Barclays Global FX Quarterly Fed on Hold Eyes on Growth
Transcript of Barclays Global FX Quarterly Fed on Hold Eyes on Growth
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Foreign Exchange Research
September 2013
PLEASE REFER TO THE LAST PAGE FOR ANALYST CERTIFICATION(S) AND IMPORTANT DISCLOSURES.
Global FX QuarterlyFed on hold, eyes on growth
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CONTENTS
Top Trades ............................................................................................... 2Our top three thematic trades are short AUD/CNH, long 6m GBP/USD put spread and long
EUR/CHF. Our top two relative value trades are short ZAR, TRY against MXN, PHP and long
EUR/CZK.
Overview ................................................................................................... 3Fed on hold, eyes on growth
The Feds decision to postpone tapering delays, but does not derail our constructive USD
outlook. We expect the delays to add USD250bn to the Fed balance sheet; hence, we expect
the USD to trade sideways with a downward bias in the near term.
Theme 1: EUR and CHF ......................................................................... 8Fed does not derail EUR/USD weakness
We expect EUR/USD to range trade over the near term with downside risks, with the ECB
likely to ease liquidity conditions through a VLTRO in late Q4. Further out, diverging growth
trends and the relative monetary policy outlook still point to EUR/USD weakness.
Theme 2: EM .......................................................................................... 13Square carry shorts until tapering
For the first time since the start of the year, we recommend taking profits on our short EM
carry positions, adopting a more neutral stance. We recommend being long the RUB,
staying short the ZAR and neutral the MXN.
Theme 3: CNY, AUD and NZD ............................................................ 17Local matters
We think the PBoC will continue to use currency appreciation, albeit at a slower pace than
this year, as a rebalancing tool. Slowing growth in China, as well as a soft outlook for
domestic economies, is likely to weigh on AUD and NZD in the medium term.
Theme 4: GBP ........................................................................................ 20Fade the rally
Against the backdrop of the delay in Fed tapering, stronger UK data and a disappointing BoE
forward guidance framework have boosted GBP recently. We think the good news is largely
priced and expect underlying headwinds to re-emerge, putting downward pressure on GBP.
Theme 5: JPY .......................................................................................... 25Grind higher, against gravity
We continue to expect USD/JPY to grind higher, driven by the relative growth and monetary
policy outlooks between the US and Japan. Political uncertainty poses downside risk in the
near term yet upside risk in the longer term.
FX Views for the Year Ahead .............................................................. 28
Open Trades .......................................................................................... 33
FX Closed Trades .................................................................................. 34
FX Forecast Tables ............................................................................... 36
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FX STRATEGY
Top trades1
Thematic trades
1. Short AUD/CNH spotChina growth is expected to remain under pressure, despite the recent bounce-back in data.
CNY appreciation will likely continue to be used as a tool for rebalancing (toward
consumption), while lower investment and growth should weigh on the AUD.
2. Long 6m GBP/USD put spread
We believe current levels offer a good opportunity to establish a medium-term view of a gradual
but persistent move lower. BoE monetary policy is set to remain loose for far longer than Fed
policy, and GBP weakness related to a rebalancing of the UK economy away from services/non-
tradable sectors toward tradable sectors is still relevant.
3. Long EUR/CHF spot
We recommend going long EUR/CHF spot on reduced fragmentation risks and significantscope for unwinds of legacy long CHF positions amid better sentiment in the euro area. A
stable EUR/USD in the near term with depreciation ahead means that we keep our long
USD/CHF position.
4. No longer underweight carry
We expect the delay in Fed tapering to provide breathing room for high-yielding EM FX and
allow some differentiation in the asset class. In our view, short EM carry is not an attractive
proposition in the near term until the likelihood of tapering increases again.
Relative value trades
1. Still Short ZAR, TRY vs MXN and PHP
A slightly more constructive global context is not enough to outweigh external funding
needs and declining activity (ZAR) and currency-mismatched balance sheets (TRY).
Structural reforms still make the MXN and PHP appealing on a relative basis, despite the
cyclical softening and dovish monetary policy for the MXN.
2. Long EUR/CZK spot
The weakness in the economy and likely downward pressure on inflation argue for central
bank intervention to weaken the crown, in our view.
1 Please refer to the Open Trades table for the specifics on these recommendations.
Jose Wynne
+1 212 412 5923
Aroop Chatterjee
+1 212 412 5622
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OVERVIEW
Fed on hold, eyes on growth
The Feds decision to postpone tapering delays, but does not derail, our constructive
USD outlook. We expect the delays to add USD250bn to the Fed balance sheet; hence,
we expect the USD to trade sideways with a downward bias in the near term.
The EUR should trade in a range until later in Q4, when we expect to re-engage in short
EUR/USD positions. Tapering and a stronger US growth outlook, combined with ECB
LTROs, should favour a weaker EUR. Fed measures and economic recovery should be
CHF-negative. We recommend tactical long EUR/CHF positions at current levels.
We expect Chinese growth to remain under pressure, despite the recent bounce back in
data. CNY appreciation will likely continue to be used as a rebalancing tool (toward
consumption), while lower investment and growth should weigh on the AUD. We
recommend short AUD/CNH in spot.
For the first time since the start of the year, we recommend taking profits on our short
EM carry positions, adopting a more neutral stance. We recommend being long theRUB, staying short the ZAR and neutral the MXN.
Stronger UK data and disappointment in BoE forward guidance have pushed GBP up.
We think the good news is priced and expect underlying headwinds to re-emerge,
putting downward pressure on GBP. Buy a 6m GBP put spread (1.60 vs 1.55).
Data and Fed delay the USD rally
We still expect the USD to strengthen in the coming months, but recent surprises on activity
and the Feds decision to delay tapering have led us to modify our views for Q4. For the first
time in months, we think it is time to take profit on our short EM carry positions held since the
start of the year. We also think a broad-based USD rally against the major currencies, including
the EUR, will have to wait until the Fed begins to taper (in December, we expect) or until
growth trends in the US and EU re-diverge. Moreover, we see the growth rebound in China as
reassuring, though headwinds from rebalancing will likely be too much for the AUD to handle.
Thus, we recommend re-engaging in AUD shorts at current levels.
The main surprise to our short EUR/USD position was in activity data from Europe and the
Feds decision. Under our base case, we expected the US economy to grow in line with what
data have shown, with unemployment dropping faster than most anticipated on a shrinking
labor force participation rate (driven by demographic forces, such as the retirement of baby
boomers), pushing the Fed to taper in September, as most market participants believed.
The reasons for the tapering delay have yet not been made clear, but we think several factors
played a part. For instance, the housing market seems to have slowed on higher mortgage
rates and economic activity has disappointed the Feds expectations. Furthermore, taperingexerted more pressure on the belly of the UST curve than could be contained by forward
guidance alone. Most of the fiscal drag from sequestration is also likely to hit between now
and year-end, and the committee may have considered it more appropriate to wait.
Additionally, significant funding pressures in some emerging markets (ie India, Indonesia,
Turkey, South Africa and Brazil) could have increased the perception of downside risks to
global growth. Perhaps even the risk of a military strike in Syria was a factor in the decision.
We now expect the tapering program to begin in December and end in June 2014 (faster
than most expect, on falling labour force participation). Such a delay would add USD250bn
to the Fed balance sheet relative to our former expectations, part of which should end up in
Jose Wynne
+1 212 412 5923
Aroop Chatterjee
+1 212 412 5622
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equities and part in bonds (given shrinking net UST issuance). We think European equities
and EM may attract inflows. We expect this to be priced fairly soon, if not already, but we
believe staying short EM carry is not an attractive near-term proposition until the likelihood
of tapering increases again.
Our view was also surprised by a synchronized growth recovery in the developed world
(Figure 1). Confidence manufacturing surveys, even in Europe, have been stronger than our
relatively optimistic forecasts. A synchronization of a euro area recovery with the US fuelsequities performance, but limits the scope for currency moves, supporting the EUR and
limiting a broad USD rally beyond versus EM, as we discuss in detail in Theme 1. During this
synchronized global recovery, including China, growth and sentiment surveys disappointed
in most parts of the EM world. Lackluster EM growth also exacerbated the downward
pressure in EM carry currencies while the market digested news on tapering.
