the EM countries seems to be decelerating while

many analysts look for relatively modest economic

upticks in the developed (DM) economies.

Actual and Forecast GDP Growth

2011 2012 2013

2014

(f)

2014

-19

(f)

2020

-25

(f)

Developed Markets (DMs)

Australia 2.4% 3.7% 2.4% 2.6% 2.3% 2.2%

Canada 2.5% 1.7% 2.0% 2.1% 2.0% 1.8%

France 2.0% 0.0% 0.2% 0.9% 1.4% 0.9%

Germany 3.3% 0.7% 0.4% 1.7% 1.6% 1.4%

Japan -0.6% 1.9% 1.5% 5.0% 1.0% 0.6%

UK 1.1% 0.1% 1.7% 1.9% 1.9% 1.1%

US 1.8% 2.8% 1.9% 2.3% 2.4% 1.7%

Emerging Markets (EMs)

Brazil 2.7% 0.9% 2.3% 1.8% 2.9% 2.8%

Mexico 3.9% 3.8% 1.1% 3.1% 2.9% 3.1%

Russia 4.3% 3.4% 1.3% 1.7% 1.8% 1.2%

India 6.2% 5.0% 4.6% 5.0% 4.8% 3.6%

China 9.3% 7.7% 7.7% 7.0% 5.9% 3.5%

Source: The Conference Board Global Economic

Outlook 2014 (May 2014)

NOTE: (f) = forecast data

Per the Conference Board’s Global Economic

Outlook, growth in Europe is expected to improve

with German and French GDP rising to 1.6% and

1.4% on an annual basis between the years 2014-

19. Similarly modest yet nonetheless solid growth is

expected in other parts of the developed world

including Japan (+1.0%), the United Kingdom

(+1.9%) and the United States (+2.4%).

GDP growth has slowed in many of the emerging

economies but such growth has nonetheless

generally surpassed that of the DMs. This will

continue to be the case per Conference Board

forecasts, albeit the gaps may narrow.

Trade surpluses that have supported many EM

economies have generally contracted along with

trade deficits in the U.S. and Europe. Despite the

Q1-14 setback, the U.S. current account deficit

shrank to 2.29% of GDP in 2013 from a peak deficit

of 5.76% in 2006. Conversely, Chinese trade

surpluses shrank from a peak of 11.00% of GDP in

2007 to 2.30% in 2013. Arguably, these trade

imbalances have been a fundamental driving engine

behind much emerging market growth over the past

several decades.

-1%

0%

1%

2%

3%

4%

5%

6%

2010

2011

2012

2013

2014

14-1

9

20-2

5

Annual GDP Growth (Mature Economies)

Germany Japan UK US

Source: The Conference Board

0%

2%

4%

6%

8%

10%

12%

2010

2011

2012

2013

2014

14-1

9

20-2

5

Annual GDP Growth(BRIC Economies)

Brazil Russia India China

Source: The Conference Board

-6%

-4%

-2%

0%

2%

4%

6%

2006

2007

2008

2009

2010

2011

2012

2013

Current Acct Balance (% GDP)(Mature Economies)

US Euro Area UK Japan


Price Performance

The factors discussed above exert an obvious impact

upon the price performance of the U.S. dollar vis-à-

vis other world currencies. In order to monitor this

price impact, CME Group has developed the “CME

USD Index” as one in a family of similarly

constructed FX Indexes. 8

The CME USD Index ended Q2-14 at a value of

1,025.85 and down 1.4% from Q1-14 mark of

1,040.10. Over the same period, EUR has turned in

8 The CME USD Index represents a basket of equally

weighted positions (as of December 31, 2010) of the USD vs. the Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar (AUD) and Chinese yuan (CNY). It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.

a spot return of -0.56% vs. USD; British pound

(GPB) is at +2.66%; Japanese yen (JPY) is at

+1.88%. Among EM currencies are Brazilian real

(BRL) at +2.60%; Russian ruble (RUB) at +3.51%;

Indian rupee (INR) at -0.49%; and, Chinese yuan

(CNY) at -0.23%. 9

Total Return

The “carry trade” has been one of the most popular

long-term FX trading strategies over the past

decade. A carry trade is deployed by borrowing in

countries with low nominal interest rates to invest in

countries with high nominal interest rates. Thus,

one sells the “low-rate” currency and buys the

“high-rate” currency.

