Renaissance of battered currencies WEDNESDAY · 5 Currency Strategy Big Picture: From Carry and...

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Renaissance of battered currencies WEDNESDAY

14 SEPTEMBER 2016

The combination of non-conventional monetary policy involving central bank bond buying and persistent low/weak global nominal growth has left investors searching even more desperately for a satisfactory yield. Global long bond interest rates have continued to fall with those in many countries nearing the levels of Japan. The FX market has always evaluated carefully the likely central bank policy outlook and relative interest rate differentials. With G10 rate differentials now very limited, currency market drivers are found to be historically uncertain. However, counterintuitively - as rates are low in most places - the FX market now regards carry as a strong theme. Relatedly, while higher yielding EM currencies began 2016 undervalued, their strong performances have boosted both carry and valuation strategies. Currently, there are clearly fewer attractive valuation cases making us less inclined to search out such prospects. Still, growing protectionism and increasing financial market regulation support suggestions that FX markets will remain range-bound with lower implied volatilities, leaving players in carry mode. Certainly, we regard the Swedish krona – which now suffers from record-low interest rates - as a funding currency vulnerable to further depreciation despite its favorable fundamentals and valuation. Within the G5 we believe concerns regarding the economic implications of Brexit were exaggerated, meaning Sterling to perform satisfactorily in coming months. However, we are more skeptical towards further outperformance in 2017 as real negotiations with the EU start up. EUR/USD has range traded for 18 months with no end in sight: most investors would clearly be surprised by a more substantial US slowdown, no Fed hikes and EUR/USD above 1.15. Before year-end we expect the BoJ to have flirted with the introduction of helicopter money, causing the JPY to suffer if we are correct. Finally, we remain bullish towards the NOK: underlying appreciation pressure is strong and the economy has troughed. Only Norges Bank stands in its way; it cannot tolerate EUR/NOK below 9.00.

EDITOR

Carl Hammer + 46 8 506 231 28

BUY THE CS BASKET We propose the following currency

basket: long NOK (35%), GBP (35%), CAD (18%), NZD (12%)

vs short JPY (35%), EUR (24%), CHF (15%). USD (14%), SEK

(10%) and AUD (2%).

BUY USD/JPY We expect the BoJ to cut its policy rate further

and to signal it is considering monetizing state debt relatively

soon. In combination with a Fed hike in dec-16 it will serve to weaken the JPY significantly (110 end-Q1 2017).

SELL EUR/NOK With an oil price forecast to trade around

USD 50/brl, continued NOK purchases by the central bank, an

appreciable yield and an attractive valuation, we expect a

stronger NOK. Only one factor weakens the case: Norges Bank is unlikely to accept EUR/NOK below 9.00

BUY GBP VS EUR AND USD. Sterling has fallen by 12% in

trade-weighted terms so far this year. While Brexit will have

the gravest implications for the UK (rather than its trading

partners), this process will take time. Consequently,

expectations are very dovish and we expect a rebound short-term.

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Currency Strategy

Forecasts and FX Scorecard FX forecasts

13-Sep 1m Q4 16 Q1 17 Q4 16 Q1 17 Forecasts 2

EUR/USD 1.12 1.15 1.12 1.10 1.09 1.09 The big picture 5

EUR/JPY 114 118 119 121 113 114 USD 12

EUR/GBP 0.84 0.85 0.81 0.79 0.85 0.85 EUR 14

EUR/CHF 1.09 1.10 1.09 1.09 1.09 1.09 JPY 16

EUR/SEK 9.53 9.60 9.45 9.30 9.30 9.20 GBP 18

EUR/NOK 9.25 9.20 9.10 9.05 9.20 9.10 CAD 20

EUR/DKK 7.44 7.44 7.44 7.44 7.45 7.46 AUD 22

USD/RUB 64.6 63.0 61.0 60.0 65.0 64.5 NZD 24

Cross rates CHF 26

USD/JPY 102 103 106 110 104 105 SEK 28

GBP/USD 1.33 1.35 1.38 1.40 1.28 1.28 NOK 30

USD/CAD 1.31 1.28 1.26 1.25 1.32 1.32 RUB 32

USD/CHF 0.97 0.96 0.97 0.99 1.00 1.00 CNY 34

AUD/USD 0.75 0.77 0.77 0.75 0.74 0.73 Contacts 36

NZD/USD 0.73 0.75 0.75 0.75 0.70 0.69 Disclaimer 38

USD/SEK 8.49 8.35 8.44 8.45 8.53 8.44

GBP/SEK 11.31 11.27 11.64 11.84 10.92 10.80

JPY/SEK 8.33 8.10 7.96 7.69 8.20 8.04

CHF/SEK 8.73 8.73 8.67 8.53 8.53 8.44

NOK/SEK 1.03 1.04 1.04 1.03 1.01 1.01

USD/NOK 8.24 8.00 8.13 8.23 8.44 8.35

USD/CNY 6.68 6.70 6.80 6.80 6.75 6.79

*Bloomberg survey FX forecasts.

SEB Consensus* Contents

,

SEB FX G10 Scorecard, Medium TermWeights USD EUR JPY GBP CAD AUD NZD CHF SEK NOK

Fundamentals 15.0% -1 -1 0 +1 +1 +1 +2 0 +1 0

Carry 25.0% 0 -1 0 0 0 +1 +1 -2 -2 0

Mon. policy 15.0% 0 -1 -3 0 0 -1 -2 -1 -1 0

Flows 15.0% 0 0 +1 -2 -1 0 -1 +2 0 +1

Valuation 12.5% -1 +1 -1 +3 +1 -2 -3 -1 +2 +3

Positioning 10.0% -1 0 -3 +3 0 -1 0 +1 0 0

Liquidity 0.0% +4 +2 +3 +2 -1 -3 -3 +2 -3 -4

Ec. Surprise 7.5% -1 -2 -2 -2 -1 -2 +3 -1 -1 -2

Event risk 0.0% 0 0 0 0 0 0 0 0 0 0

Risk appetite 0.0% -1 +1 +1 0 -2 -2 -2 +1 +1 -1

Total weighted score -0.4 -0.6 -0.8 +0.3 +0.1 -0.3 -0.1 -0.4 -0.4 +0.4

G10 FX Scorecard - Contributions to total score

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Currency Strategy

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Currency Strategy

SEB FX EM Scorecard, Medium TermWeights RUB CNY

Fundamentals 15.0% -1 -1

Carry 20.0% +4 -2

Monetary policy 7.5% -1 -1

Flows 15.0% 0 -1

Valuation 10.0% +3 -3

Positioning 7.5% 0 -3

Liquidity 0.0% 0 0

Ec. Surprise 5.0% 0 -1

Event risk 5.0% -1 0

Global cycle 15.0% +1 +1

Total weighted score +1.0 -1.2

5

Currency Strategy

Big Picture: From Carry and Trump to Helicopters

Since our latest Currency Strategy report in Jan 2016

several major, interesting and unexpected events have

occurred that have affected global markets generally and

the FX market in particular. The BOJ introduced negative

rates in January, while the JPY has subsequently rallied by

almost 20% in trade-weighted terms clearly indicating

the limits to which current global QE policies are subject.

In February, the G20 meeting in Shanghai concluded

(implicitly) that central banks should abstain from

influencing the FX market through the use of non-

conventional monetary policies. Further, the Federal

Reserve most likely faced pressure from stressed

emerging market economies (EM) at that meeting to

proceed only very carefully with future interest rate hikes.

The oil price bottomed just a few weeks before the G20

meeting, making life somewhat easier for EM commodity

exporters and helping undervalued EM equity markets

and currencies to recover strongly ever since. Decreased

upward pressure on the dollar may also explain why

outflows from China have at least temporarily ceased.

Further, the Riksbank has finally gained FX credibility

causing investors to stop chasing the SEK higher and

leaving the outlook for the currency more uncertain with

the FX market in carry mode.

Most events have one thing in common; that today’s

global economy remains fragile and capital flows face

few boundaries with regulators still operating only at

nation state level. It is therefore perhaps not surprising to

hear calls for greater protectionism from Donald Trump,

the US Republican presidential candidate, from the UK

through its decision to abandon the European Union and

from resurgent extreme nationalist parties throughout

Europe. In this article we revisit several key events and

consider how they may affect our future expectations for

G10/G20 FX market developments.

Currency 2001 2004 2007 2010 2013 2016USD 89.9 88.0 85.6 84.9 87.0 87.6Euro 37.9 37.4 37.0 39.1 33.4 31.3JPY 23.5 20.8 17.2 19.0 23.0 21.6

GBP 13.0 16.5 14.9 12.9 11.8 12.8AUD 4.3 6.0 6.6 7.6 8.6 6.9CAD 4.5 4.2 4.3 5.3 4.6 5.1CHF 6.0 6.0 6.8 6.4 5.2 4.8

CNY³ 0.0 0.1 0.5 0.9 2.2 4.0SEK 2.5 2.2 2.7 2.2 1.7 2.2MXN³ 0.8 1.1 1.3 1.3 2.5 2.2NZD³ 0.6 1.1 1.9 1.6 2.0 2.1SGD 1.1 0.9 1.2 1.4 1.4 1.8HKD³ 2.2 1.8 2.7 2.4 1.4 1.7NOK³ 1.5 1.4 2.1 1.3 1.4 1.7KRW 0.8 1.1 1.2 1.5 1.2 1.6TRY³ 0.0 0.1 0.2 0.7 1.3 1.4INR³ 0.2 0.3 0.7 1.0 1.0 1.1

RUB³ 0.3 0.6 0.7 0.9 1.6 1.1BRL³ 0.5 0.3 0.4 0.7 1.1 1.0

Total (USD bn) 1 239 1 934 3 324 3 971 5 345 5 088CAGR N/A 17,2% 19,6% 5,9% 10,4% -2,2%

Percentage shares of average daily turnover in April 2016

Global FX market turnover (BIS)

SECULAR STAGNATION AND FX

Currently, global macroeconomic policy discussions

focus on the concept of secular stagnation initiated (in

modern times) by Larry Summers. Latest developments

involving persistently weak growth and falling interest

rates “validate” this theory, which stipulates that the

world is saving too much and spending too little. The

Federal Reserve is signaling that potential growth has

fallen in recent years and that the neutral real interest

rate maybe as low as zero percent currently. Therefore,

few central banks including the Fed feel able to raise

interest rates much above their present record lows.

During 2016, bond market developments have seen most

G10 countries move down to Japanese levels. Hence, it is

becoming harder to identify FX market drivers as there

are few if any interest rate differentials left for the G10.

