HSBC Currency Outlook

Currency

OUTLOOKWill the dollar ever rally?

Macro Currency Strategy May 2011

While we had been looking for the USD to weaken in 2011, the fall has been more rapid and larger than expected. USD weakness has been based on the rotation of fiscal concerns away from Europe towards the US. While position liquidation may allow the USD to enjoy short term gains, we expect it to stay fundamentally weak for a protracted period. Risk on risk off: A disturbance in the force Recent talk of the end of risk on risk off is premature. Although correlations have fallen during recent months, they remain very high. Australian dollar: altitude sickness We have been looking for the AUD to retrace, but this call was premature. The speed and extent of its rise, its extreme overvaluation and the range of risks it faces suggest that we may see a reversal. A positive vote for the Canadian dollar Economic conditions and further tightening suggest a positive outlook.

Disclosures and Disclaimer This report must be read with the disclosures and analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it


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SummaryWill the dollar ever rally? (pg 3)

A falling USD has been a persistent feature of the FX market for much of the past ten years. While we had been looking for the USD to weaken in 2011, the fall has been more rapid and larger than we had expected. Continued USD weakness has been based on the rotation of fiscal concerns away from Europe and towards the US. At the same time, US economic data has been soft enough to keep interest rate expectations in check. While position liquidation may allow the dollar to enjoy short term recoveries, we expect it to remain fundamentally weak for a further protracted period.

Risk on risk off: A disturbance in the force

(pg 9)

There has been some talk that the period of risk on risk off might be coming to an end. We believe that such talk is premature. Speculation that risk on risk off might be ending is the result of the recent unusual behaviour of oil and the USD. Whilst it is true that correlations have fallen since the end of last year, they nevertheless remain very high.

Australian dollar: altitude sickness

(pg 17)

Since the G7 central banks intervened to sell the yen in the middle of March the AUD has risen sharply. As the highest yielding G10 currency, the AUD has been a major beneficiary of the apparent return to carry trades as risk appetite rapidly re-built. We have been looking for the AUD to retrace, but this call was obviously premature. Nevertheless, the speed and extent of the AUDs rise, its extreme overvaluation and the range of risks it faces suggest that we may yet see a reversal in the coming months.

A positive vote for the Canadian dollar

(pg 23)

CAD gains have tightened monetary conditions in Canada beyond the modest rate increases taken by the Bank of Canada last year. Current economic conditions and the Banks own forecasts suggest that further interest rate increases are needed but hiking now would lead to the very type of CAD appreciation that is currently skewing monetary conditions. Ultimately, the need for further tightening and the prevalence of USD weakness, suggests USD-CAD will remain under downward pressure in the coming months.

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New Zealand dollar Rates steady for some time

(pg 30)

The RBNZ kept rates on hold at 2.50%, at their latest meeting on 27th April, with Governor Bollard indicating that he expects rates to be on hold for some time. Falling commodity prices, US fiscal woes and ongoing concerns in the Eurozone periphery could flip the market into risk off, which would push the NZD lower.

At a glance all regions

(pg 32)

Key events Date 16 May 17 May 18 May 19 May 19 May 23 May 25 May 31 May 7 June 8 JuneSource: HSBC

Event Eurogroup meeting Ecofin meeting BoE to publish minutes of May 4-5 MPC meeting BoJ Monetary Policy Meeting ECB Governing Council meeting BoJ publishes monthly report BoJ publishes minutes of Apr 28 MPM BoC rate announcement RBA rate announcement RBNZ rate announcement

Central Bank policy rate forecasts (%) Last USD EUR JPY GBP 0-0.25 1.25 0-0.10 0.50 June 11(f) 0-0.25 1.25 0-0.10 0.50 September 11(f) 0-0.25 1.50 0-0.10 0.50

Source: HSBC forecasts for Fed funds, Refi rate, Overnight Call rate and Base rate

Consensus forecasts for key currencies vs USD 3 months EUR JPY GBP CAD AUD NZDSource: Consensus Economics Foreign Exchange Forecasts April 2011

12 months 1.372 87.92 1.643 0.997 0.962 0.727

1.381 83.45 1.608 0.988 0.993 0.734

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Will the dollar ever rally?Dollar weakness persistsA falling dollar has been a persistent feature of the FX market for much of the past ten years, and it has recently been making new record lows on a trade weighted basis (chart 1). While we had been looking for the dollar to weaken in 2011, the fall has been more rapid and larger than we had expected. Since the beginning of the year, the dollar is down about 5% on a trade weighted basis, and by 8% against the EUR. The fall in the dollar has not been restricted to weakness against a few currencies. Chart 2 shows a 20 day moving average of a dollar diffusion index. This shows the proportion of currencies against which the dollar is rising or falling. The index is measured against 14 major floating currencies and is constructed so that a value of zero would mean the dollar has been falling against every currency, and a value of 100 would mean that the dollar is rising against every currency. The index mostly moves in a 40-60 range, but has recently been at about 35, indicating a widespread and persistent period of dollar weakness.

Good reasons for dollar weaknessThe continued weakness in the dollar recently has been based on a number of factors. Probably the three most important of these are:1. Fiscal worries have rotated to the US

The fiscal worries that were seen as primarily a European problem last year have rotated to the US. This has been brought into focus by the S&P outlook warning on 18th April, and by the looming debt ceiling. Total government outstanding debt in the US stood at USD 13.6tr at the end of 2010 and is now rapidly approaching the USD 14.3tr ceiling currently mandated by Congress (chart 3). While

1. Dollar has been making new lows

Index 150 140 130 120 110 100 90 80 70 60 Jan-73 Jan-78 Jan-83

Dollar Trade Weighted (Major Currencies)

Index 150 140 130 120 110 100 90 80 70 60

Jan-88

Jan-93

Jan-98

Jan-03

Jan-08

Source: Federal Reserve, HSBC

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2. Dollar weakness has been widespread

Index 70 65 60 55 50 45 40 35 30 25 Jun-09 Aug-09 Oct-09 Dec-09 Feb-10

Dollar Diffusion Index 20 day MA

Index 70 65 60 55 50 45 40 35 30 25

Apr-10

Jun-10

Aug-10

Oct-10

Dec-10

Feb-11

Apr-11

Source: Bloomberg, HSBC

Congress has voted to increase the debt ceiling regularly in the past, the political environment will make this extremely difficult this year as Republicans and some Democrats are insisting that that an increase in the debt ceiling must be accompanied by concrete limits on future spending. Widening the argument on the debt ceiling to include broader budgetary issues means linking together an issue that requires immediate attention with one which many would not expect to be resolved until after the 2012 elections. Should the debt ceiling be reached then according to Treasury Secretary Geithner, a broad range of government payments would have to be stopped,

limited, or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, interest on debt, unemployment benefits and tax refunds. Default by the US government would be so damaging that it seems inconceivable that Congress would allow it to happen, but it does draw attention to the serious debt issue that the US (like Europe) will have to address. This has again focussed attention on the dollars role as the principal reserve currency and raised the prospect of increased reserve diversification. The initial deadline set by the Treasury Department was May 16th, when the current round of borrowing is complete. However, using cash

3. US Government debt close to USD 14.3tr ceilingUSD bn 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 US Government Debt Outstanding Debt Ceiling USD bn 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0


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4. US economic data has disappointed

US activity surprise index 10 5 0 -5 -10 -15 -20 Jun-09Source: Bloomberg, HSBC

10 5 0 -5 -10 -15 -20 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11

deposits and delaying special purpose borrowing has allowed them to revise this to August 2nd. Even then, it would be possible to delay the problem further through extraordinary measures such as assets sales. Ultimately, however, the limit will be reached, so Congress will have to act.2. US economic data have been soft, but not too soft

US in the future, rather than to undermine belief in the global recovery (chart 5). The expectation on US monetary policy has been seen as in stark contrast to the EUR, where the ECB has already begun to tighten rates. As long as the global recovery remains on track then risk appetite can remain strong and the dollar can continue to be used as a funding currency for risk asset positions.3. Market volatility constrained by central banks

After a period of upside surprises, most of the economic activity data over the past month has disappointed market expectations (chart 4). The main impact of this has been to reduce expectations of tighter monetary conditions in the

The only period this year when FX implied volatility started to rise sharply was in the aftermath of the Japanese earthquake and tsunami in March, when dollar-yen fell heavily in anticipation of repatriation flows. This was

5. US Interest rate expectations have fallen back

1.1 1.0 0.9 0.8 0.7 0.6 0.5

%

USD 2 year swap rate

% 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0.4

0.4 Jul-10

Aug-10

Sep-10

Oct-10

Nov-10

Dec-10

Jan-11

Feb-11

Mar-11

Apr-11

May-11


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6. FX implied volatility spike was reversed by central bank action

3m Global Hazard Indicator 2009-2011 24 22 20 18 16 14 12 10 Apr-09Source: Bloomberg, HSBC

24 22 20 18 16 14 12 10 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11

brought to an abrupt halt by joint central bank intervention, which not only reversed the yens rise, but pushed implied volatility sharply lower again. Although implied volatility has recently been moving up again, it is still at relatively benign levels (chart 6).

currencies to new lows, it has also seen its real effective exchange rate against a wider range of currencies reach unprecedented levels. Chart 7 shows the BIS REER measure back to 1963. The measure includes 27 economies and adjusts nominal exchange rates by relative consumer prices. On a PPP basis the dollar is about 25% undervalued against a weighted basket of other major currencies, so there is little doubt that the dollar is cheap. However, long term fundamental valuations can stay a long way out of line for a protracted period, so there is little reason to expect an imminent recovery on this basis alone.

