cme group currency market monitor q4 2012
DESCRIPTION
The South Korean won and Chilean peso led gains among global currencies in carry trade performance during the fourth quarter, posting returns in excess of 4% against the U.S. dollar, CME Group analysts said in a report. Other strong performers included the Russian ruble, which returned 3.8% against the dollar, and the Colombian peso, up 3%, during the quarter, according to the latest Currency Market MonitorTRANSCRIPT
CURRENCIES
Currency Market Monitor 4th Quarter 2012
JANUARY 11, 2013
John W. Labuszewski Sandra Ro Bluford Putnam
Managing Director Executive Director Chief Economist
Research & Product Development
312-466-7469
Research & Product Development
011 (44) 203-379-3789
Research & Product Development
212-299--2302
1 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © 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. The
total return associated with a currency is driven by
interest income associated with fixed income
instrument investment in the particular currency; as
well as pure price performance.
Many fundamental factors, including national
economic conditions, monetary and policies, current
and capital account flows, to name just a few,
impact the returns associated with the world’s
currencies.
This document represents a review of these factors
as they played out in the most recently completed
calendar quarter. We include consideration of the
so-called “carry trade” as well as a look at the
theory of “purchasing power parity” as it impacts FX
markets.
While we cover activity in a broad spectrum of
currencies, we focus on the currencies underlying
some of the most liquid of CME Group FX futures.
This includes the U.S. dollar (USD), Euro (EUR),
Japanese yen (JPY), British pound (GBP), Swiss
franc (CHF), Canadian dollar (CAD), Australian dollar
(AUD) and Mexican peso (MXN).
In addition, we have special interest in the
currencies of significant emerging market economies
including the Brazilian real (BRL), Russian ruble
(RUB), Indian rupee (INR) and Chinese yuan or
renminbi (CNY) – the so-called “BRIC” nations.
Finally, we highlight several CME Group FX Indexes
including a USD Index, a Carry Trade Index,
Commodity Country Index and BRIC Index.
Market Fundamentals
As a general rule, FX analysts will evaluate the
fundamental value of any particular currency by
reference to a number of national economic factors.
These factors including growth and inflation
prospects; monetary and fiscal policies; and, current
and capital account balances.
To illustrate, we include a brief discussion of the
economic situation prevailing in the United States as
of the conclusion of the most recently completed
calendar quarter. Of course, the U.S. dollar (USD)
may be just one side of any currency pair that may
be traded using CME Group FX futures.
A brief summary of economic conditions in various
nations, organized along similar lines, is included in
Appendix 1 of our document below. One may
compare and contrast these conditions as they exist
in the two countries whose currency pairing you may
be interested in to draw an appreciation of the
fundamental factors that impact currency markets.
Growth and Employment
Market action during the 4th quarter 2012 was
colored by the state of the U.S. economy. The
Federal Reserve did a good job in articulating the
major economic issues during the quarter, so we
frame the following analysis accordingly.
In September 2012, the Fed announced its
intentions to “increase policy accommodation by
purchasing additional agency mortgage-backed
securities at a pace of $40 billion per month … [it]
also will continue through the end of year its
program to extend the average maturity of its
holdings of securities … These actions, which
together will increase the Committee’s holdings of
longer-term securities by about $85 billion each
month … should put downward pressure on longer-
term interest rates … [and] … support mortgage
markets.” 1
These policies seem to have exerted some positive
impact as the Fed observed in December 2012 that
“economic activity and employment have continued
to expand at a moderate pace in recent months,
apart from weather-related disruptions. Although
the unemployment rate has declined somewhat
since the summer, it remains elevated. Household
spending has continued to advance, and the housing
1 Federal Reserve Press Release dated September 13,
2012.
2 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
sector has shown further signs of improvement, but
growth in business fixed investment has slowed.
Inflation has been running somewhat below the
Committee’s longer-run objective, apart from
temporary variations that largely reflect fluctuations
in energy prices. Longer-term inflation expectations
have remained stable.” 2
Reviewing the Fed’s findings, we see that 3rd quarter
2012 GDP was last reported in December at an
encouraging +3.1% and up from the 2nd quarter’s
anemic figure of +1.3%. The unemployment rate is
generally trending down but up-ticked to 7.8% in
December from November’s read of 7.7%.
While the unemployment rate generally appears to
be headed in the right direction, this optimism is
2 Federal Reserve Press Release dated December 12,
2012.
tarnished by the Bureau of Labor Statistic’s Labor
Force Participation Rate figure. This statistic
continues to slip and is most recently reported at
63.6% in December, down two notches from 63.8%
in October.
Real personal consumption expenditures (PCE) have
advanced remarkably since the height of the
subprime crisis. In fact, the November 2012 PCE
report of $9,686.6 billion represents a new high
water mark for this statistic. But these expenditures
have come at the expense of generally declining
personal savings, reported at 3.6% in October 2012.