At the beginning of September 2016, the BIS published a

new Triennial FX Report on global FX turnover, which

hardly surprisingly showed a declining global number

compared to 2013 (table above). With global trade still

weak and with various pressures on globalization factors

set to reverse, FX turnover is being adversely affected. In

addition, we might also include tougher financial

regulations, poor hedge fund performances, proprietary

desk closures and the rise of algorithmic trading, all of

which makes for some fairly irrational market

movements. Collectively, these factors lessen risk

appetite amongst investors trading FX. Nor do we expect

the situation to improve anytime soon. But falling

turnover and lower volatilities facilitate the return of

carry strategies, despite events such as Brexit which had

only a very brief impact on overall market sentiment. Tiny

interest rate differentials make this strategy vulnerable in

times of falling risk appetite. We also think it affects the

Swedish krona given record low (negative) yields in

Sweden.

Below we highlight in different sections some of the more

interesting themes we find on the FX market including: 1)

the outlook for Carry as a FX theme; 2) the shift in Global

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FX reserves and the USD flow outlook; 3) stronger USD if

Trump wins the US Presidential election; 4) weaker JPY as

BoJ approaches the use of Helicopter money; 5) the EM

rally has further to run and; 6) the new SEB FX Scorecard.

CARRY PERFORMING AGAIN For a long period the FX G10 carry strategy did not perform

well. However, that situation has changed since October

2015 with a positive post-Brexit run having brought carry

to the attention of investors once more.

Chart: Positive performance once again attracts carry flows

Also, positioning data support the suggestion that

speculative players are adopting carry positions. Our carry

investment style (mimicking carry strategies) is always

long the two G10 currencies with the highest interest rate

and short the two with the lowest. Currently the model is:

Long AUD and NZD / Short CHF and SEK. Considering

other systematic G10 carry strategies reveals a similar

picture with long AUD/short SEK positions. Using the CFTC

Commitment of Traders report on positioning it becomes

clear that the AUD has attracted an inflow over the

summer. While the CFTC does not provide positioning on

SEK, our own proxy for speculative positions clearly shows

speculative accounts adding to short SEK positions during the summer.

As the rate spread towards EM currencies is greater than within the G10, many carry positions have also probably sought longs in EM currencies. This is

confirmed by the fact that EM exchange-traded funds

(ETFs) were the biggest buyers in July while European ETFs

saw the largest outflows.

CARRY DEPENDENT ON BENIGN RISK APPETITECarry is well known to thrive when risk appetite is high

(and stable). Regarding carry performance and our risk

appetite index clearly illustrates this tight relationship. SEK

is hence vulnerable in an environment with rising risk

appetite. This is consistent with the behaviour of the usual

funding currencies JPY and CHF, although the krona is

driven by carry trades rather than “safe-haven” status (like

the JPY or CHF).

SHIFT IN GLOBAL FOREIGN EXCHANGE RESERVE

HOLDINGS. For the past two years, the US dollar

exchange rate and the value of Chinese foreign exchange

reserves have been closely related. Large capital inflows

to China from foreign direct investments (FDI) and trade

that cause the value of Chinese FX reserves to increase

have tended to coincide with a generally weaker dollar,

while a fall in the value of Chinese FX reserves have

usually signalled a stronger outlook for the greenback.

From mid-2014 growth in Chinese FX reserves at first

decelerated and eventually began to decline as the dollar

appreciated against most other currencies.

In both 2015 and 2016, there have been substantial

outflows from Chinese reserves as domestic investors

have targeted alternative investments abroad. Moreover

we suspect that the change in Chinese Yuan policy in Aug

2015, which suddenly threatened possible depreciation

of the Chinese currency against the dollar, has likely

resulted in hedge-related currency flows to protect the

value of foreign investments in China against weakening

of the Yuan.

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FX Ringside

The fall in China’s FX reserves is probably the reason why

Chinese authorities had to reduce their holdings in US

treasury securities. According to US capital flow data

Chinese officials have net sold approximately USD 130bn

in US treasury securities over the last 12 months, mostly

we suspect during the first half of this year. This would

suggest downward pressure on the USD and not the

other way around.

Moreover, China is not the only country to be a net seller

of US treasury securities. Over the last 12 months foreign

official accounts have net sold treasury securities

totalling around USD 300bn. Some of these investors are

probably oil exporters that must use part of their treasury

holdings to fund a shortfall in the government budget as

a result of lower oil revenues. Most oil producing

countries have suffered severely following the sharp fall

in the oil price during 2014 and 2015.

Most observers would probably argue that it would be

overall USD-negative if these outflows continued.

However, conversely, it appears as if the USD share of

allocated foreign exchange reserves has actually risen in

recent years. Certainly, this may be explained partly by an

increase in the value of dollar-denominated holdings due

to a stronger USD exchange rate. A more detailed

examination of changes in allocated FX reserves suggests

global reserve managers have actually been buying

dollar-denominated assets fairly aggressively. Most

recent data concerns Q1 this year when a net dollar

inflow of almost USD 200bn from global reserve

managers was reported, as the valued of allocated global

reserves (excluding China) generally increased.

While clearly the euro also attracted substantial inflows

in Q1, in recent years the dollar proportion of allocated FX

reserves has increased substantially while the euro’s

share has decreased. Overall therefore, it is difficult to

argue that the dollar would suffer from large outflows

connected with foreign official holdings. More likely,

holdings seem to have shifted between global reserve

managers, with a few (oil exporters and China)

decreasing their reserves while others have been forced

to invest their growing foreign exchange reserves. The

net effect therefore seems to be dollar neutral. Although

it may be difficult to explain the fact that the dollar tend

to gain when the value of Chinese FX reserves fall the

importance of reserve manger flows from a few particular

countries clearly should not be overstated.

STRONGER DOLLAR IF TRUMP WINS. In November, the

US Presidential election will take place. Since the 1980’s,

its predecessors have shown there is little evidence to

suggest the dollar will behave in any particular way

around them. Usually pre-election USD trends tend also

to continue afterwards. Moreover there are no common

USD developments around elections – the currency has

depreciated around some and appreciated around

others.

This time it may be different, particularly if Trump against

the odds were to win. Although surveys still indicate that

a Clinton victory is the most likely outcome, the Brexit

vote has demonstrated that the outcome of elections and

referendums may be very unpredictable. We have

considered Trump’s economic policy and there are

several different issues that may have positive or

negative effects on the currency.

- Substantial income tax cuts: Trump argues for

reduced taxes on both household and corporate

income. He proposes to lower the highest income tax

rate for households to 33% and to cut the corporate

tax rate to 15%. These suggested tax decreases are

far from fully funded and would increase the budget

deficit. As a result, they are likely to substantially

boost growth, making the Fed more likely to tighten

monetary policy faster than has otherwise been

expected. This would be USD-positive.

- Homeland Investment Act II: Trump has suggested

that US multinationals that repatriate foreign

earnings retained abroad would only have to pay

10% tax on them. Although this would be less

attractive than the HIA of 2004, which entailed an

effective tax rate of only 5.25% (compared to 35%),

it would suggest increased capital inflows to the US.

In 2004-2005, US multinationals repatriated USD

312bn, all of which was eligible for the reduced tax

rate. This was actually seen in current account data

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FX Ringside

where US acquisitions of FDI were negative in Q3 and

Q4 2005. While it is difficult to isolate historical

effects on the USD, these corporate inflows probably

contributed to the appreciation of the USD which

took place in 2005 and saw EUR/USD move from 1.35

to just below 1.20. Although the tax rebate will be

substantially smaller this time and there are still not

details regarding the proposal it is still likely to be

USD-supportive.

Global trade: In terms of global trade Trump favours

a stricter policy with increased protectionism. In

particular he supports a more aggressive policy with

tariffs on imports from countries that are deemed

currency manipulators or use illegal trade subsidies.

Full implementation of this policy will have several

consequences for the USD. Global trade relations will

suffer and most likely countries such as China, which

would face new sanctions, would be likely to take

counter-measures. In a worst case scenario Trump

trade policy may trigger a global trade war in which

trade-oriented countries would suffer most. As

usually the US economy would be least hurt and the

combination of lower risk appetite and the direct

impact on trade would therefore benefit the USD.

However, the US still relies on capital inflows from the

rest of the world to fund its current account and

budget deficits. Moreover, several countries including

China also own substantial quantities of US

securities, which makes the US economy vulnerable.

In the longer term, this may cause the USD to suffer

second round effects, although their size is difficult to

estimate.

Seemingly, we should expect a stronger dollar if Trump

were to win the presidential election in November, due to

a combination of lower global risk appetite, risks

associated with the outlook for world trade and global

growth, capital inflows connected with a new HIA and

increased US fiscal spending.

BANK OF JAPAN IS APPROACHING HELICOPTER

MONEY – BACK TO A WEAKER JPY

The Bank of Japan’s (BoJ) current policy of “Quantitative

and Qualitative Monetary Easing (QQE) with a Negative

Interest Rate (NIRP)” eases policy through three

channels: 1) Quantity - increasing the amount of asset

purchases and the monetary base; 2) Quality –

purchasing riskier assets such as ETFs vs. government

bonds; and 3) NIRP - cutting interest rates to negative. In

his Jackson Hole speech on Aug 27, Governor Kuroda

singled out NIRP as working as intended and still far from

its limit. He stated that NIRP had reduced mortgage rates

and that companies were issuing longer tenured bonds.

With his seal of approval, the next most likely action is to

reduce the policy rate to -20bps from -10bps at the Nov 1

or Dec 20 policy meetings.

At the upcoming Sep 21 policy meeting, the BoJ will also

conduct a “comprehensive assessment of the

developments… under QQE and NIRP as well as these

policy effects”. We thought this would pave the way for

use of a wider range of easing measures than “QQE with

NIRP”. However, Kuroda’s recent speeches have been full

of praise for the current framework such that new

measures seem unlikely. So why does Japan constantly

disappoint market expectations? We believe the answer

lies in changing the deflationary mindset that has

become entrenched over the past 20 years. The

government and the BoJ need to set expectations very

high. No one will listen if the bar is set low. Consequently,

dynamic policies such as “Abenomics” and “2% inflation

in 2 years, 2x monetary base” are needed to jolt the

economy out of deflation. Therefore, on a meeting-by-

meeting basis, Kuroda will tend to disappoint the high

expectations set by the BoJ.