What would make the dollar rally?With the dollar seemingly under persistent downward pressure, what are the forces that could see it make a recovery?Valuation

The continued fall in the dollar this year has not only taken its nominal exchange rate against other major

7. New lows for the dollars real effective exchange rate

Index 150 140 130 120 110 100 90 80 Jan-64Source: BIS, HSBC

USD REER

5Y MA

Index 150 140 130 120 110 100 90 80

Jan-69

Jan-74

Jan-79

Jan-84

Jan-89

Jan-94

Jan-99

Jan-04

Jan-09

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8. The fall in oil prices may prompt other position liquidation

USD/bbl 120 115 110 105 100 95 90 85 80 75 Jul-10 Aug-10 Sep-10

Crude Oil Price (WTXI active futures contract)

USD/bbl 120 115 110 105 100 95 90 85 80 75

Oct-10

Nov-10

Dec-10

Jan-11

Feb-11

Mar-11

Apr-11

May-11


Positions

If the dollar is very cheap, and positions in the market are very short of dollars, then a short term recovery could be driven by position liquidation triggered by an event outside the FX market. A good candidate for such a trigger would be the very sharp fall in crude oil prices seen in early May, which took West Texas Intermediate futures prices from a high of USD 115bbl to a low of USD 95bbl in four days (Chart 8). An even more9. Currency fund performance closely linked to the dollar

extreme move was seen in silver, which fell nearly 30% in the same period. If the sharp fall in prices is indicative of position liquidation from investment funds, then it is possible that it will trigger a similar liquidation in currency funds. As well as the dollar, we would see the AUD as a prime candidate for a correction. The question is whether funds have been very short of dollars. The IMM data suggest that short term funds are short of dollars (see IMM FX futures

Currency Fund Performance and the Dollar 1.5%

1.0% y = -0.8271x + 0.0002 R2 = 0.6411 0.5%

0.0% -1.5% -1.0% -0.5% 0.0% -0.5% 0.5% 1.0% 1.5%

-1.0%

-1.5%Source: Bloomberg, HSBC

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positions, 6th May 2011), but this is a small part of the market and may not be representative. Indirect evidence on longer term currency funds can be obtained by analysing the performance the funds against the performance of the dollar. Chart 9 shows the daily returns of the Bloomberg Active Index for Currency Funds against the dollar index since the beginning of the year. While the closeness of the relationship will be exaggerated by the fact that these funds are dollar denominated, the very strong inverse relationship does seem to suggest that the positive performance of these funds has been achieved in part by short positioning in dollars.A change in policy perceptions

ConclusionDollar weakness continues to be a persistent theme in the FX market. Concerns over US fiscal sustainability have combined with low interest rate expectations and constrained market volatility to keep the dollar on a downward trend. Having recently made new lows on a real effective basis, the dollar is undoubtedly cheap, but, other than shorter term recoveries based on position adjustment, it is difficult to see the dollar enjoying a sustained recovery until there are significant changes to market perceptions about US monetary and fiscal policy prospects.

Beyond a short term rally induced by position liquidation, a stronger performance by the dollar will probably require a change in market perceptions about the prospects for US fiscal and monetary policies. We have already argued that the end of QE2 by the Fed in June could be a time when the market starts to look seriously at the Feds exit strategy from its ultra-loose policies (see An end to QE: the next big theme Currency Weekly, March 14th 2011), though the anticipation of an end to QE2 does not seem to have had much market impact as yet. On fiscal policy, the arguments over raising the debt ceiling will most likely be resolved without firm commitments to cut spending programmes, and fiscal consolidation looks very likely to have to wait until after the 2012 elections. This will leave the US with very loose fiscal policy for a further substantial period and could raise further doubts about sustainability.

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Risk on risk off: A disturbance in the forceDown, but not outRecent talk of the end of risk on risk off is premature. Although correlations have fallen during recent months, they remain very high compared to historical levels. Before we can proclaim the end of risk on risk off with any degree of certainty, correlations must return to much lower levels and remain there for a prolonged period of time. This has not happened yet. The view that risk on risk off might be coming to an end is in part the result of the unusual behaviour of oil and the USD. Both assets have recently decoupled from the risk on risk off paradigm and are now being driven by their own idiosyncratic forces. As a result, if one focuses on these two assets it is easy to come to the view that risk on risk off is weakening. However, in order to declare the end of risk on risk off it is essential to look at a much broader set of assets. Such an analysis reveals that correlations remain stubbornly high across a range of different markets.

Correlations remain highCorrelations have fallen since the end of last year. That does not mean, however, that correlations are low. They are simply down from earlier extreme levels. Chart 1 shows the HSBC RORO Index which measures the extent to which the risk on risk off phenomenon is driving markets. A high index level does not mean that we are risk on; instead it implies that risk on risk off continues to dominate markets. The index is therefore indicative of the strength of market-wide correlations: An increase in the index implies that

1. HSBC Risk On Risk Off (RORO) Index still at elevated levels

Index 0.5

RORO Index

Average

Index 0.5

0.4

0.4

0.3

0.3

0.2

0.2

0.1 Sep-90

0.1 Sep-92 Sep-94 Sep-96 Sep-98 Sep-00 Sep-02 Sep-04 Sep-06 Sep-08 Sep-10

Source: HSBC, Bloomberg

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2. Correlations are still higher than they were following the collapse of Lehman Brothers

Index 0.45

RORO Index Lehman bankruptcy

Average

A

Index 0.45

0.40 0.35

Bernanke subprime warning Greek fiscal crisis

0.40 0.35 0.30Middle East unrest intensifies

0.30 0.25 0.20 Jan-07Source: HSBC, Bloomberg

0.25 0.20 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

correlations have increased across many different assets. For more details on how we construct the index see Risk on risk off: the full story, Currency Quant Special, 10th November 2010. The index clearly shows that correlations are now lower than they were at the end of 2010. However, although correlations have come off their all-time highs, they continue to be significantly above their historical average (Chart 2). In fact, correlations are3. Now: Correlation heat map over the last 80 days

still higher than they were during the period immediately after the collapse of Lehman Brothers. Chart 2 also shows that, following the unrest in North Africa and the Middle East, correlations have rebounded and are now in an upward trend. There are several other examples of periods during which correlations fell only to rise again following a major event.


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4. Peak: Correlation heat map corresponding to the peak in the RORO Index


This highlights the danger of prematurely forecasting the end of risk on risk off. A shortterm fall in correlations does not imply a return to normal levels. As we have previously argued, correlations need to decline and stay low for a prolonged period of time before we declare the end of risk on risk off.

uncorrelated assets, which implies that a single dominant force is driving markets. The large red region in Chart 3 illustrates that correlations remain high across a wide range of different assets. This red block includes equities and bond yields, and there is a group of commodities and commodity currencies (CAD and AUD) that are also correlated with this block. The strength of the correlations between several different assets demonstrates that risk on risk off continues to dominate markets. To give more insight into just how strong current levels of correlation are, we show two further heat maps. Chart 4 shows the heat map corresponding to the point at which the RORO index peaked (point A in Chart 2). The red region in Chart 4 is clearly larger than that in Chart 3 which demonstrates the recent decrease in correlations. In an environment in which correlations are this high, the nuances between different assets disappear and the most important factor in the market is risk on risk off.

Technicolour correlationsThe continued strength of correlations is perhaps easier to see using heat maps (Chart 35). We represent the matrix of correlations between pairs of assets as an image in which different colours correspond to different correlation strengths. Dark blue regions indicate strong negative correlations; dark red regions indicate strong positive correlations; and green/yellow regions weak correlations/uncorrelated assets. When the RORO index is at high levels, and risk on risk off dominates markets, there will be more red and blue in the heat map. When the risk on risk off phenomenon is strong there are fewer

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5. Pre-crisis: Correlation heat map for a period in 2005-2006 when correlations were low


In contrast, Chart 5 shows correlations over an 80 day period ending on 10th January 2005. This heat map thus shows correlations before the credit crisis. The large green region indicates that correlations between most assets were very low during this period, with two separate small blocks of strongly correlated equities and bonds. A comparison of Chart 3 and Chart 5 highlights how strong correlations continue to be. Historically, during many periods correlations between equities were high and correlations between bonds were high, but bond-equity correlations were low. In contrast, today bondsequity correlations are very high and, in addition, several currencies and commodities are also correlated with these assets.

bad, in which case risk is off and safe haven assets such as the USD and CHF rally. Until recently, nearly all assets fitted this paradigm well. Chart 6 shows the extent to which different assets were either risk on or risk off at the start of the year. A high positive value in Chart 6 implies that an asset was strongly risk on; for example, during this period the Dow Jones was the most risk on. In contrast, large negative values, such as the correlation of -0.8 for the VIX, imply that an asset was strongly risk off. Correlations close to zero, such as those for natural gas and GBP, indicate assets that were being driven by other forces and are behaving independently from risk on risk off.