It is not entirely clear the extent to which the Fed’s
policy with respect to mortgage financing is
responsible, but the housing market has indeed
shown clear signs of improvement. This is
evidenced by an upturn in housing activity with
building permits, housing starts and housing
completions noticeably improving.
Building permits were reported at 899 thousand
units in November and up 75% from the May 2009
trough of 513 thousand units. Similarly, housing
starts and completions were reported at 861
thousand and 677 thousand units, respectively, and
up 80% and 33% from their lows recorded over the
past several years.
This impetus has further been felt in housing values
where the S&P/Case-Shiller Housing Indexes have
posted some nice gains over the past few months.
While the October 2012 read on the Composite
Index of 10 urban cities remains 29.8% below its
all-time peak observed in June 2006, it has
4%
5%
6%
7%
8%
9%
10%
11%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
Q1 0
5
Q3 0
5
Q1 0
6
Q3 0
6
Q1 0
7
Q3 0
7
Q1 0
8
Q3 0
8
Q1 0
9
Q3 0
9
Q1 1
0
Q3 1
0
Q1 1
1
Q3 1
1
Q1 1
2
Q3 1
2
Unem
plo
ym
ent
Rate
Qtr
ly C
hange in G
DP
Growth and Employment
Seasonally Adj Real GDP Unemployment Rate
Source: Bureau of Economic Analysis (BEA) & Bureau of Labor Statistics (BLS)
1%
2%
3%
4%
5%
6%
7%
8%
9%
$8,900
$9,000
$9,100
$9,200
$9,300
$9,400
$9,500
$9,600
$9,700
$9,800
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
Pers
onal Savin
gs R
ate
PC
E (
Bil $
)
Personal Consumption & Savings
Personal Consumption ExpendituresPersonal Savings Rate
Source: St. Louis Federal Reserve FRED Database
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
000 U
nits
Housing Activity
Building Permits Housing Starts Completions
Source: Dept. of Housing & Urban Development (HUD)
3 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
rebounded 7.0% from its low water mark recorded
in April 2012.
While news on the consumer front has been upbeat,
it is not clear that the business sector has kept pace
with the consumer sector as the Fed observed. The
Index of Industrial Production improved to 97.5090
in November from 96.4932 in October. Still, the
Index remains well below pre-crisis levels in excess
of 100.
Similarly, capacity utilization has rebounded but
remains below the pre-crisis peaks above 80.0%.
The figure was most recently reported at 78.4% in
November and up from November’s 77.7%.
Corporate profitability improved 18.6% from the 2nd
to 3rd quarters 2012 to check in at $1,752.2 billion.
Inflation
These business conditions seem to be contributing to
the controlled inflation the Fed describes in its
December report. November CPI fell to 1.8% on an
annualized basis, down from 2.2% in the previous
month. Much of this was driven by declining energy
prices. Still, CPI ex-food & energy fell to 1.9% from
2.0% on an annualized basis in November from
October.
Monetary Policy
While the Fed observes some improvement in
economic conditions, it nonetheless “remains
concerned that, without sufficient policy
accommodation, economic growth might not be
strong enough to generated sustained improvement
in labor market conditions. Furthermore, strains in
80
120
160
200
240
280
320
Jan-0
0
Nov-0
0
Sep-0
1
Jul-
02
May-0
3
Mar-
04
Jan-0
5
Nov-0
5
Sep-0
6
Jul-
07
May-0
8
Mar-
09
Jan-1
0
Nov-1
0
Sep-1
1
Jul-
12
S&P/Case-Shiller Housing Indexes
Los Angeles San Diego San Francisco
Denver Washington DC Miami
Chicago Boston Las Vegas
New York Comp-10
Source: Standard & Poor's
66%
68%
70%
72%
74%
76%
78%
80%
82%
80
85
90
95
100
105
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
Capacity U
tilization
Industr
ial Pro
duction I
ndex
Industrial Activity
Index of Industrial Production Capacity Utilization
Source: St. Louis Federal Reserve FRED Database
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
120%
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
Pre
-Tax P
rofits
(Billions)
Annualized C
hange
U.S. Corporate Profitability
Annual Change Corporate Profits (Bil)
Source: Department of Commerce
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
Jan-0
4
Aug-0
4
Mar-
05
Oct-
05
May-0
6
Dec-0
6
Jul-
07
Feb-0
8
Sep-0
8
Apr-
09
Nov-0
9
Jun-1
0
Jan-1
1
Aug-1
1
Mar-
12
Oct-
12
Year-
on-Y
ear
Change
Consumer Price Index (CPI-U SA)
CPI - All Urban Consumers SA CPI ex-Food & Energy SA
Source: Bureau of Labor Statistics (BLS)
4 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
global financial markets continue to pose significant
downside risks to the economic outlook.” 3
Thus, the Fed intends to continue its mortgage
purchasing programs. The Fed further hones its
focus on labor markets, suggesting that if they do
not “improve substantially, the Committee will
continue its purchases of Treasury and agency
mortgage-backed securities, and employ its other
policy tools as appropriate, until such improvement
is achieved in a context of price stability.” 4
The Fed further intends to maintain target Fed Funds
at 0-25 basis points “at least as long as the
unemployment rate remains above 6-1/2 percent.” 5
This linkage of monetary policy with a stated target
for unemployment is quite significant.
