Risk Insight

Navigating Market Risk — 22nd September 2014

The Big Picture

Has the euro weakened enough?

Validus Risk Management Ltd.

Volume 5, Issue 38

www.validusrm.com

“Euro bonds are precisely the wrong answer. They lead us into a debt union, not a stability un-

ion”

German Chancellor Angela Merkel, 2011

“I think France has not made it clear enough to our German friends how important it is to intro-

duce euro bonds as a tool against speculation”

French Prime Minister Francois Hollande,

2012

Shorting the EUR against the USD seems like a

pretty obvious trade at the moment. With the

Federal Reserve beginning to show a tightening

bias (almost a third of FOMC members now be-

lieve that US rates will rise by at least 175 basis

points next year – which implies that they expect

rates to begin rising in March – and then to keep

rising), and the ECB (trying) to move in the exact

opposite direction with its less than impressive

QE-lite programme, it is not hard to understand

why EURUSD has traded down by about 8%

since May. Many (including Goldman Sachs, see

chart below) see this trend continuing over the

coming months and years.

WHAT ARE THE CHANCES…

..that GBPUSD touches 1.50

within the next 3 months?

10.7%

..that USDCAD finishes the year

above 1.12?

28%

..that EURUSD will be below

1.20 within the next 12

months?

16.4%

*The above probabilities have been calculated

using market data derived from the currency

options market and interest futures mar-

ket. This does not necessarily reflect the direc-

tional view of Validus Risk Management.

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Chart One: Goldman Sachs EURUSD Forecast:

With the euro now approaching our targets

(1.27 in EURUSD and 1.29 in GBPEUR), it is

worth asking the question: How much lower can

the euro go? Has the single currency weak-

ened enough, or are we just at the start of a

substantial long term trend?

For now, we still feel that the euro has (almost)

weakened enough (for now). There are four

main reasons for this view:

1. The ECB is happy with the Euro at current

levels.

The ECB wanted to see the euro weaken – and

Mario Draghi, following his various dovish com-

ments and actions over the past few months,

has now engineered a significant fall in the sin-

gle currency. ECB Governing Council member

(and head of Italy’s Central Bank) Ignazio Visco

commented last week that the euro’s recent

decline was “more or less, given the moves that

were done between June and September, the

right response.”

2. The ECB’s attempts at balance sheet ex-pansion will disappoint.

As we have noted in the past, it is much harder

for the ECB to print money than it is for either the Fed or the Bank of England. While other central banks have the vast ocean of their re-spective domestic government bond markets in which to deploy their freshly minted cash, the ECB is restricted to a dwindling pool of private assets. Further, while other central banks also control the supply of the assets that they wish to buy with their cash (i.e. they can always just issue more debt, and then print money to pur-chase it), the ECB does not. As such, the pri-vate sector can force the ECB to bid up the prices of the assets which it wishes to buy - or simply not sell. This dynamic will, in our view, act as a brake on the ECB’s ability to expand its balance sheet / print money, thereby limiting the downside of the single currency, unless the

ECB starts buying government bonds…

3. The ECB will not launch a conventional QE programme.

This assumption is key to our (relatively) benign outlook for the euro. Our belief is based upon the fact that sovereign bond buying by the ECB would contravene EU law, which prohibits the financing of governments by the central bank. We concede that this obstacle is not as impene-trable as it may initially appear – governments (and central banks) have a way of circumvent-ing the rules if they really want to (e.g. issuing

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euro bonds). However, we would view the launching of a European QE programme as the beginning of the end of the single curren-cy. Forcing the ECB to pick winners and los-ers in the sovereign bond market could open up serious rifts within the currency area – a recognition of this fact should prevent the ECB from going down this perilous road. If we are wrong on this point (30% chance), then Gold-

man’s forecast looks increasingly reasonable.

4. The Fed’s exit from QE will be a bumpy one.

The long EURUSD trade is based upon an assumption that the US will soon begin tight-ening rates. The Fed will likely end its QE programme next month, and current expecta-tions are for rates rises to begin in early 2015, and then continue, virtually uninterrupted, through to 2017. These expectations seem quite optimistic, implying a straightforward exit from the extreme monetary policy environ-ment that has been in force since 2008, with-out any significant financial market hiccups (or

heart attacks). We anticipate a much rocki-er road to monetary policy normalization – this

will represent a headwind for the USD.

