currency market monitor - cme group · 2017-06-27 · currency market monitor 2nd quarter 2014 july...
TRANSCRIPT
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
FX Research & Product Development
011 (44) 203-379-3789
Research & Product Development
212-299--2302
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)
3 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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
4 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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)
5 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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)
6 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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)
7 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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
8 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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
9 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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
10 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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
11 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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
12 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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.
13 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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.
14 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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
15 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
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
16 | Currency Market Monitor 2nd Quarter 2014 | July 3, 2014 | © CME GROUP
CME Group is a trademark of CME Group Inc. The Globe logo, CME, CME Direct and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago
Board of Trade are trademarks of the Board of Trade of the City of Chicago INc. NYMEX and ClearPort are trademarks of New York Mercantile Exchange, Inc. All other trademarks are the
property of their respective owners. Standard & Poor’s and S&P 500® are trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use by Chicago Mercantile Exchange
Inc.
Futures and options trading is not suitable for all investors, and involves the risk of loss. Futures are leveraged investments, and because only a percentage of a contract’s value is required
to trade, it is possible to lose more than the amount of money initially deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting
their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All matters pertaining to rules and specifications
herein are made subject to and are superseded by official CME rules. Current rules should be consulted in all cases concerning contract specifications.
The information within this presentation has been compiled by CME Group for general purposes only. Although every attempt has been made to ensure the accuracy of the information within
this presentation, CME Group assumes no responsibility for any errors or omissions. All data is sourced by CME Group unless otherwise stated.
This communication does not constitute a Prospectus, nor is it a recommendation to buy, sell or retain any specific investment or to utilise or refrain from utilising any particular service. This
communication is for the exclusive use of Eligible Counterparties and Professional Clients only and must not be relied upon by Private Clients who should take independent financial advice.
Circulation should be restricted accordingly. Chicago Mercantile Exchange Inc. is a Recognised Overseas Clearing House (ROCH) recognised by the Bank of England. Chicago Mercantile
Exchange Inc., Board of Trade of the City of Chicago and the New York Mercantile Exchange are Recognised Overseas Investment Exchanges (ROIE’s) recognised by the Financial Conduct
Authority .
Issued by CME Marketing Europe Limited. CME Marketing Europe Limited (FRN: 220523) is authorised and regulated by the Financial Conduct Authority in the United Kingdom.
Copyright © 2014 CME Group. All rights reserved.