Fiscal Policy
The 2013 “fiscal cliff” provided further economic
apprehension in December 2012 as executive and
legislative branches of government struggled to
reach an accord on taxes and spending cuts. By
early January, an agreement had passed both House
and Senate consideration.
This bill includes higher taxes on individuals
reporting $400,000+ and married couples with
$450,000+ in income and increases the dividend tax
from 15% to 20% on those taxpayers.
3 Ibid.
4 Ibid. 5 Ibid.
Consideration of budget issues is, however,
postponed until March.
The fiscal cliff weighed on consumer sentiment as
evidenced by the dramatic decline in the Thomson
Reuters/University of Michigan Index of Consumer
Sentiment. The figure plummeted from 82.7 to 74.5
between November and December 2012. This
decline came despite the fact that household net
worth has been climbing nicely over the past several
quarters. Fading consumer confidence is further
reflected in preliminary reports of disappointing
holiday retail sales. Flying in the face of these
reports, however, is generally strong automobile
sales.
The Federal spending deficit appears to have
stabilized after increasing into the neighborhood of
$1.2-$1.4 trillion beginning in 2009. The 2012
deficit may be expected to fall within the same
general range. Future deficits will be a function of
both economic and political considerations.
The federal government is, of course, aware of the
magnitude of the fiscal situation and has attempted
to curb spending within the context of the so-called
“fiscal cliff” tax and spending negotiations. While
progress has been made to forestall the expiration of
the Bush administration tax cuts as of this writing,
the spending debate has been postponed until March
2013, as discussed above. Further drama may be
anticipated in the form of a renewed debate on the
debt ceiling in coming months as well.
50
55
60
65
70
75
80
85
90
95
100
$40
$45
$50
$55
$60
$65
$70
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
Consum
er
Confidence I
ndex
Household
Net
Wort
h (
Tri
llio
ns) Net Worth & Consumer Confidence
Household Net Worth Consumer Confidence Index
Source: U.S. Federal Reserve & FRED Database
-$1,600
-$1,400
-$1,200
-$1,000
-$800
-$600
-$400
-$200
$0
$200
$400
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Federal Surplus/Deficit(Billions USD)
5 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
Current & Capital Accounts
In addition to the troublesome fiscal deficit, the U.S.
faces a significant trade deficit as reflected in the
current account balance. While the trade deficit
diminished in the immediate wake of the subprime
crisis, it is growing once again although it has not
yet breached pre-crisis levels. Still, the deficit
strains upwards to 4.0% of GDP in 2011 and the
highest amongst all G10 nations.
Some improvements in these figures seem to be
developing as the trade deficit decreased to $107.5
billion in the 3rd quarter from $133.6 billion in the
first quarter. The decrease in the current account
deficit may be attributed to a declining deficit on
goods and an increase in the surplus on income.
In addition to monitoring current account activity,
we may likewise study capital account flows. The
U.S. Treasury Department’s Treasury International
Capital (or “TIC”) database represents a ready
source of information. This database tracks flows
into and out of the U.S. The data is broken into
foreign stocks, foreign bonds, U.S. stocks, U.S.
corporate bonds, U.S. government agencies and
U.S. Treasuries.
Foreign investors acquired some $432.6 billion in
U.S. Treasuries, on a net basis during the first 10
months of 2012. Clearly USD-denominated
investments, specifically in the form of U.S.
Treasuries continue to be regarded as a “safe
haven” investment despite the unusually low yields
currently prevailing in the marketplace. While the
2012 inflows are unlikely to match the 2009 or 2010
investments of $538.4 and $703.7 billion,
respectively, the number is substantial and
supportive of the Treasury market.
European Sovereign Debt Crisis
In addition to developments specific to the U.S.
economy, the currency markets continue to be
colored by a number of fundamental news events
including the ongoing European sovereign debt
crisis.
German Chancellor Angela Merkel warned in an
address to usher in the new year that “the crisis is
far from over” and that a final resolution of the
issues will require “a lot of patience.” But she
further indicated that “the reforms that we’ve
introduced are beginning to have an impact.”