With these factors in mind, we are comfortable with our current euro forecasts, although we do not rule out the possibility of overshooting our downside targets (possibly to the low 1.20s in EURUSD / low 1.30’s in GBPEUR) if market panic sets in. This does not mean, however, that we are complacent with respect to the longer term economic prognosis for the euro-area. We expect that Europe will face some particularly tough economic and political challenges in the months and years ahead; the single currency still faces an uncertain

long term future.

Author: Kevin Lester

GBPUSD

Key Influences

Summary:

Sterling continued its recovery against the dollar last week amid expectations that the Scottish referendum would result in a vote against independence. By the time the result was announced on Friday, the outcome was largely priced in and hence the relief rally proved relatively short lived (in fact, having touched an overnight high of 1.6525, GBP/USD closed the week at 1.6288). Key Influences:

Sterling rallies after Scotland votes to remain part of the UK – The announcement that Scotland had voted against independence was met with a sigh of relief on Friday. Sterling advanced against all its major counterparts while the FTSE 100 opened higher, propelled by companies with strong links to Scotland. In the week prior to the referendum, UK equity outflows exceeded $1bn according to EPFR, the largest weekly outflow since records began in 2001. Whether this money will immediately return or not remains to be seen with the divisive nature of the referendum and the prospect of future devolution of power still likely to prove unsettling to investors going forward.

Fed slows QE purchases by another $10bn per month – As widely expected, the Federal Reserve continued to taper its asset purchases by $10bn per month following last week’s meeting amid signs that the economy is continuing on its recovery path. The remaining $15bn of monthly purchases is expected to end following next month’s meeting and as such, the focus is now very much on when the Fed will begin raising interest rates from the current low of 0.25%. Yellen’s statement was relatively balanced on the subject, giving little away for now. She maintained her pledge to keep rates low for a ‘considerable time’ post QE citing low inflation and significant underutilisation in the labour market. However, this was countered by noting that the economy continues to expand at a moderate pace while the labour market is also showing signs of improvement. For now, the consensus is still for the first rate rise to come in mid-2015.

Technical View: Last week’s recovery in GBP/USD has eased downside pressure on the pair in the short term although at the time of writing, further consolida-

tion is needed before we can be confident that an interim low is in place.

A sustained move back above 1.64 would significantly improve the short term outlook from a technical perspective and refocus attention on last week’s high at 1.6525 and the next resistance level at 1.6650.

A break back below 1.6200 will expose the recent low at 1.6050 again and the psychological 1.60 level. Regular readers will be aware that this has been our longstanding view and for now, our 12 month target remains unchanged at 1.5700.

Short-term Risk Factors: UK consumer focus – In a week void of any first tier data, the focus will be on the UK consumer where CBI reported sales, updates on the

housing market from Nationwide and Hometrack and the latest net consumer credit figures will all help build a profile of how the UK consumer is faring within the recovery. Last week’s average earnings figures continued to lag behind the consumer price index, but until now, rising house prices and cheap credit have been sufficient to maintain confidence.

US GDP / outlook for Fed Policy – This week brings the final reading of Q2 GDP which is expected to show that the economy expanded 4.6% (annualised) between April and June. While it’s unlikely that this pace of growth was maintained in the third quarter, this week’s PMI surveys from both the manufacturing and service sectors should offer a deeper insight into the health of the US economy and the potential implications for Fed policy.

Key Levels:

Support 1

1.6225

Support 2

1.6050

RESISTANCE 1

1.6525

Resistance 2

1.6650

GBPEUR

Key Influences

Summary:

Sterling continued its recent recovery against the euro throughout last week as it became clearer that the Scottish referendum was likely to result in a

vote against independence. Friday’s result gave a further boost to the pound resulting in GBP/EUR spiking to a new cycle high at 1.2804 before slipping

back lower to close the week at 1.2696.