What difference can 10bps or 20bps make in exiting 20

years of deflation? The BoJ understands that a backup

plan to “QQE with NIRP” is needed. This view was also

supported by Kuroda’s speech at Jackson Hole, which

signaled that in Japan inflation expectations are not

anchored as they are in the US, and that adverse

temporary shocks such as Brexit and lower oil prices may

reduce inflation expectations. More needs to be done to

raise Japan’s inflation expectations permanently. Still, the

country does have one major card up its sleeve –

monetizing government debt, a form of helicopter money

(for details on debt monetization please see Nordic

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FX Ringside

Outlook August 2016, pg. 14-15). The constant rise in

government debt is the main problem with the current

strategy of increasing monetary and fiscal policy.

Households and businesses are not consuming or

increasing investments because any good news will be

matched by a future rise in taxes (remember “Ricardian

equivalence”?). Direct monetization of government debt

solves this problem either by keeping government debt

stable or by reducing it. Monetizing debt exerts direct

pressure on BoJ equity turning it negative, weakening the

currency and steepening the yield curve. Households and

businesses pay regardless but through higher inflation

rather than higher taxes. This allows Japan to exit

deflation.

Towards the year end, Japan will be driven by the Fed

more than the BoJ. The combination of a Fed hike (which

SEB expects in December) and a 10bps rate cut by the

BoJ may push the Yen towards 110 by the end of this

year. The BoJ will likely disappoint at its Sep 21 meeting,

which we believe will provide good entry points for Yen

shorts. We do not think “debt monetization” policy will be

introduced in 2016, though any talk of or exploration of

this tool may move markets dramatically as this

represents a more drastic measure. It comprises an

effective threat that the BoJ can communicate even if it

decides not to carry it into effect. Furthermore, if Japan

ever does implement such a policy, it will have effects

worldwide as it opens the door for other central banks to

take similar action. A central bank writing down

government debt sounds like an alien and unrealistic

policy. However, we probably thought the same about

negative interest rates and asset purchase programs 10

years ago.

SIDEWAYS EUR/USD: LOOK AT STERLING INSTEAD

EUR/USD has been range-bound for a unusually long

time. Reviewing our FX Scorecard we conclude there is

little to suggest a rapid break out from the range. Judging

by leading indicators (ISM etc.) the Fed faces potentially

weaker growth in the US. The country’s central bank also

complains of low potential growth in the US and lack of

scope to hike rates without tightening monetary policy.

Flows are also weaker after reserve managers sold US

assets (see our sections on the USD and Trump). On the

other hand, the ECB seems content with its current

stance. Although most expect more QE for longer, it is

not entirely clear the central bank will deliver. Next year

will be very crucial for European politics with French and

German elections. Until the ECB amends its QE program

(by easing) or political risks increase substantially again,

we find it hard to see EUR/USD breach 1.05/1.15. If

anything risks lie on the upside with consensus

expectations positioned still for a stronger USD.

On Sterling we have a firm view: expectations are too

bearish and data are unlikely to deteriorate soon the way

sentiment stands at present. We therefore see scope for

a further rally higher before the market starts to worry

about the upcoming UK political negotiations with the EU

in 2017.

DIVERGING SCANDIES?

As regards Sweden and Norway, there is probably more

upside in NOK/SEK in coming months. Since late May we

have gradually lowered our forecasts for the SEK. The

Riksbank has gained credibility with the FX market while

the macro community is not chasing the currency higher

despite its favorable valuation and strong fundamentals.

In the carry market the SEK is a strong candidate for use

as a funding currency with rates at record low (negative)

levels. Only when the Riksbank starts to change its

strategy and begins deviating from ECB policy will the

krona benefit from all these positive underlying factors

apart from negative carry. The NOK does not yet suffer

from such low rates and the strong flow outlook is not

about to change as Norges Bank keeps buying its own

currency. Growth has bottomed, house prices are

recovering and inflation is well above target. With the oil

price at USD 50/brl, Norges Bank may be cautious about

cutting rates further. However, the central bank needs a

weak currency as the economy continues to rebalance

away from the petroleum sector. So EUR/NOK is unlikely

to be “tolerated” below 9.00. We favor selling EUR/NOK

with a target down to a low 9.

WHITHER THE EM RALLY? A key market theme in 2016 has been the recovery in EM

assets. With low global inflation and loose monetary

policies in most advanced economies, and with

continued stimulus in China, conditions are in place for

global risk appetite to remain strong and for the EM rally

to continue.

THE EM RALLY HAS FURTHER TO RUN

Our EM FX index has risen by 9.1% since bottoming on

Jan 20 this year, while the MCSI EM equity index is up by

32%. EM bonds have also rallied, with spreads against US

Treasuries narrowing from more than 500bps in January

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FX Ringside

to around 340bps in September. The rally mainly reflects

reduced fears of a hard landing in China, an unexpectedly

dovish US Fed, and depressed EM asset valuations. The

improvement in sentiment towards China is partly due to

reduced exchange rate volatility (following the

introduction of capital controls) and partly to stronger

growth. Although restrictions on financial account

convertibility represent a setback for China in its quest

for a more market-based economy, they have helped

restore confidence for now.

Signs of continued strong growth in China on the back of

significant monetary and fiscal stimulus have impacted

other EM economies. The Institute of International

Finance’s (IIF) coincident indicator suggests that EM

growth bottomed out in January and February reaching a

level consistent with real GDP growth of 4.7% in August.

Increasing confidence in China’s growth outlook has also

boosted commodity prices, which, in turn, has helped

stimulate demand for EM assets, especially equities and

currencies.

After hiking in December 2015, the US Fed became more

dovish in January, causing capital flows to favour EM,

almost three years after the 2013 “Taper Tantrum”. The

hunt for yield has resumed. After EM currencies

depreciated by 27% (against a basket comprising the

USD, EUR, JPY, CHF and GBP) and EM equities fell by

37%, valuation levels became very attractive.

Several indices may now be approaching resistance

levels. Technical analysis of the MSCI EM equity index

suggests it is only 2–3 percentage points away from a key

resistance level. Similarly, some EM currencies, for

example the BRL, are no longer cheap in real effective

terms. However, just as markets became oversold, a rally

above fair value should be expected.

CHINA AND US FED RISKS STILL LURK

Worries about a hard landing in China have not

disappeared, but simply been deferred. The country’s

credit-fuelled stimulus risks exacerbating overcapacity

and indebtedness among state-owned companies in the

medium-to-long term. Another worry is Beijing’s desired

shift away from the use of monetary policy (which has

driven construction) to fiscal policy and its effect on

commodity prices. Nevertheless, we believe that the

bottom reached in January will last for at least another

year and that a potential correction lower from current

levels should be temporary. Beijing will not risk market

volatility by tightening monetary conditions too fast,

suggesting that the construction and real estate sectors

will continue to grow and provide a floor under

commodity prices. Additionally, while the Bank of Japan

may not add to its quantitative easing program, it is still

considering ways to loosen monetary policy. Similarly,

the ECB is a long way from tightening its monetary policy.

With the US Fed unlikely to hike before December, we

believe present conditions will ensure capital continues

to flow to EM and the rally to continue to the end of the

year. Nevertheless, the single most significant threat to

EM is a sudden jump in US inflation, prompting the FOMC

to take a considerably more hawkish stance.

FX SCORECARD PERFORMANCE SINCE MAY The last

update and rebalancing of the Scorecard occurred in

May, just weeks before the Brexit vote, and was based on

the following assumptions: (1) We expected relative

monetary policy to remain the key driver for the FX

market; (2) We also believed valuation, positioning and

carry would be important for the FX market; (3) We

assumed the UK would vote to remain in the EU; and (4)

We anticipated further support for risk appetite based on

accelerating growth. In this kind of environment we

forecast that the SEK, NOK and USD would outperform

other currencies, particularly the CHF, JPY and NZD.

Looking back, almost none of these assumptions were

correct following the UK’s unexpected vote to leave the

EU. Indeed, instead of focusing on valuation and relative

monetary policy expectations, the FX market has since

the end of June concentrated solely on carry. Under these

market conditions the JPY and NZD have outperformed

all other currencies appreciating against the krona by 9%

and 12% respectively since May 24. This is the main

explanation for the weak performance of the FX

11

FX Ringside

Scorecard basket, which has fallen by 6.1% since our last

update in May.

The performance of the Scorecard approach is very much

related to long-term trends based on one or several

specific market drivers just like the dollar trend in

2014/15, which reflected expectations on relative

monetary policy divergence. In this sense present market

conditions are particularly ill-suited to this particular

methodology as it is very difficult to determine current

drivers for currencies and to observe trends in currencies

that seem long-term sustainable.

THE UPDATED FX SCORECARD The FX Scorecard takes

into account the relative importance of various

categories reflected by the weight we attach to each

category. For a long time monetary policy has been the

key driver for exchange rates. One reason that monetary

policy now receives a slightly lower weight than it has for

several years is that most central banks have likely

stretched policy to its outer bound (ECB, BOJ and

Riksbank) and that further policy easing by these

institutions is unlikely to have a significant impact on

either currencies or the real economy. Instead, actual

interest rate differentials seem to have become more

importantly. Consequently, we have reduced the

weighting for monetary policy expectations to 15%, its

lowest weight since we began ranking currencies using

the Scorecard.

Traditionally fundamentals and valuation have also

received relatively high weights but not this time. There

are several examples of currencies with strong

fundamentals and attractive valuation that remain weak,

causing these factors to appear secondary for FX

investors. Instead we have an unusually high weight for

rate differentials between currencies captured by the

carry score at 25%, making it the most important driver

in our updated Scorecard. The high weight for carry is

particularly attractive for the AUD and NZD, while it

lowers total scores for the krona.

Based on individual scores for each currency and the new

set of category weights capturing the importance of

different FX drivers, the NOK and GBP receive the highest

scores with each weighted 35% in our new Scorecard

portfolio. Next, we have a fairly positive view on the CAD

(18%) and NZD (12%). Currencies with the largest short

exposures include the JPY (35%), EUR (24%), CHF (15%)

and USD (14%). Finally, the FX basket is basically neutral

in AUD and SEK.

The following portfolio represents the FX Scorecard Currency Strategy update:

12

Currency Strategy

US dollar The dollar continues to trade with monetary policy

expectations. The story has been that further tightening by

the Fed this year and next while other central banks move in

the opposite direction s should support the greenback.

However, the Sep rate decision by the ECB and weaker than

expected growth indicators in the US have reduced the case

for monetary policy divergence, which makes the outlook

for the USD less positive. Large capital outflows as foreign

investor cut back on treasury holdings could be one risk to

the USD if it continues. Historically the dollar has not

reacted on the outcome of US elections. However, an

unexpected victory by Trump would reduce global risk

appetite and be positive for the dollar, at least initially.