Idiosyncratic forcesThe main premise of the risk on risk off paradigm is that the market either believes that the future is good, in which case risk is on and it buys risk assets such as equities, commodity currencies, and oil; or the market believes that prospects are

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6. RORO spectrum: Correlation with risk on risk off for the 80 days ending 3rd January 2011Strongly risk on Uncorrelated with risk on - risk off Strongly risk off 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 Germany 10yr yield France 10yr yield NASDAQ US 10yr yield AAA corporate yield Canada 10yr yield BAA corporate yield Euro Stoxx 50 UK 10yr yield Russell 2000 Soybean Copper Silver CAD EUR NZD Dow Jones Natural gas Wheat NOK USD AUD S&P DAX GBP JPY Heating oil FTSE 100 CAC 40 Cotton Gold CHF VIX1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 Germany 10yr yield France 10yr yield Canada 10yr yield AAA corporate yield BAA corporate yield Euro Stoxx 50 Russell 2000 UK 10yr yield US 10yr yield Soybean Copper Silver AUD CAD EUR NZD Natural gas Dow Jones Wheat USD GBP DAX Heating oil NOK S&P JPY NASDAQ Cotton CAC 40 FTSE 100 Gold CHF VIX Oil

Correlation with 'risk on - risk off'

1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 Oil


Chart 7 shows how this picture has recently changed. Oil has moved to the right of the spectrum and is no longer strongly risk on. In contrast, the USD has moved in the opposite direction: whereas at the start of the year it was the most risk off currency, it is now less risk off than both the JPY and CHF This demonstrates that although risk on risk off continues to drive markets, some assets are now also being driven by their own idiosyncratic forces. Oil and the USD are two of the most closely watched assets and both are currently behaving in

ways that at times appear incompatible with risk on risk off. Given the prominence of these assets and their unusual behaviour it is perhaps unsurprising that some have started to believe that we are witnessing the end of risk on risk off. Focusing on only one or two assets, however, can be misleading. In order to assess whether risk on risk off remains a dominant theme it is necessary to consider the behaviour of a wide cross-section of different markets. The RORO index does just this and its elevated level shows that risk on risk off continues to be an

7. RORO spectrum: Correlation with risk on risk off over the last 80 daysStrongly risk on 1.0 Uncorrelated with risk on - risk off Strongly risk off

Correlation with 'risk on - risk off'

0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0


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8. Changes in the oil price have been event driven

USD/bbl 130 125 120 115 110 105 100 95 90 03-Jan Violence in Libya intensifies

Brent crude oil Continued emerging market growth fuels 'risk on' Commodity market sell-off UN take military action in Libya Japan earthquake hits Unrest in Middle East and North Africa begins 18-Jan 02-Feb 17-Feb 04-Mar 19-Mar 03-Apr 18-Apr

USD/bbl 130 125 120 115 110 105 100 95 90 03-May


important market driver. This is further demonstrated by the extent of the red region in the heat map in Chart 3.

The curious case of oilThe change in oil from being a strongly risk on asset to behaving independently from the risk on risk off factor in only a matter of weeks is striking. This independence is largely event driven. Chart 8 highlights the effect of recent unrest in North Africa and the Middle East on the price of oil. These idiosyncratic shocks have had a bigger effect on oil than other markets and have caused it to decouple from risk on risk off.

This is demonstrated in Chart 9, which tracks how dominated oil has been by risk on risk off since before the crisis. Before the unrest, oil was strongly correlated with risk on. However, in recent weeks this correlation has decreased and oil is now neither strongly risk on nor risk off. Instead, oil is being driven by forces that are unique to it and hence its behaviour appears at odds with the risk on risk off framework.

The implications of the USD shiftThe shift in the position of the USD in the RORO spectrum has implications for the optimal currencies to trade if one has a view on whether markets are

9. Correlation of oil with risk on risk off

1.0

1.0 0.8 Lehman bankruptcy 0.6 Middle East unrest intensifies 0.4 0.2 0.0 -0.2 -0.4

Correlation with 'risk on - risk off'14

0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Apr-11



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10. Correlation between the S&P and carry exchange rates

1.00 0.80 0.60 0.40 0.20 0.00 -0.20 -0.40 01-JanSource: HSBC, Bloomberg

S&P AUDUSD correlation

S&P AUDJPY correlation

S&P AUDCHF correlation

1.00 0.80 0.60 0.40 0.20 0.00 -0.20 -0.40

13-Jan

25-Jan

06-Feb

18-Feb

02-Mar

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07-Apr

risk on or risk off. Until recently, in a risk off environment the most common way of trading this view would have been to be short AUDUSD. The CHF and JPY have, however, both become more risk off than the USD. Given this, a better trade is now to be short either AUDCHF or AUDJPY in a risk off environment. A further consideration with the JPY is the possibility of further G7 intervention to prevent it from strengthening. As we argued in Swiss franc: The last safe haven, Currency Weekly, 4th April 2011, if we move to a risk off environment the market will look to buy the CHF and the JPY. However, coordinated intervention could limit any rise in the JPY. With this in mind, we argue that the CHF might represent the last remaining safe haven. Chart 10 showing the correlation of the different exchange rates with the S&P further supports this view. At the beginning of this year, AUDUSD had a correlation of 0.53 with the S&P whereas AUDCHF was negatively correlated with it. Now, however, the correlation of the AUDCHF with the S&P (0.75) is greater than the correlation of AUDUSD with the S&P (0.56).

In fact, Chart 7 shows that the CAD is now slightly more risk on than the AUD, so a short CADCHF position provides slightly better exposure to risk off factor than a short AUDCHF position.

Conclusions: risk on risk off down, but not outCurrent talk of the end of the risk on risk off phenomenon is premature. Whilst it is true that correlations have fallen from their all-time highs, they remain at very elevated levels. Speculation that risk on risk off might be ending is the result of the recent unusual behaviour of oil and the USD. During the last few weeks, both assets have decoupled from the risk on risk off paradigm and are now being driven by their own idiosyncratic forces. Focusing on the behaviour of a small number of major assets can, however, provide a distorted view of the market. In order to make any definitive statement on risk on risk off it is necessary to look at a much wider cross-section of assets. When one does, it is clear that correlations between many different assets remain high compared to historical levels.

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We continue to argue that correlation must reach much lower levels, and stay there for some time, before we can declare the end of risk on risk off with any degree of certainty. This has not yet happened. Correlations have dipped a number of times since the crisis, only to return to high levels once again. The unusual behaviour of the USD has important implications for currency trades. Because the USD is currently driven by idiosyncratic forces, any currency view is better expressed using alternative currencies. For example, if one believes that we are moving to risk off, this view is best expressed by being short CAD or AUD against the CHF.

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AUD: altitude sicknessAUD hitting highsSince the G7 central banks intervened to sell the yen in the middle of March the AUD has risen about 10% against a generally weaker dollar, and nearly 12% against the yen. As the highest yielding G10 currency, the AUD has been a major beneficiary of the apparent return to carry trades as risk appetite had rapidly re-built. We have been looking for the AUD to retrace, but this call was obviously premature, and we have revised our forecasts to take account of its persistent strength. However, we still believe it wise to be cautious about its prospects. 37% overvalued against the USD. The continued weakness of the USD may over exaggerate the position to some extent, but even on an effective exchange rate basis the AUD is now at extreme levels. Chart 1 shows the RBAs measure of the real effective exchange back to 1970. The current level (HSBC estimate for April) puts it at levels not seen since the mid 1970s, and well above the level seen at the time of the AUD float in 1983. Chart 2 shows the REER relative to its 5 year moving average. On this basis the AUD is about 18% overvalued.

Extreme valuationThe rally in the Australian dollar since the depths of the financial crisis has seen it move from mildly undervalued to extremely overvalued on a number of measures. Relative to the OECDs measure of purchasing power parity, the AUD is

Its all about the carryThe surge to new highs has come in the wake of the G7 central bank intervention to sell the JPY. As we have argued elsewhere (Swiss franc: the last safe haven, Currency Weekly, April 4th, 2011) the intervention has changed the dynamic

1. AUD at strongest real effective rate since mid-1970s

Index 180 160 140 120 100 80 Jun-70Source: RBA, HSBC

AUD REER (March 95 = 100)

Index 180 160 140 120 100 80

Jun-74

Jun-78

Jun-82

Jun-86

Jun-90

Jun-94

Jun-98

Jun-02

Jun-06

Jun-10

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2. AUD is significantly overvalued

AUD REER (Deviation from 5yr MA) 30% 20% 10% 0% -10% -20% -30% Jun-75Source: RBA, HSBC

30% 20% 10% 0% -10% -20% -30% Jun-11

Jun-79

Jun-83

Jun-87

Jun-91

Jun-95

Jun-99

Jun-03

Jun-07

of the FX market. With USD-JPY downside now apparently protected by the central banks, investors feel more comfortable in selling JPY to buy higher yielding currencies. As the highest yielding G10 currency, the AUD has been a major beneficiary of the rapid return to carry trading. Chart 3 illustrates the speed and extent of the change in the market. The chart shows the G10 carry trade total return based on buying the three highest yielding G10 currencies (AUD, NZD, NOK) and selling the three lowest (JPY, CHF, USD). Since the G7 intervention on March 18th, the total return has been ~8%.