Furthermore, this unexpected rebound in activity in Europe has led us to push out our
forecast of further ECB easing this year from early Q4 to December. The view that the ECB
would engage in another round of VLTROs was a key ingredient in our call for a lower
EUR/USD. The ECB remains worried about the tightening of financial conditions that is
taking place as the liquidity surplus declines with LTRO money (from the past 3y LTROs)
being paid back (Figure 2). We remain enthusiastic about the idea that the central bank may
arrest the passive tightening by introducing further VLTROs at a fixed rate. In other words,
the ECB could receive fixed rates beyond the typical 3m LTRO for the first time since the
crisis, backing the recent forward guidance with a liquidity injection that would in practice
push 1y1y forward rates in Europe and EUR/USD, by extension, significantly lower.
The rebound in euro area data has removed the urgency for an immediate, large and
indiscriminate liquidity injection. Hence, it delays and mitigates our bearish EUR/USD view.
This explains why we expect EUR/USD to trade in a range over the next three months and
weaken afterward but with a lower terminal level (we have revised our 12m forecast from 1.23
to 1.27). This has become more likely with the Fed on hold and global rates stable. Had global
rates not stabilized, the ECB might have been forced to arrest tighter financial conditions with
easing measures. The weak growth trend remains a key concern for the ECB, in our view.
Finally, our lower EUR/USD call has also been challenged by the unwind of EM carry
positions. We were expecting USD, JPY and CHF to be almost the only funding currency
FIGURE 1
Synchronized rebound in global manufacturing confidence
in G4
FIGURE 2
Passive tightening to be addressed with another LTRO
(December)
Source: Barclays Research Source: Barclays Research
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Emerging economics
Euro area
UK
Japan
normalised
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Exc. Liq., eur bn, lhs 3bn payback
EONIA fixing, bp Exp. Eonia, bp
depo facility, bp refi rate, bp
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beneficiaries of the EM carry unwind (see our March FX Quarterly,Opportunities emerge as
correlation falls), but were surprised by anecdotal evidence suggesting that a good portion
of these EM positions were funded in EUR. This factor pushed the EUR higher in Q3 but is
likely to be less of a factor as EM assets stabilize in the short run.
Whats next for EUR/USD?
In Theme 1 we also argue that these surprises delay but do not derail our views for EUR/USD
and the USD more broadly. On the data, we think some of the rebound will fail to be sustainedand that soon enough divergent trends in the US versus euro area will re-emerge. Figure 3
shows that imports in the euro area have sharply underperformed those from any other parts
of the world. In contrast, corporate profitability in the US is at an all-time high and investment
intentions are up, suggesting pent-up demand (Figure 4). Furthermore, gains in US house
prices show strength in household balance sheets. Last, the US fiscal deficit is beating
expectations, providing reasons for optimism on corporate investment (supporting both the
S&P 500, which is at record highs, and tighter 5y CDS on US Treasuries).
Furthermore, we believe that the Feds decision to delay tapering may generate an even
better environment for a USD rally in Q1 14. By keeping the purchase program on hold,
there may be stronger economic activity the day the Fed begins tapering and, hence, better
conditions for a broad-based USD rally, including against the EUR (as well as others in theG4). Combined with further ECB measures to address the passive tightening in late Q4 13,
this environment is likely to be a powerful combination to get EUR/USD moving lower.
Meanwhile, we expect EUR/USD to stay range-bound, with short-term upside risks toward
1.37, and grinding lower as the rebound in the cyclical data disappoint and the weak
underlying growth trend emerges.
Still short CHF
We continue to like short CHF positions. In the context of the Feds postponement of
tightening, the CHF should underperform as risk and carry trades are tactically re-established
over the quarter. USD/CHF, however, is unlikely to move higher in the near term, given its
sensitivity to moves in front-end US rates. We keep our long USD/CHF position over the
medium-term horizon, however, since EUR/USD will likely be range-bound, at best, in the near
term, followed by subsequent depreciation. For the CHF, we see a variety of reasons to remain
bearish on the currency, as discussed in Theme 1.
FIGURE 3
Eurozone domestic demand is structurally weak
FIGURE 4
US corporate profitability at record highs
Source: Barclays Research Source: Barclays Research
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US EA Japan UK
3mma,SA 2007=100
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Corporate profits as a % of gross value added by the corporatesector (sa)
%
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China rebalancing to support CNY, weigh on AUD
In Theme 2, we focus on the FX implications of Chinas rebalancing. We think the recent
pickup in economic activity looks temporary. We expect economic growth to accelerate in Q3,
but we forecast a slowing into year-end and beyond. Indeed, we think the government intends
to rebalance the economy away from fixed investment and exports toward private
consumption which, although unavoidable, will be punitive for growth.
Despite the likely disappointing growth trend, we believe the government will continue to leanon currency appreciation as a rebalancing tool. We expect USDCNY to continue to fix lower
despite a stronger USD. This should continue to push CNY into stronger territory on
multilateral terms, albeit at a slower pace.
The recent improvement in Chinese growth sentiment helped AUD recover lost ground in
September, but we think downside pressure on AUD will re-emerge. The currency is still
15% and 12% expensive on a multilateral and bilateral basis, respectively. A slower China
and significantly slower investment demand should deter AUD optimism, despite the global
cyclical rebound.
Square EM carry shorts
The USD250bn of assets that the Fed is likely to purchase before revising its current policies
will prop up demand for EM assets and support carry. In Theme 3, we discuss these issuesand, although these inflows will not undo the large depreciation of many EM currencies over
the past quarter, we do expect this to provide breathing room for high-yielding EM FX.
Against a backdrop of muted risk aversion and relatively attractive valuations, we believe
markets will allow some differentiation in EM. These are our main picks:
Square underweight in the BRL and INR, stay neutral on the MXN. Mexicos structural
reforms are likely to deliver improved growth and a stronger currency, but the loss of
cyclical momentum and easier monetary policy implies balanced risks for the MXN.
Furthermore, the high carry offered by the BRL and INR seems attractive from a risk-
adjusted perspective, now that firm policy intervention is in place.
Short ZAR, long RUB, and cautious TRY and IDR. A slightly more constructive globalcontext is not enough to outweigh external funding needs and declining activity in
South Africa. Policymakers in Turkey and Indonesia will likely continue to use the
exchange rate as a policy instrument to limit liability mismatches. The RUB offers a
relatively high carry, and spot is supported by improving prospects for oil prices.
Long PLN and MYR. A recovery of global manufacturing activity would benefit Poland,
while we think funding pressures on the MYR are likely over. Leading indicators point to
a growth pickup in these economies, especially given their relatively low vulnerability to
a sudden spike in global interest rates.
Buy GBP put spreads to fade the rally
We were surprised by the stronger UK data and disappointed by the knockouts included in
the BoE forward guidance, which pushed the GBP higher. In Theme 4 we argue that the
good news is priced and that we expect underlying headwinds to re-emerge, putting
downward pressure on the GBP.
We expect BoE monetary policy to remain loose for far longer than Fed policy, which should
weigh on the currency. UK rates continue to price tighter policy than the BoE and our
economists expect. We think market pricing is inconsistent with the MPCs expectations for
the underlying growth trend and inflation outlook. The September FOMC meeting serves as
a warning to the market that central banks ultimately control policy and retain the power to
move rates where they see fit. We expect the MPC to bolster its forward guidance
framework, especially if UK economic data soften.
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USD/JPY to grind higher
In Theme 5 we provide an update on USDJPY. We maintain our medium-term bullish view
on USD/JPY and expect it to grind higher toward 103-105 in the next 12 months. Both the
relative growth and monetary policy outlooks favour a higher USDJPY, despite the fact that
the yen is abnormally cheap. We expect the VAT hike to slow economic activity, starting in
Q2 2014, at a time when the US economy is expected to be growing 2.5%, and tapering is
well advanced (expected to end by June 2014). We expect slower activity and a marginally
more proactive BoJ to weigh on yen in a stronger USD environment.