-$250
-$200
-$150
-$100
-$50
$0
Q1 0
4
Q3 0
4
Q1 0
5
Q3 0
5
Q1 0
6
Q3 0
6
Q1 0
7
Q3 0
7
Q1 0
8
Q3 0
8
Q1 0
9
Q3 0
9
Q1 1
0
Q3 1
0
Q1 1
1
Q3 1
1
Q1 1
2
Q3 1
2
U.S. Current Account Deficit(Billions USD)
Source: Bureau of Economic Analysis (BEA)
-$800
-$300
$200
$700
$1,200
2003
2004
2005
2006
2007
2008
2009
2010
2011
Thru
10/1
2
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
1.20
1.25
1.30
1.35
1.40
1.45
1.50
Jan-1
1
Mar-
11
May-1
1
Jul-
11
Sep-1
1
Nov-1
1
Jan-1
2
Mar-
12
May-1
2
Jul-
12
Sep-1
2
Nov-1
2
Euro/US Dollar Exchange Rate
6 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
Germany has, of course, taken on the bulk of the
burden in funding the European Stability Mechanism
as a standing bailout fund. That move, along with
the European Central Bank’s plan to purchase
soveriegn debt securities – a European quantitative
easing program if you will – has gone far to stabilize
the region and bolster the value of the Euro during
the latter half of 2012.
This is in evidence when one considers that the
Greek stock market turned in the top performance of
all Eurozone nations in 2012. The ATHEX index of
Greek equities closed out the year +33%,
surpassing the +29% performance of the German
belwether DAX Index in 2012. Still, the ATHEX
remains well above its peak of few years ago.
Price Performance
These factors 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. 6
The CME USD Index generally declined during the 4th
quarter 2012 as European sovereign debt fears were
quelled. Further, concerns about decelerating
6 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.
growth in the so-called emerging markets such as
China seems to be abating in recent months. Thus,
investors have become increasingly willing to move
funds out of USD-denominated investments.
Thus, our USD Index remains is hovering just below
1,000 or its (arbitrarily established) value as of
December 31, 2010 and near the bottom of the
range established from 2007 through the conclusion
of the 1st quarter 2011. This long-term USD
weakness may largely be attributed to the weight of
the dual U.S. fiscal and trade deficits as discussed
above.
Total Return
One of the most popular long-term FX trading
strategies over the past decade is known simply as
the “carry trade.” This practice simply suggests
that one might exploit “cost of carry” by borrowing
in countries with low nominal interest rates to invest
in countries with high nominal interest rates. Thus,
one might sell the “low-rate” currency and buy the
“high-rate” currency.
Carry trade � Sell low-rate currency &
buy high-rate currency
By so doing, one hopes to capitalize on discrepant
interest rates, and by implication, divergent
investment opportunities, in the two countries. This
strategy further recognizes that total currency return
consists of 2 components, specifically, exchange rate
or price movement plus the accrual of interest.
Total Currency
Return =
Price Movement +
Interest
The implicit assumption is that these interest rate
relationships will endure. As such, carry traders
implicitly discount classical exchange rate theories
by assuming that the interest rate relationships may
endure over extended periods of time. This
suggests that low-yielding currencies that are sold
will not advance; and, that high-yielding currencies
that are purchased will not decline.
Historically, such relationships have been known to
endure for extended periods of time, reinforcing
interest in the carry trade. In particular, vast sums
of money totaling in the trillions of U.S. dollars were
invested in the carry trade, specifically by shorting
900
950
1,000
1,050
1,100
1,150
1,200
1,250
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
CME USD Index
Long Short16.7% EUR 100% USD16.7% JPY16.7% GBP 16.7% CHF 16.7% CAD16.7% CNY
7 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
the Japanese yen (JPY) and investing in other
currencies including the Icelandic krona (ISK).
Appendix 2 below depicts the total return associated
with various currencies, relative to the U.S. dollar,
during the most recently completed calendar
quarter. Note the South Korean won (KRW) led the
pack with a quarterly return of +4.99%. The KRW
was followed by the Chilean peso (CLP) at +4.40%;
the Russian ruble (RUB) at +3.84%; and, the
Colombian peso (COP) at +3.04%.
The Japanese yen was a major loser during the 4th
quarter 2012 as its value reversed sharply
downward vs. the USD and other major currencies
with a total return of –10.11%. Other currencies
turning in a weak performance during the quarter
included the Indian rupee (-1.77%), the Icelandic
krona (-1.61%) and the South African rand (-
1.21%).
