HSBC Euro Break

Currency
OUTLOOK
Macro Currency Strategy July 2011
GBP: between a rock and a hard place

For now, it is the changing dynamics of the EUR and USD that are impacting GBP rather than a specific GBP story itself. For GBP to trade independently, we need to see a dramatic change in the UK economy, either for the better, or for the worse. Until then, GBP will remain trapped between a rock and a hard place. EUR and CHF: Where core EUR might have been Imagine the EUR had been split into two currencies in 2009: EUR-core (EUC) and EUR-periphery (EUP). These currencies would be performing very differently, with a current EUC-USD around 1.80 and EUP-USD of perhaps 1.10. Relative competitive positions within the Eurozone would be very different. Will a new tax holiday boost the USD? There has been discussion of another Homeland Investment Act that would involve a tax break that could see US multinationals repatriate funds from overseas. This could boost the US economy and the USD, at least temporarily.
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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Summary
GBP between a rock and a hard place (pg 3)
For now, it is the changing dynamics of the EUR and USD that are impacting GBP rather than a specific GBP story itself. When Eurozone sovereign risk is dominating market focus, GBP outperforms the EUR but underperforms the USD. Alternatively, when the market is in the mood to punish the USD, GBP outperforms the USD but underperforms the EUR. For GBP to trade independently, we need to see a dramatic change in the UK economy, either for the better, or for the worse. Until then, GBP will remain trapped between a rock and a hard place.
EUR and CHF: Where core EUR might have been
(pg 9)
Since the onset of the sovereign debt problems, EUR and CHF have behaved very differently, which has interesting implications for the Eurozone. Imagine the EUR had been split into two currencies in 2009, EUR-core (EUC) and EUR-periphery (EUP). These currencies would be performing very differently, with a current EUC-USD around 1.80 and EUP-USD of perhaps 1.10. Relative competitive positions within the Eurozone would be very different with the EUC area much less competitive.
Will a new tax holiday boost the USD?
(pg 15)
The US economy is slowing, QE is finished and the debt ceiling issue is lingering. In recent months there has been discussion of another Homeland Investment Act that would involve a tax break that could see US multinationals repatriate funds from overseas to promote investment and job creation. This could boost the US economy and the USD, at least temporarily.
NOK has beauty, but not everyone sees it
(pg 22)
On all metrics that we consider the NOK is more defensive than the CHF. However, the market has been buying the CHF in a frenzy of defensive activity whilst ignoring the NOK. We believe this is a mispricing. Those fleeing from the EUR and the fear of any possible systemic problems would be ill advised to rush into the CHF. It does not offer safety from a break-up scenario or any systemic problems owing to its giant-sized banking sector. In this scenario the NOK would be less exposed than the CHF.
Dollar Bloc
(pg 28)
Canada CAD easily absorbs shifting BoC policy expectations We continue to see the overall backdrop for the CAD as supportive, given still-healthy growth in emerging market economies and the associated support that provides to commodity prices, as well as Canadas superior fiscal condition and modestly better growth trajectory, relative to most other G10 countries. However, we are also hesitant to view those factors as ones that are likely to drive the CAD measurably higher.
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Australia AUD still at elevated levels The set-back in RBA rate hike expectations coupled with the recent weakness in global indicators should take its toll on the AUD. The AUD remains above 1.05 for now, but at such elevated levels we feel that the currency should retrace in the coming months. New Zealand Recovery in swing The NZD has performed well over the past few months, with the currency reaching fresh all-time highs on the back of rising rate expectations and positive domestic developments. However, with the summer months bringing a number of events that could see further risk off developments we expect a mild retracement.
Key events Date 19 July 20 July 27 July 28 July 2 August 4 August 4 August 9 August 10 August 10 August
Source: HSBC
Event BoC key policy interest rate announcement BoE publishes minutes of July 6-7 meeting Federal Reserve issues Beige Book RBNZ rate announcement RBA rate announcement BoE rate announcement ECB rate announcement FOMC rate announcement Norges Bank rate announcement BoE publishes quarterly inflation report
Central Bank policy rate forecasts Last USD EUR JPY GBP 0-0.25 1.50 0-0.10 0.50 August 11(f) 0-0.25 1.50 0-0.10 0.50 November 11 (f) 0-0.25 1.75 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 NZD
Source: Consensus Economics Foreign Exchange Forecasts June 2011
12 months 1.405 87.85 1.664 0.986 0.988 0.752
1.429 83.14 1.628 0.968 1.043 0.774
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GBP between a rock and a hard place

GBP stuck in the middle
GBP is caught in the crossfire between negative developments surrounding the EUR and USD. When Eurozone sovereign risk is dominating market focus, GBP underperforms the USD but outperforms the EUR. In this context, GBP-USD is dragged lower because it is caught in the EURs orbit as the UK has strong financial and trade links to the Eurozone. Alternatively, when the market is in the mood to punish the USD and Eurozone sovereign risk is less in focus, GBP underperforms the EUR but outperforms the USD by a small margin. In this situation, EUR-GBP goes up as the ECB is still seen trying to normalise monetary policy before the BoE. We believe the market has given GBP a slight advantage versus the USD because the UK is ahead of the curve in trying to deal with its fiscal problem and for a period believed the BoE could raise rates before the Fed. To us, it is the changing dynamics of EUR and USD that are impacting GBP rather than a specific GBP story. For GBP to trade independently, we need to see a dramatic change in the UK economy either for the better or for the worse. Although we maintain a relatively pessimistic view on the UK economy, it will also be the misfortunes of other currencies that will keep GBP trapped in the ugly contest.
1. GBP against a broad range of currencies has remained weak since late 2008
BoE GBP trade-weighted (B road index) 110 105 100 95 90 85 80 75 70 Jun-06 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Jun-08 Oct-08 Mar-09 Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Apr-11
Source: HSBC, Bloomberg
110 105 100 95 90 85 80 75 70
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Arise Sir Sterling!...Not...

A persistent feature since the peak of the global financial crisis is GBPs inability to rally (chart 1). When measuring GBPs performance against a broad basket of currencies, it remains nearly as weak as it did back in 2008. We have long been cautious on GBP, believing that the looming fiscal tightening would keep UK growth sluggish and in turn keep the currency subdued. The issue for GBP, however, is that its directional pull for some time has been dictated more by developments in other currencies, in particular the EUR and USD. This is shown in our GBP diffusion index below.
The index is scaled between 0 and 100 such that a reading of zero implies that the GBP is falling against all fourteen currencies, and a reading of 100 implies that GBP is rising against all of the currencies. In order to extract information from this index, we take a 20-day moving average.
GBP a sideshow to other currencies
GBPs diffusion illusion

One way to show whether the market is overly focused on GBP is to look at a diffusion index. This measures the breadth of its movements against a host of currencies (chart 2). Our GBP diffusion index analyses the direction of the daily GBP movements against 14 currencies and measures the proportion that are rising or falling against GBP. Each currency is given an equal weight, as we are looking at the breadth of the rise or fall in GBP rather than the magnitude.
The diffusion index has tended to move in a 35-65 range since the beginning of 2009. When periods of significant GBP strength have occurred against a range of currencies, it has usually been very brief and the index has been associated with a reading near 65. Likewise, when there have been periods of extreme GBP weakness, the index has briefly been below 35. The index is currently at the rise-fall 50 level, which means GBP has been basically rising and falling equally against a broad range of currencies. In other words, GBP has been treated as a sideshow to other currencies, as the market has been fixated with EUR and USD risks. The last time that the market was really focused on GBP, albeit in a negative way, was around the UK election last year. GBP has not had primacy for
2. GBP has been more of a sideshow but the lesson learned over the past couple of years is the markets focus can change quickly
7 5. 0
G B P D iffu s ion In de x 20 dm a
GB P c au g h t in th e m idd le o f E u roz o n e s o ve reig n risk a n d U S de b t p rob le m s . I t h a s b e e n m ore ab o u t U S D an d EU R t h a n G BP in re ce n t m o nt h s
75 . 0
6 5. 0
65 . 0
5 5. 0
55 . 0
4 5. 0
45 . 0
3 5. 0 Hu n g p a r lia m en t co n ce r n s f o r G B P
35 . 0
2 5. 0 J a n-0 9
25 . 0 M a y-0 9 S e p -09 J an -1 0 M a y-1 0 S e p -1 0 J an -1 1 M ay -11
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3. US and UK activity surprise indices trending down

US activity surprise 20.0 10.0 0.0 -10.0 -20.0 -30.0 -40.0 -50.0 Jan-10 UK activity surprise 20.0 10.0 0.0 -10.0 -20.0 -30.0
4. US and UK inflation surprises trending up

-10.0 US inflation surprise (LHS) UK inflation surprise (RHS) 80.0
-15.0 -20.0
70.0
60.0 -25.0 50.0
-30.0
-40.0 -50.0 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11

-35.0 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 40.0
some time, but of course the risk with a weak UK economy is that the market starts to punish GBP. For a specific GBP event to happen now, we would need to see a significant change in the outlook for the economy, in either direction. However, the long-term trends in our UK activity and inflation surprise indices are not as dramatic as those for the US (charts 3 and 4). The UK economy is slowly but surely disappointing, while inflation continues to beat expectations; but these trends are not as pronounced as those for the US. This has been a constant theme since April last year.
Flip flopping on UK interest rates

Despite the weak growth and high inflation story that has been prevalent for some time, the market has notably changed its view on UK interest rates (chart 5). Initially it was quick to price in BoE rates hikes as headline inflationary pressures were rising. But it steadily became apparent to the market that as real wages remain negatively coupled with the disinflation impact from fiscal tightening, rates were not going to rise. In this low inflation environment, some may consider rising rate expectations to be associated with a stronger
5. The market is no longer expecting BoE rate increases this year

GBP forward sw ap Jan 2012 (expected BoE policy rate in J an 2012) 1.1 The interest rate market priced in BoE rate hikes early this year but has more recently priced them out. The interest rate futures see the BoE keeping interest rates unchanged this year 1.1
1.0
1.0
0.9
0.9
0.8
0.8
0.7
0.7
0.6
0.6
0.5 Jan-11
0.5 Jan-11 Feb-11 Mar-11 Apr-11 May -11
Source: HSBC, ICAP, Bloomberg
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6. Interest rate differentials suggest GBP-USD should be lower

1 .2
Short Sterling spread Dec 2011 (UK-US) (LH S) GBP-USD (RHS)
1.72
1 .0
1.67
0 .8
1.62
0 .6
1.57
0 .4
1.52
0 .2
1.47
0 .0 Jun -10
1.42 Aug-10 O ct-10 Dec-10 Feb-11 A pr-11 Jun-11
GBP, and as these expectations waned, GBP should have fallen back again. We have shown previously how relative interest rate differentials were a powerful indicator for GBP-USD, especially in the pre-crisis environment. But we have also suggested that in the post-crisis environment relative interest rates do not provide as good a guide for GBP-USD (chart 6). The relationship between interest rate differentials and GBP-USD has been breaking down over the past couple of months, as GBP-USD should have traded lower as UK rate expectations fell away. In fact, if the relationship still held, then GBP-USD should be closer to 1.55. The breakdown in this relationship illustrates how USD-negative dynamics dominated more than the negative headwinds for GBP. We have long argued that in the post-crisis world other factors can swamp interest rate differentials. Our explanation for this change comes down to the relative fiscal forces at play. After all, the UK is set to adopt aggressive fiscal tightening while the US looks set to increase its debt ceiling yet again. Also,
with a US Presidential election next year, the appetite to deal with the deficit in any meaningful way is lacking. So one might expect GBP to be dragged up against the USD, but on the other foot sits the EUR, which could drag GBP down.
GBP is not immune to Eurozone concerns