In the very near term, we think political uncertainty in the US and Japan poses downside risk
to our forecast, and as a result, we do not recommend being long USDJPY just yet. In the US,
the debt-ceiling issue (to be addressed by mid-October) and the budget for the next fiscal
year remains unresolved. In Japan, PM Abe is widely expected to go ahead with the VAT
hike as planned, but disappointments could put downward pressure on equities and USDJPY
in Q4.
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THEME: EUR AND CHF
Fed does not derail EUR/USD weakness
The main surprises to our short EUR/USD position came from euro area activity data and
the Feds decision to delay tapering. We expect EUR/USD to range trade over the near term
with downside risks as the ECB re-takes control of the short end of the yield curve and
eases liquidity conditions through a VLTRO in late Q4. Further out, diverging growth trends
and the relative monetary policy outlook still point to EUR/USD weakness. A stable
EUR/USD near-term with depreciation ahead means that we keep our long USD/CHF
position. We recommend going long EUR/CHF spot on reduced fragmentation risks and
significant scope for unwinds of legacy long CHF positions amidst better sentiment in the
euro area.
Fed action has delayed the broad USD rally, which we had expected to encompass low
yielders such as the EUR. Indeed, the bigger disappointment emerging from the September
2013 FOMC, in our view, was continued reticence in allowing the short end of the yield
curve to price in rate hikes than the decision to delay the tapering in asset purchases. So far
in H2 13, the Fed has been more successful than the ECB in controlling the short end of the
yield curve, and the relative movement in short rates has supported EUR/USD.
Although we do not expect any aggressive policy shifts by the ECB, we expect it to cap any
steepening in the rates curve and/or a decline in the liquidity surplus. As such, we see
EUR/USD stuck in a range initially (1m forecast: 1.35), potentially weakening at the 3m
horizon (3m: 1.32) as the ECB responds to the liquidity tightening with a new LTRO. We still
believe monetary policy divergence will favour the USD over the EUR in the medium term,
though the pace of depreciation is likely to be relatively slow as the US curve is allowed to
steepen only gradually. We expect the weakening trend in EUR/USD to persist (6m forecast:
1.30, 12m: 1.27), with diverging medium-term prospects implying a more aggressive ECB than
the Fed. Euro area events that pose downside risks to our forecast profile include package
renegotiations in Portugal, Greece and Cyprus, as well as added political uncertainty (Italy).
Why is EUR/USD not lower?
The resilience of the EUR is owing to a less-than-credible forward guidance (FRG)
framework, a backup in rates that has happened more rapidly than in the US (especially
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Aroop Chatterjee
+1 212 412 5622
FIGURE 1
Correlation of 1y1yf rates in the euro area and the US
FIGURE 2
Importance of each factor (beta * standard deviation)
Source: Barclays Research Source: Barclays Research
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Relativeequities
10Yspread
1Yspread
3MLIBORspread
3MLIBORspread(level)
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recently) and signs of an improved outlook in the euro area, which have led to a fresh influx
of foreign capital flows. These add to other inflows into the euro area such as from euro
area banks disposing of foreign assets, as well as investors unwinding/hedging EM risk in
the tapering-related EM asset sell-off in summer 2013.
We had argued that the imposition of forward guidance regimes should be negative for the EUR
to the extent that the frameworks are able to control front-end rates. The ECBs inability to
achieve this is striking, as Figure 1 shows, with correlations between euro area and US rates
recoupling only a month after the announcement at the July meeting. Although the euro areas
emergence from recession may have something to do with the steepening in EUR rates, the
lions share has clearly been driven by the backup in US rates (correlations are 80-90%).
The EUR has been particularly sensitive to these developments: the EURs beta to 1y rate
spreads is the strongest driver per our FFV model (Figure 2), and the movement in relative
interest rates contributes nearly two-thirds of the EURs rally since July (Figure 3). What is
striking is that other factors such as relative equity returns (which capture improved euro
area growth prospects and sentiment versus the US) have not contributed as much to the
EURs stability (about 20% of its move), even though European equities have moderately
outperformed those in the US over the past three months.
However, there is some evidence to suggest that investor flows into the euro area haspicked up recently after years of being underweight the region. Flows into Europe ex-UK
show a noticeable pickup from early July onwards. Given our overweight view on European
equities (Global Outlook,26 Sep 2013), we expect these flows to provide some additional
support for the currency.
Further, BIS data show that euro area banks continued to sell assets outside of the region into
Q1 13. Cross-border lending by euro area banks has dropped $105bn since the end of Q3 13.
The largest declines were against developed market countries, with lending into the G10 (ex-
euro area) falling about $147bn. Inasmuch as these loans are FX hedged, we would expect a
disposal of assets to generate an FX flow back into the euro area, adding to the EURs resilience.
Finally, the EUR/USD may have received additional support from the unwind of EM carry
positions. We were expecting the USD, JPY and CHF to be almost exclusively the currencybeneficiaries of the EM carry unwind (see the March 2013Global FX Quarterly), but were
surprised by the anecdotal evidence suggesting quite a bit of these EM positions were
funded in EUR.
FIGURE 3
Breakdown of EUR/USD moves using our FFV model since
July 2013
FIGURE 4
Equity mutual fund flows into each country/region, 2013
(mm, cumulative)
Source: Barclays Research Source: EPFR, Haver Analytics, Barclays Research
0
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US-EA cyclical divergence
On the cyclical outlook, we believe diverging trends in the US versus EU will re-emerge as
2014 begins. There are a variety of reasons to be positive on underlying US growth. We
expect the drag from the spending cuts/sequestration to lessen into 2014. At the same
time, the wealth effects generated from higher financial assets and housing prices should
continue to bolster consumer spending; we estimate that higher prices on financial assets
and houses will generate 1% more consumption growth in 2014, offsetting the drag from
the fiscal headwinds. On the investment side, cleaner balance sheets and improved
profitability in the corporate sector, aided by loose credit conditions, are likely to spur credit
growth and investment. In the euro area, tight credit conditions, deleveraging and banking
sector issues are likely to restrain growth. The credit crunch in the periphery has continued
(Figure 5). The upcoming asset quality review ahead of the first stage of the banking union
is a risky exercise that may increase the credit issues of the periphery, implying downside
risks to growth. With full employment in the euro area still a far-off prospect (NAIRU
estimates are about 8%, compared with a prevailing unemployment rate of north of 12%),
monetary policy in the euro area will very likely remain far looser for longer than in the US.
Over the medium term, we expect this divergence in US and euro area growth to persist and
drive the relative monetary policy outlook. For the Fed, we expect tapering to begin in
December 2013, though that is likely to have a limited effect on EUR/USD, given itssensitivity to the short end of the yield curve rather than the long end (on which QE has a
bigger effect). However, into 2014, we expect the stronger underlying trend to the US
economy to give the Fed some comfort in allowing the market to price in higher rates. And
after the September surprise from the Fed, the next policy surprise over the coming three
months may indeed arrive from the ECB.
ECB to respond
We expect the ECB to find it tough to control EUR rates beyond the front end of the money
market curve as data in the euro area improve faster than market expectations. However,
we do expect the ECB to regain control of the very front end through the unveiling of
another VLTRO program in Q4 13. This would address any liquidity pressures (ie, as the
liquidity surplus falls below EUR200bn) and prevent EONIA moving up too sharply inside the
corridor. At the September press conference, ECB President Draghi included a paragraph on
liquidity conditions for the first time, and while stating the current level of excess liquidity
(c.EUR220bn) was adequate, the ECB will act to offset any future declines that affect the
FIGURE 5
Continued signs of a credit crunch
FIGURE 6
1y1y Eonia rates to stay capped
Source: Barclays Research Source: Barclays Research
-2
0
2
4
6
8
10
12
14
16
92 94 96 98 00 02 04 06 08 10 12
M3 M1 Loans to private sector
% y/y
1.20
1.25
1.30
1.35
1.40
1.45
1.50
-0.4
0.0
0.4
0.8
1.2
1.6
Sep-10 Sep-11 Sep-12 Sep-13
1y1yf Rate differential EURUSD
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EONIA fixing. Additionally, it would smooth the exit from the previous LTROs, so that there
is no jump in rates after the previous ones expire, and would help (even if only on the
margin) to unlock lending to SMEs. Since we expect any new LTRO to be tailored towards
periphery SMEs, however, this may limit the scale of the liquidity injection, something
whose necessity is arguably reduced as the recovery in the euro area gains traction.