Carry trade � Sell low-rate currency & buy high-rate currency

By so doing, one hopes to capitalize on discrepant

interest rates, and by implication, divergent

investment opportunities, in the two countries. This

strategy further recognizes that total currency return

consists of 2 components including exchange rate

fluctuation plus interest accrual.

As such, carry traders implicitly discount classical

exchange rate theories by assuming that the interest

rate relationships may endure over extended periods

of time. I.e., low-yielding currencies that are sold

will not advance; or, high-yielding currencies that

are purchased will not decline.

Total Currency

Return =

Price Movement + Interest

As a practical matter, such relationships have been

known to endure for extended periods of time. E.g.,

vast sums were invested in the carry trade prior to

the outbreak of the subprime crisis, often by

shorting the low-yielding Japanese yen (JPY) and

investing in other high-yielding currencies.

Appendix 2 depicts the total return associated with

various currencies relative to USD in Q2-14. Among

the DMs, the EUR generated a total return of -0.50%

9 The “spot return” of a currency, or the outright price

movements, is distinguished from the “total return” which includes price movements plus interest accrual.

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

2006

2007

2008

2009

2010

2011

2012

2013

Current Acct Balance (% GDP)(BRIC Economies)

Brazil Russia India China

900

950

1,000

1,050

1,100

1,150

1,200

1,250

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Jan-1

3

Jul-

13

Jan-1

4

CME USD Index

Long Short14.3% EUR 100% USD14.3% JPY14.3% GBP 14.3% CHF 14.3% CAD14.3% AUD14.3% CNY


for the quarter; GBP at +2.80%; and, JPY at

+1.89%. To the extent that interest rates remain

at near zero levels in these mature economies, the

total returns are not much different than spot

returns as reported above.

But interest accruals may exert a much greater

influence in less mature economies. The BRL posted

a total return of +5.41% for the quarter; RUB was

seen at +5.90%; INR at +1.72%; and, CNY at

+0.87%.

The CME FX Carry Index follows the performance of

a basket of currencies offering relatively high rates

and have historically generated favorable total

returns. 10 The CME FX Carry Index closed Q2-14

at 839.83 and up 1.38% from Q1-14’s 828.38.

Purchasing Power Parity

The purchasing power parity (PPP) theory dates to

the 16th century and the School of Salamanca but

was further developed in the early 20th century by

economist Gustav Cassel. 11 It is based upon the

assumption that exchange rates are in equilibrium

when purchasing power is equivalent amongst

various countries.

On a granular level, PPP is based Adam Smith’s “law

of one price” or the notion that identical products

should be priced at the same level in different

national markets adjusted for exchange rates.

Typically, this law is qualified by the absence of

significant trade barriers or other artificial

constraints on commerce.

But the theory of PPP expands the application of the

law of one price from any single good or product to

generalized prices in any particular economy as

measured by inflation indexes, e.g., Consumer Price

Index (CPI) or Producer Price Index (PPI). The

implication of this theory is that inflation rates and

exchange rates should exhibit negative correlation.

If inflation increases

� Currency value should decline

If inflation decreases

� Currency value should advance

Thus, if inflation as measured by an inflation index

increases, the value of the currency should decline

to maintain price equilibrium. Similarly, if inflation

declines, the value of the currency should advance.

10 The CME FX Carry Index represents a basket of equally

weighted positions (as of December 31, 2010) which is long a basket including the Australian dollar (AUD), Brazilian real (BRL), Mexican peso (MXN), New Zealand dollar (NZD), South African rand (ZAR) and Turkish lira (TRY) vs. short positions in the USD and EUR. It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010. The long components of the CME FX Carry Index were selected in light of high local interest rates during the post-financial crisis era through 2010. The short components of the index were identified because of the low interest rates offered.

11 See Cassel, Gustav, “Abnormal Deviations in International Exchanges” (December 1918).

-1%

0%

1%

2%

3%

4%

5%

6%

7%

EUR-USDUSD-CHF

USDUSD-CLPUSD-ZARUSD-CNYUSD-ISK

USD-MXNUSD-INRUSD-JPY

NZD-USDUSD-TWDAUD-USDGBP-USDUSD-TRYUSD-CADUSD-BRL

USD-KRWUSD-RUBUSD-COPUSD-ARS

Carry Return (Q2 2014)

700

750

800

850

900

950

1,000

1,050

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Jan-1

3

Jul-

13

Jan-1

4

CME FX Carry Index

Long Short16.7% BRL 50% USD16.7% AUD 50% EUR16.7% ZAR 16.7% NZD16.7% TRY16.7% MXN


The theory of PPP is closely related to the

International Fisher Effect (IFE). This theory

suggests that the disparity between nominal interest

rates in two countries drive the future path of

exchange rates. Thus, one expects that the value of

a currency with a low nominal interest rate will

increase into the future. Or that the value of a

currency with high nominal rate will decline.