As we have seen many times in the past, carry trades can rapidly unwind if market perceptions change and months of accumulated returns can be wiped out in a very short space of time. Those buying the Australian dollar will no doubt point to the strong fundamental background as justifying its extremely high level, and it is the case that, compared with other G10 countries, Australia is in a strong position.

Big terms of trade boostWith the Australian economy having avoided the deep recession that hit much of the world in the aftermath of the financial crisis, and with the

3. Carry trade surges since yen intervention

Index 111 109 107 105 103 101 99 97 95 Jan-10

G10 Carry Trade total return

Index 111 109 107 105 103 101 99 97 95

Mar-10

May-10

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

May-11


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4. Australia current account deficit not widening sharply...

5. ...thanks to very strong terms of trade

Australia current account (% GDP) 4% 2% 0% -2% -4% -6% -8% Mar-70 4% 2% 0% -2% -4% -6% -8% Mar-80 Mar-90 Mar-00 Mar-10

160 145 130 115 100 85

Index

Dollar bloc - terms of trade NZD CAD

Index AUD

160 145 130 115 100 85 70

70 Mar-70

Mar-80

Mar-90

Mar-00

Mar-10



currency so strong, it might be expected that the current account position would be deteriorating rapidly as imports surge and exports remain weak. However, this has not been the case in Australia. As can be seen in chart 4, the current account deficit, while erratic, has been narrowing in recent years, and now stands at just 2% of GDP. This has been possible because of the dramatic improvement in Australias terms of trade the price of its exports relative to the price of its imports. Chart 5 shows a terms of trade index for Australia and for two other commodity currencies NZD and CAD. While the rise in oil and other commodity prices has benefitted all three countries in the past three years, Australias6. Persistent current account deficits mean large external liabilities...

gain has been by far the biggest. In fact, the RBA estimates that the terms of trade are now at their strongest since the 1950s. While the rise in commodity prices has significantly improved Australias trade performance in recent years, persistent current account deficits over a very long period have left Australia with a large net overseas liability position (chart 6). Interest and dividend payments on these liabilities mean that Australia still runs a significant net foreign income deficit of about 4% of GDP. Any weakening of the trade position would therefore see the current account deficit increase sharply

Australia net foreign liabilities (% GDP) 65% 60% 55% 50% 45% 40% 35% Sep-88Source: RBA, HSBC

65% 60% 55% 50% 45% 40% 35% Sep-90 Sep-92 Sep-94 Sep-96 Sep-98 Sep-00 Sep-02 Sep-04 Sep-06 Sep-08 Sep-10

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7. ...and a large net foreign income deficit

% GDP 5.0 4.5 4.0 3.5 3.0 2.5 2.0 Sep-88

Australia - net foreign income deficit

% GDP 5.0 4.5 4.0 3.5 3.0 2.5 2.0

Sep-91

Sep-94

Sep-97

Sep-00

Sep-03

Sep-06

Sep-09

Source: RBA, HSBC

again. So a levelling off of commodity prices could easily cause the current account deficit to widen out again.

Growing risksDespite its stellar performance the AUD faces growing risks. The three most important of these are:1

8 shows net announced cross border M&A deals involving Australia by month since 2005. The outflow seen in 2005-07 started to turn decisively positive in 2009. Chart 9 shows the one year cumulative inflow over the same period. In the year to March 2011, the net announced inflow was about USD 40bn, more than enough to cover the current account deficit over the same period. This inflow however, may well be at risk in the future. The Australian government has announced that it is blocking the proposed

A slowing of M&A inflows. Since global M&A activity began recovering in 2009 Australia has seen a significant net inflow, especially in the natural resource sector. Chart

8. Net M&A flows have turned positive for Australia over the past two years

USD bn 15 10 5 0 -5 -10 -15 -20 Jan-05Source: Bloomberg, HSBC

Australia Net Announced Cross Border M&A Inflow

USD bn 15 10 5 0 -5 -10 -15 -20

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

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9. Cumulative net inflow over the past year more than cover the current account deficit

USD bn 60 40 20 0 -20 -40 -60 -80 -100 -120 Jan-05Source: Bloomberg, HSBC

Australia Net Announced Cross Border M&A Inflow (12 month sum)

USD bn 60 40 20 0 -20 -40 -60 -80 -100 -120

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

takeover of Australia Stock Exchange Ltd by Singapore Exchange, saying it was not in the national interest. This move may indicate a more nationalistic approach to industrial policy by the government and may reduce the direct investment inflows going forward. M&A inflows cannot last forever so to maintain a bullish AUD view one would need to believe that portfolio inflows will pick up further to compensate.2

radically in the market in a short space of time. The apparent resurgence of JPY-funded carry trades makes the AUD particularly vulnerable. Should Japanese investors begin to repatriate funds for reconstruction on a scale sufficient to see the JPY strengthen again, it is not clear how soon G7 central banks would intervene again, and some of the recently instituted long AUD position could be rapidly unwound The risk on risk off factor is still an important driving force for the markets, with

A change in the risk on environment. As we saw in March, expectations can change

10. IMM data suggest long speculative AUD positions are close to record highs

10 9 8 7 6 5 4 3 2 1

0 May-09Source: Bloomberg, HSBC

Bil

USD bn

AUD Net (LHS)

AUD-USD (RHS)

AUD-USD 1.20 1.10 1.00 0.90 0.80 0.70 0.60

Sep-09

Jan-10

May-10

Sep-10

Jan-11

May-11

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11. AUD closely linked to the performance of the Chinese economy

yoy 35%

AUD and Chinese electricity production China electricity production 3m MA (LHS) AUD TWI (RHS)

yoy 40% 30% 20%

25% 15% 5% -5% -15% Mar-00Source: Bloomberg, HSBC

10% 0% -10% -20% -30% Mar-02 Mar-04 Mar-06 Mar-08 Mar-10

the AUD and the JPY at opposite ends of the spectrum. As can be seen in Chart 10, IMM data suggest long speculative positions remain at high levels. This will make the AUD particularly vulnerable to anything which changes market perceptions of risk.3

the US. Tighter monetary conditions in Australia will only increase the risks of a downturn in the domestic housing market.

ConclusionEconomic fundamentals in Australia justify a strong currency. The economy avoided recession and has continued growing strongly. The dramatic improvement in the terms of trade means the external accounts have not deteriorated despite strong domestic growth and an overvalued currency. Monetary tightening makes Australian yields attractive relative to the rest of G10. That is why we were the first to forecast the currency to hit parity. However once it hit 1.00 we turned bearish seeing risk rather than reward. Hence despite all these positives, the AUD faces growing risks that make it difficult to justify buying it at current elevated levels. In fact any turn in the current risk on scenario and the most obvious currency to sell will be the AUD.

A slowdown in China. Australias links to the performance of the Chinese economy are well known with a close relationship between growth in the Chinese industrial sector and the performance of the AUD (chart 11). We have previously warned that a weakening of the Chinese housing market could adversely affect attitudes towards the AUD (see Will China ruin the AUD party? Currency Weekly, 7th June 2010) because of the damage it could potentially do to Australian banks. As the Chinese authorities continue to tighten monetary conditions (reserve requirement ratio up 200bp since December, interest rate up 75bp) so this risk grows. In addition, the domestic Australian housing market is looking more vulnerable. According to the housing policy consultancy Demographia the median Australian house price is now 6.1 times the median household income, compared with a multiple of 3.0 in

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A positive vote for the Canadian dollar

The CAD to remain strongThe Canadian election on May 3rd ended with significant changes to the countrys political landscape. The Conservative Party managed to obtain enough electoral support to form a majority government. This is a better than expected result for the party, as prior to the election the Conservative Party only managed to have a minority government. The likelihood of a more stable government in Canada is positive for the CAD. Apart from better political stability helping the CAD, the currency is also supported from a favourable fundamental backdrop, including decent economic growth and a better fiscal standing. The commodity linked economy has been at the core of the CADs appreciation in recent years. The currencys attributes are also being complemented by an overall weak USD environment, which has clearly been a key factor behind USD-CADs declines. CAD gains have tightened monetary conditions in Canada well beyond the modest interest rate increases taken by the Bank of Canada last year. Indeed, this creates a more complicated policy debate for the BoC, as current economic conditions and the Banks own forecasts strongly suggest that further interest rate increases are needed. But doing so now would lead to the very type of CAD appreciation that is currently skewing monetary conditions. Ultimately, we expect the BoC will come down on the side of further tightening. That outcome, and the prevalence of USD weakness, suggests USDCAD will remain under downward pressure for

longer than we previously expected. We now expect USD-CAD to remain at the 0.95 level for the next 6 months or so, before drifting to parity by the end of the first quarter of 2012. CAD strength creating more headwinds The CAD continues its slow but deliberate appreciation against the USD, a development which has effectively tightened monetary conditions in Canada. Although the Bank of Canada has regularly cited challenges stemming from the persistent strength of the CAD, its most recent policy statement on 12 April 2011 placed heightened focus on the currency. It said, the persistent strength of the Canadian dollar could create even greater headwinds for the Canadian economy, putting additional downward pressure on inflation through weaker-than-expected net exports and larger declines in import prices. So while there is no question that the BoC still assesses current policy rates as leaving considerable monetary stimulus in place, the strength in the CAD is creating an unfavourable balance in the overall policy stance, creating more headwinds for the export sector. The BoC would rather control its policy stance through the overnight target rate, which currently stands at 1.0%, and has a more broad based impact on the economy.