We expect the market to take EUR150-250bn of new liquidity in a new long-term program
(beyond the expiry of the current 3y LTRO in February 2015). The amounts could be larger ifthe overall risk environment does not deteriorate and/or the terms are made extremely
attractive. A fixed-rate, long-dated program would likely be taken as a very dovish policy shift
by the market and help the ECB gain more traction with its FRG. Our rate strategists expect a
VLTRO announcement along the lines described above to push 1y1yf EONIAs to decline to
10-20bp (from approximately 35bp). All else equal (assuming no change to US rates and
broader risk appetite), it would imply EUR/USD could depreciate 3-4%, using the sensitivities
in our FFV model. We acknowledge this by pushing our 3m forecast down to 1.32.
Keep on the radar
After a relatively calm (in policy terms) summer, the coming quarter is likely to bring several
key policy issues back to the table. Our economists have highlighted (seeEuro Area Focus:
Busy Schedule for Finance Ministers) the large degree of uncertainty over the upcoming
asset quality review, details of which will be revealed by mid-October. While conditions for
European banks have improved significantly in the past year, it is not known how potential
capital shortages will be tackled. Policy discussions on the issue may also offer a source of
market volatility since any disagreements would delay subsequent stages of
implementation of the banking union, increasing fragmentation and worsening prevailing
financial conditions. These present downside risks to the EUR since it would invite
aggressive monetary support from the ECB.
Second, troika-programme countries are reaching important deadlines. While significant
progress has been made in Ireland (indeed, we expect the country to regain market access),
the environment for Portugal is more challenging. Negotiations on the current program are
likely to begin in November, and our economists believe that another program will be
necessary for Portugal, which is likely to reignite the PSI debate, given the hostility towards
FIGURE 7
2s10s spreads in the periphery have stabilised after periods
of stress in the past three years
FIGURE 8
Swiss banks total CHF foreign assets minus liabilities (LHS,
CHF mn) versus average Spanish and Italian deposit growth
(y/y, RHS)
Source: Barclays Research Source: SNB, Haver Analytics, Barclays Research
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
-100
-50
0
50
100
150
200
250
300
350
400
Jan-09 Jan-10 Jan-11 Jan-12 Jan-13
Italy Spain EURUSD
-5
-4
-3
-2
-1
0
1
2
3
-120000
-100000
-80000
-60000
-40000
-20000
0
Dec-11 Apr-12 Aug-12 Dec-12 Apr-13
CHF A-L Spain/Italy y/y deposit growth
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further public sector debt relief in parts of northern Europe (seePortugal: More funding and
debt relief needed). Program reviews are also due to be discussed in Greece and Cyprus
over the coming quarter and could pose downside risks to EUR/USD in the near term.
Third, the risk of political uncertainty continues to linger in the euro area, most notably in
Italy. The recent decision by the Italian Senate to strip former PM Berlusconi of his
parliamentary immunity against prosecution increases the chances for his party to
withdraw support from the government, thereby threatening political stability.
For the EUR, the risk premium associated with negative tail events has slowly been priced
out, given the improvement in financial conditions and reduction in fragmentation (Figure 7).
Accordingly, the spill-over of local risk events into other bond markets and FX has been
increasingly small. Any one of the above events may increase the need for the market to
buy downside protection to the EUR (higher vol) and/or sell the EUR.
We remain medium-term bearish CHF
In a context of the Feds postponement of tightening, the CHF should underperform as risk
and carry trades are tactically re-established over the quarter. USD/CHF, however, is
unlikely to move higher in the near term, given its sensitivity to moves in front-end US rates.
We keep our long USD/CHF position, however, since, at best, EUR/USD will be rangebound
in the near term and followed by subsequent depreciation. For the CHF, we see a variety of
reasons to remain bearish.
With regards to domestic policy, while the SNB now anticipates somewhat higher inflation
in 2014, they note there are no signs of inflation risks, and the cap remains the prime policy
tool. The improvement in recent core data has been relatively sharp, but while this has
come hand in hand with a strengthening CHF, we continue to believe that the principal
drivers of the franc are external in nature.
There remains significant scope for unwinds of legacy long CHF positions, primarily those
held on deposit in the Swiss banking system. While this has started to gain traction (Figure 8),
the scale of the flows post-crisis suggests that in the absence of any major global risk
aversion (such as an escalation in the events outlined above), the steady unwind of depositsshould continue. We also view the gradual reduction in fragmentation across the
Eurosystem as a necessary condition for deposit unwinds from Switzerland, and there is
growing evidence that this is happening: with the exception of Cyprus, Eurosystem deposit
flows have moved back towards the periphery over the past 12 months (Figure 8).
Given the commitment to the floor and the scope for further unwinds of deposit flows, we
view the risks of the CHF trade as asymmetric over the medium term and recommend using
it as a funding currency. There is good reward potential in initiating long EUR/CHF (or CHF
funded selective carry) in the near term (1m). Further, we would position for this in spot FX
rather than options, since the move higher is likely to be relatively gradual and there is an
obvious location for a stop-loss (below the 1.20 floor). Accordingly, we go long EUR/CHF at
1.23050 (target: 1.2600; stop-loss: 1.1980).
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THEME: EM
Square carry shorts until tapering
We recommend taking profits on our year-to-date short EM carry strategy. We favour an
overall carry-neutral stance on EM currencies and recommend squaring our
underweight carry positions (BRL, TRY, INR, and IDR). We like long CNY, MYR, and PLN
positions ahead of the rebound in manufacturing activity. We remain long RUB, PHP,
RON, and ILS. Our preference for short ZAR and neutral MXN positions has not changed.
The quarter of a trillion USD of assets the Fed is likely to purchase before revising its current
policies should prop up demand for EM assets. These capital inflows are unlikely to fully
offset the exodus of funds from EM that has taken place this last quarter (Figure 1).
However, we do expect these investments to provide some much-needed breathing room
for EM policymakers, many of whom face challenging macro backdrops that include
funding pressures, dwindling global and domestic growth, inflationary pressures, declining
reserves, and political instability.
Against a backdrop of muted risk aversion and relatively attractive valuations (Figure 2), we
believe markets will price the different realities among EMs. We favour currencies ofeconomies likely to gain from the early signs of a synchronized resuscitation of developed
market economic activity and from Chinas apparent stabilization. Our preferred strategy is
to take profits on our short carry trades and to then combine long and short positions
within EM FX, aiming for an overall carry-neutral exposure to the asset class.
Policies and credibility: No longer short BRL and INR, still neutral on MXN
Mexicos structural reforms are still appealing and likely to deliver improved growth and a
stronger currency. However, the loss of cyclical momentum, which is likely to translate into
easier monetary policy and a worrisome erosion of the governments political capital in
Mexico, leads us to prefer a neutral stance on the peso ahead of crucial votes in Congress
regarding the energy reform.
Emerging market economies running significant current account deficits have also
experienced an upwards adjustment of their currencies carry (Figure 3). The volatility
dampening associated both with more supportive global risk tolerance and effective albeit
Koon Chow
+44 (0)20 7773 7572
Sebastin Brown
+1 212 412 6721
FIGURE 1
QEs survival will not fully reverse the outflows from EM
FIGURE 2
but it is likely to be supportive of under-valued currencies
Source: Barclays Research Source: Barclays Research
1.0
1.2
1.4
1.6
1.8
2.0
2.22.4
2.6
2.8
3.0
3.2
-10
-8
-6
-4
-2
0
2
4
6
8
10
Sep-12 Dec-12 Mar-13 Jun-13 Aug-13
Local govt. bonds Equities UST 10yr yield, RHS
$bn %
CZK
HUF
ILS
PLN RON
RUB
ZAR
TRYBRL
CLPMXN
CNY
INR
IDR
KRW
MYR
PHP
TWD
THB
-40%
-30%
-20%
-10%
0%
10%
20%
30%
-20% -10% 0% 10% 20% 30%
BEERvaluation
REER (current level / 10y average)
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not always efficient policymaking pushes the risk-adjusted carry returns of both the BRL
and the INR to levels we consider attractive. Note, however, that relative to a year ago, long-
term risk premia seem low across the major EM currencies other than the BRL (Figure 4).