Because the carry trade has become such an
important and widely followed transaction in the
global FX markets, CME Group has developed the
CME FX Carry Index. This novel index is designed to
follow the performance of a basket of currencies that
offer relatively high interest rates and have, at least
on an historical basis, generated favorable total
returns. 7
7 The CME FX Carry Index represents a basket of equally
weighted positions (as of December 31, 2010) which is effectively long a basket including the Australian dollar (AUD), Brazilian real (BRL), Mexican peso (MXN), New Zealand dollar (NZD), South African rand (ZAR) and
Purchasing Power Parity
The theory of purchasing power parity (PPP) dates to
the 16th century and the School of Salamanca but
was further developed in the early 20th century by
economist Gustav Cassel. 8 The theory is based
upon the assumption that exchange rates are in
equilibrium when purchasing power is equivalent in
the two countries.
On a granular level, PPP is based on the “law of one
price” or the notion that identical products should be
priced at the same level in different national markets
adjusted for exchange rates. Typically, this law is
qualified by the absence of significant trade barriers
or other artificial constraints on commerce.
But the theory of PPP expands the application of the
law of one price from any single good or product to
generalized prices in any particular economy as
measured by inflation indexes, e.g., Consumer Price
Index (CPI) or Producer Price Index (PPI). The
implication of this theory is that inflation rates and
exchange rates should exhibit negative correlation.
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 the high local interest rates that prevailed in those countries during the post-financial crisis era through 2010. The short components of the index were identified because of the low interest rates offered.
8 See Cassel, Gustav, “Abnormal Deviations in International Exchanges” (December 1918).
-12%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
USD-JPYUSD-INRUSD-ISKUSD-ZARUSD-CAD
USDUSD-BRLNZD-USDGBP-USDUSD-MXNAUD-USDUSD-TWDUSD-CNYUSD-ARSUSD-TRYEUR-USDUSD-CHFUSD-COPUSD-RUBUSD-CLP
USD-KRW
Carry Return (Q4 2012)
700
750
800
850
900
950
1,000
1,050
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
CME FX Carry Index
Long Short16.7% BRL 50% USD16.7% AUD 50% EUR16.7% ZAR 16.7% NZD16.7% TRY16.7% MXN
8 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
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 generally
decline to maintain price equilibrium. Similarly, if
inflation declines, the value of the currency should
advance.
The theory of PPP is closely related to another
classic theory that addresses exchange rate values
known as the International Fisher Effect (IFE). This
theory suggests that the disparity between nominal
interest rates in two countries drive the future path
of exchange rates.
Per this theory, one might expect that the value of a
currency with a low nominal interest rate might
increase into the future. Or that the value of a
currency with high nominal rate might decline.
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
negatively correlated. Similarly, PPP suggests
inflation and exchange rates negatively correlated.
As such, the IFE theory is generally consistent with
the PPP theory.
Putting the classic theory of purchasing power parity
into practice requires a measurement of inflation in
order to calculate the proportion by which any
particular currency is (theoretically) over- or under-
valued relative to the norm. There are three popular
methodologies that have been referenced 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.
Actually, 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.
Note that the most over-valued currency, per our
methodology, remains the Norwegian krone (NOK)
at +44.25% relative to the USD. Other highly
valued currencies include the Swiss franc (CHF) at
32.68%; the Australian dollar (AUD) at +26.86%;
the Swedish krona (SEK) at +23.29%; and, the
Danish krone at +19.23%. These overvaluations
advanced a bit during the 4th quarter due to relative
weakness of the USD vis-à-vis the Euro and other
emerging market currencies.
Under-valued currencies per our analysis include the
Hong Kong dollar (HKD) at -50.77%; the Polish zloty
(PLN) at -48.43%; the South African rand (ZAR) at
-46.92%; and, the Mexican peso (MXN) at -46.15%.
One might recommend creating “baskets” of several
currencies to buy and sell on the basis of this
analysis in order to diversify risks to a certain
extent. However, it is important to recognize that
currencies might remain in apparent states of over-
or under-valuation for extended periods of time. In
fact, the carry trade as discussed above, takes a
completely opposite approach to the classic PPP
theory by buying high-rate currencies and shorting
low-rate currencies.
9 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
Impact of Commodities
As a general rule, the nations whose currencies have
remained top performers over the past decade may
be identified as those whose national income is tied
heavily to commodity production.
Commodity prices have advanced rather sharply
over the past decade as seen in the rise in the value
of energy, grain, livestock, precious metals and
industrial metals. These price advances have largely
been driven by emerging market demand in nations
including China and India.
CME Group has developed the CME FX Commodity
Country Index to follow the performance of a basket
of currencies from nations that rely heavily upon the
exportation of commodities and other raw materials.
To the extent that commodities have been in great
demand over much of the past decade, these
currencies have, on a historical basis, generated
favorable total returns. 9
The 4th quarter 2012 witnessed declining energy
values. Still, the the CME FX Commodity Country
Index exhibited some gains, attributed perhaps
more so to USD weakness in spite of soft commodity
values.