Key Influences:

Sterling rallies after Scotland votes to remain part of the UK – The announcement that Scotland had voted against independence was met with a sigh of relief on Friday. Sterling advanced against all its major counterparts while the FTSE 100 opened higher, propelled by companies with strong links to Scotland. In the week prior to the referendum, UK equity outflows exceeded $1bn according to EPFR, the largest weekly outflow since records began in 2001. Whether this money will immediately return or not remains to be seen with the divisive nature of the referendum and the prospect of future devolution of power still likely to prove unsettling to investors going forward.

ECB reports disappointing take-up for its TLTRO – Last week saw the first offering of the ECB’s targeted long term refinancing operations re-sult in a much lower than expected take up for the cheap funds. As highlighted in previous editions of this report, the outcome shouldn’t have bene overly surprising given that liquidity hasn’t been a problem for some time now, instead the problem lies with the Bank’s appetite for funds. Overall, it suggests that asset purchases are the key tool in the ECB’s arsenal and as such, it increases the likelihood that asset purchases will indeed follow in the months ahead. Either way, long dated swap rates have continued to fall and the euro remains on the back foot suggesting that the strategy is having the desired impact in the short term at least.

Technical View: After breaking up through 1.2700 last week to make a fresh cycle high at 1.2804, near term risk remains skewed to the update for the pair.

Before getting too bullish, it is worth noting that the pair briefly broke the bottom end of the range a little over two weeks ago (implying risk of a move lower) although the move wasn’t sustained. While the recent break higher appears to have greater momentum, it is worth remembering the pair’s range bound tendencies.

If the break higher isn’t sustained, there is clear risk back towards 1.2600 before the first level of support is encountered ahead of the bottom end of the range at 1.2450.

Short-term Risk Factors: Eurozone PMI Surveys (Tuesday) – This week brings the latest PMI surveys from both the manufacturing and service sectors. Both are ex-

pected to remain relatively stable and just above the key ‘50’ level that separates contraction from expansion. However, any sign that the econo-my is slowing further will likely weigh heavily on the euro amid expectations that it will further prompt the ECB to provide additional monetary stimulus.

UK consumer focus – In a week void of any first tier data, the focus will be on the UK consumer where CBI reported sales, updates on the housing market from Nationwide and Hometrack and the latest net consumer credit figures will all help build a profile of how the UK consumer is faring within the recovery. Last week’s average earnings figures continued to lag behind the consumer price index, but until now, rising house prices and cheap credit have been sufficient to maintain confidence.

Key Levels:

Support 1

1.2440

Support 2

1.2265

RESISTANCE 1

1.2550

Resistance 2

1.2700

EURUSD

Key Influences

Summary:

After a relatively quiet start to the week which saw EUR/USD slowly edge back towards 1.3000, the pair came under heavy selling pressure on Friday

to close the week at fresh cycle lows of 1.2829. After the ECB’s TLTRO saw a little interest from the European banks, analysts were quick to assume

that the ECB will be forced to engage in asset purchases if it is to provide additional stimulus.

Key Influences:

ECB reports disappointing take-up for its TLTRO – Last week saw the first offering of the ECB’s targeted long term refinancing operations re-sult in a much lower than expected take up for the cheap funds. As highlighted in previous editions of this report, the outcome shouldn’t have bene overly surprising given that liquidity hasn’t been a problem for some time now, instead the problem lies with the Bank’s appetite for funds. Overall, it suggests that asset purchases are the key tool in the ECB’s arsenal and as such, it increases the likelihood that asset purchases will indeed follow in the months ahead. Either way, long dated swap rates have continued to fall and the euro remains on the back foot suggesting that the strategy is having the desired impact in the short term at least.

Fed slows QE purchases by another $10bn per month – As widely expected, the Federal Reserve continued to taper its asset purchases by $10bn per month following last week’s meeting amid signs that the economy is continuing on its recovery path. The remaining $15bn of monthly purchases is expected to end following next month’s meeting and as such, the focus is now very much on when the Fed will begin raising interest rates from the current low of 0.25%. Yellen’s statement was relatively balanced on the subject, giving little away for now. She maintained her pledge to keep rates low for a ‘considerable time’ post QE citing low inflation and significant underutilisation in the labour market. However, this was countered by noting that the economy continues to expand at a moderate pace while the labour market is also showing signs of improvement. For now, the consensus is still for the first rate rise to come in mid-2015.