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1. Strong CAD tightens monetary conditions

Index 8.0 6.0 4.0 2.0 0.0 -2.0 -4.0 -6.0 -8.0 Jan-04

Bank of Canada MCI (LHS)

Bank of Canada Overnight Target Rate (RHS)

%

5.0 4.0 3.0 2.0 1.0 0.0

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Source: Bank of Canada, Bloomberg

Strong CAD enhances the gulf between monetary policy and monetary conditions

To illustrate the effects of the currency on monetary conditions, we looked at developments in the BoCs Monetary Conditions Index (MCI), an indicator composed of the trade-weighted CAD and the three-month commercial paper interest rate. Although the BoC stopped using the MCI as an input in its policy deliberations some years ago, in current circumstances it helps to provide some perspective on the extent to which CAD strength is impacting the Banks policy stance. Chart 1 shows the MCI and the Bank of Canadas overnight target rate. Both moved together fairly2. CAD has been on appreciating trend since 2009

closely, right up through 2008. That is logical as the majority (two-thirds) of the weight in the MCI is based on short-term interest rates, which correlates highly with the overnight target rate. However, from early 2009, the MCI has increased substantially compared to the fairly modest gains in the overnight target rate. That is clearly a function of the sharp appreciation in the CAD over that time frame, with the BoCs Canadian dollar effective exchange rate index (CERI) appreciating 25% since the beginning of 2009 (chart 2). Not surprisingly, the bulk of the CERIs rise stemmed from the CADs gains

Index 125 120 115 110 105 100 95 90 Feb-09

Canadian dollar effective exchange rate index

Index 125 120 115 110 105 100 95 90 May-11

May-09

Aug-09

Nov-09

Feb-10

May-10

Aug-10

Nov-10

Feb-11


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3. Diverging BoC and Fed policy keep yield spreads favouring CAD

US-Canada Yield Spread (March 2012 Eurodollar, BA futures (LHS)) 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -1.2 -1.4 -1.6 Jan-10Source: Bloomberg, HSBC

USD-CAD (RHS) 1.10

1.05

1.00

0.95

0.90 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11

versus the USD, which is 75% of the indexs weight.

Policy dilemma at the BoCSo what can or will the Bank of Canada do? Well, direct intervention in the CAD remains very unlikely. The BoC has not intervened in the CAD since 1998 and they are a consistent advocate of market-determined exchange rates. So we see no obvious signs they will shift to a more activist currency policy now. But there have been instances when the CAD appears to have played a bigger role in the Banks policy deliberations. In late 2007, the BoC reversed a 25bp rate hike undertaken just months after USD-CAD plunged from 1.05 to near 0.9000 between August and November of that year. And more recently, the BoC halted its tightening program in 2010 as USD-CAD registered modest but deliberate declines back towards parity. There were, of course, other considerations in both of these instances. Late 2007 marked the beginning of the financial and economic crisis, and many of the worlds central banks had moved into easing mode around that time, not just the BoC. This past autumn, increased downside risks to US growth created additional headwinds for the

Canadian economy. Moreover, additional easing by the Fed, via QE2, risked creating excessive divergence between Canadian and US monetary policies. But within all of that, the exchange rate was clearly a consideration in the BoCs policy deliberations. The strength of the currency at present is one factor that would seemingly argue against further tightening in the near-term (other things being equal), tightening that might otherwise support an even stronger CAD.Canadian inflation rises unexpectedly

But not only are other things not equal, they have recently become more complicated. Canadian CPI jumped to 3.3% y/y in March from 2.2% in February, above the top of the BoCs 1%-3% target zone for the first time in 2-1/2 years (chart 4). In addition, core CPI unexpectedly rose to 2.1% y/y in March from 1.2% y/y in February and after rising 1.6% and just 0.6% in 2010 and 2009 respectively. Indeed, exceptionally low levels of inflation had given the BoC flexibility to move more slowly to normalize monetary policy. The March spike in headline inflation is explainable through energy and taxes and therefore is potentially seen as transitory. But if the spike in core CPI persists or extends, it would warrant tighter monetary policy sooner.

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4. Canadian inflation jumps higher

% yr 4.0 3.0 2.0 1.0 0.0 -1.0 Jan-07

Canadian CPI

Canadian Core CPI

% yr 4.0 3.0 2.0 1.0 0.0 -1.0

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11


As it stands, the BoCs own forecasts call for the output gap to close by the middle of 2012, having brought forward the timing by six months in their updated forecasts released with the Monetary Policy Report on April 13. With growth expected at 2.9% this year and 2.6% in 2012, the current overnight target rate of 1.0% will need to be adjusted, and probably sooner rather than later. Our economists look for the BoC to resume the tightening cycle with a 25bp in July, and current money market rates have 50bp of tightening priced in by year-end. While some of the CADs current level presumably reflects those

expectations, it would still be viewed as more helpful for the currency than not.CAD benefits from its risk on status

Beyond the fundamental backdrop in Canada, there are other dynamics that also continue to favour the CAD. We often group the CAD into risk on currencies. And there are good reasons to do so, as Canada ranks well in terms of growth among developed economies, its fiscal position is among the best, and because of its commoditylinked economy and export base. As we regularly discuss, these all provide good reasons to like the CAD, but none are particularly new. So while we

5. Oil price gains have exceeded forecasts, and support the CAD

USD/bbl 120 110 100 90 80 70 60 50 40 30 Dec-08Source: Bloomberg, HSBC

Crude Oil (LHS)

USD-CAD (Inverted, RHS)

0.90

1.00

1.10

1.20

1.30 Apr-09 Aug-09 Dec-09 Apr-10 Aug-10 Dec-10 Apr-11

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6. Risk asset returns since 2010

7. Risk asset returns 2011 YTD

Risk asset erformance from 2010 to present (% return) 50 40 30 20 10 0 CAD S&P NOK BRL Gold Average Oil ZAR NZD AUD EUR 50 40 30 20 10 0 35 30 25 20 15 10 5 0

Risk asset performance 2011 ytd (% return) 35 30 25 20 15 10 5 0 BRL NOK NZD Average Oil EUR AUD CAD Gold ZAR S&P



understand why that supports the currency and why that helps the CAD to assimilate with other risk on assets, we also feel the ability of these factors to drive the currency even higher should be limited. But within that group of factors, one potential source of CAD support which we clearly underestimated comes specifically from higher energy prices (chart 5). Hence, our CAD forecast has been for a steady and strong currency, not an even stronger currency. Now, with EM-led global growth expected to remain fairly strong, and with global central banks still providing high levels of liquidity, the expectation is for energy prices to remain high for the foreseeable future. Against that backdrop, there seems a much better chance that the CAD too will stay stronger for longer than we previously expected, and we are adjusting our forecasts accordingly.But not all risk assets are createdor at least are performingequally

Year-to-date, those same assets have returned 9.5%, but the CADs returns have been just over half of that (chart 7). By these simple but telling measures, the CAD has tended to underperform. That fits with our existing assessment that there is already a lot of good news priced into the currency at current levels. And it also is one factor that discourages us from expecting further, substantial currency gains going forward.

Pronounced USD weakness a key element of USD-CAD declinesThe current dynamic is not only a question of CAD strength, but also of USD weakness. And this year, USD weakness has become even more pronounced. Just last week, the Fed not only reiterated that it intends to continue its full USD600bn asset purchase program through June, as originally planned, but that it also plans to continue to reinvest maturing debt in the months after the program concludes, so as to prevent any shrinkage in its balance sheet. That means policy will be eased further in the coming two months, and that it will then be kept at those ultra-accommodative levels for some period thereafter. In an environment where other most other central banks are either tightening policy, are preparing to do so, or have at least stopped easing, the Feds policy stands out, and must be a factor considered when assessing the

We would also point out that within a cross section of risk currencies and risk assets, the CAD has not been a standout performer. From 2010 to present, our cross section of risk assets, which includes the AUD, NZD, CAD NOK BRL, EUR, ZAR, oil, gold and the S&P 500, generated an average return of 19%, while the CAD rose 11% over that time (chart 6).