CME Group has further developed the CME FX BRIC
Index to follow the performance of select “emerging
9 The CME Commodity Country Index is constructed to be
effectively long AUD, BRL, CAD, Norwegian krone (NOK), NZD and ZAR vs. a short position in USD. It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.
market” economies and their national currencies,
namely the Brazilian real (BRL), Russian ruble
(RUB), Indian rupee (INR) and Chinese yuan (CNY),
that have created much of the demand for
commodities in the world today. 10
The CME FX BRIC Index was essentially neutral
during the 4th quarter but gained some late strength
on abating fears of emerging market economic
deceleration. Still, the BRIC Index is tracking near
the bottom of its long-term range.
Conclusion
CME Group 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.
10 The CME BRIC Index is constructed of equal weightings
of long Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese yuan (CNY) vs. a short position in the USD. Like other CME FX indexes discussed above, the BRIC Index was equally weighted and calibrated to equal an arbitrary 1,000.00 as of December 31, 2010.
650
700
750
800
850
900
950
1,000
1,050
1,100
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
CME FX Commodity Country Index
Long Short16.7% AUD 100% USD16.7% BRL 16.7% CAD 16.7% NOK16.7% NZD16.7% ZAR
800
850
900
950
1,000
1,050
1,100
1,150
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
CME FX BRIC Index
Long Short25% BRL 100% USD25% RUB 25% INR 25% CNY
10 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
Appendix 1: Summary of World Economic Conditions
Australia Brazil Canada
Growth,
Inflation
& Fiscal
Policy
With China’s growth likely to stabilize in 2013 and global commodity demand to rise, the Australian economy should do well in the
coming year.
Economic growth slowed in 2011, and remained sluggishness in 2012. Lower rates and fiscal stimulus provided in the past year are likely to see their impact in higher real
GDP growth rates in 2013.
Canada’s ties to the US mean that it may benefit from the relatively good expected
performance of the US economy in 2013, now that the US has avoided the worst of the fiscal
cliff.
Monetary
Policy
Short-term interest rates were lowered in 2012 to cushion economic growth without fear
of inflation pressures accelerating. Further rate declines in 2013 are unlikely unless significant currency strength emerges.
The short-term SELIC rate was brought down in 2012 narrowing the premium over the
prevailing inflation rate. Further rate reductions may occur in 2013 if the central bank decides to lean against the wind of
potential currency appreciation.
While the Bank of Canada welcomed the appreciation of the currency through parity with the US dollar, the resulting dis-inflation impact means Canada may need to consider
cutting short-term rates in 2013 given the US Fed’s commitment to zero rates.
Special
Factors
The Australian dollar was once a favorite for the long-side of the carry trade versus the
Japanese yen. With Japan adopting a “weaken the yen” approach to policy, the
Australian dollar may again receive inflows from this source.
The major factor impacting the Brazilian real in 2013 is likely to revolve around the zero interest rate policies of the US, UK, Europe, and Japan, as currency traders expand their
risk appetites for higher rate currencies.
The Canadian dollar may be on the receiving end increased volatility from the coming
debate in the US on raising the debt ceiling. In addition, energy pipeline politics may swing
in favor of Canada in 2013.
China European Union India
Growth,
Inflation
& Fiscal
Policy
Economic growth in 2012 decelerated faster than many had projected or hoped. With new
leadership and a brighter global outlook for 2013, China’s real GDP growth is likely to
stabilize in the 6% to 7% range.
The fiscal austerity related to the sovereign debt crisis will continue to be a major drag on economies within the EU in 2013, even as the debt situation is downgraded from a crisis to a
long-run problem.
Like China and Brazil, India saw a rapid deceleration of economic growth in 2012. India has taken a number of steps in the
direction of policy reform, especially regarding foreign investment, that should work to help
the economy regain its balance in 2013.
Monetary
Policy
The new leadership in China will be putting in place a new head of the central bank.
Expanded bank lending and a push toward more rapid development of financial
institutions is likely.
The ECB is likely to keep short-term rates very low through the year to support the
banking system and to make sure fears of a euro breakup do not come back to haunt the
markets.
The monetary authorities have less scope to lower short-term rates than other emerging
market countries, because of elevated inflation. Nevertheless, rate cuts are possible in 2013, especially if the currency takes a turn
toward appreciation and inflation declines a bit.
Special
Factors
An end to economic deceleration portends a more balanced supply and demand for the RMB, and this may allow for a faster pace toward normalizing the currency in 2013.
Elections in Italy early in the year and in Germany later in the year will add significant
political volatility to the path of the euro.