ECONOMIC FUNDAMENTALS T After a weak start to the

year with disappointing growth in both Q1 and Q2 there

were signs that the US economy started to pick up speed

into the second half of the year. The positive tone in US

data changed in Aug when the composite ISM was a lot

weaker than expected. In Q2 most growth was related to

private consumption. To sustain our positive growth

outlook other parts of the economy have to catch up.

Expansive financial conditions should be supportive for

investments. However, declining sentiment indicators has

increased uncertainty. Despite some temporary weakness in

Q2 the labour market has been strong over summer

although Aug was a disappointment. -1

MONETARY POLICY US inflation has remained muted with

the PCE core inflation (Fed’s favourite measure) still being

below the 2% target and it is not expected to pick up much

over the coming year. Moreover, market based measures for

inflation expectations remain well below the 2% inflation

target. In contrast there are signs of accelerating wage

growth as labour market conditions tightens. Although the

correlation between wage growth and inflation has been

rather poor faster wage growth should eventually lead to

rising cost pressure in the economy, which is likely to spur

further tightening by the Fed. Our assessment is one more

rate hike this year at the Dec. meeting. 0

FLOWS Despite attractive US bond yields compared to most

other developed markets foreign investors have scaled back

substantially on their holdings of US long-term securities. In

particular it seems like foreign official accounts have been

net sellers of large amounts of US treasury securities with

the net outflow over the last 12 months until June

amounting to USD 335bn. One obvious reason for this

outflow is that holdings of long-term securities have partly

been needed in public funding as a consequence of falling

commodity and energy prices. The US current account

balance has stabilized at 2-3% of GDP. It is divided between

surpluses on services and net income and a deficit in goods

trading, where non-petroleum goods nowadays account for

most of it. Historically a current account deficit of present

size has been manageable as the US economy tends to

attract sizable capital inflows. However, would capital

outflows continue a current account deficit even at today

size could be a challenge. 0

EUR speculative positions

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EUR/USD

The lack of significant upside progress in EUR/USD makes the current substantial net long speculative position a burden. Should the sub-1.29-area be revisited, speculative longs will have to be reduced.

13

Currency Strategy

US dollar VALUATION Real and nominal trade weighted indexes

for the dollar would suggest the greenback has moved

into overvalued territory. Our internal long-term fair value

model, SEBEER, indicates that long-term valuation has

moved in the same direction as the spot exchange rate,

which would suggest the USD trades roughly around its

long-term fair value in trade weighted terms. Stronger US

growth and expectations of widening rate differentials

caused a recovery for the USD since May 2014, which also

feeds into the valuation model. Although the dollar

approaches stretched territory according to some models

it is too early to argue for a weaker dollar just because of

its valuation. Based on the real effective exchange rate

the dollar is still below valuations in previous dollar peaks

in 1985 and 2002. -1

POSITIONING Speculative accounts have mostly been

long USD since May 2014. However, after the rate hike in

December last year the net long position was unwound

and even switched to a small net short position in May.

Since then speculators have gone long USD again but to a

far less extent compared to before the rate hike: current

positioning is 1.1 standard deviations below the three

year average position. However, the reason for the

current positioning score of -1 is the sharp trend lower

lately, representing a negative USD sentiment. -1

LIQUIDITY, EVENT RISK AND GLOBAL CYCLE With its

superior liquidity the USD has traditionally been seen as a

typical safe haven currency, which is negatively

correlated with risk appetite. However, in recent years it

has actually behaved the other way around with the USD

being positively correlated with risk appetite. Instead

currencies like the EUR and the JPY, which obviously

could be seen more as funding currencies with their low

interest rates tend to gain whenever there are increased

stress on financial markets. One obvious reason could be

that the outlook for the USD is closely related to

expectations on Fed monetary policy and the timing and

pace of coming rate hikes, which makes it more closely

related to the growth outlook. We have moreover

observed that the classical relationship between the oil

price and the dollar seems to remain intact. Finally it

seems like the dollar is correlated to changes in the

Chinese currency reserves. Going forwards we expect

China FX reserves to continue to fall, albeit at a slower

rate, which should prevent the USD from weakening too

much.


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14

Currency Strategy

The euro The euro remains stable. With ECB monetary policy

options almost exhausted, monetary policy itself is no

longer the most important driver of the currency. Instead,

a high current account surplus, falling budget deficits and

a lower inflation rate than in most other industrialized

countries all support the euro. But the institutional

framework of the euro area remains weak and is

therefore a threat to the currency.

ECONOMIC FUNDAMENTALS Latest readings of the

composite purchasing managers index (PMI) and the

European Commission’s Economic Sentiment Indicator

(ESI) indicate that the economy remains resilient to the

Brexit vote. The moderate recovery in the euro area

continued at the start of H2 2016. Domestic demand is

driving the expansion while exports are suffering from

weak foreign demand. We expect real GDP to grow by

1.6% in 2016 and 1.7% in 2017, allowing the budget

deficit to decline by 0.3 percentage points to 1.6% of

GDP in 2017. Negatively, growth remains uneven across

the region, while politically further progress towards

increased integration appears to have been side-lined.

National interests dominate all discussions. Moreover,

reform momentum has slowed in most vulnerable

countries, which is of major concern, preventing as it

does stronger growth momentum within the union.

Following the EU’s decision not to fine member states

that perpetually break deficit rules, the Stability and

Growth Pact is now dead in the water. Consequently, the

euro area remains vulnerable to external shocks. -1

MONETARY POLICY The ECB is in ‘wait-and–see’ mode.

The Brexit vote has created a new downside risk to

growth. As it remains wholly unclear to what extent

economic recovery in the euro area will be affected, the

ECB is awaiting more hard data to form the basis for

further policy decisions. Latest economic indicators

suggest there is no urgent need to act. Inflation rates are

slowly increasing. In recent months the annual CPI rate

has become positive once again, and is expected to move

above 1.0% by the year-end. Consequently, real ECB

policy rates will become more negative, making monetary

conditions even more favorable. ECB staff left the bank’s

GDP growth projections largely unchanged in September.

Inflation forecasts will continue to indicate a slow upward

trend in CPI rates. ECB will extend the QE-program in dec-

16 making monetary policy still euro-negative. -1

FLOWS In the 12 months ending in June 2016 the

cumulated current account surplus rose to EUR 347.8bn

or 3.3% of GDP, compared with a surplus of EUR 302.1bn

for the 12 months to June 2015. In coming months we

expect the current account to remain solidly positive,

thereby continuing as the most important supportive

factor for the euro. During the same period, combined

direct and portfolio investments by euro area-based

investors reached EUR 937bn, surpassing investments by

foreigners in the euro area by EUR 628bn. Going forward,

net capital outflows are expected to remain very high. 0


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Risk appetite

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EUR Weighted score: -0.6

15

Currency Strategy

The Euro VALUATION When the euro began to depreciate in 2014

it was clearly overvalued in trade weighted terms

according to most valuation measures including the

SEBEER long-term fair value model. The common

currency began to weaken after the ECB had announced

further policy easing including rate cuts and eventually an

extensive asset purchase program, while the oil price fell

sharply and the dollar benefited on expectations of Fed

tightening. Today, the valuation of the euro is quite close

to its estimated long-term fair value in trade weighted

terms. The SEBEER long-term fair value estimate against

the dollar fell to 1.10 after the latest update. The euro

appears slightly undervalued according to other valuation

measures as the real effective exchange rate or the

nominal trade weighted index. Altogether valuation

should be slightly positive for the euro going forward.

+1

POSITIONING Speculators are net short EUR vs. USD and

has so been since May 2014. Current positioning is right

at its three year average. Judging by the less severe short

peaks April 2015, December 2015 and most recently July

2016 the long term bearish EUR sentiment is losing

ground. For now, the lack of an extreme positioning or

sharp trend in positioning renders a neutral score for

EUR. 0

LIQUIDITY, EVENT RISKS, GLOBAL CYCLE Although

underlying economic structural problems are still much

present, ECB QE has certainly made bond markets forget

about these issues. The economic outlook is reasonably

ok with economic growth at/just above trend. Risks are

instead building in the political area where the coming 12

months holds crucial political elections/referendums in

the euro-zone. Should Marie le Pen stage a major surprise

and be elected French president, the euro will suffer as

the market starts to fret about Frexit. From an event risk

perspective it is still reasonable to add a risk premia to

the euro outlook.


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16

Currency Strategy

Japanese yenThe JPY strengthened over 16% from 120 to slightly

above 100 in the first eight months. The main driver for

JPY strength was the combination of BoJ under-delivering

on further easing and the Fed under-delivering on rate

hikes. Due to the strong currency, its stock market also

tumbled over 15%. Going forward, we expect JPY

weakness to 110 in 6 months as BoJ starts conversation

on helicopter money via writing off future debt issuance

or debt that BoJ has already purchased.

ECONOMIC FUNDAMENTALS The economic recovery

post the VAT tax hike in April 2014 has been

disappointing. The economy has only recovered to 0.4%

y/y average growth in H1 2016. Growth has been weighed

down on all sides with exports low from weak global

demand (including China), low investment as businesses

remain cautious and consumers expecting future tax

hikes. Going forward at least consumption should

stabilize since the VAT hike has been delayed from April

2017 to October 2019. Also, fiscal stimulus of 6% of GDP

should increase leading up to the 2020 Tokyo Olympics

and counter the lackluster growth in exports. Hence,

growth should trickle higher to 0.5% for 2016. 0

MONETARY POLICY BoJ is facing difficulties in reaching

its “2% inflation in 2 years” promise and running out of

tools. The asset purchase programs are reaching a limit

as BoJ has been dominating transactions in both the

bond and equity market. Negative interest rates are

facing major push back from the banking sector. We

think Bank of Japan will start discussing a form of

helicopter money where BoJ automatically monetizes

future debt issuances from Ministry of Finance or go one

step further and write-off parts of JGBs the BoJ owns.

Another possible direction is to add a nominal GDP target

in addition to the 2% inflation target. These discussions

alone will get the markets moving on BoJ easing

expectations and will be negative JPY. -3

FLOWS Flows have been neutral. The capital flow is

clearly pointing outwards where corporates are investing

and buying overseas as there is plenty of liquidity

domestically and returns are higher abroad. Portfolio

managers are also going abroad in hunt for yield.

Typically, this leads to JPY weakness but this time, it’s

been offset by rising current account surplus. The current

account has grown from the trade surplus as energy

prices have reduced imports. Also, Japan has restarted

nuclear power plants and has further reduced imports.

+1


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JPY Weighted score: -0.8

17

Currency Strategy

Japanese yenVALUATION Different long-term valuation measures for

the JPY give different messages concerning its valuation.