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prospects for the USD broadly, including USDCAD. Moreover, high levels of Fed-supplied liquidity continue to support the risk trade, which also supports the CAD. In addition, the decision by Standard & Poors to put the USs AAA sovereign credit rating on watch for a possible downgrade also highlights the considerable deterioration in the US fiscal backdrop in recent years, as well as the inability of politicians to credibly address the problem. It is true that many countries experienced significant fiscal deterioration during the financial crisis. But we continue to see the USD as particularly vulnerable to such concerns, given that roughly half of the stock of marketable US Treasuries are held abroad, and because the USD remains by far the worlds most widely held reserve currency (by a margin of over 2-to-1 over the next closest currency, the EUR). More foreign holdings of the USD create more risk for the currency when confidence is shaken.Reserve manager USD recycling

weighing on the USD and supporting currencies such as the CAD

Although this cycle of reserve manager USD recycling does not have infinite sustainability, it has persisted for the majority of the past decade and there are no obvious signs it will change in the foreseeable future. Recall that just last month, the G20 meeting brought about no voiced concern about USD weakness, the distortions associated with the persistence of fixed and rigid EM exchange rate regimes, and the upward pressure those regimes put on other freely floating currencies. Of course, getting wide agreement on such issues is difficult in the best of circumstances. Nonetheless, the persistence of current global FX policy arrangements will continue to see other freely floating currencies bearing the burden of the USDs adjustment, an important dynamic supporting the CAD.

Those same factors also encourage reserve managers to limit the extent of their USD holdings. Although there has been some increase in the pace of appreciation in Asian currencies of late (the CNY rose 0.9% against the USD in the month of April), the slow pace of gains generally implies there is still sizeable USD intervention taking place. In addition, higher oil prices are generating windfall USD receipts for oil producing countries in the Middle East and elsewhere, many of whom peg their currencies to the USD. The upshot is that reserve manager USD recycling remains an important dynamic in the market, one that is both weighing on the greenback generally but also supporting currencies such as the CAD.

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8. USD-CAD forecasts Q2 2011 New OldSource: HSBC

Q3 2011 0.95 1.05

Q4 2011 0.97 1.05

Q1 2012 1.00 1.05

Q2 2012 1.00 1.05

0.95 1.00

ConclusionThe CAD has benefited in the wake of the Canadian election given the Conservative Party achieved a majority. Prior to the election, the CAD was not impacted negatively with their being a minority government. That said, greater certainty and stability for the government should be a good feature for the CAD. CAD strength complicates the policy deliberations of the Bank of Canada, but ultimately the BoCs own economic forecasts suggest that a resumption of the rate hike cycle is coming, and we think that begins again in July. And that contrasts with the ultra accommodative policy stance by the Fed, keeping downward pressure on the USD. Moreover, the continued outperformance of risk on assets and the broader process of reserve manager USD recycling weighs specifically on the USD while supporting currencies such as the CAD.

None of these are especially new concepts or developments. Although some have carried on further than we have expectedparticularly the rally in risk assetswe also feel there is a lot of good news already priced into the CAD. On balance, we see scope for the CAD to remain strong in the coming months, with USD-CAD averaging 0.95 through the third quarter before drifting modestly higher towards year-end and into 2012, as some modest portion of its overvaluation reverses (table 8).

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New Zealand Rates steady for some time

Rates on holdThe RBNZ left the official cash rate (OCR) unchanged at 2.50% at their latest meeting on 27th April, as expected. The post-decision statement contained few surprises and suggested little about the timing of a return to more normal rates. Governor Bollard indicated that he expected rates to be on hold for some time' given the outlook for core inflation to comfortable return to target and the continued disruption to economic activity stemming from the recent earthquakes. He noted some signs of recovery, particularly in farm investment and the housing market, and that the recent weakness has been largely contained to quake-affected Christchurch.Inflation remains above target

the outlook for 'core' inflation was for a return to target. With Q1 inflation data published in midApril showing that inflation is still tracking higher (chart 1), and is now well above the RBNZs target, this was somewhat of a surprise. Particularly since non-tradables inflation a guide to domestic inflationary pressures was strong, rising by 5.2% on the year; its highest rate in over a decade. Even so, the RBNZ seem content to attribute the current high level of CPI inflation entirely to the effect of last year's tax changes.NZD surges

One area that differed from our expectation was just how sanguine the RBNZ seems about the outlook for inflation. The Governor did mention some concerns about oil prices, but also pointed out that the OCR level was appropriate because

Another area of interest was the Governor's concern about the high level of the NZD. The exchange rate is currently at a high level against the USD, trading around 80 cents (chart 2). However, on a trade weighted basis the currency is still below its highs of 2010, which is an indication of the extent to which it reflects USD weakness rather than NZD strength. Nonetheless, the Governor's comments are likely to fuel further debate about the level at which the RBNZ might become uncomfortable with the exchange rate.

1. Inflation accelerates in the first quarter

2. NZD-USD hitting highs

% 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Mar-01

New Zealand CPI

% 6.0 5.0 4.0 3.0

0.9 0.8 0.7 0.6 0.5 0.4 0.3 Jan-01

NZD-USD

0.9 0.8 0.7 0.6 0.5 0.4 0.3

RBNZ target band

2.0 1.0 0.0

Mar-03

Mar-05

Mar-07

Mar-09

Mar-11

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11



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Overall, our read of the recent economic data shows that a recovery was in process before the quake and that while the quake had a significant impact on Christchurch, the broader economy has been firming. Therefore, we still expect economic conditions to warrant a rate rise before year-end.Risk on risk off the key driver

While domestic economic conditions do affect the currency, the main driver is the markets appetite to buy risk assets. While the NZD has performed strongly since March on the back of continued growth in emerging markets, buoyant commodity prices and the risk on market environment, we feel it is vulnerable to a correction lower if risk off makes a comeback. The recent sharp drop in oil prices due to a liquidation of positions shows that the market remains very uncertain about the global outlook and that investors are ready to squeeze through the risk off door if there is an appropriate trigger. As a commodity currency the NZD will be heavily exposed if there is a more widespread fall in commodity prices. In addition, the recent focus on the fiscal troubles in the US, another downgrade of Greeces credit rating and concerns over other periphery countries are ongoing events that could push the market away from risk assets. Such a shift would be harmful for the NZD, which we see retracing to 0.72 against the USD by year-end.

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Europe at a glanceEUR-CHF

1.70 1.62 1.54 1.46 1.38 1.30 1.22 Jan-04 Jan-05 Jan-07 Jan-08 Jan-11 Jan-02 Jan-03 Jan-06 Jan-09 Jan-10

1.80 1.60 1.40 1.20 1.00 0.80

euro-swiss (LHS)Source: Thomson Reuters Datastream

dollar-swiss (RHS)

Switzerland: CHF remains resilient The CHF has remained resilient against both the USD and EUR. Although the CHF benefits when times are bad, we believe domestic economic conditions show that the currency is not impacting growth materially and should be considered more of a pro-growth currency. The SNBs Hildebrand recently said the economy was growing vigorously even though the CHF is very strong. While we remain positive on the CHF, inflationary pressures remain benign, suggesting the likelihood that the SNB will follow the ECB in raising rates is reduced. We do not expect the SNB to raise rates in June but feel that a 25bp hike to 0.50% at its September meeting is most likely. We see the CHF as a supreme outperformer in bad times, yet should be more favoured in good times as well. The next key focus includes Swiss GDP on 31 May, Swiss CPI on 7 June and the SNB monetary policy meeting on 16 June.

EUR-NOK

10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00 Jan-02 Jan-03 Jan-04 Jan-05 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-06

10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00

Norway: Norges bank tighten policy We remain of the view that the NOK is a currency to own in good times and bad. While the NOK did suffer from the recent fall in oil prices, it has since recovered all its ground against the EUR. While a more sustained fall in oil prices would be an obvious negative factor for Norway's economic outlook, its recovery since the crisis has been robust and its fiscal situation is excellent. As a result, we continue to believe that the NOK is an attractive currency. A strong housing sector and high real wage growth prompted the Norges bank to raise rates by 25bp to 2.25% at its latest meeting on May 12th. We expect the Norges bank to continue tightening policy this year and see the policy rate at 2.75% come year-end. Overall, the NOK's outlook is positive and we expect further strength in the coming months.