India has shown some signs of becoming more friendly toward foreign investment. This is likely to help the rupee to appreciate along with other high-rate currencies in response to the very low rates from the US, UK, Europe,
and Japan.
11 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
Appendix 1: Summary of World Economic Conditions, cont.
Japan Mexico Russia
Growth,
Inflation
& Fiscal
Policy
Japan’s economy will be hit in 2013 from phased-in rises in the national sales tax. To offset this, additional spending is likely from
the newly elected Government.
With brighter prospects for economic growth in the US economy and with the worst of the
fiscal cliff being avoided, Mexico should benefit from increased trade with its partner
to the north.
Elevated crude oil prices are benefitting Russia’s economy, but an aging population and a difficult
environment for foreign investment suggest slower economic growth in the years to come.
Monetary
Policy
The Bank of Japan will get a new leader in the spring and the BoJ is being pushed to adopt expansive quantitative easing to weaken the
yen.
Currency strength in 2012 may have the lagged effect of helping to reduce inflation
pressures in 2013. The central bank may be able to make further modest reductions in
short-term interest rates.
Russia has accumulated a large quantity of foreign reserves giving the authorities some
firepower to counter any ruble weakness, if they so choose, during periods of oil market weakness.
Special
Factors
Japan’s outstanding government debt load tops the world tables in debt per person. Only the long-term zero-rate policy keeps the debt overhang from becoming a serious challenge for markets. A policy-induced weaker yen
may well spell increased volatility in the JGB market.
Mexico’s currency has emerged as one of the favorites for the long-side of the carry trade, funded by zero-rate short-term US dollars.
Russia’s energy supply dominance of Europe may be challenged over the next 5-10 years if the
natural gas fracking and supply revolution spreads to continental Europe.
Switzerland United Kingdom United States
Growth,
Inflation
& Fiscal
Policy
Switzerland is not immune to the ramifications of the long-term debt problems facing the European Union. Economic growth will be
constrained for another year.
The UK’s fiscal austerity has constrained economic growth. As we start to look toward
future elections, even well down the road, fiscal policy may get a little less restrictive.
US economic growth in 2013 faces some increased fiscal austerity. On the positive side,
the economy was improving in the second half of 2012, the rebuilding effort from Super-storm
Sandy will help growth, and the worst of the fiscal cliff has been avoided helping to build long-term
economic confidence.
Monetary
Policy
As the EU debt crisis has morphed into a long-term problem, the Swiss have little flexibility and are likely continue to keep a lid on the
Swiss franc relative to the euro.
The Bank of England, now led by a Canadian, is likely keep rates very low and focus its
efforts on financial supervision.
The Federal Reserve has set a target of 6.5% unemployment rate before starting to
incrementally raise the federal funds rate. The last rounds of QE may run their course in 2013 and not be renewed. Even so, the federal funds rate is likely to hold near zero for the whole year.
Special
Factors
The post-2008 financial crisis has led to increased regulation of financial institutions all
over the world. Increased regulation poses additional challenges for the traditional model
of Swiss secrecy and the overall role of Switzerland in the world’s financial system.
Tensions between the UK and the European Union are only likely to intensify. Any push by the EU to impose financial transaction taxes will only worsen tensions. UK politics may lead to a non-binding referendum on EU
membership around 2015.
While the New Year’s Day tax deal avoided the worst of the fiscal cliff, the battle over raising the debt ceiling and cutting spending is likely to be bitterly fought. US Treasuries and the US dollar are likely to be volatile as market participants
trade the political winds.