Real trade weighted indices suggest the JPY is fairly

cheap. With a long-term fair value at 114 against the

dollar the SEBEER-model, however, proposes the yen

actually is somewhat overvalued after its recovery since

the beginning of 2016. Altogether it therefore seems

appropriate to take the middle way and go with the

nominal trade weighted index which says the JPY not

trades too far from its long-term valuation. -1

POSITIONING Speculative accounts have built a large net

long JPY position in 2016 which has been supported JPY.

Current positioning is 1.9 standard deviations above the

three year average which tends to be an unsustainably

large deviation. The positioning score is -3, reflecting the

high probability of a normalization of positioning which

would weigh on the Japanese currency. -3

LIQUIDITY, EVENT RISK AND GLOBAL CYCLE There are

several risks to Japan in this category. First, JPY still

retains its safe haven status and global risk off events will

make the JPY strengthen just as we saw with Brexit.

Events such as Trump victory in the US will be seen as a

risk-off event and can strengthen JPY. Second, if BoJ

embarks on writing off JGB debt that can be a game

changer for JPY’s perception as a safe haven currency.

BoJ writing down government debt means BoJ goes into

negative equity. That is a clear sign of BoJ weakness, loss

of independence and becoming much more of a dovish

central bank. The action alone will weaken JPY but since

these adjustments are permanent (until inflation target is

reached), BoJ’s credibility will be hit and JPY can easily

lose its safe haven status. Lastly, BoJ intervention will

remain a possibility. In the past when BoJ has intervened,

even unilaterally, it has been successful and marked the

end to JPY strength.


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18

Currency Strategy

British pound sterling Since the Brexit vote was indicated in Q4 last year the

GBP has weakened substantially against almost all

currencies. At its extreme the exchange rate discounted a

virtual disaster for the UK economy. However, data so far

have been stronger than most expected and suggest

more “business as usual” than a crisis. With the

speculative market net short the GBP and absent a

significant deterioration we expect a sterling recovery in

coming months. Long-term risks related to Brexit

negotiations remain. The outcome might well harm the

economy which is why we don’t expect the GBP to

recover fully.

ECONOMIC FUNDAMENTALS The Brexit vote was

unexpected leaving most people still struggling to

understand its political and economic consequences.

Studies prior to the referendum warned there would be

serious negative effects on the economy and that was

also what most people feared in July when all sentiment

indicators slumped to recession levels. However, this

initial reaction was excessive. Instead, the impact on the

economy is unlikely to be as bad as many had feared, not

least because the UK will remain an EU member until new

conditions have been negotiated. Moreover, financial

conditions have eased substantially since the

referendum was announced with falling interest rates, a

weak sterling, bond purchases and liquidity provision by

the central bank all bolstering the economy. Indeed,

while post-Brexit data are still incomplete and

uncertainty remains high, we are quite confident the

gloomiest forecasts are unlikely to materialize. Long-

term the objective is to make the UK a “super-

competitive economy”. +1

MONETARY POLICY The Brexit vote forced an

immediate response from the BOE, which moved quickly

to prevent any liquidity shortages and maintain the

credibility of the financial system. After assessing the

situation it proceeded to cut its policy rate by 0.25pp to

0.25% in August and restart its bond purchase

programme including Gilts and Corporate bonds. Going

forward the bank stands ready to support the economy if

necessary. Currently we expect a further bank rate cut at

the November meeting to the lower bound of 0.05%.

However, this reduction is far from certain. Indeed, if

economic indicators show that the economy has

shrugged off the Brexit vote the bank would not hesitate

to leave its present policy rate unchanged. 0

FLOWS The UK current account deficit has widened to

around 7% of GDP in the last two quarters. Much of this

is attributable to a shift in the income balance as a

previous surplus has turned into a widening deficit.

However, the trade-related deficit has also increased in

recent quarters. The trade related deficit is likely to

improve though, given present pound weakness. A

deficit of the current size is unsustainable, as it requires

massive capital inflows to finance the shortage in

domestic savings, which makes the GBP vulnerable given

present political uncertainty. -2


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Fundamentals

GBP Weighted score: 0.3

19

Currency Strategy

a

British pound sterling VALUATION The GBP has depreciated substantially since

the referendum on the EU-membership was initiated in

November last year. The sell-off in the GBP accelerated

after it was clear the UK had voted to leave. Prior to this

Brexit-related depreciation the sterling was slightly

overvalued in trade weighted terms, although the

updated SEBEER long-term valuation model indicated it

was roughly around fair value. However, following the

depreciation there is no doubt – the GBP is substantially

undervalued today, which makes it an interesting long-

term valuation case. Clearly current valuation is

unsustainable unless the economy suffers badly from the

vote. So far indicators, however, show only a limited

impact on the economy. Current valuation reflects a more

negative development. +3

POSITIONING Speculators are sitting on a close to record

net short GBP position which was quickly established

after the Brexit vote. Deviation from the three year

average is a whopping -2.5 standard deviations which is

stretched and the positive positioning score of +3 reflects

the fact that a downscaling of this unusually large net

short position will support GBP. +3

EVENT RISK, LIQUIDITY AND GLOBAL CYCLE

Traditionally the outlook for the GBP has been closely

related to the outlook for UK growth and BOE monetary

policy. After the Brexit vote in June this is indeed still the

case. The GBP is long-term undervalued against most

other currencies after the EU-vote due to political

uncertainties and potential consequences on the

economy. The obvious topic for discussion is whether the

expected negative impact on the British economy has

been exaggerated. Currently it seems to be the case.

Would the UK economy continue to improve in line with

sentiment indicators, which are back well above the 50-

level, the GBP looks like an attractive buy at current

levels. The GBP was also punished after the August rate

cut from BOE and the restart of bond purchases. These

decisions have clearly lowered UK bond yields in a GBP-

negative way. Would the tight correlation between the

GBP and relative bond yields persist this could limit the

upside potential for the GBP.


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20

Currency Strategy

Canadian dollar The CAD was appreciating fast against the USD in the

first quarter, but has basically trended sideways since

April thus moving more or less in lockstep with oil prices.

After the huge depreciation in 2015-2016, the bigger

picture is that the loonie is still supercharged thus helping

the Canadian economy growing above its potential

growth rate. If anything, we expect CAD to outperform its

peers due to its current valuation, gradually increasing oil

prices and extensive connections to the US economy

which is returning to more robust growth.

ECONOMIC FUNDAMENTALS In the second quarter, the

economy took a hit from the Alberta wildfires and real

GDP growth contracted 1.6% at an annual rate. In all

likelihood the plunge is temporary and we are expecting a

growth rebound to well above the potential growth rate in

H2 and beyond. A pickup in the US economy and federal

infrastructure spending are important drivers while easy

financial conditions, in part reflecting the past

depreciation of the Canadian dollar, are supporting

growth too. The cheap CAD is boosting competiveness

and is helping the economy adjust to lower commodity

prices; a reallocation of investment and employment

from the resource sector to the non-resource sector is

underway. Despite the generally slow growth backdrop in

recent quarters, the unemployment rate has been drifting

down and is currently sitting below the NAIRU. While this

is suggesting less slack in the economy, wage growth is

decreasing and the output gap is not expected to close

until the end of 2017. +1

MONETARY POLICY After keeping its policy rate at 1%

for over four years, BOC cut rates twice last year to 0.50%

where the target for the overnight rate is sitting today.

Sluggish growth in recent quarters, the difficult

adjustments in the resource sector and the output gap all

suggest that a rate hike is off the table for at least a year

in our view. According to market pricing, the probability

of a cut is actually higher than the probability of a hike for

as long as the eye can see. So why not cut rates again in

order to provide an extra boost to the economy? In our

view, the infrastructure spending projects mean less

pressure on the Bank to do the heavy-lifting. Moreover,

against the backdrop of rapidly increasing house prices

and the real estate market close to overheating, a rate cut

may not be the best medicine. 0

FLOWS Recent data on goods exports have been on the

weak side, in part reflecting the temporary slowdown in

US investment earlier this year. As such, the current

account deficit has increased but we expect a turnaround

as export growth picks up again. Meanwhile the trends in

the basic balance and the broad basic balance are

showing signs of turning around. -1


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CAD Weighted score: 0.1

21

Currency Strategy

Canadian dollar VALUATION The Canadian dollar traded at rich levels for

a long time after the financial crisis, which indisputably

has been negative for Canadian competitiveness. The

sharp decline in commodity prices, and in particular lower

prices on oil, have weakened the currency significantly in

trade weighted terms since 2014. In nominal terms the

CAD seems undervalued compared to its long-term

average. Our model gives a slightly different message as

the its long-term fair value estimate has been falling in

recent years. Valuation probably is a fairly neutral factor

for the CAD. However, would Canadian terms-of-trade

deteriorate further on the back of a lower oil price there is

probably more downside risk for the CAD from current

levels. +1

POSITIONING Speculative accounts are net short CAD as

has been the norm since 2014. Currently the net short is

far larger than normal; to be exact it is 1.2 standard

deviations below the three year average, which is the

second most extreme position in this report. However,

the net short is not large enough to render positive CAD

score that would indicate high probability of a correction.

The trend with speculators adding to their net short

position, which began in November 2015, has corrected

slightly but is not strong enough yet to render a negative

slope score. All in all the positioning score for CAD is

neutral/cautiously negative in this report. 0


Historically the Canadian dollar has correlated positively

with general risk appetite and the performance of the US

equity market. Lately however it is foremost the oil price

that dictates the development of CAD. RBA’s favoured

fair value model seems to work well for the CAD and is

based on terms of trade and the real interest rate spread

versus US, Europe and Japan. Terms of trade have been

under pressure since 2011 but the decline increased

greatly from mid-2014 when oil prices tumbled. From

March to May 2016 oil prices corrected higher and the

USD generally weakened giving a bounce in the model

again. CAD also responded positively to this

development. Our near-term forecast for oil and relative

interest rates (sideways) also produce a range bound

environment for the loonie.

The Bank of Canada’s inflation-control target must be

renewed every five year and the current period ends 31

December 2016. While not our base scenario, there are

speculations that its current target could change. We

think that the details of the renewal will be presented in

November.


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22

Currency Strategy

Australian dollar The economy is hampered by a large decline in business

investment, although other sources of domestic demand

are growing at or above trend. Evidence suggests the

country’s transformation from a resource-based economy

to a service economy is gaining speed. Both the recovery

in commodity prices and the stabilisation of Chinese

economic activity have provided support for the

Australian dollar, although terms of trade remain much

lower than they have been in recent years. The RBA cut

the cash rate in February and August. Inflation is below

target and provides an argument - along with the central

bank’s wish to avoid an appreciating exchange rate - for

further monetary easing.