Lets not forget that GBP is vulnerable to developments in the Eurozone. GBP is not immune when we consider the UK economys financial and trade links with the Eurozone. The first mechanism by which problems in the Eurozone could be negative for GBP is through the exposure of UK banks to problem Eurozone sovereign bonds. According to BIS figures, UK banks hold about USD 170bn of Greek, Portuguese and Irish sovereign debt, and an additional USD 170bn of Spanish and Italian sovereign debt (table 7). We recognise that one needs to be careful drawing too many conclusions from the BIS data. Nevertheless, any fallout from Greece that triggers contagion in the periphery will have a substantive knock-on impact on the UK financial system.
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7. BIS consolidated foreign claims of reporting banks (USDbn) Claims vis--vis France Germany Spain Switzerland UK USA Total
Source: HSBC, BIS
Greece 57 34 1 3 14 7 146
Ireland 30 118 10 14 135 51 462
Portugal 27 36 85 3 24 5 202
Spain 141 182 18 107 47 709
Italy 393 163 31 18 66 37 867
Meanwhile, table 8 shows that a very high proportion of UK exports are shipped to the Eurozone, with over 6% bound for Ireland alone. With the sovereign debt problems in Europe testing investors nerves, this does not seem like a good time to be a trading partner relying on Eurozone growth. The fall in the EUR has seen Germany attack the overseas markets with a volume expansion; this lowers the unemployment rate and stimulates the domestic economy. In the next section, we show that without the peripheral economies in the EUR, the core EUR would be trading at 1.80 or above. The main point we are making is that Germany has been able to capitalise on the weakness of the EUR.
The UKs response to a fall in GBP was not to increase the volume of goods exported, but to take a value adjustment that boosted profitability. However, the second-round impact on the economy is small compared with a volume expansion that creates jobs. Perhaps that is because the UK has not been as successful as Germany in making and shipping goods to the buoyant emerging market economies. The hopes for an export-led recovery based on the large fall in GBP in the latter half of 2008 has not panned out. Instead, the UK recovery has been lacklustre; and with UK exports highly exposed to developments in the Eurozone, we do not expect a strong pick-up anytime soon.
8. UK exports exposed to the Eurozone Exports by destination 2010 US Germany Netherlands France Ireland Belgium-Luxembourg Spain Italy China Sweden Switzerland Hong Kong UAE Japan Canada Value (GBPbn) 38.0 27.8 21.3 19.1 16.9 13.6 9.9 8.8 7.6 5.6 5.2 4.5 4.0 4.3 4.1 % total 14.3 10.5 8.0 7.2 6.4 5.1 3.7 3.3 2.9 2.1 1.9 1.7 1.5 1.6 1.6
BRICs Eurozone EU-27

Source: ONS
17.5 125.4 141.8
6.6 47.3 53.5
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What could see GBP escape the trap?

There are two scenarios that could see GBP move out of its current trapped state. One is that the UK economy powers ahead and the fiscal situation gets resolved this would see the UK as the role model of how to handle the crisis. Under this scenario, GBP could easily trade at 1.75 or above against the USD. The opposite scenario is the one that seems to be playing out at present: a fiscal tightening turns into a slowdown. In this situation the UK is the example of how not to do things. Here GBP-USD could easily trade at 1.45. In the absence of either of these scenarios playing out, fair value is between 1.55 and 1.65, and there is little reason GBP-USD should break out on either sides of this range.
When markets are focused on Eurozone sovereign risk, GBP underperforms the USD, but outperforms the EUR. In contrast, when the markets focus shifts to the US, GBP underperforms the EUR, but marginally outperforms the USD. Before GBP trades more independently, we believe that there needs to be a major change in the outlook for UK economy either for the better or for the worse. We have a fairly pessimistic view on the UK economy, which the market has now also come to accept. Should UK growth deteriorate further, which is a clear risk, we could soon see the market paying closer attention to UK fundamentals than elsewhere. This would not be a good development for GBP.
Conclusion
GBP is currently stuck between a rock and a hard place, which are negative developments surrounding the EUR and USD. In this environment, GBP is less driven by a UK-specific story, but is instead dominated by the changing dynamics of the EUR and USD.
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EUR and CHF: where core EUR might have been

Will the SNB follow the ECB?
With the ECB having raised interest rates for a second time to 1.5% at the July 7th meeting, market attention is turning towards the Swiss National Bank. Former SNB Vice President Niklaus Blattner has said that price stability is threatened by the expansion of the money supply and that a rate increase would be in order also because of signs of overheating on the property market. As can be seen in chart 1, Swiss interest rate policy has mirrored that seen the Eurozone for most of the past ten years. With ECB rates rising again, it is natural that some expect the SNB to follow suit at some point. Relative inflation experience, however, suggests that historical relationships in monetary policy are no longer valid. Whilst Swiss CPI is currently 0.6% year on year, Eurozone inflation is currently 2.7% (chart 2). Core inflation in the Eurozone is lower, at 1.5% year on year, but it is flat in Switzerland.
Currency performance is the key

The main driving force behind this inflation divergence is the performance of the currency. Since the emergence of the sovereign credit problems in the Eurozone in 2010, the EUR has lost about 20% against the CHF, having spent much of the previous 10 years in a 1.45-1.65 range (chart 3). The new exchange rate environment can be seen even more clearly in chart 4. This shows the sixmonth rolling correlation of daily changes in EUR-USD and USD-CHF. When the EUR and
1. ECB and SNB policies have historically moved together
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
EUR and CHF Policy Rates
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Jul-01
Jul-02
Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jul-10
Jul-11
Source: Bloomberg, HSBC
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2. Swiss and Eurozone inflation has diverged
% y-o-y 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 Mar-99
Swiss and Eurozone Inflation YoY Swiss Eurozone
% y-o-y 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0
Mar-01
Mar-03
Mar-05
Mar-07
Mar-09
Mar-11
CHF move together, this correlation is very high, as it was for most of the 1999-2009 period. The correlation did fall to some extent during the financial crisis, but it was fully re-established during the early part of the recovery in 2009, before falling sharply once the sovereign credit issues emerged. A further demonstration of the changed relationship between EUR and CHF can be seen in implied options volatility. As we argued in Swiss Franc - the last safe haven, Currency Weekly 4th April 2011, central bank intervention in
USD-JPY has made CHF the only viable safe haven currency, which makes it more susceptible to swings in risk on-risk off sentiment and therefore more volatile. Chart 5 shows implied 3month EUR-CHF compared with the average of other Euro crosses (NOK, SEK, PLN, HUF, and CZK). Until the crisis and again in 2009, EURCHF volatility was below 5%. Since 2010, it has moved above 10% and is well above the average as other volatilities have declined.
3. EUR-CHF stability broke down in 2010
1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 Jan-00
EUR-CHF
1.80 Sovereign credit problems 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
10
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4. The correlation between EUR and CHF movements has fallen sharply
100% 90% 80% 70% 60% 50% 40% 30% Jun-99
EUR-USD and USD-CHF - 6m rolling correlation
100% 90% 80% 70% 60% 50% 40% 30% Jun-11
Jun-00
Jun-01
Jun-02
Jun-03
Jun-04
Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Jun-10
For Swiss monetary policy, the implications of this new CHF behaviour can best be analysed by using monetary conditions indices.
economy by combining the effect of interest rate and exchange rate movements. Chart 6 shows an MCI for Switzerland using April 2002 as a benchmark and giving an 80% rate to changes in real interest rates and a 20% weight to changes in the effective exchange rate. As can be seen, there was relatively little change in the MCI between 2002 and 2009, but since then conditions have tightened by the equivalent of about 450bp in interest rates. This strongly suggests that the SNB should be in no hurry to increase interest rates.
Monetary Conditions Index

A monetary conditions index (MCI) aims to measure the effect of both real interest rate changes and exchange rate moves on the economy. If the exchange rate is strengthening then, other things being equal, monetary conditions will be tightening, and vice versa. An MCI can be used to gauge whether (relative to some benchmark period) monetary conditions are boosting or restraining the
5. EUR-CHF implied volatility is now above the European average
% 25
EUR-CHF vol versus EUR-other Europe vol Average EUR-Europe vol EUR-CHF vol
% 25 20 15 10 5 0
20 15 10 5 0 Jan-99
Jan-01
Jan-03
Jan-05
Jan-07
Jan-09
Jan-11
11
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6. Swiss monetary conditions have tightened sharply because of currency appreciation
6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% Apr-02
Switzerland - MCI (Apr 2002= 0)
6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0%
Apr-03
Apr-04
Apr-05
Apr-06
Apr-07
Apr-08
Apr-09
Apr-10
Apr-11
Where core EUR might have been

The behaviour of the EUR and CHF over the past 18 months and the tightening of monetary conditions in Switzerland have interesting implications for the Eurozone. Imagine that the EUR had been split into two currencies in 2009, call them EUR-core (EUC) and EUR-periphery (EUP) where EUC members were those that had no significant public sector funding problems. Given the close association between the behaviour of the Swiss economy and the German economy (chart 7), it would not be unreasonable to suggest that EUC-CHF would have remained fairly stable.
Assuming EUC-CHF had remained at 2009 EURCHF levels (1.50) this would imply a current EUC-USD of 1.83(about 28% higher than EUR). This would also mean EUC-JPY of 144 and EUCGBP of 1.13. What would be the value of EUP-USD? There are several possible ways of estimating this. The two simplest are shown in table 8. The first column assumes that the current EUR is just a simple average of the values of the hypothetical EUC and EUP. This would mean EUP-USD of about parity. If the EUR is a weighted average of EUC and
7. Swiss and German economies tend to move together
113 108 103 98
German IFO and Swiss KOF Indices IFO (LHS) KOF (RHS)
3.5 2.5 1.5 0.5
93 88 83 78 Dec-94 -0.5 -1.5 -2.5 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10
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8. Alternative estimates for hypothetical EUP exchange rates Cross Rate EUP-USD EUP-GBP EUP-JPY EUP-CHF EUP-AUD EUP-CAD
Source: HSBC
Using 50/50 weights 1.00 0.62 79.0 0.82 0.93 0.96
Using GDP weights (65% EUC, 35% EUP) 0.65 0.40 51.4 0.53 0.60 0.62
EUP then, based on approximate GDP weights this would mean EUP-USD of about 0.65. What would this mean for economic performance? With a much weaker currency EUP area exports would probably have been performing better and fiscal consolidation may have been slightly easier if there was the prospect of stronger activity. Inflation in the EUC area would probably be very subdued and the EUC central bank may not have felt the need to raise rates. Inflation in the EUP area would probably be higher but, rather like the UK, the impact would be mostly felt on real incomes and the EUP central bank may also have been reluctant to tighten. EUC area holder of EUP bonds would, of course, have suffered a big currency loss (assuming they were not hedged) in the same way EUR holders of gilts did in 2007/08.
Relative competitive positions in the Eurozone would have been very different. Chart 9 shows the BIS real effective exchange rates for Greece, Switzerland and Germany. With higher domestic inflation, Greeces REER has moved steadily higher, but Germanys has fallen implying a stronger competitive position. With a split EUR or a situation where the peripheral Eurozone deflated internally, Germanys REER would have been higher and the Greek REER would have been significantly lower. Although the financial cost of the sovereign debt problems may be high for the core countries, they have gained a competitiveness boost from having a currency much less strong than it otherwise could have been.
9. German and Greek real effective exchange rates would look very different
Greece REER 120 115 110 105 100 95 90 85 80 Jan-00 Jul-96 Jan-98 Jul-99 Jan-01
Swiss REER
Germany REER (BIS, rebased 95'=100) 120 115 110 105 100 95 90 85 80
Jul-02
Jan-04
Jul-05
Jan-07
Jul-08
Jan-10
13
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Conclusion
The SNB seems very unlikely to follow the ECB in raising rates because monetary conditions in Switzerland have already been tightened significantly by the strength of the CHF. The sharp change in behaviour of EUR-CHF since the beginning of the Eurozone sovereign debt problems raises the question of how a split euro would have performed over the past eighteen months. Assuming a core euro would have remained relatively stable against the CHF, then monetary conditions in the core Eurozone would also be significantly tighter, and the central bank would perhaps not have decided to tighten policy. There seems little doubt that a euro-periphery currency would by now be significantly weaker than the EUR. Would two EURs have been better than one? This is impossible to say given the counter-factual nature of the argument. The relationship between the EUR and the CHF does, however, suggest how things might have been different for the Eurozone.
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Will a new tax holiday boost the USD?