IFE further assumes that real interest rates (i.e., the

risk-free interest rate less inflation) should generally

be equal across countries. This implies that nominal

interest rates and inflation are positively correlated.

If inflation increases

� Rates

increase �

Currency value should decline

If inflation decreases

� Rates

decrease �

Currency value should advance

The IFE suggests interest rates and exchange are

negatively correlated. Similarly, PPP suggests

inflation and exchange rates are negatively

correlated. As such, the IFE theory is generally

consistent with the PPP theory.

Putting the classic PPP theory into practice requires

a measurement of inflation in order to calculate the

proportion by which any particular currency is

(theoretically) over- or under-valued relative to the

norm. There are three popular methodologies that

have been used in this regard.

• OECD - The Organization for Economic Co-

operation and Development (OECD) provides data

that is useful in this regard by comparing price

changes in a representative basket of goods in

various countries.

• Bloomberg - Bloomberg offers an analytical tool

that is grounded in a very long-term assessment

of inflation, as measured by either CPI or PPI in

various countries extending from January 1982

through June 2000.

• Big Mac - Finally, the Economist’s “Big Mac PPP”

methodology compares the price of a (almost)

universally available product with verifiable pricing

in the form of the McDonald’s Big Mac hamburger

in various countries.

All three methodologies may readily be referenced

on Bloomberg quotation devices. Appendix 3 below

provides data from all three methods. Further, we

have taken the average of the three assessments

(where available) for a variety of national currencies

and rank-ordered the set from most over-valued to

most under-valued.

Norwegian krone (NOK) stands out as the most

over-valued currency per this analysis at +31.63%.

NOK is followed by Swiss franc (CHF) at +31.08%;

New Zealand dollar (NZD) at +23.02%; Danish

krone (DKK) at +19.25%; and, Icelandic krona

(ISK) at +18.23%.

Under-valued currencies include Turkish lira (TRY) at

-59.85%; Polish zloty (PLN) at -53.00%; South

African rand (ZAR) at -59.00%; Polish zloty (PLN) at

-53.00%; and, Malaysian ringgit (MYR) at -52.91%.

One may wish to create baskets of several

currencies to buy and sell on the basis of this

analysis in order to diversify risks. However, it is

important to recognize that currencies might remain

over- or under-valued for extended periods of time.

In fact, the carry trade, as discussed above, takes a

completely opposite approach to the classic PPP

theory by buying high-rate currencies and shorting

low-rate currencies.

Commodity Countries

Top performing currencies are often found in nations

whose national income is tied heavily to commodity

production.

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

$2,000

$20

$40

$60

$80

$100

$120

$140

$160

Jan-0

7

Jan-0

8

Jan-0

9

Jan-1

0

Jan-1

1

Jan-1

2

Jan-1

3

Jan-1

4

Gold

($ p

er

troy o

z)

Cru

de O

il (

$ p

er

Bbl

Crude Oil & Gold

Crude Oil Gold

Source: Bloomberg


Commodity prices have sometimes seen steep

advances during the past decade as seen in the rise

in the value of energy, grain, livestock, precious

metals and industrial metals. Price advances have

frequently been fueled by demand from EM

economies, although some of these trends have

corrected in the past couple of years with EM

deceleration.

The CME FX Commodity Country Index tracks a

basket of currencies from nations that rely heavily

upon the exportation of commodities and other raw

materials. 12 The CME FX Commodity Country

Index closed Q2-14 at 883.60 and up 0.96% from

Q1-14’s 875.19, largely on strength in the energy

sector.

12 The CME Commodity Country Index is constructed to be

effectively long Australian dollar (AUD), Brazilian real (BRL), Canadian dollar (CAD), Norwegian krone (NOK), New Zealand dollar (NZD) and South African rand (ZAR) vs. a short position in the U.S. dollar (USD). It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.

Conclusion

CME offers a broad array of currency futures and

option contracts covering a wide range of currency

pairings (where one side is the U.S. dollar) and

cross-rate pairings (which do not involve the U.S.

dollar). These products provide facile and liquid

vehicles with which one may express a view on

prospective market movements. Or, to manage the

risks associated with currency holdings or

international investments during turbulent times.