12 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
Appendix 2: Select Currency Performance (4th Quarter 2012)
Currency Ticker Spot Quote
(12/31/12) Quote
Convention 3-Mth Rates
(12/31/12)
Current Quarter Year-to-Date
Total
Return1
Spot
Return2
Interest
Return3
Total
Return1
Spot
Return2
Interest
Return3
Argentine Peso USD-ARS 4.9155 USD per 1 ARS 17.75% 2.39% -4.45% 7.16% 14.82% -12.52% 31.26%
Australian Dollar AUD-USD 1.0394 AUD per 1 USD 3.12% 1.02% 0.16% 0.85% 5.93% 1.82% 4.03%
Brazilian Real USD-BRL 2.0516 USD per 1 BRL Na 0.12% -1.23% 1.37% -2.49% -9.00% 7.16%
British Pound GBP-USD 1.6255 GBP per 1 USD 0.48% 0.67% 0.54% 0.12% 5.43% 4.58% 0.81%
Canadian Dollar USD-CAD 0.9921 USD per 1 CAD 1.16% -0.55% -0.85% 0.30% 4.23% 2.94% 1.25%
Chilean Peso USD-CLP 479.20 USD per 1 CLP Na 4.40% -0.94% 1.39% 14.26% 8.42% 5.38%
China Renminbi USD-CNY 6.2322 USD per 1 CNY 4.55% 1.88% 0.87% 1.00% 2.68% 1.03% 1.63%
Colombian Peso USD-COP 1,767.00 USD per 1 COP Na 3.04% 1.90% 1.12% 14.91% 9.71% 4.74%
Euro EUR-USD 1.3193 EUR per 1 USD 0.10% 2.62% 2.59% 0.03% 2.27% 1.79% 0.47%
Icelandic Krona USD-ISK 128.07 USD per 1 ISK 5.90% -1.61% -2.98% 1.42% 0.72% -4.19% 5.13%
Indian Rupee USD-INR 54.9950 USD per 1 INR 8.75% -1.77% -3.88% 2.20% 5.91% -3.51% 9.76%
Japanese Yen USD-JPY 86.75 USD per 100 JPY 0.09% -10.11% -10.13% 0.03% -11.21% -11.34% 0.15%
Mexico Peso USD-MXN 12.8533 USD per 1 MXN 4.85% 1.00% 0.04% 0.96% 12.60% 8.42% 3.85%
New Zealand Dollar NZD-USD 0.8288 NZD per 1 USD 2.80% 0.55% -0.16% 0.71% 9.68% 6.64% 2.85%
Russian Ruble USD-RUB 30.5250 USD per 1 RUB 7.75% 3.84% 2.15% 1.66% 12.51% 5.28% 6.87%
South Africa Rand USD-ZAR 8.4735 USD per 1 ZAR 5.05% -1.21% -1.88% 0.68% 0.13% -4.53% 4.88%
South Korean Won USD-KRW 1,064.40 USD per 1 KRW 2.72% 4.99% 4.41% 0.55% 11.16% 8.27% 2.67%
Swiss Franc USD-CHF 0.9154 USD per 1 CHF -0.29% 2.65% 2.67% -0.01% 2.70% 2.48% 0.22%
Taiwanese Dollar USD-TWD 29.033 USD per 1 TWN 0.87% 1.19% 0.96% 0.22% 5.20% 4.29% 0.87%
Turkish Lira USD-TRY 1.7836 USD per 1 TRY 6.28% 2.45% 0.76% 1.68% 15.78% 6.02% 9.21%
United States Dollar USD 1.0000 USD 0.32% 0.09% 0.00% 0.09% 0.45% 0.00% 0.45%
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
13 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
Appendix 3: Purchasing Power Parity (“PPP”) Analysis (as of 12/31/12)
% Over/Under Valued
Currency Ticker Average OECD Bloomberg
(CPI)
Bloomberg
(PPI) Big Mac
Norwegian Krone NOK 44.25% 39.67% 15.52% 77.57%
Swiss Franc CHF 32.68% 35.70% 23.26% 10.12% 61.62%
Australian Dollar AUD 26.86% 36.91% 33.56% 27.94% 9.02%
Swedish Krona SEK 23.29% 26.70% -3.25% -1.68% 71.37%
New Zealand Dollar NZD 20.82% 21.09% 30.02% 36.37% -4.21%
Danish Krone DKK 19.23% 28.12% 16.37% 17.40% 15.01%
Brazilian Real BRL 12.82% 12.82%
Colombian Peso COP 11.26% 11.26%
Euro EUR 10.58% 6.02% 15.37% 13.36% 7.58%
Icelandic Krona ISK 9.95% 9.95%
Canadian Dollar CAD 7.54% 18.92% 15.99% 5.11% -9.86%
British Pound GBP 6.44% 9.58% 13.46% 2.66% 0.05%
Japanese Yen JPY 0.85% 16.51% 1.61% -0.76% -13.97%
Chilean Peso CLP -1.41% -1.41%
Argentina Peso ARS -11.05% -11.05%
Czech Koruna CZK -16.12% -16.12%
Singapore Dollar SGD -16.56% -16.56%
South Korean Won KRW -25.40% -30.38% -20.42%
Turkish Lira TRY -29.22% -64.42% 5.99%
Phillipines Peso PHP -34.10% -34.10%
Thai Baht THB -38.09% -38.09%
Hungarian Forint HUF -41.47% -67.69% -15.24%
Chinese Renminbi CNY -42.13% -42.13%
Russian Ruble RUB -43.82% -43.82%
Indonesian Rupiah IDR -44.28% -44.28%
Malaysian Ringgit MYR -44.28% -44.28%
Mexican Peso MXN -44.50% -53.77% -35.22%
South African Rand ZAR -46.92% -46.92%
Polish Zloty PLN -48.43% -63.67% -33.19%
Hong Kong Dollar HKD -50.77% -50.77%
Notes
Please note that data regarding all countries is not generally available.
Source: Bloomberg
14 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP
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