Technical View: Given that prices haven’t managed to rally back beyond the psychological 1.30 level, near term risks remain skewed to the downside.

From a short term perspective, having made a new cycle low last week, there is now clear risk towards 1.2750 (2012 lows) which also repre-sents our three month target.

For a more bullish outlook, the pair needs to consolidate back beyond the psychological 1.30 level thereby offering signs that an interim base has been created.

Short-term Risk Factors: Eurozone PMI Surveys (Tuesday) – This week brings the latest PMI surveys from both the manufacturing and service sectors. Both are ex-

pected to remain relatively stable and just above the key ‘50’ level that separates contraction from expansion. However, any sign that the econo-my is slowing further will likely weigh heavily on the euro amid expectations that it will further prompt the ECB to provide additional monetary stimulus.

US GDP / outlook for Fed Policy – This week brings the final reading of Q2 GDP which is expected to show that the economy expanded 4.6% (annualised) between April and June. While it’s unlikely that this pace of growth was maintained in the third quarter, this week’s PMI surveys from both the manufacturing and service sectors should offer a deeper insight into the health of the US economy and the potential implications for Fed policy.

Key Levels:

Support 1

1.2825

Support 2

1.2750

RESISTANCE 1

1.3000

Resistance 2

1.3120

USDCAD

Key Influences

Technical View: Despite last week’s rally to 1.1100, the move hasn’t been sustained and the subsequent slide back into the recent range means that there is

little change to the outlook.

As previously highlighted, a sustained move through the 1.1200 highs from earlier this year is required for a more bullish outlook.

However, while this level remains unbroken, there is still risk back towards the 1.0800 support zone and this summer’s lows at 1.0600 where additional support is likely to be encountered.

Short-term Risk Factors: Canadian retail sales (Tuesday) – This week’s retail sales numbers for July should further shape expectations for when the Bank of Canada

might begin raising interest rates. Last week’s inflation figures were stable just above the bank’s 2% target so any signs that the consumer is faring better will start to make a case for tighter policy. At this stage, there looks to be little prospect of a rate hike before the middle of next year, but any indication that the BoC’s stance is starting to become more hawkish is likely to have a positive impact on the CAD.

US GDP / outlook for Fed Policy – This week brings the final reading of Q2 GDP which is expected to show that the economy expanded 4.6% (annualised) between April and June. While it’s unlikely that this pace of growth was maintained in the third quarter, this week’s PMI surveys from both the manufacturing and service sectors should offer a deeper insight into the health of the US economy and the potential implications for Fed policy.

Key Levels:

Support 1

1.1000

Support 2

1.0830

RESISTANCE 1

1.1200

Resistance 2

1.1279

Summary:

The US dollar began last week as the dominant force over its Canadian namesake but failed to sustain its advance after a series of weaker than ex-pected data releases, coupled with an indecisive message from the Fed left the US currency on the back foot. Having touched 1.1100 on Monday,

USD/CAD dipped back briefly below 1.09 on Friday before recovering slightly to close the week at 1.0963.

Key Influences:

Canadian dollar unchanged after inflation holds steady – According to Statistics Canada, headline inflation was unchanged at 2.1% in August although the core measure (which excludes the volatile food and energy items) was slightly firmer. The Bank of Canada sets its target at 2% but at this stage, the slightly above target number is unlikely to prompt the central bank into any action at this stage. Given that oil prices have retreated from their recent highs and for the time being, food prices remain stable, it is unlikely that the BoC will feel under pressure to raise rates any time soon.

Fed slows QE purchases by another $10bn per month – As widely expected, the Federal Reserve continued to taper its asset purchases by $10bn per month following last week’s meeting amid signs that the economy is continuing on its recovery path. The remaining $15bn of monthly purchases is expected to end following next month’s meeting and as such, the focus is now very much on when the Fed will begin raising interest rates from the current low of 0.25%. Yellen’s statement was relatively balanced on the subject, giving little away for now. She maintained her pledge to keep rates low for a ‘considerable time’ post QE citing low inflation and significant underutilisation in the labour market. However, this was countered by noting that the economy continues to expand at a moderate pace while the labour market is also showing signs of improvement. For now, the consensus is still for the first rate rise to come in mid-2015.