For more information please visit our website at

www.cmegroup.com/trading/fx.

$2

$4

$6

$8

$10

$12

$14

$16

$18

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Jan-1

3

Jul-

13

Jan-1

4

$ p

er

Bushel

Grains

Corn Soybeans Wheat

Source: Bloomberg

650

700

750

800

850

900

950

1,000

1,050

1,100

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Jan-1

3

Jul-

13

Jan-1

4

CME FX Commodity Country Index

Long Short16.7% AUD 100% USD16.7% BRL 16.7% CAD 16.7% NOK16.7% NZD16.7% ZAR


Appendix 1: Summary of World Economic Conditions

Australia Brazil Canada

Growth,

Inflation

& Fiscal

Policy

Australia’s economy is now growing at a good pace and the inflation is close to 3%, all this despite the uncertainties related to China and

global commodity markets.

Economic growth has been slow in Brazil. Modestly improved real GDP growth is

expected in the second half of 2014. Inflation may have peaked and may finish 2014 close to

6%.

Canada is benefiting from the continued jobs expansion in the US. A positive decision on

the Keystone pipeline could help the Canadian dollar, but political uncertainties abound.

Monetary

Policy

Monetary policy has been on hold in Australia, but with better growth, a short-term interest rate rise could occur if new data shows more

inflation pressure.

Short-term interest rates above 10% have provided solid support for the currency, which has appreciated nicely in 2014. Rate cuts are

possible in the second half of 2014.

Canada’s short-term interest rates are low. Some inflation pressures appear to be

developing. The Bank of Canada may consider a rate rise, especially if US job growth remains

robust.

Special

Factors

The Australian dollar has gained on most major currencies in 2014 with economic

activity resuming a healthy pace and signs of a possible rate rise in the second half of 2014.

A successful World Cup has the potential to give the markets a boost of confidence in the Brazilian economy and currency ahead of fall

elections.

A rate rise in Canada could add support to the Canadian dollar, if it comes. A negative US decision on the Keystone pipeline, if it goes that way, would hurt the Canadian dollar.

China European Union India

Growth,

Inflation

& Fiscal

Policy

Chinese real GDP may decelerate further to around 6.5% to 7% real GDP growth in 2015. The economy is likely to avoid a hard landing but continues to face significant challenges.

Europe is likely to post only small gains in economic growth in 2014. The banking

system remains under-capitalized and not able to expand lending at a pace to support

stronger growth.

India’s elections in May brought in new leadership and enthusiasm for change. So far,

the currency has reacted positively.

Monetary

Policy

With the RMB weakening in the first half of 2014, China did not accumulate US Treasury securities. In the past, China has bought US Treasuries to prevent RMB volatility during

periods of upward pressure on the currency.

The ECB announced negative deposit rates in an attempt to encourage banks to use that money to lend to private enterprises. Our

view is that negative deposit rates are a tax and will hurt bank profitability and not

encourage new lending.

Short-term interest rates have been cut 0.5% in 2014, and more cuts are possible if the

currency continues to gain ground and inflation pressures diminish, even incrementally.

Special

Factors

China has widened the bands for currency volatility, and the RMB weakened by 2.5%

from end-2013 through 2Q/2014. The weakness may have run its course – for now.

The EU Parliamentary elections in May 2014 gave fringe parties much more voice. Most of

the fringe parties are not supportive of Brussels, and this could encourage a further

split with the UK.

The Indian rupee is on the mend. The elections in May brought the possibility of

meaningful economic reforms.


Appendix 1: Summary of World Economic Conditions, cont.

Japan Mexico Russia

Growth,

Inflation

& Fiscal

Policy

As consumers sought to beat Japan’s hike in its national sales tax, January-March real GDP was exceptionally strong. Some setback is expected when the April-June quarterly data is released.

Mexico is benefiting from improved growth in the United States. Mexico has also increased its imports of relatively inexpensive natural gas

through its pipeline link with Texas.

Russia’s annexation of the Crimea and further political turmoil in the Ukraine have led to costs and

economic sanctions that possibly could cause a recession.

Monetary

Policy

The Bank of Japan may consider expanding its already massive quantitative easing (asset purchase) program if real GDP fails to meet

expectations in the second half of 2014.