A new tax holiday on US corporate earnings held abroad?
With the US economy weak, politicians are under increasing pressure to take additional measures to stimulate job growth. Those already-difficult efforts are severely complicated by the more immediate negotiations on raising the debt-ceiling limit, due both to the time it diverts from other matters, as well as the associated fiscal constraints. Nonetheless, in an effort to address the countrys economic troubles, some members of Congress are once again advocating a tax holiday that would allow US corporations to repatriate overseas earnings at a reduced tax rate. This type of legislation and the associated flows had a profound impact on the USD in 2005 as can be seen by the circled area in chart 1. US Representative Kevin Brady (R., Texas) introduced legislation that would allow companies to repatriate foreign earnings at a 5.25% tax rate instead of the current 35% rate. Not surprisingly, the legislation has strong support in the business community, and some previous political opponents to the proposal have recently appeared to soften their position. Hence, the FX market has understandably focused in on the possibility of a corporate tax holiday and the associated repatriation as a potential support for the USD. Nonetheless, as senior congressional leaders and the White House progress in their negotiations on the debt ceiling and the broader debt and deficit problem, it appears that more items and proposals are being put on the table, and we cannot completely discount the possibility that proposals such as the Brady bill will be given more serious consideration. Hence, some review of its detail and the potential FX implications is useful.
1. USD gains during the 2005 HIA program have peaked interest in new proposals
DXY Index 125 115 105
Dollar Index (DXY)
DXY Index 125 115 105
2005 USD rally 95 85 75 65 2000 95 85 75 65 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
15
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2. Weak labour market pressures Washington to act
11 10 9 8 7 6 5
US Unemployment Rate
11 10 9 8 7 6 5
4 Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
4 Jul-11
Sizeable amounts of USD repatriation are estimated

As noted, the Brady bill (H.R. 1834, titled the Freedom to Invest Act of 2011) calls for a onetime 85% relief in the tax burden on repatriated foreign earnings of US corporations. There are varying estimates on the amount of repatriation potentially stemming from the program, ranging from USD500bn up to USD1trln. For purposes of comparison, we will focus on figures provided by the bi-partisan congressional JCT, which estimates total repatriation associated with the program at USD700bn. Importantly, the JCT estimate, as well as the broader range of USD500bn to USD1trln, are greater than the total repatriation which stemmed from 2004 Homeland Investment Act (HIA), also known as the American Jobs Creation Act (AJCA). A 2008 report authored by Melissa Redmiles, an
economist at the Internal Revenue Service (IRS), estimates that total repatriation from HIA was USD362bn, the bulk of which occurred in 2005. This moved the USD substantially in 2005 and the fear is it will have the same impact. We look at this below.
USD repatriation would likely be larger today than under the 2004-2005 HIA program
Higher estimates of repatriation for the current proposal relative to the original HIA stem from several factors. The Bureau of Economic Analysis reports that the foreign operations of US corporations generate 24% of profits from overseas operations, compared with 21% in the 2000-2009 period, and 14% in the 1990-1999 period. Both the current level of foreign earnings and the upward trend in the series suggest a notably higher amount of accumulated earnings abroad relative to 2004.
3. 2005 HIA Repatriation by Industry Industry Manufacturing - Computer/Electronic - Pharmaceutical Wholesale and retail trade Information Finance, insurance, real estate All others Total
Source: Redmiles (IRS), 2008
USD bn 289.4 68.6 105.5 14.7 14.6 13.3 29.8 361.8
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4. 2005 HIA Repatriation by country, as a percent of total repatriation
% 30 25 20 15 9.9 10 5 0 Netherlands
2005 HIA Repatriation by Country, percent of total 26.1
% 30 25 20 15
9.7 7.6 7.1 7.0 6.2
10 5 0
Switzerland
Bermuda
Ireland
Canada
Luxembourg
UK
Beyond that, the economy is roughly 23% larger today than at the end of 2004 (using nominal GDP measures), with correspondingly larger corporate earnings. And anecdotally, following the 2004-2005 HIA experience, there may well now be some tendency for corporations to accumulate earnings overseas in anticipation of another tax holiday. In order to assess the potential impact of those flows on the FX market, we should consider them in the context of the change in total FX volumes between 2004 and the present. According to the 2004 BIS Triennial Central Bank Survey, the total daily volume of spot and outright forward transactions combined was USD840bn at that time. The same survey in 2010 showed the total daily volume of spot and outright forwards was USD1.965trn, some 2.3 times greater than in 2004. The working assumption on the potential repatriation in the new proposal of USD700bn is 1.93 times greater than the USD362 of actual repatriation in 2005 cited in the Redmiles IRS report, leaving it roughly near the change in overall FX volumes that has occurred over the same time. Hence, some may conclude the spot impact of repatriation coming into the FX market now could well be similar to that in 2005. And while we are primarily referencing the JCT
estimate of potential repatriation, the wider range of estimates (USD500bn to USD1trn) leave some level of uncertainty in this process.
The geographic distribution of 2005 repatriation is instructive
The Redmiles IRS report also breaks down geographically the primary sources of the funds repatriated under the HIA program, accounting for roughly three-quarters of the total flows. Among those, Eurozone countries dominate the list (the Netherlands, Ireland and Luxembourg are specifically cited), accounting for 40.7% of the total USD362bn in flows. Other key sources were Switzerland at 9.9%, Canada at 7.1% and the UK at 6.2% (chart 4). While shifting dynamics in the global economy and, in some cases, changes in local tax structures may have resulted in some changes today relative to 2004, those figures provide some reasonable basis for estimating the sources of repatriation going forward.
Overseas earnings most likely to be held in local currencies
There is also the potential that some portion of the accumulated earnings being held abroad may already be in USD. This is difficult to estimate and the data is not readily available. However, assessing the matter from an accounting perspective, we think
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5. 2005 HIA Repatriation by country, and estimates for the newly proposed tax holiday
USD bn 200 150 100
2005 HIA Potential Repatriation From New Tax Holiday
USD bn 200 150 100
50 0 Netherlands
50 0 Sw itzerland Bermuda Ireland Canada Luxembourg UK
that most foreign subsidiaries of US corporations are local currency functional (that is, their books are not in USD); holding USD would create income statement volatility at the local level, which would be undesirable. Hedging these USD balances via FX derivative contracts introduces hedging costs, along with the additional administrative demands of managing a hedging program (rolling hedges, risk reporting, disclosure, etc.). Hence, US multinationals are more likely to hold the local currency, where the yields locally will likely be higher than those of USD paper. There are some corporations which have global USD functional subsidiaries, but they are in the minority. Viewed in that manner, it suggests that a majority of these holdings are in local currency and not in USD.
On the surface, those figures appear to be fairly small compared with total volumes in the FX market. Not only are those sums a fraction of the ~USD 2trn in daily volumes in the FX market (spot and forward outright transactions), but the potential repatriation flows would be spread out over a period of time, further diluting their impact on exchange rates. Moreover, some may want to make a modest downward adjustment to these figures to account for some portion being held in USD notwithstanding that we think the bulk of the funds are held in foreign currencies.
The 2005 USD rally had several sources

Recall during the 2005 HIA experience, forecasts for total USD purchases relative to the size of the FX market were fairly small, and the estimated impact on the USD was also thought to be limited. But as it happened, the USD performed well during 2005, generating a strong counter-trend in the midst of its broader 2002-2008 decline. There were several factors supporting the USD in 2005, a key development being stronger-than-expected US growth, accompanied by a more aggressive Fed tightening trajectory. In addition, with the USD having fallen sharply and fairly consistently in the 2002-2004 period, corrective forces within
Estimating potential future repatriation

Using the 2004-05 HIA example, and extrapolating that out into current estimates, generates some reasonably sized USD purchases/foreign currency sales, including: USD 285bn in EUR-USD USD 70bn in USD-CHF USD 50bn in USD-CAD USD 43bn in GBP-USD
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6. Cyclical forces were big factors in the USDs 2005 rally

%
6.0 5.0 4.0 3.0 2.0 1.0 0.0 Jan-04 Fed Funds Target Rate (LHS) USD Index, DXY (RHS)
DXY Index
96 94 92 90 88 86 84 82 80
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
the broader downtrend also worked to the currencys advantage. And within that broader dynamic, additional HIA-related inflows also contributed to the USDs gains.
2005 vs. today: some similarities, but more differences

There are some similarities, but seemingly more differences, in the FX market and the global economy today relative to six years ago. One important similarity is that the USD is trading at relatively weak levels. The Dollar Index is currently trading near three-year lows, albeit near the bottom of the three-year range, rather than having essentially moved straight down for the past three years, as was the case from 2002 to 2004. Another similarity is that the expected USD repatriation from a new tax holiday on foreign earnings would be small relative to total FX market volumes. That was the case in 2005, but the USD still performed well. The differences now are most glaring in terms of US and global growth, and as well as in the role that risk appetite has on the FX market. Clearly, economic growth rates in the US and other developed economies are well below those which prevailed six years ago, i.e., pre-crisis. And because of factors
such as the severe debt overhang and clogged credit channels, the prospect of a US-growth-led boost to the USD seems very low at this stage. The importance of risk appetite and the risk on-risk off (RORO) dynamic, which remains a key feature in financial markets, is a further complicating condition. In essence, the ongoing shifts in risk appetite have and can continue to overwhelm traditional fundamentals as drivers for currencies.
Repatriated funds as economic stimulus

But importantly as well, there is also the concept that capital inflows stemming from the proposed tax holiday could act as stimulus for the broader economy. Indeed, that is the primary rationale supporting the proposal. Along those same lines, some analysts are even likening it to another round of Fed quantitative easing, with potentially even greater benefits as the repatriated funds would go directly to corporations and theoretically trickle down to the rest of the economy, rather than remain concentrated as excess liquidity in the banking and financial system. Those are issues for economists to debate. But if it were to actually develop in that manner and support US growth, this would theoretically be
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7. Congress under pressure to improve the economy
%
100 90 80 70 60 50 40 30 20 10 0 Oct-09 Jul-09 Jan-10 Jan-09 Apr-09 Apr-10
%
100 90 80 70 60 50 40 30 20 10 0 Apr-11 Jul-11
Congressional Job Disapproval Congressional Job Approval
Oct-10
Jul-10
Source: HSBC, Gallup
USD supportive. But there are several good reasons to be sceptical of such rationale. First, in a RORO world, better US economic growth is positive for risk appetite in a manner that tends to work against, rather than for, the USD. Similarly, if the effects were similar to those of Fed QE, the added liquidity and boost to risk appetite have proven to be USD-bearish in recent years. Finally, because the original HIA program was generally not deemed as having generated broad economic benefit (it primarily was seen as helping individual corporations and their shareholders), the notion that a new tax holiday will support growth now is far from assured. Balancing those factors against one another, we are sceptical that a new tax holiday on foreign earnings would provide sustained support for the USD. That does not preclude the potential for some temporary gains in the currency, as markets may anticipate the flows and/or as they actually occur. But the limited size of the flows in relation to the FX market, the weak cyclical position of the US and associated accommodative Fed policy stance, and the exceedingly poor fiscal backdrop in the US, are factors that suggest to us that a
repatriation-related boost to the USD will be difficult indeed.
Congressional passage appears unlikely for now