In Brazil, the aggressive USD60bn intervention is likely to keep BRL volatility contained.
While we still expect a weaker BRL for structural reasons, the real could remain rangebound
in the short run. In the absence of large price movements, we recommend investors not
hedge their exposure to the BRL given the currencys 8% 3m FX-implied yield.
Similarly, the RBIs credibility has improved. Furthermore, its recent decision to hike the
official repo rate while lowering the MSF to provide liquidity leads us to believe that
controlling inflation might not have excessive costs in terms of growth. Likely reforms to the
local bond market and the implementation of measures to encourage capital repatriation
suggest a more neutral INR stance is warranted to avoid missing the 12% yield implied by
3-month forwards.
When sentiment is not enough: Cautious TRY and IDR and stay short ZAR
Despite the temporary rehabilitation of some high-yielding currencies, we believe there
are structural weaknesses in the countries that have experienced credit-driven economic
growth over the past five years (Figure 5). And while an intervention of USD60bn can
temporarily blur the structural weaknesses of Brazils economy and their effect on the BRL,
there is no such shield for the IDR and the TRY. Policymakers in Turkey and Indonesia will
continue to use the exchange rate as a policy instrument as currency-mismatched balance
sheets in the government and private sector turn any sell-off into an extremely costly event.
Thus, while we remain neutral, we recommend selling TRY and IDR on rallies.
A slightly more constructive global context is not supportive enough to expect anything
other than further depreciation of the ZAR. The ZARs well-known structural woes, external
funding needs, and declining activity, along with increasing inflationary pressures, shape
our very pessimistic view on the ZAR.
Upcoming elections in Indonesia, Turkey, and South Africa during 2014 are yet another
reason to be cautious about exposure to these currencies. To highlight the differencebetween EM economies facing structural bottlenecks and those pushing for structural
improvements, as well as the effect of these diverging paths on the value of their currencies,
we reiterate our recommendation of being long a basket of MXN and PHP funded by a short
position in a basket of TRY and ZAR.
FIGURE 3
Attractive risk-adjusted carry of some CA-deficit currencies
FIGURE 4
but long-term real premia is low, except in Brazil*
Source: Barclays Research Note: * EM real yields US real yields EM CDS spreads. Source: Barclays Research
0.0
2.0
4.0
6.0
8.0
10.0
12.0
INR
BRL
TRY
RUB
CLP
ZAR
IDR
RON
MXN
HUF
CNY
PLN
MYR
KRW
THB
ILS
SGD
CZK
%
Last
3m FX implied yields (last, 25 percentile and 75percentile over last 1y)
-150-100
-500
50100150
200250300350
Brazi
l
Po
lan
d
Thailan
d
Turkey
Mexico
Korea
Israe
lSA
FX 10y real premium FX 10y real premium, 1y ago
Bp
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Beneficiaries of a synchronized recovery: Long CNY, MYR, and PLN
While a timid yet globally-synchronized rebound of manufacturing is not enough for the
ZAR, we believe its effects on the Chinese, Malaysian, and Polish economies could be
significant. Leading indicators point to a growth pickup in these economies, which should
lead an appreciation of their currencies, especially given these economies relatively low
vulnerability to a sudden spike of global interest rates.
To express our views on the CNY, we recommend being short AUD/CNH spot (ref. 5.72,target: 5.40, stop: 5.88). In addition to Malaysias improving growth outlook, we think the
MYR has sold off excessively over the past two months and recommend selling SGD/MYR
1m NDF (1m fwd ref. 2.5680, target: 2.50, stop: 2.60). Finally, we reiterate our
recommendation to remain long PLN/short EUR.
Idiosyncratic longs: RUB, ILS, PHP, and RON
The relatively low vulnerability of these currencies to external funding pressures and
favourable growth outlooks allow us to capitalize on supportive idiosyncratic factors across
these countries (Figure 6).
The RUB offers a relatively high carry, and the spot is supported by improving prospects for
oil prices. We recommend a long RUB position funded by a basket of EUR and USD.
From a more structural standpoint, we still like the PHP and think that after the recent sell-
off, it offers significant room for appreciation due to its reforms. We look for a rebound of the
PHP and like selling the USD/PHP 1m NDF (1m fwd ref. 43.26, target: 42.50, stop: 43.65).
The RON is also attractive due ongoing reforms in Romania and its exposure to rebounding
activity in Europe, so we recommend being short EUR/RON. Finally, we like the ILS because
policymakers in Israel have given up on depreciating the shekel and only hope for managed
appreciation, so we also recommend a long ILS position funded in EUR.
FIGURE 5
Credit-driven growth economies face currency pressures
FIGURE 6
Who can survive higher global interest rates?
Source: Haver Analytics, Barclays Research Source: Barclays Research
Turkey
Russia
S. Africa
Poland
Hungary
Romania
Ukraine
NigeriaGhana
Serbia
India
KoreaTaiwan
Indonesia
PhilippinesThailand
Malaysia
Brazil
MexicoChile
Peru
ColombiaVenezuela
-30
-20
-10
0
10
20
30
-15 -5 5 15 25Changeinbankingsystem's
LTDratio
Change in domestic credit since 2007 (% GDP)
0
20
40
60
80
100
120
140
HUF
PLN
TRY
CLP
ZAR
THB
RUB
IDR
MXN
MYR
PHP
COP
BRL
Externaldebt % GDP
Government Private sector
HUF, PLN, TRY:Cannot affordsustaineddepreciation
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THEME: CNY, AUD, NZD
Local matters
Recent stronger-than-expected China data have overcome hard landing concerns,
supporting CNY outperformance relative to its regional peers. Although we expect a
weaker growth trajectory in 2014, we think the PBoC will continue to use currency
appreciation, albeit at a slower pace than this year, as a rebalancing tool. For the AUD,
weak domestic data and the RBAs aversion to currency strength are likely to cap gains
in the near term, offsetting a further pickup in Chinese activity and potential USD
weakness into year-end. In 2014, slowing China growth, a stronger USD and ongoing
weak Australian domestic activity will see AUD/USD depreciate to 0.83 in 12 months.
China hard landing fears subside; rebalancing-led slowdown in 2014
Recent economic data for China have confounded expectations of a hard landing that were
ubiquitous three months ago. Market sentiment gauged by the Shanghai composite index
and copper prices has been recovering gradually from its late-June trough at the height of
the interbank liquidity squeeze (Figure 1). The PBoCs hawkish stance and the perceived
willingness of the new government to avoid policy stimulus while deleveraging theeconomy fuelled the worst hard-landing fears for China since 2011.
The trigger for a turn in market sentiment was hard economic data and began with the official
manufacturing PMI unexpectedly moving into expansionary territory in July. More recently, the
acceleration in industrial production growth to 10.1% y/y in July-August, from 9.1% in Q2,
was significant, signalling an improvement in Q2s 7.5% y/y growth rate to 7.7% in Q3. As
such, we recently fine-tuned our 2013 growth forecast to 7.6% from 7.5%. However, the
recent pickup in economic activity reflects the traditional drivers of Chinese GDP growth and is
being led by infrastructure investment, similar to the temporary rebound in Q4 12.
While we expect economic growth to accelerate in Q3, we forecast a slowing into year-end
and recently lowered our 2014 GDP growth forecast to 7.1% y/y from 7.4%, as rebalancing
increasingly takes hold (seeChina: The new norm No pain, no gain,18 September 2013).