The Bank of Mexico has made small cuts in short-term interest rates, in part, to make sure the currency does not appreciate too rapidly to

jeopardize trade prospects.

Russia has had to raise short-term interest rates to protect the currency during the Ukraine turmoil.

Special

Factors

The Japanese yen has remained quite stable since mid-2013, trading between 100 and 103 yen per US dollar. The Bank of Japan can be expected to resist any yen appreciation outside this range, yet

may welcome yen weakness should it develop.

Mexican inflation is well contained. If it were not for the Bank of Mexico short-term rate cuts, the

peso might have been much stronger.

Over the long-term, the big issue for Russia is global oil and natural gas prices. Russia has agreed a deal to ship natural gas to China. The Iraq turmoil has

raised oil prices to Russia’s benefit.

Switzerland United Kingdom United States

Growth,

Inflation

& Fiscal

Policy

Switzerland is seeing some benefits from Europe’s stabilization. Moreover, stronger growth in the

US may also help exports.

The UK’s growth prospects are steadily improving. The London housing market is booming, due to

foreign buyers. The budget deficit as a percent of GDP is also declining.

The US economy suffered through a tough winter in midwest and northeast, but appears to have bounced

back. The Federal budget deficit is likely to be balanced by FY-2016. State and local finances have

improved enough to end the job losses from this sector.

Monetary

Policy

As the EU debt crisis has morphed into a long-term banking capital adequacy problem, the

Swiss have little flexibility, and they are likely continue to keep a lid on the Swiss franc relative

to the euro.

The Bank of England may well revisit plans to keep rates low. It is possible that the UK could be the first major country to raise rates during

the post-crisis economic expansion. The pound is already rising on rate hike anticipation.

The Yellen-led Federal Reserve is on track to end the Bernanke-Fed’s quantitative easing by year-end

2014. The next decision, in 2015, will be when or if to abandon the near-zero federal funds rate target.

Special

Factors

The post-2008 financial crisis has led to increased regulation of financial institutions all over the world. On net, this increased regulation poses

additional challenges for the traditional model of Swiss secrecy and the overall role of Switzerland

in the world’s financial system.

The vote in Scotland on independence in September is a major uncertainty. The outcome

will depend on the tug of war between the pocket book and the heart strings. Economics says

independence would hurt Scotland and the UK. But Scots can achieve at the ballot box what

eluded Robert Bruce and William Wallace.

Some small signs of incremental inflation in the US may emerge in the second half of 2014. Even a whiff of inflation pressure, along with steady progress on

the jobs front, could bring forward the market’s expectations of when the Fed might make a decision

to raise its federal funds rate.


Appendix 2: Select Currency Performance (2nd Quarter 2014)

Currency Ticker Spot Quote

(6/30/14) Quote

Convention 3-Mth Rates

(6/30/14)

2nd Quarter 2014 2014 Year-to-Date

Total

Return1

Spot

Return2

Interest

Return3

Total

Return1

Spot

Return2

Interest

Return3

Argentine Peso USD-ARS 8.1310 USD per 1 ARS 39.19% 6.07% -1.59% 7.79% -1.95% -19.83% 22.30%

Australian Dollar AUD-USD 0.9433 AUD per 1 USD 2.89% 2.53% 1.82% 0.69% 7.23% 5.79% 1.37%

Brazilian Real USD-BRL 2.2132 USD per 1 BRL 5.41% 2.60% 2.74% 12.39% 6.67% 5.36%

British Pound GBP-USD 1.7109 GBP per 1 USD 0.55% 2.80% 2.66% 0.13% 3.58% 3.32% 0.25%

Canadian Dollar USD-CAD 1.0671 USD per 1 CAD 1.15% 3.87% 3.55% 0.30% 0.13% -0.45% 0.59%

Chilean Peso USD-CLP 552.45 USD per 1 CLP 0.38% -0.63% 1.02% -3.03% -4.97% 2.05%

China Renminbi USD-CNY 6.2046 USD per 1 CNY 4.70% 0.87% 0.23% 0.65% -1.48% -2.40% 0.94%

Colombian Peso USD-COP 1,877.50 USD per 1 COP 5.92% 4.99% 0.88% 4.41% 2.77% 1.59%

Euro EUR-USD 1.3692 EUR per 1 USD 0.15% -0.50% -0.56% 0.06% -0.25% -0.37% 0.12%

Icelandic Krona USD-ISK 112.86 USD per 1 ISK 5.85% 1.40% -0.06% 1.47% 5.08% 2.06% 2.96%