Of course, key to all of this is getting the current bill moved into law, and that appears to face some serious headwinds. In general terms, Democrats in Congress tend to oppose the bill because they feel it will primarily support large corporations and their shareholders, with few obvious benefits for the middle class and/or broader economy. They cite the lack of trickle down effects from the 2004-2005 HIA program as evidence of such. Moreover, with the JCT estimating the cost of the current legislation at USD78bn over 10 years, both Democrats and Republicans will have a seriously difficult time supporting the legislation during a period when fiscal considerations and constraints are so severe. It is also the case that the immediate and overwhelming focus in Washington is on the debtceiling negotiations, and that issue is precluding debate and consideration of most other items. In addition, any discussion of changes in the broader tax regime taking place in the context of the debtceiling negotiations are focused more on
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comprehensive tax reform, which would entail both individual and corporate tax policies. The Brady bill, a one-time tax holiday, is not consistent with those efforts (it essentially creates another tax loophole), which also creates impediments to its passage. Bill sponsors understand these hurdles and currently remain focused on the more immediate debt ceiling issue. They will attempt to garner more support for the legislation in the coming months and make a stronger push for it in the autumn. There are a few factors that maintain some scope for this bill to move forward, including the dire state of the economy/labor market and the ensuing need for politicians to be seen as addressing it, as well as the notion that all things are on the table in the current debtceiling negotiations. But, based on current priorities in Washington, and the increasing importance of fiscal consolidation to both parties, it seems very unlikely that this bill will become law in the immediate future, and its prospects for passing at a later date also appear limited.
However, current conditions in the US and global economy, as well as the drivers in the FX market, are different now, making it more difficult for the USD to benefit from repatriation flows in the same way it did in 2005. Moreover, the current legislation faces fairly stiff resistance in Congress at this stage, and appears unlikely to progress into law. Still, with many items being considered in the current debtceiling negotiations, and pressure on Congress to address ongoing economic weakness, efforts to promote the tax holiday will continue on Capitol Hill, and in so doing they will continue to garner the attention of the FX market.
Conclusion Not a slam dunk for the USD

Efforts to implement a tax holiday for US corporations to repatriate foreign earnings have picked up some momentum recently as Congress feels pressured to respond to ongoing weakness in the economy. The FX market has understandably taken interest in these proceedings, given the potential for the USD to benefit from repatriation flows. While the overall amount of expected repatriation stemming from the proposal is small relative to total flows in the FX market, that was also the case during the 2004-2005 HIA episode, and the USD appreciated notably during the period.
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NOK has beauty, but not everyone sees it

Why CHF and not the NOK?
The markets love affair with the CHF continues. As the Arab spring and the Eurozone crisis intensified, it made sense that the ultra-defensive CHF would do well. In fact, when the G7 intervened in the JPY, we assumed that by limiting the upside on the other defensive currency, the JPY, further upward pressure would be exerted on the CHF. Closing the door on the JPY meant that the much less liquid CHF would have to bear most of the defensive flows. Now we find ourselves asking why this squeeze into CHF has not spilt over to what we would see as an even better defensive play, namely the NOK. We look at a host of defensive indicators and try to ascertain why the market has not pushed some of the excess liquidity into the NOK. It seems strange to us that since the beginning of the year the NOK has been trading as a proxy for the EUR, with EUR-NOK trading in a tight 3% range (chart 1). However, the NOK and the Eurozone have little in common, and in our view the NOK looks very undervalued versus the CHF. We would advise switching out of CHF into NOK.
Inflation and rates a score draw

On the rates and inflation front there is barely a cigarette paper between the two economies. In an environment of nominal returns the NOK just about pips the CHF. The Norges Bank started raising rates at the tail end of 2009 and they currently stand at 2.25%, whereas CHF rates are stuck at a mere 0.25%. Even in real terms the NOK comes out on top. CHF inflation is 0.4% giving a negative real return of 0.15%, whereas
1. Since the beginning of the year EUR-NOK has traded in a tight range
EUR-NOK 8.00 7.95 7.90 7.85 3.2 % 7.80 7.75 7.70 7.65 Jan-11
EUR-NOK
EUR-NOK 8.00 7.95 7.90 7.85 7.80 7.75 7.70 7.65
Feb-11
Mar-11
Apr-11
May-11
Jun-11
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2. CHF and NOK policy rates since 2008
% 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Jan-08
Norway
Switzerland
% 6.0 5.0 4.0 3.0 2.0 1.0 0.0
May-08
Sep-08
Jan-09
May-09
Sep-09
Jan-10
May-10
Sep-10
Jan-11
May-11
NOK has a real positive return of 0.65%. So, if one were to hold the currency in a real deposit account, the NOK pips the CHF. Of course, if one wants to move into local equities then the CHF offers more liquidity. The Norwegian equity market, the OBX, has a market cap of a mere ~EUR 163bn (NOK1.27trn) versus the SMI Swiss equity market of ~EUR 675bn (CHF800bn), some four times larger. In terms of performance, they are both down around 5% this year. Having said that, this does raise the question: if you are going into the CHF for defensive reasons why buy an asset class that
counteracts those defensive qualities? Thus the relative size of the equity markets does not explain the rally in the CHF relative to the NOK.
Budgets and Current Account NOK wins

On the budget and current account front there is little contest. The Swiss budgetary position has improved, and they are expecting a surplus in 2011, which in a global context is quite the result. Compared to many of their G10 counterparts, this puts the CHF in an excellent position. However, when comparing this with the Norwegian
3. Norways excellent budgetary position outshines the strong Swiss position
% GDP 25.0 20.0 15.0 10.0 5.0 0.0 -5.0 Jan-90

Swiss bugetary position
Norway budgetary position
% GDP 25.0 20.0 15.0 10.0 5.0 0.0 -5.0
Jan-93
Jan-96
Jan-99
Jan-02
Jan-05
Jan-08
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4. Switzerland and Norway as equals...
5. but Norways net debt to GDP ratio is a clear winner
% 250 200 150 100 50 0 Japan
Gross debt to GDP
% 250 200 150 100 50 0 -100 -200 200 100 0
Net debt to GDP
200 100 0 -100 -200
Switzerland
Japan
United Kingdom
Source: HSBC, IMF
Source: HSBC, IMF
budgetary position, an embarrassment of riches becomes apparent Norway, helped by oil, has an excellent budget surplus. So, from this perspective, it is not difficult to understand why the CHF has been one of the best performing currencies this year. However, it is hard to explain why the NOK has lagged the CHF. It is even harder to explain why the NOK has been so closely tied in with the EUR (see chart 1). From a budgetary situation Norway and the Eurozone are like chalk and cheese. Looking at gross debt to GDP ratios, which the IMF defines as all liabilities that require payment or payments of interest and/or principal by the debtor to the creditor at a date or dates in the future, Switzerland and Norway appear equals. Both countries have gross debt to GDP ratios of around 50%; this is very positive and is half the level of many countries and a quarter of the size of Japans (chart 4). However, if we take into account net debt to GDP, which the IMF calculates as gross debt minus financial assets corresponding to debt instruments1, Norway is the clear outperformer.
While Switzerland maintains its strong position, Norway is in a league of its own as its net debt to GDP is a surplus of over 150% (chart 5). The reason that Norways net debt to GDP ratio is so much better than its gross level is largely due to the Norwegian Government Pension Fund (discussed later). This is absolutely incredible and shows why the NOK should not be trading in a tight range against the EUR. Lastly, when we look at current accounts, both Switzerland and Norway have fantastic surpluses (chart 6).
CHF is marvellous but NOK is spectacular
So there is no doubt that the budgetary position, debt to GDP, and current accounts of Switzerland put it in a fantastic position relative to many countries in the world. These statistics underlie the defensive stability of the CHF. For this reason some are still happy to buy the CHF, despite it being one of the most over-valued currencies in the world on an OECD PPP basis. In particular, those looking for protection from any break-up scenario, or any other possible disaster scenario that may befall the EUR, are obviously looking for value preservation and are therefore still happy to buy the CHF despite the somewhat tenuous FX valuation metrics.
These financial assets are: monetary gold and SDRs, currency and deposits, debt securities, loans, insurance, pension, and standardized guarantee schemes, and other accounts receivable.
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Switzerland
Euro area
United Kingdom
Euro area
Norway
Norway
abc
6. Swiss and Norwegian current accounts both show large surpluses
% of GDP 20 16 12 8 4 0 Mar-00
Switzerland C/A
Norway C/A
% of GDP 20 16 12 8 4 0
Mar-02
Mar-04
Mar-06
Mar-08
Mar-10
On an OECD PPP basis the NOK is not that far behind the CHF as both are equally over-valued currencies ~+40%. However, with the metrics shown above, we would far prefer to hold the NOK than the CHF. Meanwhile, these metrics also beg the question of why the AUD is as equally overvalued. On this basis we would rather own either NOK or CHF rather than the AUD.
Liquidity argument cuts both ways
but it should have also seen the even less liquid NOK rise at even faster pace. This has not been the case as the NOK has underperformed the CHF over recent months (chart 7). This then continues to raise the question as to why the market shunned the defensive properties of the NOK in favour of the CHF.
CHF Banks versus Petroleum funds holding of EUR assets

The size of the two biggest Swiss banks relative to GDP is some 300%. The Swiss problems with their banking system during the crisis led some to believe that the CHF was losing its safe-haven status. For a while this seemed true. However, it would seem the memories of that particular issue remain in the Eurozone but not in Switzerland.
Swiss exposure to Eurozone
One often cited reason why the NOK has not performed as well as the CHF is that the CHF offers greater liquidity. However, we would turn the argument on its head. We would argue that, in a world of excess liquidity that is looking for a defensive home, the less the liquidity the greater the move. We used this argument to justify why post the JPY intervention the CHF would be squeezed higher. That is, when the G7 shut the door on the USD300bn a day spot yen market, the defensive money would have to squeeze into the USD92bn a day CHF spot market. This argument seemed to work well. However, the spot NOK market according to the BIS is ~USD12bn a day. Hence it would take a lot less money flowing into the NOK to push the currency higher. Thus, with the market looking for a defensive home it caused the CHF to rise and this has indeed been the case;
According to the BIS data Swiss banks exposure to Greece, for example, are a mere USD3bn; and to Greece, Ireland, Portugal, Spain and Italy combined is USD56bn, about the same size as French banking exposure to Greece alone. Of the USD56bn about 50% of claims are against banks and the private sector and roughly 20% of claims against sovereigns are secured with guarantees and collateral. Nevertheless, if one is buying CHF
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7 The NOK has underperformed the CHF over the past couple of months as Greece becomes a worry again
CHF-NOK 6.70 6.50 6.30 6.10 5.90 5.70 Jan-11