ECONOMIC FUNDAMENTALS The economy continues to

suffer from falls in mining-related investments while

spending on non-mining activities, except for housing,

has so far failed to pick up. However, low interest rates

support domestic demand while the weaker exchange

rate helps the export sector, which we expect will

contribute positively to growth. Although labour market

indicators are mixed, employment is forecast to continue

growing. Prospects for households have improved, as

shown by rising consumer confidence, which is likely to

result in higher household spending going forward.

Significantly, indicators suggest that economic activity is

switching more rapidly to the non-resources sector.

Overall, GDP growth remains healthy, having accelerated

for four consecutive quarters so far to 3.3% y/y in Q2.

Further more rapid increases are expected towards 3.5%

y/y in 2017-2018, above potential growth. +1

MONETARY POLICY Headline inflation decelerated

further in Q2 to 1.0% y/y; well below the target range of

2-3%. Core inflation is also below the lower part of the

target range, while wage growth remains slow. Recent

appreciation by the AUD has renewed the downward

pressure from import prices in recent years and may drive

inflation even lower in the near-term, although we

forecast inflation will accelerate to 1.5-2.5% by the end of

2018. This is because we expect an improving labour

market to result in gradually rising labour costs. The RBA

reduced the cash rate by 25 basis points in May and

August but left it unchanged in September. Currently the

cash rate is 1.50%. A more stable situation in China and a

recovery in commodities prices have made further RBA

easing less likely in the short term. However, low inflation

provides an argument for looser monetary policy while

the RBA is also keen to avoid an appreciating exchange

rate. Future Fed policy is important. -1

FLOWS The current account deficit has deteriorated

dramatically in recent quarters to currently almost 5% of

GDP. The trade deficit is partly offset by net portfolio

inflows involving equity securities and direct investments.

Compared to other developed economies, Australian

yields are relatively high, providing scope for carry trade

inflows. 0


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-0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8

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USD Weighted score: -0.4

23

Currency Strategy

Australian dollar VALUATION Falling commodity prices have resulted in a

significant deterioration in terms of trade from highs back

in 2014, supporting a lower valuation. They were also the

reason for the RBA’s statements that it regarded the

Australian currency as overvalued. In trade weighted

terms, both real and nominal, the AUD trades very close

to its long-term average after being overvalued since

2010. According to our model, however, the currency’s

long-term valuation continues to fall making it look

expensive despite the depreciation in recent years.

Altogether the AUD appears overvalued, but remains far

from previous extremes. Although the currency’s

valuation may not be a driver in itself, its present value is

unlikely to slow down further depreciation going forward.

-2

POSITIONING Speculative accounts have built a large net

long AUD position during the summer. This coincides

with the increasing popularity of carry trades with

standard G10 strategies generally using the AUD as the

major long currency. Current positioning is 1.7 standard

deviations above the three-year average, which is

generally unsustainable and likely to be followed by a

correction that would weigh on the AUD. Positioning

therefore scores -1. With carry trades at least partly

responsible for long positioning in AUD, we would remain

wary on risk appetite, as an especially sharp deterioration

may cause a short squeeze when carry positions are

unwound. -1


Previously, considerable support for the AUD was

attributable to high commodity prices, which attracted

foreign capital inflows to the mining sector.

Consequently, falling commodity prices have proved

particularly disadvantageous for the AUD. However, in

the current low yield environment Australian interest

rates contribute to preventing capital outflows. The

recovery in commodity prices and yields - both of which

are relatively high compared to other developed

economies - has helped the AUD to appreciate during

2016. However, a sustained rise in commodity prices is

unlikely, limiting AUD upside from current levels. The RBA

has already cut the rate twice in 2016, while a more stable

situation in China and higher commodity prices have

made further easing in the short-term less likely. But the

Chinese growth slowdown is expected to resume in 2017

and may exert downward pressure on the AUD. Inflation

well below target provides another argument for

monetary easing.


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24

Currency Strategy

New Zealand dollar The New Zealand economy continues to perform well

compared to most other developed countries. While GDP

growth is hampered by weak dairy prices and exports,

robust domestic demand has ensured it remains above

2%. Low inflation has forced the RBNZ to cut the OCR

twice so far this year to currently 2.0%. More easing is

expected. The NZD has appreciated recently contributing

to negative inflation in the tradables sector. As a result,

the inflation objective has become more difficult to meet,

which exerts pressure on the RBNZ to try to weaken the

exchange rate.

ECONOMIC FUNDAMENTALS The divergence between

New Zealand’s external and domestic environments

continues. Low prices for export goods are a drag on

growth. Although activity in the Chinese economy has

stabilised recently, its slowdown is expected to continue

in 2017. Australian growth is being maintained at a

modest rate. However, New Zealand’s domestic economy

is performing well, with GDP growth accelerating to 2.8%

y/y in Q1. Migration, construction activity, strong tourist

spending and looser monetary policy will continue to

support growth. The labour market is solid with

unemployment edging downward in Q1 and associated

forecasts revised lower. Employment is increasing while

net immigration will continue to add to labour supply.

Low interest rates will continue to support household

spending; retail sales accelerated in Q2. +2

MONETARY POLICY The RBNZ cut its OCR in March and

in August to currently 2.00%. Since the present monetary

policy cycle began in June 2015, rates have been eased by

150 basis points. Inflation remained at 0.4% in Q2, well

below the 1-3% target. CPI inflation is being squeezed by

negative tradable inflation, and is expected to weaken

further in Q3 according to the RBNZ, due to the recent fall

in fuel prices. The NZD has appreciated in recent months

and is substantially stronger than assumed in the central

bank’s June statement, weighing further on tradables

inflation. The RBNZ has stated that more monetary policy

easing is required and argues that 35 bps of additional

OCR cuts are necessary to move inflation back within the

target band. -2

FLOWS The terms of trade have declined significantly in

recent years. Weak global demand and strong supply in

some markets will continue to weigh on New Zealand’s

commodity exports. The RBNZ forecasts that the terms of

trade will improve slowly from 2017. The current account

deficit is expected to remain around 3% of GDP. A

positive balance on external goods and services is

outweighed by an investment income deficit. Compared

to other developed economies yields are relatively high,

providing some scope for carry trade inflows. -1


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EUR/USD

The lack of significant upside progress in EUR/USD makes the current substantial net long speculative position a burden. Should the sub-1.29-area be revisited, speculative longs will have to be reduced

-0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8

Risk appetite

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NZD Weighted score: -0.1

25

Currency Strategy

New Zealand dollar VALUATION Lower commodity prices and inflation well

below the target finally changed the monetary policy

stance of RBNZ previously being one of few central banks

tightening policy. This was the trigger for a normalization

of the NZD-valuation from stretched levels. At most the

NZD weakened by roughly 17% in trade weighted terms.

However, this year the NZD has recovered around half of

it, which once again makes it look a bit expensive. At the

same time as the currency has depreciated its long-term

fair value according to our SEBEER long-term fair value

model has moved in the opposite direction making the

valuation stretch according to this model smaller.

Altogether a high valuation is still a risk to the NZD in the

longer terms, although we doubt it will weigh on the

currency as long as it benefits from higher bond yields

attracting inflows. -3

POSITIONING: Speculators are almost squarely

positioned in NZD and as there has not been any specific

trend lately the positioning score is neutral. Interestingly

NZD/USD has headed higher in 2016 but speculators

seem to have had little interest in the currency as

positioning has been light and shifted between net long

and net short many times. 0

LIQUIDITY, EVENT RISK AND GLOBAL CYCLE Global

growth remains below trend. Moreover, while in China it

has stabilised recently, the economy is expected to

decelerate further in 2017 as the effects of previous

monetary easing diminish. A larger Chinese slowdown

would not only have direct negative effects on the NZ

economy but also indirect consequences including

potentially weaker Australian growth. The housing market

boom is still a major risk to the NZ economy. Macro-

prudential measures introduced in November 2015

(tighter loan-to-value restrictions) initially reduced house

price inflation. However, since March this year, Auckland

price pressures have re-emerged, spreading to nearby

regions, to produce a more generalised resurgence in

housing prices nationwide. With banks heavily exposed to

the sector, the RBNZ is clearly concerned about financial

stability risks. A house price correction could push a NZ

risk premium higher or even tighten liquidity due to the

country’s high dependence on overseas refinancing.

Currently, the RBNZ is considering additional macro-

prudential policy options that may be introduced before

the end of this year.


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The lack of significant upside progress in EUR/USD makes the current substantial net long speculative position a burden. Should the sub-1.29-area be revisited, speculative longs will have to be reduced

26

Currency Strategy

Swiss franc The Swiss franc probably remains cautiously overvalued.

On a trade weighted basis the currency is still around

9.0% higher than it was before the EUR/CHF floor at 1.20

was abandoned. So far the Swiss National Bank (SNB) has

successfully stabilized the CHF but has failed to weaken

it. We believe the central bank will continue to resist any

upward pressure on the currency. With CPI inflation

becoming positive in coming months, we expect the franc

to weaken slightly.

ECONOMIC FUNDAMENTALS GDP growth slowed to

0.1% in Q1 2016, from 0.4% during Q4 2015.