The Third Plenary Session of the 18th Central Committee in November will represent a
major marker on how the government intends to rebalance the economy away from fixed
Nick Verdi
+65 6308 3093
Hamish Pepper
+65 6308 2220
Jian Chang
+852 2903 2654
FIGURE 1
Measures of China sentiment have improved recently
FIGURE 2
Real GDP growth has tended to slow post-rebalancing
during past episodes
Source: Bloomberg, Barclays Research Note: *China data are for the period since 2009. Source: WDI, Barclays Research
Hard landing concerns have
receded, with economic
momentum likely to have
improved further in Q3
6300
6800
7300
7800
8300
8800
1,800
1,900
2,000
2,100
2,200
2,300
2,400
2,500
Jan-13 Mar-13 May-13 Jul-13 Sep-13
USD/MTIndex Shanghai composite (index)
Copper (USD/tonne, RHS)
25 July - China
announces ministimuluspackage
1 Aug - Upside PMI surprisebegins period of better China data
Japan
(1990)
Korea
(1996)
China
(2009)
Avg. ann. GDP growth 4.6 8.8 10.3
Cum. chg. in fixed capitalformation (%GDP)
2.8 10.2 13.4
Cum. chg. in consumption
(%GDP)-5.1 -8.0 -7.7
Avg. ann. GDP growth 1.1 2.9 9.1*
Cum. chg. in fixed capital
formation (%GDP)-3.5 -6.1 3.1*
Cum. chg. in consumption
(%GDP)4.6 2.3 2.2*
10y pre-rebalancing
10y post-
rebalancing
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investment and exports towards private consumption. Some of the fundamental challenges
facing the Chinese economy industrial sector overcapacity, a latent property bubble,
financial risks and lower potential growth remain unaddressed. However, it is becoming
increasingly clear that the government is willing to tolerate slower growth to address these
issues. Indeed, on 3 September, President Xi said, We would rather bring down the growth
rate to a certain extent in order to solve the fundamental problems hindering our economic
development in the long run.
Chinas rebalancing process is underway, but is in the early stages. Although consumptions
share of GDP has increased, it has not yet led to a meaningful decrease in investment.
Historical parallels including Japan and Korea which faced rebalancing, albeit as a result of
financial crises support our view that GDP growth slows next year and beyond (Figure 2;
see alsoFX Mid-quarter Update: How does China matter for FX,15 August 2013). However,
if the economy slows more sharply than we expect in 2014, the authorities willingness to
provide further stimulus at the expense of rebalancing will be tested. An important lesson this
year is the governments efforts to support the economy whenever hard landing fears
intensified, suggesting that USD/CNY volatility will remain subdued.
For now, the upside surprise in Chinas growth momentum has seen a decline in portfolio
outflows, to about USD32bn in July and August, respectively, from USD48bn in June. In
addition, a pickup in PBoC FX purchases in August suggests CNY appreciation pressures are
building (Figure 3). Reflecting this, in the recent EM FX sell-off, USD/CNY has remained
stable, appreciating almost 4% since 1 May 2013 on a nominal effective exchange rate basis
and outperforming its EM counterparts (Figure 4).
Market sentiment on China will likely continue to be supported through November, in
response to the improving economic momentum that we expect to be reflected in the Q3
data. That suggests USD/CNY will trend lower in the coming weeks. After that, we expect
USD/CNY to continue to move lower as the Chinese authorities use a stronger currency as a
rebalancing tool. However, 2014 will be framed by a stronger USD environment, in our view,
suggesting that the pace of CNY will slow. Furthermore, the CNY has appreciated
significantly this year and on a real effective basis is more than two standard deviations
above its 2010-13 average.
The rebalancing experience in
Japan and Korea points to
slower GDP growth
Portfolio outflows have slowed
FIGURE 3
Recent portfolio outflows are likely to turn around on
improving economic data
FIGURE 4
CNY outperformed its EM counterparts in the recent selloff
Source: CEIC, Barclays Research Source: Barclays Live
-80
-60
-40
-20
0
20
40
60
80
100
120
Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13
USD bn
Estimated portfolio capital inflow
Change in PBoC FX purchase
88
93
98
103
108
May-13 Jun-13 Jul-13 Aug-13 Sep-13
NEERIndex
CNY
EM Asia (ex China and India)
EEMEA
LatAm
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AUD: Conflicting forces give way to weakness in 2014
An improving China growth outlook has seen AUD/USD rally 5.2% through September,
following a 14% decline during May-August. But in the context of a stronger USD and a fairly
weak outlook for Australian domestic activity, we maintain our view of AUD/USD depreciation
over the coming year. We forecast GDP growth will decline to 2.1% y/y in 2014 from 2.5% this
year. While there are concerns about strong growth in housing finance recently, consumer
spending remains subdued, and last years pickup in non-mining investment has been
unwound. As such, growth in overall bank lending remains low. The labour market also
remains weak, and the unemployment rate has continued to move higher in recent months. In
addition, recent declines in Australian exports to China are concerning (Figure 5), and our
forecasts for Australias commodity prices are fairly mixed (Figure 6). RBA forecasts imply an 8-
10% drop in Australias terms of trade over the next year or so. However, net exports are likely
to provide a partial offset to weaker growth, as previous mining sector investment comes online
(allowing a pickup in mining exports) and mining-related capital imports decline.
Consistent with a weak domestic economic outlook, the RBAs low tolerance for a stronger
currency is an AUD negative, in our view. Concerns about a rapidly recovering housing market
indicate that the central bank is keen to achieve looser financial conditions through a weaker
exchange rate, rather than adding to the 225bp reduction in the cash rate already administered
during this cycle. The RBA would also welcome further AUD weakness to help the economyrebalance away from resources investment toward other sources of demand, noting in the
minutes of its 3 September policy meeting: Some further decline in the exchange rate would
be helpful in achieving such an outcome. However, if the AUD appreciates further, thereby
tightening monetary conditions, we think the likelihood of a rate cut increases, as the central
bank would likely become increasingly concerned about the downside risks to the non-mining
sector. This factor will limit AUD gains from here, in our view.
The effect of a weak domestic outlook and the RBAs aversion to a stronger currency is
likely to be mostly offset by a pickup in Chinese economic activity and some USD weakness
in the context of Fed tapering being off the agenda until December. This combination will
see AUD/USD broadly flat at a one-month horizon, in our view.
However, we expect this sell-off to become more pronounced towards the end of this year
and through 2014, driven by a stronger USD environment, continued weakness in
Australian economic conditions and slowing Chinese economic activity. We continue to
AUD domestic concerns and
slower China growth point to
AUD/USD downside
The RBA is uncomfortable
with AUD strength
FIGURE 5
Chinese imports from Australia have declined recently
FIGURE 6
A mixed outlook for Australias commodity prices
Source: Bloomberg, Barclays Research Note: Percentage in parentheses refer to commodity weight in the Reserve Bank
of Australias commodity price index. Source: Bloomberg, Barclays Research
60
70
80
90
100
110
120
10
13
16
19
22
25
28
Jan-10 Jan-11 Jan-12 Jan-13
Chinese imports from Australia, 3m rolling USD bn
RBA commodity price index (USD, RHS)
-15%
-10%
-5%
0%
5%
10%
Gold (8%) Crude oil (6%) Copper (5%) Aluminium(5%)
Q2 Q3f
Q4f 2014f
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think the AUD, as a high-yielding G10 currency, remains vulnerable to rising US interest
rates. Moreover, our analysis suggests the AUD is the most vulnerable to a China growth
surprise, encapsulating commodity and high-beta currency characteristics (see FX Mid-
quarter Update: How does China matter for FX, 15 August 2013). Combined with still-
significant overvaluation (AUD/USD is 12% overvalued based on our Behavioural
Equilibrium Exchange Rate model), we believe these factors will ultimately weigh on the
AUD; thus, we maintain our forecast for AUD/USD to reach 0.83 in 12 months.
Relative domestic factors to lead AUD/NZD lower
Further near-term improvement in Chinese economic activity bodes well for the NZD, in the
context of strong domestic growth and elevated terms of trade. AUD/NZD has declined
about 9% year to date, and we expect this to continue as economic outlooks and
commodity prices diverge further. The RBNZ expects increased consumption and the
reconstruction of Canterbury to drive GDP growth to 3.5% y/y in mid-2014, significantly
higher than our forecast for Australian GDP growth of 2.1% y/y in 2014. A pickup in export
demand from an improving global economy is also likely to contribute to economic activity.
Despite the recent strength in the NZD, export revenues are currently being protected by
high NZ commodity prices, which have increased almost 20% this year in world terms,
while Australias commodity prices are flat year to date.