6.70 6.50 6.30 6.10 5.90 5.70 Feb-11 Mar-11 Apr-11 May-11 Jun-11
for protection against a disaster scenario of a banking crisis or a Eurozone break up, one has to ask how the CHF banks could remain immune to systemic contagion. According to the SNB stability report, at the end of 2010 the total assets of the Swiss banking sector amounted to CHF 3,582 billion, which is more than six times the annual gross domestic product (GDP) of Switzerland. Furthermore they say the two big banks UBS and Credit Suisse account for twothirds of total assets, which is roughly four times Swiss GDP. Compared with the other G10 countries, the ratio of the two biggest banks assets to GDP is highest in Switzerland. Although the direct exposure to the periphery is small, the Swiss authorities continue to worry about contagion effects. In fact, they believe credit and market risk, amplified by potential contagion effects from the sovereign debt crisis in the peripheral euro area, would constitute the most important source of risk for these banks under the adverse scenario. In fact, they say: The potential losses under this scenario would be substantial. It should be noted, however, that a resurgence of problems in the euro area periphery is exactly one of the potential triggers for the
adverse scenario. Therefore, the impact of direct exposures to the peripheral euro area must be considered in a broader sense, where the two big banks would also be affected by credit and market losses caused by an overall deterioration of the economic and financial market situation. This raises the question of why buy the CHF if one is worried about a major problem in the Eurozone and the associated problems this would cause in the banking system. On this front the CHF does not offer protection at all. So, from a pure currency perspective, it seems to make sense to buy and own NOK. Here one would have a currency that would be immune from both a banking crisis and a euro break-up scenario.
Norway owns a lot of Eurozone assets as well
Although there are some concerns about the links of Swiss banks exposure to the Eurozone, what about Norways Government Pension Fund (GPF), which owns a lot of Eurozone assets? It makes sense to look at the GPF given Norwegian banks are comparatively small compared to Swiss banks. As background, the GPF has approximately USD600bn (NOK3.1trn) assets under management, which is nearly 50% larger than Norways economy.
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8. Switzerland has an outstandingly large banking sector Size of the banking sector (ratio of total assets to annual GDP) Belgium* Canada France* Germany* Italy* Japan Netherlands* Sweden* Switzerland United Kingdom* United States * Banking sector figures as at end of June 2010
Source: SNB
Size of the largest banks (ratio of total assets to annual GDP) 2.6 0.8 1.9 1.1 1.0 0.6 3.3 2.2 4.3 2.5 0.3
3.2 2.2 3.2 3.4 1.6 2.0 4.4 3.5 6.6 7.0 1.1
Just like Switzerland, whose banks are a multiple of GDP, the GPF is a multiple of GDP, albeit smaller. From a currency perspective, around 80% of the GPFs assets are denominated in EUR, GBP, JPY and USD. The funds asset mix is about 60% equities and between 35 and 40% in fixed income. Nearly 30% of the equity holdings are held in Europe whilst nearly 60% of the fixed income investments are European paper. So, the exposure to Europe via its assets holdings is substantial. That said, the direct holdings of sovereign government bonds in the peripheral part of Europe are small. For instance, the holdings of Spain, Greece, Ireland and Portugal government bonds are a little over USD6bn or a mere 1% of its portfolio. The GPF also holds a substantial portion of Eurozone banks bonds and equities, which would feel the strain from contagion. Do we have the same potential problem as Switzerland where the direct exposure is small but the indirect exposure is large? We would argue no. The difference is that one is a fund where it can absorb losses without a material impact on the economy and the banking system. The same cannot be said for Switzerland. Those worried about a European break-up and systemic banking
problems that rushed into the CHF should, for all intents and purposes, have their holdings in NOK.
Conclusion Switch out of CHF and into NOK

The market has fled into the CHF as the key defensive currency of choice. We too have advocated the CHF, especially following the coordinated intervention against the JPY in March. But we believe the market is overlooking some key risks for the CHF if significant stress emerges from the Eurozone. The reason being that Switzerlands indirect exposure to the Eurozone is very high. The SNB alluded to the problems for Swiss banks from the Eurozone under a very adverse scenario. When we look at a range of measures, we find the CHF is a fantastic currency versus the USD, EUR, GBP and JPY. But on all these metrics the NOK is in an even sounder position and should be considered in a league of its own. Moreover, the NOK has traded in a narrow range versus the EUR and should be making substantive headway. Those that have sought solace in the CHF should take a closer look at the NOK. .
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Dollar Bloc
CAD easily absorbs shifting BoC policy expectations
While there have been further developments and changes in Canadas economy and the central bank policy outlook, USD-CAD continues to hold in the approximate 5-cent range in which it has trade since the beginning of this year. We continue to see the overall backdrop for the CAD as supportive, given still-healthy growth in emerging market economies and the associated support that provides to commodity prices, as well as Canadas superior fiscal condition and modestly better growth trajectory, relative to most other G10 countries. But we are also hesitant to view those factors, or more recent cyclical developments, as ones that are likely to drive the CAD measurably higher. On May 31, the Bank of Canada altered the language in its policy statement, signaling that some of the considerable policy stimulus currently in place will eventually be withdrawn. Even so, we observed at the time that despite the seeming increase in the scope for a summer rate hike by the BOC, the CAD would have trouble benefitting from such an event, partly because some amount of tightening was already priced into the curve, but more because the currency was already trading at relatively high levels.
Challenging backdrop
deteriorated in a manner that clearly got the attention of Canadas policy makers. The most dramatic events stemmed from the Eurozone sovereign debt crisis, and the ripple effects that could have on the global economy. In addition, the soft patch which had developed in the US economy since the spring persisted and threatened to evolve into an outright slowdown. Most obvious in that regard was, and continues to be, the deterioration in the labor market, with job growth remaining anemic, and the unemployment rate rising from 8.8% in March up to 9.2% in June.
More dovish BoC
In the weeks that followed, the Canadian data flow was reasonably good, better readings on indicators such as employment and the PMI were countered by disappointing outcomes in international trade and labor productivity. But more importantly, the international backdrop
Against that backdrop, BoC Gov. Carney, in comments on June 24, observed that Canadas economy faced substantial headwinds and that monetary policy may still need to be stimulative in order to close the output gap and in order to get inflation back on target. So while the signal in the May 31 policy statement was presumably designed to prepare the market for the eventual normalization in policy, Carneys subsequent comments in late-June were notably more dovish. As it happened, front-end Canadian yields had already been falling in the run-up to Carneys June 24 remarks, as markets became increasingly aware of the downside risks to growth. The implied yield on the March 2012 BA future fell 25 bp between May 21 and June 24, and that was part of the broader 68bp decline from the April peak 2.23% to the low in late June of 1.55%. That helped US-Canada yield spreads narrow roughly 50 bp since April, reducing some of the carry appeal of the CAD. On balance, USDCAD has correlated reasonably well with
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1. Shift in US-Canada yield spreads reduces the CADs interest rate cushion
US-Canada Yield Spread (March 2012 Eurodollar, BA futures) (LHS) -0.5 -0.7 -0.9 -1.1
USD-CAD (RHS)
1.06
1.02
0.98 -1.3 -1.5 Aug-10

0.94 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11
developments in the yield spread over the past year, although the larger magnitude of the rise in the spread in the past few months might have been expected to see the exchange rate rise more than it did, if recent history was any guide. But in that regard, we would make several observations. First, there were several periods over the past year where the volatility in the spread exceeded that in the exchange rate, and that has developed again more recently. Second, even with the spread narrowing, Canadian yields are still roughly a full percentage point higher at that term (3-month rates in March 2012), keeping some carry in place for the CAD.
Several sources of support
currencies, accumulating USD in the process. And that supports the cycle of reserve manager USD diversification, which continues to weigh on the greenback more broadly, and support currencies such as the CAD. Developments in US growth specifically continue to be important for the CAD, given the Canadian economys sensitivity to that in the US. Hence, if the current soft patch in US growth were to persist or intensify, it could present more immediate risks to Canadian growth. Indeed, this is one factor we think will keep the Bank of Canada sidelined at the July policy announcement. And it may also present more direct risks to the CAD, particularly if markets begin to see more pronounced weakness in the Canadian economic data. That said, we would note that the US economic soft patch from last summer through the autumn was generally accompanied by an appreciating CAD versus the USD. Of course, the fact that the Bank of Canada was tightening policy during part of that period did not hurt either. But the CADs resilience in the face of US economic weakness in the recent past was notable.
Beyond the yield-related considerations, there are other, mostly familiar, factors that are also favoring the CAD. While commodity prices have pulled back from their recent highs, many remain at elevated levels. Although growth in some developed economies has stumbled, growth in emerging market economies continues to hold up well, suggesting that EM-led demand for commodities will persist, maintaining a source of support for the CAD. Also on the EM theme, reserve managers continue to intervene to limit appreciation in their own
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Conclusion
In the more immediate term, scheduled key events for the CAD are the aforementioned BoC policy statement on July, followed by readings on inflation, retail sales, monthly GDP and employment in the days and weeks afterwards. And unscheduled events, such as the type that influence risk appetite, could be equally important, if not more so. But amid all of that, our outlook for the CAD remains pretty consistent. Essentially, we see limited additional upside for the CAD versus the USD, primarily because with USD-CAD approaching 0.9500, there is already a lot of good news priced into the loonie. That does not preclude the CAD from remaining strong if the favorable conditions cited above persist (or falling if they dont), but we remain skeptical that the currency can register further gains from here.
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AUD still at elevated levels

The AUD has remained resilient despite a number of threats that could have harmed the currency, including the recent downgrade of some Australian banks and fears of a China slowdown. However, the shocking US non-farm payrolls print that has already weighed on the AUD, may just be the first of a series of risk off events that could cause the currency to retrace. To call the US labour market statistics disappointing is an understatement, and the report has not only continued the trend of weaker US activity data in recent months, but suggests an intensification of the economic "soft patch" in a manner that could well lead to additional calls on the Fed to take more action. As the AUD remains exposed to global events as a result of the ongoing risk on risk off phenomenon, the AUD looks vulnerable.
Tightening cycle to be more elongated
maligned carbon tax and also unrest in Greece, which was prominent in the media in Australia. Nonetheless, the RBA are likely to continue with their wait and see approach. With the Australian activity surprise index also trending down (chart 2) an August tightening seems far less likely. Markets have responded to recent developments by pricing in easing by the RBA. We think this is overdone and partly reflects global investors using the Australian bond market to buy insurance against the possibility of a large negative global financial event triggered by European developments. We think the chance of an RBA cut is very small. We continue to expect the next RBA move to be up, but are pushing back the timing of our call from August to Q4, with a more elongated tightening cycle of another 50bp to follow through 2012. We expect the cash rate to reach 5.50% by Q4 2012. The bottom line is that even with an elevated CPI print on 27th July we still expect a 0.8% rise the RBA will probably need more time to let the smoke clear before they respond. The fragile global financial situation and weak local confidence will keep them sitting on their hands.
On the domestic front, the strength of the AUD also looks overdone as the RBA are likely to keep rates on hold for longer than previously thought. While Australian employment has continued to rise modestly, as have retail sales, the Australian consumer and business confidence indices have fallen. Indeed, consumer confidence is now at its lowest level since June 2009 (chart 1). Our Australian economist, Paul Bloxham, believes this weakness is temporary partly due to the much
1. Consumer sentiment takes a tumble
2. Australia activity surprise index trending down
Index 130 120 110 100 90 80
Consumer sentiment
Index 130 120 110 100 90 80 70
85 80 75 70 65 Jan-10 Apr-10
85 80 75 70 65 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11
70 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10

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AUD game changer
The set-back in RBA rate-hike expectations, coupled with the recent weakness in global indicators, should also take its toll on the AUD. The US non-farm payrolls release may prove to be a tipping point as risk off makes a strong comeback. The AUD fell aggressively in the aftermath of the report and, while the RBA had hoped that the downturn in global growth was temporary, this report will start to raise questions about whether global weakness could persist. The AUD remains above 1.05 for now, but at such elevated levels we feel that the currency should retrace in the coming months.
be strong, so our GDP forecasts were already quite high the highest in the consensus survey so we have left them unchanged this quarter. We still expect GDP growth of 1.7% in 2011 and 4.3% in 2012. Inflation pressures are expected to build and, somewhat worryingly, inflation expectations have already risen to the top of the RBNZs comfort zone. We continue to expect inflation to hold above the RBNZs target band well into 2012 (chart 3).
Time to tighten
New Zealand Recovery in full swing

The New Zealand economy is finally recovering, after a long period of economic malaise and some false starts. The economy has been weak since early 2008, so its well overdue for a pick-up. Prospects for growth in H2 are strong on the back of high meat and dairy prices, which are boosting incomes and rural investment; the Rugby World Cup, with 85,000 visitors expected in September and October; and the rebuilding and repair of the quake-damaged Canterbury region, with 8% of GDP to be spent over coming years. We have long thought the quakes impact would be geographically contained and that H2 2011 would
Time will tell if Marchs rate cut in response to the quake was a policy error we think it may have been. While the RBNZ kept the cash rate on hold at 2.50% in their latest meeting, the postmeeting statement was more hawkish than the market expected, with the Governor shifting his tone from rates on hold for some time to rates are on hold for now. The more hawkish tone sent NZD-USD as high as 0.83 (chart 4). The more upbeat tone from the Governor and rising inflation expectations suggests a policy reversal is to come sooner rather than later. We continue to expect the next hike to come in Q4 this year, but the risk is for an earlier move. Over a longer time frame, we still expect 175bp by end 2012, but see upside risks to inflation that
3. Inflation continues on upward path
4. 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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could see more aggressive rate hikes needed next year.