Source: Thomson Reuters Datastream

EUR-SEK

12.00 11.60 11.20 10.80 10.40 10.00 9.60 9.20 8.80 8.40 Jan-03 Jan-04 Jan-07 Jan-08 Jan-10 Jan-11 Jan-02 Jan-09 Jan-05 Jan-06

12.00 11.60 11.20 10.80 10.40 10.00 9.60 9.20 8.80 8.40

Sweden: Room for further SEK strength The SEK has stabilised versus the EUR in recent weeks but we maintain there is room for the currency to strengthen further. Recent economic indicators point to robust growth in the Swedish economy, implying the need for additional rate hikes by the Riksbank going forward. The Riksbank raised its policy rate to 1.75% on 20 April but the policy rate remains low by historical standards. We expect the key rate to be increased by another 75bps this year. However, this is contingent on labour market conditions remaining strong and on external conditions, in particular whether sovereign risk within the Eurozone intensifies. Further rate increases should support the SEK but the positive story for the currency is broader than just expected rate increases. The SEK also stands to benefit from a country with relatively sound fiscal and current account balances. Key events released in the coming weeks include confidence surveys on 26 May and Q1 GDP on 27 May.


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Asia regional overviewInflation is still the focusDespite the early May correction, the fundamental incoming data reinforces our strategic bullish view on Asian currencies. Inflation continues to creep higher resulting in a number of Asian central banks e.g. Malaysia, Singapore and India, having to tighten monetary conditions surprisingly aggressively. This has occurred not only via the interest rate channel but also increasingly using FX as well. There are lingering risks that policy makers will try to introduce capital measures, as seen in recent months by Indonesia and Korea. However, these measures are merely to filter out short term speculative flows from longer term investments, rather than to stop capital inflows altogether and prevent currency appreciation. As such, we continue to expect Asian currencies to appreciate against the USD across the board this year. minimal social uncertainty, the government would like to ensure inflation is within a more comfortable level. As such, it will use all tools available, including FX, to limit inflationary pressure. In light of that in the short term we expect the RMBs appreciation pace to persist, but to slow as inflation peaks which our economist is expecting around 2H of this year.

But global conditions matterWhile fundamentals and the RMB trend support broader regional currency strength, the external environment will still matter. Key to our view is that the ongoing developments in Europe, particularly the peripheral European countries do not devolve into a new globally systemic event. Our fixed income strategy team does not expect Greece to exit from the European Union or announce any debt restructuring in the short term. However, until the market sees an improvement in Greeces fiscal situation, including filling the finance gap it has in Q2 2012, Asian currencies, though buffered, will not be immune to global market jitters. Until markets find more stable footing, the most heavily positioned Asian currencies will be the most vulnerable ones for further short-term corrections, even as the broader appreciation trend remains intact.

Faster RMB appreciation anchoring the regional trendIn the near-term, the ongoing gradual appreciation of the RMB will also help keep Asian currency appreciation relatively buffered from volatility in markets elsewhere. Over the past few weeks, the Chinese authorities have suggested that FX will become a more active tool in their policy kit to fight inflation. However, as we have reiterated in our latest China trip notes (See Asian FX Focus: Faster appreciation for now RMB trip notes, 4 May 2011), the recent change in tone to use FX policy is mainly political rather than for economic reasons. As we approach the end of this year, the Chinese authorities will be convening a new government. To ensure a stable political handover with

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Asia at a glanceUSD-CNY8.40 8.10 7.80 7.50 7.20 6.90 6.60 6.30 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jul-06 Jul-07 Jul-10 Jul-05 Jul-08 Jul-09 Jul-11 8.40 8.10 7.80 7.50 7.20 6.90 6.60 6.30

China: Acceleration in RMB appreciation to persist, for now The common narrative in offshore markets, that acute inflation concerns have caused a shift in the FX policy, could not be corroborated during a recent trip onshore. We find that RMB policy continues to be a complex outcome of domestic politics. Combined with other factors; weakness of the USD, ongoing pressure in the international political calendar, and a surprisingly strong external sector; the near-term acceleration in RMB appreciation will persist in the coming months. However, the same political equation also means that any expectation of a one-off revaluation is unfounded in our view. Moreover, if the acceleration of RMB appreciation is the result of the coincidence of several near-term cyclical factors, rather than a shift in Chinas approach to FX policy, then RMB appreciation will likely slow again. We therefore maintain our relatively conservative year-end forecast of 6.35.


USD-HKD

7.86 7.84 7.82 7.80 7.78 7.76 7.74 7.72 7.70 97 99 01 03 05 07 09 11

7.86 7.84 7.82 7.80 7.78 7.76 7.74 7.72 7.70

Hong Kong: Onshore-offshore spreads widened again The past month saw a notable increase in RMB appreciation expectations, as inflation concerns rose and the pace of RMB appreciation increased. The resultant increase in offshore positioning in the CNH market has widened the onshoreoffshore spreads again, with the offshore RMB at one point trading at as much as a 0.5% premium to the onshore RMB, vs the USD. We continue to expect a narrow spread to emerge from time to time, driven by variations of appreciation expectations in the offshore markets. Meanwhile, the launch of the RMB Fiduciary Account Service, designed to address issues with counterparty credit limits facing the clearing bank, BoC (HK), has only taken off slowly. A recent HKMA circular further clarifying the original announcement should accelerate the implementation of the scheme, which should see the offshore deliverable forward curve finally flatten out.


USD-SGD

1.90 1.80 1.70 1.60 1.50 1.40 1.30 1.20 97 99 01 03 05 07 09 11

1.90 1.80 1.70 1.60 1.50 1.40 1.30 1.20

Singapore: appreciation to come given MAS move MAS further tightened policy by re-centring the S$NEER band upwards, keeping the width and slope unchanged. However, the move was more nuanced and less hawkish. By re-centring below the prevailing level of the S$NEER MAS signals that much tightening has already been delivered in the past, and a full additional dose is not warranted. We still think this is a hawkish stance by the MAS and we remain bullish on SGD. Growth is expected to be strong, inflation should remain elevated and SGD should continue strengthening as the NEER is still on a modest and gradual appreciation pace. In addition, the size of MAS intervention, since October estimated intervention has been around USD16bn, suggests the fundamental pressure is clearly for continued appreciation. This move should help the MAS reduce its FX intervention activities until the NEER trades towards the top of the band once again.


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Asia at a glance continuedUSD-KRW

2000 1800 1600 1400 1200 1000 800 97 99 01 03 05 07 09 11

2000 1800 1600 1400 1200 1000 800

Korea: More allowance of currency strength We think authorities will become more tolerant of a stronger KRW in light of two key factors. First, rising inflation expectations have increased the necessity for further tightening via both interest rates and exchange rates. The recent decision to hold rates steady was accompanied by a hawkish statement highlighting inflationary pressures, and a comment that BoK was seriously looking at Won volatility. Second, FX policy is becoming an increasing focus for the international community particularly in Asia. With the US Treasury semi-annual currency report upcoming and a potential addition of a currency requirement in a US-Korea free-trade agreement, we think greater appreciation will continue to be permitted. FX policy is likely to become more symmetrical, as BoK looks to curb volatility rather than stop appreciation outright. The strong fundamentals remain intact and short USD-KRW positions are also looking more attractive from a risk reward profile.


USD-MYR

4.8 4.4 4.0 3.6 3.2 2.8 2.4 97 99 01 03 05 07 09 11

4.8 4.4 4.0 3.6 3.2 2.8 2.4

Malaysia: Strong bullish case The fundamental bullish case remains for the ringgit with MYR the best placed Asian currency to benefit from continued commodity price strength. The strength of the economy has been notable, while the recent Bank Negara Malaysia (BNM) decision to hike rates 25bp (where the market was not expecting a shift) confirms their reputation as one of the most hawkish central banks in the region. The commitment to fight inflation should benefit Malaysias bond market flows, complementing the strong current account inflows. MYR has up until recently been something of a laggard in the region, with FX policy having become more resistant to currency strength in late Q1 and early Q2. However, following the MAS decision to tighten and allow continued appreciation, we have also seen Malaysian authorities shift to allow a faster move lower in USDMYR. We think the BNM will allow appreciation to continue given how its peers are also allowing greater currency strength.


USD-IDR

16000 14000 12000 10000 8000 6000 4000 2000 97 99 01 03 05 07 09 11Source: Thomson Reuters Datastream

16000 14000 12000 10000 8000 6000 4000 2000

IDR: More regulatory measures but no change in trend Bank Indonesia (BI) extended the required holding period on SBI certificates to 6 months (from 1 month previously).The key reasons for this change, in our view, are (1) to manage liquidity more efficiently, (2) to limit FX volatility and (3) to deepen the debt market by pushing liquidity into the government bill and bond markets. Since the introduction of the one month holding period in June 2010, investors in SBIs have been mainly longer term investors. Therefore they would have little need to shift their holdings. Even if this results in some marginal reversal of SBI holdings, it is unlikely to change the appreciation trend for IDR particularly given strong fundamental flows (current account surplus and FDI). Furthermore, with BI continuing to signal an ongoing desire to tighten monetary conditions largely via FX, this should continue to result in inflows from both domestics and the international community.