However, market expectations for RBNZ rate hikes (of about 75bp over next 12 months) are
likely overdone in the context of inflation outcomes below the lower end of the RBNZs
1-3% inflation-targeting band and the recent announcement of macro-prudential measures
to cool the housing market. We do not expect the RBNZ to hike rates until Q2 14, in line
with RBNZ forecasts.
Slowing Australian and Chinese economic growth in 2014, which together take almost 40%
of New Zealands exports, is likely to weigh on the NZD further ahead, in the context of
broad-based USD strength. As such we forecast NZD/USD to reach 75 cents in 12 months.
We do not think a rebalancing of Chinese economic activity away from investment towards
consumption will be an important driver of AUD/NZD. Despite New Zealands large
proportion of agricultural commodity exports relative to Australia, which suggests NewZealand should benefit to a greater degree from the rebalancing of Chinese growth, we
recently found that the import content of investment and consumption goods in China is
not as large or dissimilar as markets tend to believe (see FX Mid-quarter Update: How does
China matter for FX,15 August 2013).
Trade recommendation: short AUD/CNH
Short AUD/CNH spot (ref. 5.72, target: 5.40, stop: 5.88). Further AUD/USD appreciation is
unlikely, given weak domestic economic activity and the RBAs low tolerance for further
currency strength. However, we acknowledge the possibility of USD weakness in the
coming weeks as markets play out Septembers no taper Fed decision. As such, we prefer
to express AUD weakness versus CNH (a proxy for CNY spot), with improving Chinese
growth driving portfolio inflows near term, and CNH appreciation aiding economicrebalancing further out.
AUD/NZD downside in
prospect on relative
domestic outlooks
However, slowing Australian
and Chinese GDP growth
will likely weigh on NZD/USD
in 2014
https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181https://live.barcap.com/go/publications/content?contentPubID=FC1958181 -
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THEME: GBP
Fade the rally
Against the backdrop of the delay in Fed tapering, stronger UK data and a disappointing
BoE forward guidance framework have boosted GBP recently. We think the good news is
largely priced and expect underlying headwinds to re-emerge, putting downward
pressure on GBP. BoE monetary policy is set to remain loose for far longer than Fed
policy, and GBP weakness related to a rebalancing of the UK economy away from
services/non-tradable sectors toward tradable sectors is as relevant today as in the
post-crisis period. We recommend buying a 6m GBP/USD put spread (1.60 (ATM) vs
1.55) to express our view of a gradual but persistent move lower.
Upside surprises for GBP in Q3
Circumstances were conducive to GBP strength in Q3, during which the currency was
second only to the NZD in terms of performance. Economic data in the UK consistently
surprised to the upside during much of Q3, with the market caught being too bearish on the
economic prospects (Figure 1). The UK recovery has been relatively broad-based, with
survey data suggesting a continuation of the improvements into Q4. The better news
implied that stretched GBP short positioning had to be covered (Figure 2).
Some of the bearishness toward GBP heading in to Q3 related to the announcement of the
MPCs forward guidance framework a tool for keeping interest rates low in a cyclical
recovery by focusing the market on the long-term issues of economic slack and structural
rebalancing. Yet reaction to the unveiling of the BoEs forward guidance suggests the MPC
may struggle to contain market enthusiasm about better cyclical data. The correlated GBP
appreciation and selloff in short rates (Figure 2) suggest that the market viewed the forward
guidance framework as quite soft, and the inclusion of relatively ambiguous knockouts (since
dubbed thresholds) has raised questions about the BoEs commitment to the framework.
Finally, GBP was expected to depreciate versus the USD as the Fed finally moved to endasset purchases and, more important, allowed the market to price in more aggressive rate
hikes at the short end of the curve. Indeed, the Feds message of low for longer rates at
the September FOMC was yet another disappointment for short-GBP positions and, in our
view, more important than the decision to delay the tapering in asset purchases.
Aroop Chatterjee
+1 212 412 5622
Chris Walker
+44 (0) 20 3555 5863
FIGURE 1
UK data have consistently surprised the market during Q3
FIGURE 2
Combined with steepening UK rates, this has put pressure on
bearish GBP positions
Source: Barclays Research Source: Bloomberg, CFTC, Barclays Research
-5
-4
-3
-2
-1
0
12
3
4
-0.15
-0.10
-0.05
0.00
0.05
0.10
0.15
0.20
0.25
Jan-13 Mar-13 May-13 Jul-13 Sep-13
DSI
UK DSI (LHS) GBP NEER
%
-15
-10
-5
0
5
10
15
20
25
-0.40
-0.30
-0.20
-0.10
0.00
0.10
0.20
0.30
Jan-13 Mar-13 May-13 Jul-13 Sep-13
%
GBP net long (% open interest, LHS) UK 3m2y slope
bp
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Reasons to be bearish GBP in the medium term
BoE monetary policy is set to remain loose for far longer than Fed policy, continuing to
weigh on the currency. UK rates continue to price tighter policy than the BoE and our
economists expect. Short sterling futures currently price the first hike around March
2015, more than 12 months before our economists expect action (August 2016). While
this premium in the curve may be partly justified by the improvements in cyclical data, it
is not in line with levels the MPC sees as consistent with the longer-term outlooks for
growth and inflation. The September FOMC meeting serves as a warning to the market
that central banks ultimately control policy and retain the power to move rates where
they see fit. We expect the MPC to bolster its forward guidance framework, especially if
UK economic data soften.
We do not expect much follow-through in USD weakness against low-yielding currencies
like GBP from the September FOMC since the Feds low-for-longer message effectively
arrests the move in the short end of the yield curve instead of pushing it lower. The
underlying cyclical trend is still very positive in the US with consumption remaining strong,
investment picking up and labour market resilient. We expect the market to revisit the issue
of rate hikes once tapering is underway, leading to the long-awaited broad USD rally.
We expect GBP, like the EUR, to be stuck in a range in the near term as recent sources ofsupport are set to hold firm. Our 1m and 3m forecasts are 1.59 and 1.57; further out, we see
a gradual depreciation in the currency to 1.55 and 1.53 in 6m and 12m, respectively.
The longer-term divergence between the UK and the US is even more telling. The output
gap in the UK is only expected to narrow very slowly versus the US (Figure 3). Weak
productivity levels and an economy that has to rebalance away from services towards
tradable sectors will keep growth slower than trend, which is something that UK monetary
policy will have to accommodate by being dovish.
Is dovish monetary policy crucial for GBP weakness?
Although GBPs depreciation of more than 22% on a nominal effective exchange rate basis
since its peak in 2007 has coincided with aggressive monetary policy by the BoE, we do not
think monetary policy has been the sole driver of currency weakness. If monetary policy is
credible, long-term inflation expectations should be stable since central bank easing would
largely be endogenous ie, in response to deterioration in the real economy. As long as
prices adjust, any currency weakness in the short run would be temporary. However, when
long-term inflation expectations have risen and the currency has remained persistently
FIGURE 3
Output gaps in the US and UK
FIGURE 4
GBP/USD spot vs the level implied by monetary policy
expectations (RNFV)
Source: IMF WEO, Barclays Research Source: Haver Analytics, Barclays Research
-8
-6
-4
-2
0
2
4
6
2007 2009 2011 2013 2015 2017
% potentialGDP
US UK
1.10
1.30
1.50
1.70
1.90
2.10
2.30
Jun-05 Jun-07 Jun-09 Jun-11 Jun-13
GBPUSD spot GBPUSD RNFV
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weak, it is possible that central bank easing was largely viewed as exogenous (see
Broadbent (2011) for a discussion of this). But can we pin down a fair value level for
GBP/USD that is consistent with the movement in inflation expectations?
In a risk-neutral world, with financial market equilibrium and purchasing power parity
holding over the long term, nominal GBP/USD should be such that an investor is indifferent
between investing in a long-term (10y) zero-coupon inflation linked bond in the UK (currency
unhedged) or in the US. We follow the work of Clarida (2012) to determine this so-calledrisk-neutral fair value (RNFV) level for the currency the one that is largely determined by
relative long-term inflation expectations and interest rates (ie, monetary policy) Assuming UK
and US interest rates and inflation expectations in the US are constant, an increase in UK
inflation expectations would drive down real yields and imply a lower RNFV for GBP/USD.