Subsequently, the KOF economic leading indicator has

signalled some acceleration in growth. In the six months

to August 2016 it averaged 102.2 points, up from 99.6

points during the preceding six months. Therefore, the

Swiss economy appears set to post real GDP growth of

between 1.0% and 1.5%, in line with the SNB’s

expectations. Regarding inflation, Switzerland reported a

negative annual CPI rate of only 0.2% in July 2016, a

significantly higher reading than back in December 2015

when it declined by -1.3%. The rate is expected to

become positive once again before the year-end. 0

MONETARY POLICY The SNB has kept a steady hand in

recent months and we expect it to continue to do so

going forward. FX reserves are increasing meaning the

SNB will not tolerate EUR/CHF to decline below 1.07-1.08

anytime soon. With the dampening effects of low energy

prices further abating in coming months, the annual CPI

rate will soon become positive for the first time since

August 2014, i.e. consistent with the central bank’s

definition of price stability of “below two percent but

positive”. Price trends suggest there is no need for

additional rate cuts at present. Therefore, the SNB will

keep its policy rates stable and concentrate on fighting

any upward pressure on the franc. Its GDP growth

projection for 2016 will remain stable at “between 1 and

1.5 percent” in September. In its conditional inflation

forecast the bank will continue to expect the annual

inflation rate to turn positive in Q4 2016. -1

FLOWS Sight deposits by Swiss commercial banks with

the central bank are a reliable indicator of SNB

interventions in currency markets. Since the end of 2015,

these have grown by CHF 46.2bn. In the two weeks

following the Brexit vote a larger increase of around CHF

10bn indicated rising capital inflows, which the SNB was

compelled to absorb. Since then, the flow situation shows

there has been no permanent increase in demand for

safe-haven currencies. +2


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Risk appetite

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CHF Weighted score: -0.4

27

Currency Strategy

Swiss Franc VALUATION Strong trends in valuation measures like

nominal and real trade weighted currency indexes for the

CHF make it difficult to judge what its appropriate long-

term valuation is. The historical averages against the euro

and the dollar suggest it would be substantially

overvalued after its appreciation since 2008. In contrast

the CHF trades spot on the SEBEER long-term fair values

against the euro and the dollar suggesting it would rather

be fairly close to a more sustainable valuation. The

combined approaches therefore indicate the CHF

probably is somewhat overvalued although its valuation

is too close to its long-term sustainable level for valuation

to be a driver for the CHF. -1

POSITIONING Speculators are currently net long CHF vs

USD. After the peg broke early 2015 positioning has been

gyrating between small short and long positions. Lately

speculators added quite largely to their net long position

which renders a small positive positioning score as the

trend is expected to continue and support CHF. +1

LIQUIDITY, EVENT RISKS AND GLOBAL CYCLE The SNB

continues to intervene in the FX market in order to

prevent EUR/CHF moving down towards parity again.

Although market reactions to Brexit have been fairly

muted it is a reminder of the uncertain European political

landscape. In the coming 12 months there are several

European events potentially increasing political risk

premia including the Italian constitutional referendum

(Oct 2016), French Presidential- (May 2017) and German

elections (Sept 2017). All these will be a recap to nervous

investors of the fragile state the euro zone is in making a

case for more capital flows seeking shelter in the Swiss

franc.


28

Currency Strategy

E one


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Swedish krona

Riksbank monetary policy - which indirectly aims to keep

the SEK artificially weak - has won credibility with market

participants. As such, despite strong fundamentals and

an attractive valuation, the market lacks a credible trigger

to realise the currency’s potential. This catalyst remains

connected with relative monetary policy differences

between Sweden and Euro-land. SEK risks include weaker

than anticipated global growth and the use of the krona

as a funding currency. The outlook is neutral now, but

positive going into 2017.

ECONOMIC FUNDAMENTALS Sweden has outperformed

most peers: the economy grew by 5-6% q/q AR by late

2015/early 2016. As the result of record-fast population

growth, housing starts and residential investments are

contributing strongly to GDP, as are public consumption

and investments. Recently, economic growth appears to

have slowed partly due to surprisingly weak exports, we

expect GDP to rise by around 2.5% next year. While

employment growth is very strong, unemployment is

falling only very slowly as more immigrants enter the

labour market. There are no signs of underlying wage

pressure despite several indicators showing neutral to

firm resource utilisation. In relative terms, the Swedish

economy remains strong although several policy areas

(e.g. housing, immigration/integration etc.) raise longer

term concerns. +1

MONETARY POLICY Having prolonged the QE program

yet again in April, the Riksbank appears finally to have

won credibility for its hard stance on the exchange rate.

Inflation remains stubbornly low and the effect on CPIF

from previous krona depreciation is fading. Despite few

near-term triggers for a much stronger SEK, the Riksbank

can hardly lower its guard short-term. We therefore

expect a fresh round of QE (albeit modest) in December.

Currently, the FX market is trading on a carry theme, so

monetary policy is contributing to a very weak SEK

outlook. This will change in due course with the nearest

potential trigger being a potential change in the Riksbank

mandate (the possible adoption of an inflation interval

could be seen as hawkish). -1

FLOWS The current account surplus remains relatively

high (5%/GDP) despite growth being driven by strong

domestic demand. Foreign real money investors have

lowered their ownership rate for Swedish government

bonds fairly drastically (from 50% to 31%). Also,

speculative investors have finally heeded repeated

warnings from the Riksbank not to chase the currency

any higher. Consequently, positioning is currently

neutral/short SEK for the first time in a long while. As

Swedish FX hedge ratios remain low, further SEK positive

flows from domestic accounts are possible also including

financial institutions. To unlock the potential for a

stronger flow outlook Riksbank is the ultimate trigger

when policy diverges from ECB. 0

-0.8 -0.6 -0.4 -0.2 0.0 0.2 0.4 0.6 0.8

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Event risk

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Fundamentals

SEK Weighted score: -0.4

29

Currency Strategy

Swedish krona VALUATION The trade weighted krona remains under-

valued compared to our long-term fair value model

(SEBEER). It appears to be roughly 5-6% undervalued in

trade weighted terms based on the SEBEER-estimate.

Hence valuation is not severely stretched. As SEK has

continued to slide a weaker exchange rate now

contributes to a pick-up in imported prices. This is

important for Riksbank as it fights to reach for the 2%

inflation target. Nevertheless maintaining a weak SEK is

desired by the central bank as it will support

competitiveness and support higher inflation. In real

trade weighted terms the krona seems still cheap, which

makes it complicated to argue Sweden would need an

even weaker krona. +2

POSITIONING Our speculative proxy position for SEK

versus USD indicates that speculators just switched into a

small short SEK position. Meanwhile our positioning

analysis of speculators positioning in SEK versus EUR

which is based on client flows has shown a negative SEK

sentiment during summer with mostly net SEK selling.

However, lately the interest has been waning and last

week the sentiment was basically neutral indicating a

possible shift in sentiment. However, the positioning

score in this report is zero as the overall position is not

excessive compared to historical levels and the recent

less SEK negative trend is not large enough. 0

LIQUIDITY, EVENT RISK AND GLOBAL CYCLE Liquidity

remains poor at times and Riksbank government bond

purchases (SEK 215 bn) have worsened this liquidity

premia. SEK correlations to risk appetite has changed

during 2016, we think SEK should have relatively low

correlation to risk appetite longer-term.

Main risks for the krona are: 1) Inflation to remain well

below target meaning Riksbank has to extend QE. 2)

Adverse developments on the Swedish housing market

which could trigger a foreign exodus of portfolio

investments. However, we still attach a low probability to

this event happening; 3) Squeeze on money market

especially shortage of USD liquidity making SEK even

more of a funding currency.


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8.9

9.0

9.1

9.2

9.3

9.4

9.5

9.6

9.7‐70%

‐50%

‐30%

‐10%

10%

30%

50%

70%

2015.01.05

2015.02.02

2015.03.02

2015.03.30

2015.04.27

2015.05.25

2015.06.22

2015.07.20

2015.08.17

2015.09.14

2015.10.12

2015.11.09

2015.12.07

2016.01.04

2016.02.01

2016.02.29

2016.03.28

2016.04.25

2016.05.23

2016.06.20

2016.07.18

2016.08.15

EUR/SEK (reversed)

Weekly sentiment index

SEK flows versus EUR/SEK

Buy high volume Buy avg volume Buy low volume

Sell high volume Sell avg volume Sell low volume

EUR/SEK reversed

30

Currency Strategy

Norwegian krone The krone has been hurt by plunging oil prices, which has

spurred fears of a Norwegian recession and unconventional

monetary policy. Such risks have now been significantly

reduced, but the krone still trades cheap relative to its long-

term fair value. With the NOK still closely tied to oil prices,

our $55/b average forecast for next year is supportive.

Moreover, as growth momentum picks up further, Norges

Bank will switch to a more neutral policy stance and relaxed

attitude against the krone. In the near-term, however,

Norges Bank is likely to watch the 9-handle in EUR/NOK

carefully. We favour to sell EUR/NOK on rallies towards

9.40.

ECONOMIC FUNDAMENTALS Extensive cutbacks in the oil

sector has slowed growth over the past years. Fears of even

more severe negative secondary effects have lingered but

various sentiment indicators and economic data have

recently confirmed that the low point was passed last

winter. To wit, sequential growth in mainland GDP firmed in

spring by rising 0.4%. The composition of growth was

favourable with stronger non-oil domestic demand on back

of resilient private consumption and rebounding mainland

investment. However, the recovery will be modest due to

still sharply falling petroleum investment and high inflation

squeezing households’ spending power. We expect below-

trend growth in mainland GDP of 0.9% in 2016 and 1.8% in

2017. 0

MONETARY POLICY Norges Bank has noted that downside

risks to growth have eased although it expects the economy

to remain weak in the coming period. The “certain”

September cut in the bank’s June path was thus a bit

surprising and signals the bank remains on guard against a

too rapid and speculation-driven appreciation of the NOK.

Monetary policy going forward will be a trade-off between

positive economic data and stronger krone. EUR/NOK

above 9.10 would give the bank room to adopt a wait-and-

see approach. Hence, we expect Norges Bank to remain on

hold while keeping a clear dovish bias in its rate path. A

further pick-up in growth next year will render a more

neutral policy and allow for EUR/NOK to trade below the 9-

handle. A repricing of market’s expectations has already

occurred, but long-term rate prospects remain very

subdued. 0

FLOWS Expansionary fiscal policy generates positive NOK

flows as the government is using an increasing share of its

oil revenues to cover the non-oil budget deficit. Norges

Bank will carry on purchasing 900-1000m NOK per day

against FX in 2016, upholding the positive NOK flow.

Despite OBX being heavily energy-related, foreigners’

ownership ratio has been surprisingly stable over the past

years and is expected to remain around 36-37% in coming

months. As investors’ search for yield continues, Norwegian

bonds should become increasingly attractive on a relative

basis. Such flows have not been sufficient to have a material

impact on the krone so far and we expect fast money to

continue dominating flows. +1


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31

Currency Strategy

eric

Norwegian krone VALUATION Lower oil price and a recoupling of NB

monetary policy with other central banks have been

extremely harmful to the NOK. The krone reached

extreme levels of more than two standard deviations

from long-term averages against both the EUR and the

USD at the beginning of this year, which rarely is

sustainable. Our long-term fair value model (SEBEER) also

suggests that the NOK is undervalued in trade weighted

terms with fair value in EUR/NOK at 8.25. However, when

considering the rapid growth in labour compensation for

more than two decades, the NOK depreciation has so far

only neutralized part of the sharp increase in Norwegian

labour costs. Basically all valuation measures indicate the

NOK has reached undervalued levels. With a more stable

oil price, signs that the economy starts to recover and a

long-term NOK-positive flow outlook current stretch in

valuation is unlikely to persist. +3

POSITIONING Our proxy for speculative positioning in

NOK versus USD indicates that speculative accounts are

somewhat long NOK. Current positioning is 1.0 standard

deviation above the three year average as the strong USD

trend is still in the calculation. The past two weeks the

long NOK position has been scaled back marginally but

both the level of the position and the recent change are

too small to generate anything but a neutral positioning

score. 0

LIQUIDITY, EVENT RISK AND GLOBAL CYCLE

Performance of the krone remains closely tied to

developments in oil prices. The correlation between NOK

and oil increased substantially when oil prices plunged in

late 2014 and remains high. We expect the correlation to

be maintained as long as oil prices impact the outlook for

growth outlook and Norges Bank. We believe that the oil

market is rebalancing with crude stocks sliding as

demand is healthy and supply side is contracting in 2016.

