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February 2016

Year Ahead 2016: Volatility Resurrection

David Simmonds

Head of Currency Research

+44 207 085 2455

david.simmonds@rbs.com

Important disclosures can be found at the end of this presentation.

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Inflation targeting central banks won’t give up on their mandate. Inflation

expectations are fragile

Source: RBS, Bloomberg

Five Year Break-evens

Source: RBS, Bloomberg

Euro 5Y5Y Inflation swap

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.5

Oct 12 Jan 13 Apr 13 Jul 13 Oct 13 Jan 14 Apr 14 Jul 14 Oct 14 Jan 15 Apr 15 Jul 15 Oct 15

US UK Germany

1.45

1.65

1.85

2.05

2.25

2.45

Dec 12 Mar 13 Jun 13 Sep 13 Dec 13 Mar 14 Jun 14 Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15

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Euro zone money supply growth accelerates. But lending to business is weak and

inflation is close to zero and hence far from target

Euro M3 Money Supply Growth

Expected change in lending to Business Survey

Source: RBS, Bloomberg Source: RBS, Bloomberg

Euro HICP inflation

Source: RBS, Bloomberg

-2

0

2

4

6

8

10

12

14

Jan-04 Jan-09 Jan-14-1

0

1

2

3

4

5

04 06 08 10 12 14

-10

-5

0

5

10

15

20

25

Dec-09 Dec-12 Dec-15

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Source: IIF, Datastream, national sources

ECB has more room for more easing, probably in March

ECB, Fed and Bank of Japan balance sheet size,

Dec 2008 = 100

80

130

180

230

280

330

Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13 Dec 14 Dec 15

Fed ECB BOJ

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Source: RBS, Bloomberg

To paraphrase Ben Bernanke post crisis: ‘My job is to make equities go up’. He

did that. But what now?

Fed balance sheet and S&P 500

600

800

1000

1200

1400

1600

1800

2000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

4500000

5000000

2016201520142013201220112010

Fed balance sheet S&P 500

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We may be exiting the world of crushed volatility and entering a world of

Volatility Resurrection

VIX Index, 2012-

Source: Bloomberg

MOVE Index, 2013-

Majors FX Vol Index, 1992- EURUSD 1Y ATM, 2008-

Source: Bloomberg Source: Bloomberg

Source: Bloomberg

45

55

65

75

85

95

105

115

125

Jun

13

Aug

13

Oct

13

Dec

13

Feb

14

Apr

14

Jun

14

Aug

14

Oct

14

Dec

14

Feb

15

Apr

15

Jun

15

Aug

15

Oct

15

Dec

15

5

10

15

20

25

30

35

40

45

Oct 1

2

Dec 1

2

Feb

13

Apr 1

3

Jun

13

Aug

13

Oct 1

3

Dec 1

3

Feb

14

Apr 1

4

Jun

14

Aug

14

Oct 1

4

Dec 1

4

Feb

15

Apr 1

5

Jun

15

Aug

15

Oct 1

5

Dec 1

5

4

9

14

19

24

29

1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015

5

7

9

11

13

15

17

19

2009 2009 2010 2010 2011 2011 2012 2012 2013 2013 2014 2014 2015 2015

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The astonishing ‘stat’ of the year … China poured more concrete in three years

from 2010 than the US did in the whole of the 20th century

0

1

2

3

4

5

6

7

US (20thcentury)

China (2011) China (2012) China (2013) China (2011 -2013)

Billi

on

me

tric

to

ns

Cement consumption: China in the years 2011-2013

versus US in the whole of the 20th century

Source: RBS, US Geological Survey

“Any discussion has to start with

China, which poured more concrete

between 2010 and 2013 than the

US did in the entire 20th century. A

reading of the recent history of

investment-driven economies —

whether in Japan before the oil

shock of the 1970s and 1980s or

the Asian tigers in the late 1990s —

tells us that growth does not fall off

gently.”

Lawrence Summers, FT, October

7th 2015

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Total debt level versus change in total debt, 2007-mid 2014

Source: Bloomberg

China’s very rapid build-up in total debt - in international context

CAD

DKK

NOK

SEK

CHF

USD

GBP

CZKPLN

RONRUB

TRY

HUF

CLP

MXN

PEN

BRL

COP

ILS

ZAR

AUD KRW

CNY

MYR

THB

INR

IDR

PHP

0

50

100

150

200

250

300

-30 -20 -10 0 10 20 30 40 50 60 70 80 90 100

Gro

ss T

ota

l D

ebt

(2015,%

of

GD

P)

Change in Total Debt (2007 to Q2-2014, % of GDP)

JPY (64, 426)

SGD (129, 177)

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60

70

80

90

100

110

120

130

14019

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

8

China REER

Source: BIS, Bloomberg

In REER terms, renminbi has gone from very cheap to very expensive in 10

years. China needs to flex some mercantilist muscle. Weaker currency needed!

Plus 1 SD

Plus 2 SD

Minus 2 SD

Minus 1 SD

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Volatility resurrection: Global FX reserves are shrinking as capital flees China and as

Middle east and Russia reserves evaporate due to the energy price decline

Source: RBS, Bloomberg

Global foreign exchange reserves (change, % year/year)

-10

-5

0

5

10

15

20

25

30

35

Mar 04 Mar 05 Mar 06 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Mar 12 Mar 13 Mar 14 Mar 15

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Top Themes 2016

The Year Ahead in 250 words [November 24 2015]

Currency wars intensify in a mercantilist slugfest as world trade growth weakens. Over-capacity persists in global

commodity, capital and consumer goods markets. Oil falls, dis-inflation grips and capex is moribund. Wage growth

stays weak as economic returns accrue yet more to technology, less to labour. Hence, anti-austerity political

populism steadily rises. Central banks of open economies try hardest to weaken their currency: export your

deflation somewhere else before someone exports theirs to you! In Europe that means more negative policy rates

and (for some) more direct intervention. China’s competitiveness loss has been acute and the renminbi weakens

as capital flight persists. But Bank of Japan, unable to buy ever more JGBs, concedes currency war leadership

and the yen gains on crosses. The US economy trundles along and the Fed trundles with it, tightening absolutely

little but relatively lots. Policy divergence lives as the most compelling FX directional theme in years and EUR/USD

easily breaks parity. Sterling is cyclically resilient then (ultimately) structurally vulnerable as EU referendum

cacophony builds. Global risk assets grind higher for a while as still-plentiful cash seeks a home. But macro

liquidity skies darken on Fed liquidity withdrawal and falling global FX reserves. A stronger dollar lifts dollar debt

servicing/repayment cost across EM and focus on relative reserve adequacy intensifies. Inflation in some

emerging economies reflects extreme currency weakness, a most malevolent strain. Global market liquidity risks

intensify and exit windows are narrow. Scepticism builds around inflation targets and around the central banks

mandated to pursue them.

Source: RBS

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