Risk off to weigh on the Kiwi
The NZD has performed well over the last few months, with the currency reaching fresh all-time highs on the back of rising rate expectations and positive domestic developments. The recent talk of the potential for more QE by the Fed has also pushed the currency higher. However, as the dominant driver of the currency continues to be the fluctuations between risk on and risk off, and while QE3 in the US may be a temporary support, the fact that the US economy is performing so poorly is likely to weigh on risk and harm the NZD. Therefore, in the medium term we continue to expect the currency to retrace. The summer months also bring a number of events that could see further risk off developments. In particular, focus will be on the US debt-ceiling issue; but with troubles in the Eurozone periphery still lingering and contagion fears spreading to the likes of Italy, the markets appetite for risk is likely to be curtailed and this will weigh on the NZD in the months to come.
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Europe at a glance
EUR-CHF
1.70 1.60 1.50 1.40 1.30 1.20 1.10 Jan-06 Jan-02 Jan-04 Jan-05 Jan-07 Jan-08 Jan-10 Jan-11 Jan-09 Jan-03
1.70 1.50 1.30 1.10 0.90 0.70
EUR-CHF (LHS)
Source: Thomson Financial Datastream
USD-CHF (RHS)
Switzerland: The markets love affair with CHF continues The ongoing Eurozone crisis keeps sending CHF to new record highs against the EUR as the market rushes to the perceived safety of the ultra-defensive currency. We expect the CHF to continue to appreciate in the current environment, and consider CHF as a fantastic currency versus the G4 currencies. However, it seems the market is overlooking key risks for the CHF if the Eurozone crisis deteriorates. It makes little sense to buy CHF if fleeing from fears of systemic problems or a break up scenario, due to Switzerlands giant sized banking sector. The SNB kept rates on hold at 0.25% in June and made several dovish remarks regarding the Swiss economic outlook. The CHF ascent is perceived as a key threat to exports and growth. Inflationary pressures remain benign, and we do not expect a rate hike until Q1 2012. While we believe the CHF will stay strong for now, our preferred call in a risk-off environment is the NOK.
EUR-NOK
Norway: NOK has beauty, but not everyone sees it
10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00 Jan-03 Jan-04 Jan-06 Jan-07 Jan-09 Jan-10 Jan-11 Jan-05 Jan-08 Jan-02
10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00

See pages 22 28.
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-06 Jan-07 Jan-09 Jan-10 Jan-11 Jan-05 Jan-08 Jan-02
12.00 11.60 11.20 10.80 10.40 10.00 9.60 9.20 8.80 8.40
Sweden: Sensitive to risk off but fundamentally sound The SEK has stabilised versus the EUR in recent weeks, but we maintain there is room for the currency to strengthen, especially if global risk appetite improves. Recent economic indicators still point to robust growth in the Swedish economy, implying the need for additional rate hikes by the Riksbank. The Riksbank last raised its policy rate to 2.00% on 5 July, but the policy rate remains low by historical standards. We expect the key rate to be increased by another 50bps 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. Like the NOK, the SEK also stands to benefit from being a country with relatively sound fiscal and current account balances. Key events released in the coming weeks include Q2 GDP on 29 July and CPI on 11 August.
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Asia regional overview

Relatively more attractive
We continue to believe that Asian currencies offer good value over the medium-term. However, with debt issues in the developed world continuing to fester and overshadow the global environment, and with a reacceleration in the Asian data unlikely to manifest itself until the next cycle of monthly data, we believe there will continue to be better opportunities in trading Asian FX via relative value and regional crosses in the coming weeks (see "Asian FX Focus: Bullish Strategies for Choppy Markets", 18 May 2011). A glance at simple risk-adjusted spot returns reveals that, since May, several relative value trades within Asia have outperformed any trade that pits Asian currencies against the USD or EUR. In particular, long SGD-THB, long KRW-TWD, long SGDTWD, and long KRW-THB stand out having generated the best risk-adjusted returns. This highlights two particularly well performing currencies SGD and KRW, as well as two particularly poor performing ones THB and TWD. On the positive side, SGD's relative low volatility, as well as its explicit FX policy of gradual appreciation against a basket comprising many regional peers, should persist even beyond the next MAS policy meeting in October. KRW's positive performance has been more surprising to us - the result of more FX policy management against KRW weakness, which we had anticipated, but also due to greater policy permissiveness for KRW strength, which we had underestimated. On the funding side, THB's underperformance has coincided with uncertainty leading up to the parliamentary elections, which concluded last week with a surprisingly stable result. Thus THB's underperformance may not necessarily last, though some volatility is likely. However, for TWD we had earlier identified particular vulnerability to external demand, growth sensitive equity flows, and China more broadly. Thus TWD should continue to underperform so long as growth and global conditions in general remain in question.
1. Risk-adjusted returns on short USD-Asia have been poor
2. Asia cross trades have offered better risk-adjusted returns
1.5
2.0 1.5 1.0
Sharpe ratio since 1-May -11 Short USDINR Sharpe ratio = 1.353
1.0
0.5
0.5
0.0 KRW CNH TWD IDR SGD THB PHP INR MYR
0.0 KRWTWD SGDTWD INRTWD INRIDR KRWIDR SGDTHB KRWTHB SGDIDR INRTHB KRWPHP MYRTWD
Sharpe ratio v s USD since 1-May -11

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Asia at a glance
USD-CNY
8.40 8.10 7.80 7.50 7.20 6.90 6.60 6.30 Jul-05 Jul-08 Jan-05 Jan-06 Jan-07 Jan-09 Jan-10 Jan-08 Jan-11 Jul-11 Jul-06 Jul-09 Jul-07 Jul-10 8.40 8.10 7.80 7.50 7.20 6.90 6.60 6.30
China: CNY appreciation pace steady The CNYs pace of gradual appreciation has become more stable and independent, against heightened volatility in FX markets elsewhere. The latest round of economic data, with continuing solid growth and inflation peaking at 6.4% reinforce a view that Chinas tightening stance will persist. This should translate into an ongoing gradual appreciation for the currency. Moreover, with more acute financial market instability associated with sovereign debt concerns in the developed world, there is an incentive to reinforce perceptions of stability in Chinas currency markets, which the authorities continue to have full control over. We expect the pace of appreciation to slow in the coming months as inflation demonstrates that it has peaked and begins to trend-decline, and as the tightening cycle ceases by end 3Q. We expect the longer-term gradual appreciation pace of around 4% per annum to persist.
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: : CNH market continues to steadily grow The offshore RMB (CNH) market continues to grow, most recently with the introduction of an official USD-CNH fix by the Hong Kong Treasury Markets Association. A PBoC circular regarding cross-border RMB transactions clarifies some rules, but should generally ensure that cross-border RMB continues to grow steadily. The CNH bond market continues to grow, with the emergence and growth of a high-yield class of offshore RMB bonds. Meanwhile, a US heavy equipment manufacturer announced its second CNH bond offering and the biggest foreign CNH issuance yet. We continue to see the RMB onshore-offshore spread to be a function of appreciation expectations and risk appetite; hence the re-narrowing of this spread in recent months. However, we continue to believe CNH to be the best place to hold long RMB positions.
USD-IDR
16000 14000 12000 10000 8000 6000 4000 2000 97 99 01 03 05 07 09 11
16000 14000 12000 10000 8000 6000 4000 2000
Indonesia: IDR still not overvalued IDR remains attractive to us, despite appearing to be the most overvalued currency on a range of our usual valuation metrics. We do not believe this stretched valuation will preclude IDR from continuing to see real appreciation over the medium term. The structural shift the economy is undergoing is hard to quantify on most valuation measures. For example, the sovereign debt rating is just one notch away from investment grade and on positive watch on Fitch and S&Ps ratings. Achievement of investment grade would structurally increase foreign demand for the already popular Indonesian bond market. This type of structural flow-shift is difficult to model. Beyond these issues, the stability of a sizable fundamental external surplus reinforces a sanguine view of IDR valuation, and adds further to the fundamentally bullish story we have outlined for IDR since the start of the year.
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Asia at a glance continued

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: SGD - NEER-ly uncorrelated value Long SGD against a basket of currencies of its major trade partners (S$NEER) to hedge against global risk is increasingly attractive. Over the past few months, S$NEERs correlation with EUR seems to be declining. This in our view is in part due to SGDs characteristic as a safe haven currency in Asia. In addition, with inflation still a concern, MAS is also more inclined to keep the NEER on the strong side of the band. As such, this should reduce the downside risk for S$NEER, making SGD an attractive currency to buy against the basket. For Octobers MPC meeting, we think it is still too early to call. However, given inflation is showing signs of peaking, there is less pressure on the MAS to tighten for now. In addition, Aprils MPC statement clearly suggests the hurdle for further tightening is much higher than before. In the absence of inflation accelerating again, the likelihood is that MAS will maintain S$NEERs modest and gradual appreciation.
USD-KRW
2000 1800 1600 1400 1200 1000 800 97 99 01 03 05 07 09 11
2000 1800 1600 1400 1200 1000 800
South Korea: KRW Asias most RORO currency KRW is the most highly correlated Asian currency with the Risk on-Risk off factor. This means KRW-USD rallies the most when risk is on and suffers the most when risk is off. The liquid nature of the equity market and relatively accessible bond market mean KRW and Koreas status as one of the larger Asian economies sees a lot of shorter term portfolio flows. These more speculative flows are likely to be most highly responsive to changes in risk appetite. Although FX policy has shifted to curbing volatility, this has not reduced KRWs high correlation with the Risk onRisk off factor. For the time being, sovereign concerns in developed markets, and a slowdown in economic data, are making it difficult for risky assets to rally. However, if one believes that things are about to turn up and the world looks a better place, KRW would appear to be the best buy in Asia against the USD.
USD-THB
55 50 45 40 35 30 25 20 97 99 01 03 05 07 09 11
55 50 45 40 35 30 25 20
Thailand: THB better placed post-elections In May and June, THB's underperformance coincided with uncertainty leading up to the parliamentary elections and global concerns. Previously, THB has been able to shrug off domestic political events. Exposure, however, has changed. Foreign capital flows are now having a much large influence on THB. Foreign holdings of Thai bonds are close to record highs, and these flows have been largely into short-term instruments. While the relative stability seemingly achieved from Peau Thais election victory will help to boost shorter term sentiment on THB, we are wary of some volatility in the currency given this exposure to foreign flows. Over the medium term, we remain constructive on THB given that the current account surplus is likely to widen out again and the BoT remains one of the regions most hawkish central banks, with further rate hikes expected through the year.
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Latin America regional overview