We thus expect the oil price to recover estimating Brent

crude to average $55/b in 2017. Given the correlation the

outlook supports our positive view on the krone.

However, one cannot exclude a renewed downturn in oil

prices. There are signs of increased activity in the US with

the number of active oil rigs having jumped by ~30%

since late May. Should this trend continue the oil market

will remain in surplus next year, depressing the outlook

for the oil price. Such a scenario risks fuel NOK-negative

speculative flows as 1) market would re-focus on rate

cuts, and 2) Norges Bank would maintain a

currency/growth-oriented policy.

32

Currency Strategy

Russian rouble The correlation between the RUB and the price of oil has

weakened, due to rising global risk appetite driving

capital to high-yield Emerging Markets. Nevertheless, the

RUB’s fortunes remain highly dependent on energy

prices. With Brent set to average $50/b in H2 16 and the

Russian central banks (CBR) rebuilding reserves, we see

USD/RUB hovering around 64.00 for the remainder of

the year. We see the risk as being evenly distributed

between an unexpected strengthening and a weakening.

ECONOMIC FUNDAMENTALS The price of oil in RUB

terms is now close to the 2016 budget assumption of

RUB 3,150/b. The price recovery has eased fears of a

further slowdown in economic activity and reduced the

pressure on the RUB exchange rate. Nevertheless, due to

high inflation undermining the purchasing power of the

RUB, the government will still have to cut expenditure

sharply. It will delay some budget cuts by tapping into

the reserve fund, but it cannot avoid the inevitable. As a

result, economic recovery will be slow. Real GDP looks

set to fall by 0.4% in 2016 and grow by only 1.0% in

2017. At the same time, inflation will remain elevated at

7.3% this year and 6.0% in 2017, above the 4.0% target.

While the recession appears to be bottoming out,

consumption has been hit hard by a fall in household real

income, which will remain a drag on overall growth.

Due to a strong dependence of public finances on oil

(roughly 50% of federal government revenue come from

the hydrocarbon industry), the central bank will not let

the RUB appreciate unless oil also rallies. Another reason

for resisting an appreciation of the RUB is that it would

hurt fledgling non-oil exports. -1

MONETARY POLICY The CBR resumed its rate-cutting

cycle in June after having been on hold since August

2015. With confidence returning and inflation edging

down, the CBR will cut interest rates by 50bps to 10.00%

on September 16 and by another 100 bps before the end

of 2016. CBR governor Elvira Nabiullina enjoys a good

relationship with President Putin, who has avoided

criticising the bank. The CBR has been quite hawkish,

staying committed to bringing down inflation to 4% by

2017, despite pressure from lower-level politicians to

loosen policy. We do not expect the CBR fully to succeed

to bring down inflation to the target, which will limit the

downside potential to rates. If high interest rates attract

capital inflows, the CBR will respond by accumulating

reserves rather than cutting rates. -1

FLOWS The current account surplus has narrowed in H1

2016 compared to the same period in 2015 due to lower

exports. Yet, it will continue to generate a surplus. The

pace of capital outflows has slowed, even turning into a

surplus in Q2. Reserves have risen by almost 8% since

January. With a strong global risk appetite, reduced

political uncertainty, including talks of easing sanctions,

and high yields in Russia, capital flows will be supportive

for the RUB. 0


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33

Currency Strategy

Russian rouble VALUATION The RUB remains severely undervalued in

real, standing more than 20% below its detrended

average. However, the appreciation impetus from the

undervaluation of the REER is currently offset by the low

value of oil in RUB terms. Assuming that oil remains close

to the current level around $48/barrel (±$3.0), in order to

bring the price of oil in RUB to the inflation-adjusted

mean since July 1994, the RUB would need to depreciate

by some 10% against the USD. However, fearing an

inflationary impact, we expect the CBR to keep interest

rates attractive enough to avoid a selloff in the RUB.

While the REER is not a reliable guide in terms of the

valuation of the RUB, it suggests that the RUB is unlikely

to depreciate much further, leaving the currency as an

interesting carry target. +3

POSITIONING Speculators in the RUB have become

increasingly bullish and have added to their net long RUB

positions since the begging of 2016 very much in line with

the recovery in oil prices. Net longs reached a 5-year high

on August 30, but the jump was not large to generate a

positive positioning score. 0

EVENT RISK, LIQUIDITY AND GLOBAL CYCLE The rouble

is facing two key risks: 1) a renewed fall in the price of oil;

and 2) increasing tensions in relations with the EU and

US.

The relative stability in the oil market in 2016 suggests

that it has found, if not an equilibrium point, at least an

equilibrium range close to $45–$50 per barrel. If Brent

goes below that range US production starts to shut down,

sapping supply, and vice versa if prices rise above the

range.

Regarding relations with the “West”, they have

deteriorated to the point of a new cold war. However, the

current cold war is not as tense as the one during the

Soviet era. Russia is highly unlikely to increase tensions

much further permanently. Intervening militarily in a Nato

country, for example the Baltics, would risk much more

severe sanctions than did the annexation of Crimea and

involvement in eastern Ukraine. It could even include a

military confrontation with Nato. The long-term cost

would be too high and the benefits would be dubious.

Event risk is nevertheless high, but should be followed by

periods of fence building. We are currently in a calmer

period in relations with the West, but an easing of

sanctions is unlikely before 2H 2017.


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Currency Strategy

E one


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Chinese yuanWe expect USD/CNY to end this year at 6.80. China will

continue to slowdown and more strict tightening

measures will be implemented in late 2016 and into 2017

to control the rising debt and property market. The

slowdown will weigh on the currency. We don’t expect

large depreciation on the currency because we are

entering a sensitive political season heading into Q4 2017

when the top members of the communist party change

every 5 years. President Xi would want to keep economic

and politics as stable as possible going into this meeting

to make sure he can appoint his people. That would pave

the way for potential more reforms in the following 5

years. Also, President Xi won’t become a target of

investigation once he leaves office in 2022.

ECONOMIC FUNDAMENTALS China had a healthy

growth of 6.7% in the first half led by monetary and fiscal

support. However, the outlook is to decelerate to 6.6% by

year end further to 6.3% in 2017. The slowdown should

come from the construction and housing sector that has

performed too well. Property prices in major cities like

Shanghai and Beijing are rising over 30% y/y and that has

reignited construction activity and commodity demand.

However, now the government has started to implement

austerity measures to cool down the housing market. In

addition, capex from businesses should slow as Chinese

companies look abroad to acquire new technologies and

export excess capacity. -1

MONETARY POLICY Monetary policy stance has shifted

to neutral from an easing bias. Interest rates and reserve

requirement ratios (last cut in March) have been stable

but other forms of lending using local government bond

issuances have added as monetary stimulus in late 2015

and early 2016. We expect this to slow, policy to shift to

neutral and dampen economic growth into 2017.

Government officials are commenting that growing by

debt is the same economic model as the past that has

gotten them into trouble and will slowly move away from

debt driven growth. Inflation may rise temporarily in Q4

due to floods increasing food prices but that should come

down in 2017 and hence, inflation risks remain low. +1

FLOWS The mass outflows have abated with a more

stable currency and some capital controls. However,

going forward the pressure is for outflows to restart.

Generally, households want to diversify from holding

100% of their assets denominated in RMB and demand

for buying foreign assets will only increase. Corporates

also want to invest abroad as China’s economy slows.

Corporates also want to buy foreign companies to acquire

technology and move up the value chain. We think the

combination of outward flows and keeping the currency

stable into 2017 political shift will lead to more depletion

in FX reserves. China’s central bank will continue to sell

foreign assets. -1

35

Currency Strategy

Chinese YuanVALUATION China’s government and IMF both stated in

2015 that CNY has reached fair value. Since then, CNY

has become undervalued by almost 10%. The RMB index

published by the government continues to weaken and

many investors are worried that government policy is to

weaken CNY on a trade weighted basis. We don’t think

the government wants to weaken CNY on a long term

basis and this is one step in creating two-way volatility.

The CNY will again strengthen on NEER and REER basis in

the next 6 months to prevent one-way bets. +1

POSITIONING This is difficult to gauge but we estimate

based on long term and short term. Long term, we still

think most domestics are long CNY. These positions were

accumulated over 10 years post the depeg and domestic

corporates still have not learned to hedge FX exposure

and still need to liquidate long CNY positions. Short term,

we look at how spot is trading relative to daily fixing and

the band of +/- 2%. Spot is now swinging around the

fixing, meaning markets are neither long nor short CNY.

0

LIQUIDITY, EVENT RISK AND GLOBAL CYCLE Even

CNY has succumbed to the mighty USD and the global

cycle. CNY and CNH will weaken mildly on one or two Fed

hikes. The risk is if US enters a regular tightening cycle.

You can see the risk when the CNY and CNH spread

widens. The CNY market is still controlled by a closed

capital account but the “more open” CNH market shows

stress on the currency and the CNY and CNH spread

starts to widen in times of stress. Another risk we see is

on FX policy. The central bank is not letting the currency

weaken according to fundamentals for political reasons.

That means pressures are rising for CNY to weaken. We

think there is a risk of another one-off devaluation post

the next transition in the communist party in 4Q 2017.

-1


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36

Currency Strategy

Contacts

STOCKHOLM

Carl Hammer (editor)

+46 8 506 231 28

[email protected]

Richard Falkenhäll

+46 8 506 231 33

[email protected]

Mattias Bruer

+46 8 506 232 94

[email protected]

Per Hammarlund

+46 8 506 231 77

[email protected]

Andreas Johnson

+46 8 506 232 95

[email protected]

Karl Steiner

+46 8 506 231 04

[email protected]

FRANKFURT

Thomas Köbel

+49 69 97 27 12 45

[email protected]

OSLO

Erica Blomgren

+47 22 82 72 77

[email protected] SINGAPORE

Sean Yokota

+65 6505 0500

[email protected]

37

Currency Strategy

Notes

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38

Currency Strategy

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Currency Strategy

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