Figure 4 shows the GBP/USD RNFV over time. It is clear that most of the decline in
GBP/USD in the early post-crisis years was not driven by monetary policy considerations.
The portion that is unexplained by monetary policy shifts could relate to: fundamentals that
affect the real value of the currency; or currency risk premia. We find that about 20% of the
changes in the deviation of spot from the RNFV (since the crisis) can be explained by
fundamentals that drive value of the currency over the medium term 2
We find that monetary policy has actually been a bigger driver of GBP/USD since the
beginning of 2013, with the GBP/USD RNFV declining as expectations of a more activist BoE
versus the Fed have grown and the backup in US real interest rates has far outstripped
those in the UK. The gap driven by fundamentals/risk premium has declined to the extent
that GBP/USD is not trading above its RNFV, implying either better fundamentals or lower
risk premium. The latter is not likely given the still-elevated levels of government debt and
disproportionately large financial sector compared with the size of the economy. What have
the developments been on fundamentals?
. The remainder are
driven by pure risk premia shifts ie, political/fiscal/financial risks.
Rebalancing: Another reason for a weaker GBP
The importance of services, especially finance (contributing 92% of the 4.7% average
growth in GVA from 2000-09), has left the economy susceptible to financial sector shocks.
2 These are relative productivity, terms of trade, net foreign assets and relative government consumption as specifiedin our BEER model please see Currency valuation from a macro perspective, June 2011, for more details.
FIGURE 5
GVA for financial services, goods production and
construction (% total)
FIGURE 6
GVA breakdown by sector in 2012 (% total)
Source: Haver Analytics, Barclays Research Source: Haver Analytics, Barclays Research
0
2
46
8
10
12
14
16
18
20
03 04 05 06 07 08 09 10 11 12
Finance and Insurance
Total Goods Production
Construction
Total Goods Production
Construction
Distribution, Leisure
ICT
Finance and Insurance
Real Estate
Professional & supportservicesGovernment services
Other
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Because these events coincided with a weak public sector balance sheet, the scope for
countercyclical fiscal policy was reduced. Healthy job creation without public sector
assistance requires the economy to rebalance away from finance into other sectors,
including tradable. The recent strength in GBP is, we think, an impediment to a much-
needed reallocation of resources.
The rebalancing process has not gone very far. For one, the UKs current account position
has remained roughly the same as it was pre-crisis. Digging deeper into the productiondata, we find that total goods production (manufacturing and mining) has been in steady
decline since before the crisis. Despite the significant GBP depreciation following the crisis,
the goods production sectors share of total gross value added (GVA) has remained broadly
flat (Figure 5). The financial and insurance services share of GVA peaked in 2009 at 10%
and has since fallen by roughly 3pp. A 3pp GVA shift away from finance and insurance can
be seen on the margin as rebalancing, but is, at best, minor, in our view. In 2012, total
production of goods still contributes a relatively minor amount of UK output relative to the
dominant service sector (Figure 6).
What about forward-looking indicators? If the rebalancing process were proceeding well, we
would expect equity markets to price in higher value added/profitability in the tradable sector
versus the non-tradable sector. We gauge this by looking at the performance of the UK equity
market at the sectoral level3
We ran regressions of the returns on the different sector quintile baskets on the level of the
currency (versus the RNFV) in the previous period, controlling for the currency return and
broad equity market return. Figure 8 shows that a higher level of GBP leads to
outperformance of the non-tradable sector baskets (T5 and T4) versus the tradable baskets
. We characterise the various sectors on the basis of their relative
sensitivity to GBP movements (we regress weekly sector returns on the broad market and the
GBP NEER, using data from 2004-07; see the Appendix, Figure 9) and construct equal-
weighted quintile baskets. These baskets, based on the tradability of the sector, are shown in
Figure 7, with T5 the least tradable basket and T1 the most tradable. The significant
underperformance of T1 briefly in 2011 and, more recently, since 2012 is striking.
3 We use sectoral data of the FTSE 350 index. We exclude sectors that are composed of fewer than three differentcompanies to avoid capturing stock-specific drivers. We exclude the financial sectors to minimize the importance ofthe financial crisis and its aftermath.
FIGURE 7
Cumulative price returns of equity sector baskets on the
basis of tradability (Jan 2009=100)
FIGURE 8
Regression of equity sector baskets on the basis of
tradability on market variables
d (GBP) d (FTSE) GBP (t-1) Const
T5 0.12 0.71*** 2.62 0.22
T4 -0.13 0.75*** 0.90 0.20
T2 -0.29*** 0.83*** 0.14 0.24
T1 -0.24* 1.32*** -0.89 -0.36
T5-T1 0.36** -0.61*** 3.51 0.57
Note: We regress weekly sector returns on the broad market and the GBP NEER,
using data from 2004-07 and construct equally weighted quintile baskets based
on the estimated coefficients on GBP. T5 and T1 represent non-tradable and
tradable sectors, respectively. Source: Bloomberg, Barclays Research
Note: We regress weekly returns of the different basket returns on GBP and FTSE
returns, as well as the GBP level versus the RNFV, in the past week.
*** significant at the 1% level; ** significant at the 5% level; * significant at the
10% level. Source: Barclays Research
50
100
150
200
250
300
350
Feb-09 Jan-10 Dec-10 Nov-11 Sep-12 Aug-13
Index
T5 T4 T2 T1
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(T1 and T2). Its effect on the difference in performance between the extreme baskets (T5
and T1) has the right sign but the effect is not statistically significant. There appears to be
limited evidence that the low level of GBP has helped differentiate the performance of the
tradable versus the non-tradable sector.
There are structural reasons that may explain why the tradable sectors have not performed
as well over the medium term. These issues relate to wider questions of competitiveness
(which has been on a persistent decline), the nature of goods/services exported (price-insensitive) and the high import content of exported goods (ie, a weaker GBP increases
import costs). This suggests that in order to achieve any successful rebalancing, GBP will
have to remain weaker for far longer.
Where do we go from here?
We believe current GBP levels are attractive for establishing a medium-term short. On the
one hand, we have argued that BoE monetary policy will remain loose for far longer than the
Fed, continuing to weigh on the currency. On the other, the real factors for GBP weakness
related to rebalancing the UK economy away from services/non-tradable sectors toward
tradable ones are as relevant today as they were in the post-crisis period.
We favour establishing medium-term downside positions in GBP/USD via a 6m put spread
with strikes at 1.60 and 1.55 at a cost of 1.05% of notional. Over the next three months, Fed
and BoE policy are unlikely to shift markedly. However, we expect the market to price in more
aggressive Fed rate hikes once tapering is announced (in December, we expect). UK economic
data have been unusually strong recently (as suggested by our data surprise index), and there
are signs that the market has become too optimistic about the UK outlook. A retrenchment of
market expectations for the UK would add further weight to the currency. Finally, the medium-
term structural negative from the rebalancing remains very much in place.
Appendix
FIGURE 9
Sensitivity of FTSE 350 sectors to changes in GBP NEER from 2004 to 2007 (we exclude financial services from our baskets
given their specific role in the crisis)
Source: Barclays Research
-1.0
-0.8
-0.6
-0.4
-0.2
0.0
0.2
0.4
IndustrialMetals
Oil&Gas
Construction
Mining
Investment(Fins)
Industrialeng
FoodProduction
Software
Banks
Engineering
Beverages
TechHardware
FinancialServices
ElectronicEquip
Pharmaceuticals
Non-lifeInsurance
Leisure
SupportServices
Aerospace
Media
HouseholdGoods
Chemicals
Investment(Realest)
Telecommunications
Gas
Oilequipment
Generalretail
Foodconsumption
T1 T2 T3 T4 T5
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THEME: JPY
Grind higher, against gravity
Despite a surprise from the Fed, we continue to expect USD/JPY to grind higher, driven
by the relative growth and monetary policy outlooks between the US and Japan. The
pace of appreciation is likely modest given the Feds gradualism to policy normalization
and the stretched valuation of JPY. Political uncertainty poses downside risk in the near
term yet upside risk in the longer term.
The Fed on hold, but effect expected to be limited
The Fed surprised the market by not announcing tapering this month. We do not expect it
to have much effect beyond the near term, however, given that the market is already pricing
in Feds renewed