Treading Water
Latam currencies remain relatively strong, but are struggling to post meaningful fresh gains into new ranges due to the uncertain global environment (see chart below, showing HSBCs tradable Latam FX Index). We would expect this situation to persist at least until an acceptable resolution can be found to the US debt-ceiling negotiations and the situation in Europe, although there are other uncertainties also keeping investors sidelined, including stubbornly high US unemployment and concerns of a hard landing in China where inflation rose again in June (though we would note our economists expect Chinas inflation to roll over in 2H). Recent fund flow data for Latam has also been less supportive for Latam currencies, with data for the latest week from EPFR showing net outflows in both fixed income and equity funds from the Latin America region. Meanwhile, Brazilian FX flow data from the central bank showed that the country posted its first monthly net outflow of funds of the year in June. Lower portfolio inflows puts more pressure on the foreign direct investment (FDI) channels of the regions capital accounts. The good news is that FDI as a share of inflows is increasing, and we expect total FDI for the Latam region to exceed USD136bn this year, up from USD109bn last year. For Brazil specifically, the 12-month rolling FDI figure exceeded that of portfolio flows at the beginning of this year (for the first time since the global financial crisis hit in late 2008). In other words, while external conditions will still dictate short-term moves in Latam FX, we still believe that the longer-term picture remains constructive, based on stronger growth, higher yields and robust balances of payments.
Where we see value

We like the COP, where the FDI picture remains very solid, oil production is expanding and while public sector inflows are being held back as far as possible, we do not expect capital controls to be used. The BRL still has room to rally over the medium term, but we believe short-term strength is likely to be hampered by new FX measures and heavy market positioning. Meanwhile, we still see room for MXN strength, but only insofar as US economic data can improve. Finally, we remain sidelined in CLP and PEN, where we see limited room for strength thanks to ongoing central bank intervention and Chinas efforts to cool its economy (where much of Chile and Perus commodity exports are destined).
1. Latam currencies holding ground, despite external noise
108 106 104 102 100 98 96 94 92 90 Jan-10 Apr-10

Jul-10 Oct-10 Jan-11 Apr-11 HSBC Latam FX Index
Jul-11
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Latin America at a glance

USD-COP
3000 2800 2600 2400 2200 2000 1800 1600 Jan-03 Jan-05 Jan-06 Jan-07 Jan-08 Jan-10 Jan-11 Jan-04 Jan-09 Jan-02
3000 2800 2600 2400 2200 2000 1800 1600
Colombia: COP supported by strong capital flows Private sector flows, composed primarily of long-term capital flows (FDI) into the oil and mining sector, remain buoyant and supportive of a stronger COP. Rising oil, coal and gold production will keep these investment flows on a positive track. To counter these inflows authorities are using a mix of tools to limit COP strength, including daily USD purchases, withholding both Ecopetrol dividends and external financing flows offshore, hedging external debt and setting up an oil windfall fund. However, some of these tools may be reaching the limits of their effectiveness (for example, the hedging program is almost complete), and the government has said it has no plans to implement capital controls. We remain constructive on the medium-term outlook for the COP, especially in the wake of the sovereigns upgrade to investment grade. We would look to use any risk aversion moves towards 1800 to sell USD-COP.
USD-BRL
Brazil: BRL in the cross-hairs again
4.0 3.5 3.0 2.5 2.0 1.5 1.0 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
4.0 3.5 3.0 2.5 2.0 1.5 1.0
New measures aimed at reducing local banks short USD positions were announced on 8th July. These involve 60% nonremunerated reserve requirements on positions over USD1bn, a tightening of the previous measures that were announced last January. Banks were given just five days to adjust to the new measures, compared to the three months they were given following the January announcement. In late June, local banks held total short USD positions of USD14.7bn, up from USD9bn in May. Officials indicated they would prefer to see these positions reduced down to below USD10bn again. Meanwhile offshore investors long BRL position on the local futures exchange stand close to USD20bn, suggesting some vulnerability for the BRL based on current market positioning. That said, we maintain our year-end BRL1.52/USD target based on continued strong FDI and equity flows.
USD-CLP
800 750 700 650 600 550 500 450 400 Jan-06 Jan-07 Jan-11 Jan-02 Jan-03 Jan-04 Jan-05 Jan-08 Jan-09 Jan-10
800 750 700 650 600 550 500 450 400
Chile: CLP still at the mercy of copper prices There are various factors both helping and hindering the CLP at present. On the positive side, copper prices have recently broken higher, and the strong correlation seen between copper and the peso has helped the currency to firm in early July. Also helping the CLP has been the interest rate tightening cycle, which has seen nominal O/N rates hiked by 475bps over the last year. Meanwhile, working against the CLP is ongoing central bank intervention (USD50m per day) and concerns about a hard landing in China (the primary recipient of Chiles main export, copper). With growth and interest rate differentials potentially peaking soon, plus ongoing intervention planned to total USD12bn through the year and continued efforts by China to slow growth and reduce inflation, we remain cautious on the CLP. We expect the USD to firm modestly through 2H11 and to see USD-CLP ending the year at 480.
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EMEA: regional overview

Turning more cautious
EMEA central banks on a wait & see stance We turn more cautious
In the past two months, an increasing number of central banks in the EMEA region have adopted a neutral bias regarding the monetary policy. After having increased its interest rates by 100bp in H1, the Polish central bank has signalled its intention to make a pause. Similarly, the Russian central bank has said that further tightening is not needed at this stage. Even, the Bank of Israel seems to have loosened its very aggressive stance. The other central banks, which were not in a tightening mode, have simply reiterated that the current monetary conditions were consistent for now with the macroeconomic trends and risks. This is typically the case in Czech Republic, Hungary, Romania, South Africa and even in Turkey. Recent signs of a slowdown in the global economy and the risks attached to the sovereign debt issue are obviously the primary factors behind the cautious approach of EMEA central banks. The retreat on commodity and energy prices, and also on food prices, has offered some comfort to the central banks. Most of the central banks believe that they will be able to achieve their inflation target in the medium term with current policy rates. Therefore, we do not expect any changes in policy rates during the summer and only minor increases in Czech Republic, Israel and eventually Turkey before year-end.
The central banks neutral stance is not without consequences for FX. The lack of carry momentum combined with signs of slowing economic activity may maintain without clear direction, particularly during the summer period. The Eurozone sovereign crisis represents obviously a downside risk. Consequently, we have adjusted some of our forecasts. We now no longer see upside potential on the PLN for the rest of the year. A central bank on hold, high inflation and deteriorating balance of payments are not PLN-supportive. If anything, those factors are negative, but the FX interventions of the Ministry of finance may limit the downward pressures on the zloty. We have also revised our forecast on USD-TRY to 1.65 for end of Q3 as the central bank is firmly dovish and expectations of rate hikes are pushed back. Meanwhile, we continue to see the risk of a wider and sudden depreciation with USD-TRY surging to the 1.70-75 area. Nevertheless, our constructive view on the HUF and the RON are intact. The emergence of a large current-account surplus, a prudent monetary policy and a fiscal consolidation programme will support the forint. We see EUR-HUF trending to 255. In Romania, we see the recent upgrade by Fitch to investment grade as supportive for capital inflows. Moreover, a recovering economy, a tight fiscal policy, high interest rates and narrowing current account deficit should drive EUR-RON towards 4.00 by year-end.
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EMEA at a glance
EUR-PLN
5.00 4.60 4.20 3.80 3.40 3.00 Jan-08 Jan-11 Jan-02 Jan-03 Jan-05 Jan-06 Jan-07 Jan-09 Jan-10 Jan-04
5.00 4.60 4.20 3.80 3.40 3.00
Poland : Limited room for appreciation The macroeconomic parameters are not PLN-supportive. The economy is giving some signs of slowdown, inflation is well above the central banks target and the current account deficit is widening. In parallel, the foreign direct investment flows are very weak pushing coverage of the current account deficit by FDI to historically low levels. The deficit is mainly financed via portfolio flows with non-resident holdings of Polish bonds at alltime highs. In such a context, and with a central bank having adopted a wait & see stance, the upside potential of the zloty appears very limited. We would rather envisage a weakening of the currency, but the FX intervention policy of the Ministry of Finance limits the risk of depreciation. Therefore, we stay neutral on the PLN in the near-term with risks for a weaker currency.
EUR-HUF
320 310 300 290 280 270 260 250 240 230 220 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-02
320 310 300 290 280 270 260 250 240 230 220
Hungary: From fragile to resilient Since the 2008 global financial crisis, the sensitivity of the Hungarian forint to an external shock has decreased considerably. While the HUF fell sharply in the wake of the Lehmans bankruptcy, the currency depreciation was more limited when the Eurozone sovereign crisis erupted in 2010, and even less so during the re-emergence of the sovereign Greek issue this year The emergence of a large current account surplus, a prudent monetary policy and a fiscal consolidation programme are HUF-supportive factor. We have been bullish on the HUF since the start of year and this is playing out. We retain our constructive view and still see some upside potential left, with EUR-HUF trending to 255 on a 1-3-month horizon.
USD-TRY
1.90 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-08 Jan-09 Jan-10 Jan-11 Jan-07
1.90 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10
Turkey: Dovish central bank keeps the lira weak The Turkish central bank reaffirmed its dovish stance. The CBRT sees the recent signs of a slowdown of economic activity and the easing of inflationary pressures as reasons to keep its monetary policy unchanged. If anything, it considers that the risks have titled to the downside. On the credit growth and the current account deficit, the expectations are still for an improvement from Q4 this year. With such a monetary policy and the persistent macro imbalances, the TRY is likely to remain weak. In the case of a sudden change in capital flows dynamics, the lira may even suffer a wider and sharper depreciation given its very wide current account deficit (8% of GDP). The CBRT signalled that it would cancel its daily FX purchases and narrow the interest rate corridor in such a scenario. We doubt that these measures will be enough to avoid a fall of the lira if this risk scenario materialises.
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HSBC Volume-Weighted REERs

For full details of the construction methodology of the HSBC REERs, please see HSBCs New Volume-Weighted REERs Currency Outlook April 2009.
How should we weight the basket?

If we are trying to create an index for the change in value of a currency against a basket of other currencies, we now need to decide on how to weight our basket. One possible solution would be to simply have an equally-weighted basket. The rationale for this would be that there is no a priori reason for choosing to put more emphasis on any one exchange rate. However, this could clearly lead to the situation where a large move in a relatively small currency can strongly influence the REERs and NEERs for all other currencies. To avoid this, the indices are generally weighted so that more important currencies get higher weighting. This, of course, begs the question of how importance is defined.
Mark McDonald FX Strategist HSBC Bank plc +44 20 7991 5966 mark.mcdonald@hsbcib.com
The value of a currency

Since FX prices are always given as the amount of one currency that can be bought with another, the inherent value of a currency is not defined. For example, if EUR-USD goes up, this could be because the EUR has increased in value, the USD has decreased in value, or a combination of both. One possible method for getting some insight into changes in the value of a currency is to look at movements in the value of a basket of other currencies against the currency of interest. For example, if EUR-USD increased over some time period, one could see how EUR had performed against a range of other currencies to determine whether EUR has become generally more valuable or whether this was simply a USD-based move. An effective exchange rate is an attempt to do this and to represent the moves in index form. There are two main approaches to building an effective exchange rate: Nominal Effective Exchange Rates (NEERs) and Real Effective Exchange Rates (REERs). NEERs simply track the weighted average returns of a basket of other currencies against the currency being investigated; REERs deflate the returns in an attempt to compensate for the differing rates of inflation in different countries. The reason for doing this is that, particularly over long time frames, inflation can have a large impact on the purchasing power of a currency.
Trade Weights
Weighting the basket by bilateral trade-weights is the most common weighting procedure for creating an effective exchange rate index. This is because the indices are often used to measure the likely impact of exchange rate moves on a countrys international trade performance.
Volume Weights
The daily volume traded in the FX market dwarves the global volume of physical trade. From this it is possible to make a convincing argument that the weighting which would be really important would be to weight the currency basket by financial market flows, rather than bilateral trade. To do this properly would require us to have accurate FX volumes for all currency pairs
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considered in the index. However, these are not available. The BIS triennial survey of FX volumes only gives data for a small number of bilateral exchange rates. However, the volumes are split by currency for over 30 currencies. From these volumes we can estimate financial weightings for each currency. We believe that this gives another plausible definition for importance, and one which may be more relevant for financial investors than trade weights. We call this procedure volume weighting and the indices produced through this procedure we call the HSBC volume-weighted REERs. We would argue that if you are a financial market investor, the effective value of a currency you would be exposed to is more accurately represented by the HSBC volume-weighted index rather than the trade-weighted index.
Data Frequency
This is something which is rarely considered when constructing REERs inflation data is generally released at monthly frequency at best so the usual procedure is to simply create monthly indices by default. However, some countries release their inflation data only quarterly. The usual procedure for these countries is to simply pro-rata the change over the period. Here there is an implicit assumption that the rate of inflation changes slowly. We take this assumption one step further and assume that it is valid to spread the inflation out equally over every day in the month.
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HSBC Volume Weighted REERs