Indian Rupee USD-INR 60.0435 USD per 1 INR 8.25% 1.72% -0.49% 2.22% 7.39% 2.68% 4.59%

Japanese Yen USD-JPY 101.33 USD per 100 JPY 0.02% 1.89% 1.88% 0.01% 3.96% 3.93% 0.03%

Mexico Peso USD-MXN 12.9682 USD per 1 MXN 3.31% 1.44% 0.69% 0.74% 2.03% 0.53% 1.49%

New Zealand Dollar NZD-USD 0.8758 NZD per 1 USD 3.72% 1.97% 1.10% 0.86% 8.35% 6.62% 1.62%

Russian Ruble USD-RUB 33.9783 USD per 1 RUB 9.24% 5.90% 3.51% 2.32% 0.76% -3.27% 4.17%

South Africa Rand USD-ZAR 10.6387 USD per 1 ZAR 6.50% 0.54% -0.99% 1.55% 1.16% -1.36% 2.56%

South Korean Won USD-KRW 1,011.95 USD per 1 KRW 5.76% 5.22% 0.50% 4.89% 3.75% 1.10%

Swiss Franc USD-CHF 0.8868 USD per 1 CHF -0.01% -0.25% -0.25% -0.01% 0.67% 0.69% -0.01%

Taiwanese Dollar USD-TWD 29.870 USD per 1 TWN 0.87% 2.22% 2.00% 0.21% 0.15% -0.27% 0.42%

Turkish Lira USD-TRY 2.1185 USD per 1 TRY 8.90% 3.63% 1.05% 2.55% 6.80% 1.40% 5.32%

United States Dollar USD 1.0000 USD 0.27% 0.06% 0.06% 0.11% 0.11%

Notes

(1) Return from price movement and interest (2) Return from currency price movement vs. USD as “base currency”

(3) Return from interest at prevailing 3-month rates or implied NDF rate

Source: Bloomberg


Appendix 3: Purchasing Power Parity (“PPP”) Analysis (as of 6/30/14)

% Over/Under Valued

Currency ISO

Code Average OECD

Bloomberg

(CPI)

Bloomberg

(PPI) Big Mac

Norwegian Krone NOK 31.63% 31.98% 10.10% 52.80%

Swiss Franc CHF 31.08% 35.45% 24.41% 10.51% 53.95%

New Zealand Dollar NZD 23.02% 21.19% 33.23% 39.92% -2.25%

Danish Krone DKK 19.25% 29.06% 19.13% 17.24% 11.56%

Icelandic Krona ISK 18.23% 18.23%

Australian Dollar AUD 16.00% 26.71% 26.56% 21.25% -10.54%

Swedish Krona SEK 12.88% 25.05% -5.95% -2.96% 35.36%

Euro EUR 10.86% 6.02% 18.11% 13.46% 5.86%

Canadian Dollar CAD 7.25% 10.48% 7.33% 7.58% 3.62%

British Pound GBP 5.79% 13.46% 16.73% 0.92% -7.95%

Brazilian Real BRL 3.59% 3.59%

Colombian Peso COP -11.76% -11.76%

Japanese Yen JPY -18.27% -0.60% -18.10% -14.98% -39.39%

Singapore Dollar SGD -20.97% -20.97%

South Korean Won KRW -25.14% -25.78% -24.50%

Chilean Peso CLP -25.61% -25.61%

Czech Koruna CZK -26.22% -26.22%

Thai Baht THB -42.09% -42.09%

Chinese Renminbi CNY -42.69% -42.69%

Hungarian Forint HUF -46.95% -75.58% -18.32%

Phillipines Peso PHP -47.11% -47.11%

Argentina Peso ARS -47.36% -47.36%

Indonesian Rupiah IDR -47.88% -47.88%

Russian Ruble RUB -50.02% -50.02%

Hong Kong Dollar HKD -51.93% -51.93%

Mexican Peso MXN -52.83% -66.67% -38.99%

Malaysian Ringgit MYR -52.91% -52.91%

Polish Zloty PLN -53.00% -67.66% -38.34%

South African Rand ZAR -59.00% -59.00%

Turkish Lira TRY -59.85% -98.51% -21.19%

Notes

Please note that data regarding all countries is not generally available.

Source: Bloomberg


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Currency Market Monitor - CME Group · 2017-06-27 · Currency Market Monitor 2nd Quarter 2014 JULY...

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