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Latin America regional overviewA correction, not a trend reversalThe recent USD rally, which we view as a shortterm correction rather than a reversal trend, has marginally improved valuations and helped improve positioning across LATAM FX. The recent drop in commodity prices is less supportive, but we find still elevated levels to be largely positive for the regions terms of trade. Overall, we maintain our bullish outlook for LATAM FX and continue to recommend selling USDs on spikes. On that, we have recently added a short USD-BRL trade to our EM FX Portfolio (see EM FX Roadmap April 2011), adding to our existing short USD-UYU position. We view the recent USD rally in the region as a short-term correction. While the USD is cheap by most metrics, our G10 colleagues maintain that a sustained recovery of the greenback requires a change in perception over US monetary and fiscal prospects. In the absence of either, we maintain a bearish USD view. In contrast, the fundamental picture across Latin America remains strong. While arguably much of the outperformance in emerging markets (EM) is already priced in, the prolonging of abundant liquidity will see investors continuing to look for opportunities to put cash to work in EM, we believe. FDI flows, which are less sensitive to currency levels than to long-term trends, continue to reach new highs in many LATAM countries, supporting the trend for even stronger currencies. Indeed, commodity prices remain another important driver for FDI into the region. While it is unlikely that LATAM FX can resume its rally should commodity prices embark on a downward trend, we note that the regions currencies have broadly outperformed the recent slide in commodities prices. Despite the speed of the correction in commodities, we remain bullish on precious metals prices, and even a stabilization of commodities at current levels would still be very favourable for terms of trade and as an investment magnet for the region, in our view. The unwinding of short USD trades has cleared overcrowded positioning in LATAM FX. As case in point, net foreign investor USD-BRL shorts at the Brazilian Mercantile and Futures Exchange (BM&F) are down to USD14.3bn from an alltime high of USD20bn over the last month. Overall, the improvement in positioning leaves the region better placed to resume the trend higher against the USD. As such, we believe that the USD rally represents an opportunity to sell USD against selected currencies in the region. Currently we are recommending clients are long the BRL and UYU, and also maintain constructive outlooks on the COP, PEN and MXN. Indeed, for USD-MXN we have just revised down our year-end forecast to 11.30 from 11.80 based on the countrys benign domestic conditions, continued inward FDI and portfolio investment, a continued weak USD and higher oil prices (see Mexican bliss, 12 May, 2011)

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Latin America at a glanceUSD-BRL

4.00 3.50 3.00 2.50 2.00 1.50 Jan-03 Jan-06 Jan-04 Jan-07 Jan-09 Jan-10 Jan-05 Jan-08 Jan-11 Jan-02

4.00 3.50 3.00 2.50 2.00 1.50

Brazil: Funding pressures normalising We see the recent mover higher in USD-BRL as opening attractive levels to express our constructive view on BRL. In short, we believe the trend for a stronger BRL is well sustained by booming FDI and other long-term financial flows, and maintain a year-end 1.52/USD forecast. Onshore dollar funding is also normalizing. Recently the combination of spot dollar purchases (less supply of dollars) and new regulations extending the IOF tax on short term USD funding up to two years has resulted in higher domestic USD rates. However, these pressures have since somewhat abated, leaving more room for BRL strength. Exporters with unremitted USD receipts also offer topside USD-BRL resistance. Finally, improved market positioning at present, with net foreign BRL longs at the BM&F down from a recent high of USD20bn to USD14.3bn means less downside risks for the BRL, we believe.


USD-MXN


15.75 14.75 13.75 12.75 11.75 10.75 9.75 8.75

Mexico: Peso strength set to continue While Mexico is not completely immune to the challenging external environment, it nevertheless enjoys a more comfortable position than most economies, reaping the fiscal benefits of higher oil prices yet with a benign inflation outlook. Additionally, non-economic issues such as presidential elections and security concerns do not constitute, in our view, market risks for the time being. This makes us optimistic about the short-and-medium-term outlook for the Mexican economy, and as such we are upgrading our MXN forecasts vs the USD. We now see USD-MXN moving lower to end the year at 11.30 from 11.80 previously. We see MXN strength in an environment of Mexicos improved terms of trade, especially vs China, ongoing increases in foreign investor portfolio inflows and an improving outlook for foreign direct investment (FDI). We see FDI rising to USD25bn this year and USD28bn in 2012.


USD-CLP

800 750 700 650 600 550 500 450 400 Jan-11 Jan-02 Jan-03 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-04

3000 2800 2600 2400 2200 2000 1800 1600

Chile: Limited CLP upside as China cools Is the government waving the white flag on the peso? Having maintained a strong anti-appreciation stance for many months Chiles government recently admitted that it is unable to counter the international problem of a weaker dollar. The government has also said it will possibly soon return to the USD bond market, after a one year hiatus based on avoiding CLP strength on the back of repatriation of funds raised overseas. Meanwhile the central bank, despite its continued USD50m per day USD purchase intervention, is more concerned about inflation at the present time. This suggests to us that we are unlikely to see a step up in daily USD purchases despite the strength of the CLP (the policy is re-set monthly). That said, we see less upside for the CLP from here compared to other currencies in the region, based on Chinas continuing efforts to slow its economy which we expect to preclude copper gains.


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EMEA regional overviewDifferent fortunesEMEA currencies have strengthened, particularly against the USD, in the recent weeks. However, the abrupt correction on EUR-USD has triggered a significant downward correction. Against the EUR, they continued to hold up well but at current levels most of them do not appear attractive. We expect EUR-CEE to trade in narrow range in the near-term, while dollar currencies might have divergent fortunes.In CEE we favour the RON and the HUF

inflation trend we do not expect any reduction in interest rates.We retain our bearish view on the TRY

Polands decision to sell EU funds in the FX market is an important factor for the directional trend of the zloty. Nevertheless, we do not expect any significant appreciation in the near-term, the current account is widening and the capital flows dynamic is deteriorating. In CEE, we see more value in the RON and the HUF. In Romania, rising inflation leaves no choice to the central bank but to let the currency rise. Moreover, an adjustment of monetary policy to achieve the 2012 inflation target, which would be RON-supportive, cannot be ruled out as the IMF has emphasised recently. The RON will also be supported by an improving external position (lower trade deficit, higher capital inflows). Therefore, we see EUR-RON moving down to 3.95. The valuation metrics still suggest that the HUF is cheap. The strong increase in the trade surplus is favourable, while the government fiscal plan has reduced investors worries about the fiscal sustainability. Uncertainties surrounding the new MPC members have also eased and given the

We stay bearish on the lira as the premium offered is unattractive compared to the macroeconomic risks. Credit is still expanding at a very strong pace, banks are reluctant to tighten lending conditions to households and the current account deficit is spiralling out of control, reaching 8.0% of GDP. With a central bank keeping its unconventional monetary policy and having no intention to hike the repo rate, the TRY is likely to stay weak. The risk of a larger depreciation cannot be ruled out if the economy does not give rapid signs of cooling off.We are neutral on the ZAR and the RUB

The RUB has reached its highest level since end2008 as commodity prices continue to fuel trade related inflows. The currency has posted substantial gains since the start of the year and we do not think that the upward momentum is sustainable. It may run out of steam as trade dynamics are likely to deteriorate on stronger imports and the central bank is reluctant to tighten significantly. The rand is strong from a valuation standpoint but the currency continues to be supported by improving terms of trade on the back of higher commodity prices. We prefer to stay sidelined for now.

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EMEA at a glanceEUR-PLN

5.00 4.60 4.20 3.80 3.40 3.00Jan-03 Jan-05 Jan-07 Jan-08 Jan-09 Jan-10 Jan-06 Jan-04 Jan-11 Jan-02

5.00 4.60 4.20 3.80 3.40 3.00

Poland : a new FX policy to support the PLN The government and the central bank have designed a new FX policy to support the currency. Last month, they announced that the EU funds (about EUR 13bn) will be sold directly on the FX market instead of transiting via the central bank. A stronger currency would help the central bank to achieve its inflation target of 2.5% as inflation is mainly driven by higher commodity prices. For the government, a stronger zloty would maintain the debt level relative to GDP below the threshold of 55% thanks to valuation effects. Although FX intervention policy is a supportive factor for the PLN, the upside potential appears limited in the near-term. The widening of the current account deficit, the decline in FDI and heavy positioning are the obstacles for appreciation. Therefore, we expect EUR-PLN remaining range bound in the coming 1-3 months.


USD-TRY

1.90 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 Jan-03 Jan-04 Jan-06 Jan-07 Jan-08 Jan-10 Jan-11 Jan-02 Jan-05 Jan-09

1.90 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10

Turkey: the CBRT keeps the lira weak The central bank has recently reiterated that its unconventional monetary policy will stay in place in coming months with the reserve requirement rate remaining the main policy tool to slowdown the economy. New increases in RRR would imply less need to increase the key repo rate, which is the pivotal rate for the TRYs performances. With the hikes in repo rate being delayed and the magnitude being small, the TRY is likely to remain weak. The success of CBRTs policy still uncertain with the credit still growing at a very strong pace and the current account deficit reaching new historical highs. In absence of rapid concrete results, the TRY is facing the risk of further depreciation, particularly because there is no risk premium offered in exchange of the macroeconomic risks. Therefore, we retain our TRY-negative bias for the near-term.


USD-RUB


37.0 35.0 33.0 31.0 29.0 27.0 25.0 23.0

HSBC Currency Outlook

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