$ /€ /£ 3M 6M 1Y

GBPUSD

1.64 1.64 1.57

Consensus 1.62 1.62 1.62

GBPEUR

1.29 1.25 1.16

Consensus 1.25 1.25 1.25

EURUSD

1.27 1.32 1.35

Consensus 1.30 1.30 1.30

USDCAD

1.10 1.12 1.14

Consensus 1.11 1.11 1.12

FX FORECASTS

Consensus forecasts provided by the Consensus Economics monthly survey of 250 prominent currency forecasters.

*These are still awaiting an update following the recent move in sterling.

Validus forecasts are based on in-house analysis using technical, fundamental and market indicators.

ECONOMIC DATA & MARKET INDICATORS

Sentiment & Positioning

Currency (vs. USD) Speculative Positioning 3 Month Trend Risk Reversals (1 Month, 25d) 3 Month Trend

EUR -0.14m Lower -0.4525 (EUR Negative) Neutral

UK -7k Lower -0.5600 (GBP Negative) Neutral

CAD 8k Higher 0.8450 (CAD Negative) Higher

Economic Matrix

GDP CPI Unemployment Industrial

Production

Retail Sales Current Account

% GDP

Budget Balance

% GDP

10 Year Yield

US 4.20% 1.7% 6.1% 4.12% 5.0% -2.25% -3.1% 2.567%

EUR 0.70% 0.40% 11.5% 2.2% 0.8% 2.20% -4.1% 1.032%

UK 3.2% 1.50% 6.2% 1.7% 0.2% -4.52% -5.74% 2.522%

CAN 3.15% 2.1% 7.0% 0.78% 5.9% -2.8% -0.99% 2.230%

WEEKLY ECONOMIC CALENDAR

Country Current Rate Last Change Date of Change Next Meeting UK 0.50% -0.50% 5th March 09 9th October 14 US 0.00 – 0.25% -0.75% 17th September 14 29th October 14 CAN 1.00% +0.25% 8th December 10 22nd October 14 EUR 0.05% -0.10% 4th September 14 2nd October 14

Date Location Time Indicator For Previous Forecast 22/09/2014

US 15:00 Existing Home Sales Aug 5.15m 5.2m

US 15:00 Existing Home Sales (m/m) Aug 2.4% 1.0%

EZ 15:00 Consumer Confidence Sep -10.0 -10.5

23/09/2014

EZ 9:00 Markit Eurozone Manufacturing Sep 50.7 50.6

EZ 9:00 Markit Eurozone Services Sep 53.1 53.0

EZ 9:00 Markit Eurozone Composite Sep 52.5 52.5

UK 9:30 Public Finances (PSNCR) Aug -9.7b 6.0b

CA 13:30 Retail Sales (m/m) Jul 1.1% 0.5%

US 14:45 Markit US Manufacturing PMI Sep 57.9 58.0

24/09/2014

GE 9:00 IFO Business Climate Sep 106.3 105.8

US 15:00 New Home Sales Aug 412k 430k

25/09/2014

EZ 9:00 M3 Money Supply (y/y) Aug 1.8% 1.9%

EZ 9:00 M3 3-month average Aug 1.8% 1.9%

UK 11:00 CBI Reported Sales Sep 37 33

US 13:30 Initial Jobless Claims Sep 280k 298k

US 13:30 Continuing Claims Sep 2429k 2440k

US 13:30 Durable Goods Orders Aug 22.6% -18.0%

US 14:45 Markit US Services PMI Sep 59.5 59.2

US 14:45 Markit US Composite PMI Sep 59.7 n/a

26/09/2014

GE 7:00 GFK Consumer Confidence Oct 8.6 8.5

US 13:30 GDP Annualised (q/q) 2Q 4.2% 4.6%

US 13:30 Personal Consumption 2Q 2.5% 2.9%

US 13:30 Core PCE (q/q) 2Q 2.0% 2.0%

US 14:55 Univ. of Michigan Confidence Sep 84.6 84.7