USD REER index
USD Trade-Weighted REER 1996=100 160 USD Volume-Weighted REER 1996=100 160
1996=100 120
EUR REER index

EUR Volume-Weig hted REER EUR Trade-Weighted REER 1996=100 120
140
140
105
105
120
120
90
90
100
100
75
75
80 Jul-95
80 Jul-98 Jul-01 Jul-04 Jul-07 Jul-10

60 Jul-95 60 Jul-98 Jul-01 Jul-04 Jul-07 Jul-10
Source: HSBC
Source: HSBC
JPY REER index

JPY Trade-Weighted REER 1996=100 120 JPY Volume-Weighted REER 1996=100 120
GBP REER index

1996=100 140 GBP Trade-Weighted REER GBP Volume-Weighted REER 1996=100 140
105
105
125
125
90
90
110
110
75
75
95
95
60 Jul-95 Jul-98 Jul-01 Jul -04 Jul-07 Jul-10
60
80 Jul-95
Source: HSBC
Source: HSBC
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CAD REER index

CAD Trade-W eighted REER 1996=100 150 140 130 120 110 100 90 80 Jul-95 Jul-98 Jul-01 Jul-04 Jul-07 Jul-10 CAD Volume-Weighted REER 1996=100 150 140
CHF REER index

CHF Volume-Weighted REER 1996=100 110 CHF Trade-Weighted REER 1996=100 110
100
130 120 110 100
100
90
90
80
80
70
90 80
70
60 Jul-95
Source: HSBC
Source: HSBC
AUD REER index

AUD Trade-W eighted REER 1996=100 160 AUD Volume-Weighted REER 1996= 100 160
NZD REER index

NZD Volum e-Weighted REER 1996=100 140 NZ D Trade-Weighted R EER 1996=100 140
140
140
120 120
120
120
100 100
100
100
80
80
80
80
60 Jul-95
60 Jul-95
60 Jul-98 Jul-01 Jul-04 J ul-07 Jul-10
Source: HSBC
Source: HSBC
SEK REER index

SEK Trade-Weighted REER 1996=100 110 SEK Volume-Weighted REER 1996=100 110
NOK REER index

NOK Trade-Weighted REER 1996=100 130 NOK Volume-Weighted REER 1996=100 130
100
100
120
120
110
110
90
90
100 100
80
80
90 90
70
70
80
80
60 Jul-95
70 Jul-95
Source: HSBC
Source: HSBC
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HSBC forecasts vs forwards

Euro dollar vs forwards
USD/EUR 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12
Euro Swiss vs forwards

Forecast
USD/EUR 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80
Forward
CHF/EUR 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 Jan-00 Jan-02 Jan-04
Forward
Forecast
CHF/EUR 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10
Jan-06
Jan-08
Jan-10
Jan -12
Source: Thomson Financial Datastream, Reuters, HSBC
Cable vs forwards
USD/GBP 2.10 2.00 1.90 1.80 1.70 1.60 1.50 1.40 1.30 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Forward Forecast USD/GBP 2.10 2.00 1.90 1.80 1.70 1.60 1.50 1.40 1.30
Euro sterling vs forwards

GBP/EUR 1.00 0.95 0.90 0.85 0.80 0.75 0.70 0.65 0.60 0.55 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12
Forward
Forecast
GBP/EUR 1 .00 0 .95 0 .90 0 .85 0 .80 0 .75 0 .70 0 .65 0 .60 0 .55
Dollar yen vs forwards

JPY/USD 135 125 115 105 95 85 75 Jan-00 Jan-02 Jan-0 4 Jan-06 Jan-08 Jan-10 Ja n-1 2
Euro yen vs forwards

Forward Forecast
JPY/USD 135 125 115 105 95 85 75
JPY/EUR
175 165 155 145 135 125 115 105 95 85 Jan-00 Jan-02
Forward
Forecast
JPY/EUR
175 165 155 145 135 125 115 105 95 85
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
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Short rates
3 Month Money End period North America US (USD) Canada (CAD) Latin America Mexico (MXN) Brazil (BRL) Argentina (ARS)* Chile (CLP)* Western Europe Eurozone Other Western Europe UK (GBP) Sweden (SEK) Switzerland (CHF) Norway (NOK) EMEA Hungary (HUF) Poland (PLN) Russia (RUB)* Turkey (TRY) Ukraine (UAH) South Africa (ZAR) Asia/Pacific Japan (JPY) Australia (AUD) New Zealand (NZD) Asia-ex-Japan China (CNY) Asia ex-Japan & China Hong Kong (HKD) India (INR) Indonesia (IDR) Malaysia (MYR) Philippines (PHP) Singapore (SGD) South Korea (KRW) Taiwan (TWD) Thailand (THB) Notes: * 1-month money. Source HSBC 3.9 7.0 9.5 3.7 4.8 3.4 4.8 1.8 5.3 3.5 8.3 7.8 3.6 3.7 2.5 5.7 2.2 3.7 1.0 9.2 12.0 3.4 6.1 1.4 4.7 1.0 3.6 0.1 5.1 6.6 2.3 3.9 0.7 2.8 0.5 1.4 0.1 4.6 6.6 2.6 3.9 0.7 2.8 0.5 1.4 0.6 5.5 6.6 2.8 3.9 0.6 2.5 0.7 1.4 0.3 6.3 7.0 2.9 4.5 0.4 3.1 0.7 1.7 0.3 6.2 7.6 2.9 5.0 0.7 3.3 0.7 2.2 0.3 6.0 7.1 2.9 5.3 0.8 3.6 0.7 2.3 0.3 6.4 7.3 2.9 5.3 0.8 3.8 0.7 2.3 0.3 6.8 7.3 2.9 5.3 0.9 3.8 0.9 2.3 0.5 7.0 7.3 2.9 5.3 1.0 4.1 1.0 2.3 1.8 3.3 1.7 1.7 1.7 1.7 1.7 1.7 1.7 1.7 1.7 1.7 0.4 6.5 7.7 0.6 7.3 8.9 0.6 4.1 6.0 0.3 4.1 3.0 0.2 4.4 2.8 0.2 4.9 3.3 0.2 4.9 3.3 0.2 4.9 3.3 0.2 5.0 2.7 0.2 4.9 2.7 0.2 5.1 2.9 0.2 5.2 3.3 8.1 4.2 6.5 17.6 7.6 9.2 7.6 5.1 6.3 16.0 6.6 11.3 10.0 5.8 20.6 15.5 20.0 11.4 6.2 4.2 6.6 7.5 16.1 7.1 5.5 4.0 4.2 7.6 8.0 6.5 5.3 3.8 3.4 7.7 5.6 6.6 5.4 3.7 4.0 7.5 5.5 6.6 5.4 3.7 7.0 7.5 9.0 6.6 5.4 4.3 7.5 7.8 8.0 6.6 5.4 4.2 8.0 8.1 7.0 6.6 5.6 4.8 8.0 8.5 7.0 6.6 6.2 4.7 7.8 9.0 9.0 6.6 7.2 12.8 7.1 5.0 3.7 5.3 3.3 2.1 3.9 7.3 11.2 10.0 7.1 4.6 5.9 4.7 2.6 5.9 8.2 13.0 17.1 8.5 2.9 2.8 2.5 0.6 4.0 4.6 8.7 10.4 1.8 0.7 0.6 0.5 0.3 2.2 4.6 9.1 9.1 1.2 0.6 0.6 0.5 0.2 2.3 4.5 10.8 9.1 1.9 0.7 0.7 0.6 0.1 2.8 4.6 10.7 9.2 4.0 0.8 0.7 1.0 0.2 2.6 4.6 10.8 9.5 5.0 0.9 0.8 1.8 0.2 2.6 4.8 11.9 9.6 5.8 1.3 0.7 2.0 0.3 2.7 4.8 12.8 9.7 6.5 1.5 0.8 2.4 0.2 2.9 5.0 12.7 9.7 7.0 1.8 0.7 2.5 0.2 3.3 5.2 12.7 9.6 7.0 2.0 0.9 2.7 0.2 3.4 5.3 4.2 4.7 4.5 1.4 1.9 0.3 0.5 0.3 0.4 0.5 0.8 0.3 1.2 0.3 1.2 0.3 1.2 0.3 1.2 0.3 1.5 0.3 1.9 2006 2007 2008 Q4 Q4 Q4 2009 Q4 Q1 2010 Q2 Q3 Q4 Q1f 2011 Q2f Q3f Q4f
Important note
This table represents three-month money rates. These rates may not give a good indication of policy rates.
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Emerging markets forecast table

14-Jul-11 last 2010 Q1 x x Q2 x Q3 x Q4 x 2011 Q1 x Q2 x Q3f x Q4f x 2012 Q1f x Q2f x
Latin America vs USD

Argentina (ARS) Brazil (BRL) Chile (CLP) Mexico (MXN) Columbia (COP) Peru (PEN) Venezuala (VEF)
4.12 1.57 463 11.69 1760 2.74 4.29
3.87 1.78 525 12.36 1920 2.87 4.30
3.93 1.80 546 12.89 1917 2.83 4.30
3.96 1.69 484 12.62 1799 2.80 4.30
3.97 1.67 468 12.36 1920 2.81 4.30
4.06 1.63 478 11.89 1872 2.80 4.30
4.11 1.56 467 11.71 1769 2.76 4.30
4.12 1.54 475 11.45 1750 2.73 4.30
4.15 1.52 480 11.30 1750 2.72 4.30
4.25 1.52 485 11.30 1750 2.71 4.30
4.34 1.52 490 11.30 1750 2.70 4.30
Eastern Europe vs EUR

Czech Republic (CZK) Hungary (HUF) Russia vs USD (RUB) 24.41 269 28.05 25.41 266 29.36 25.69 285 31.20 24.57 277 30.40 25.09 278 30.48 24.56 266 28.43 24.33 266 28.08 24.20 260 30.20 24.00 255 30.80 23.80 255 28.40 23.70 260 30.80
Rom anian (RON) Turkey vs USD (TRY)

S im ple rate
4.28 1.64 4.03
4.09 1.52 3.86
4.15 1.59 4.14
4.25 1.45 3.98
4.28 1.54 3.96
4.12 1.55 4.03
4.05 1.62 3.98
4.10 1.65 3.95
4.05 1.55 3.90
4.00 1.55 3.85
3.95 1.50 3.80
Poland (PLN)
Middle East vs USD

Egypt (EGP) Israel (ILS)
x 5.96 3.44
x 5.48 3.80
x 5.50 3.85
x 5.71 3.75
x 5.70 3.57
x 5.90 3.56
x 6.00 3.50
x 6.00 3.45
x 6.00 3.40
x 6.10 3.38
x 6.25 3.35
Africa vs USD
South Afric a (ZAR) Interest rates 6.84 7.34 6.90 7.67 7.14 6.97 0.00 6.62 0.00 6.76 0.00 6.78 0.00 6.90 0.00 6.80 0.00 6.80 0.00 6.80 0.00
Source: HSBC
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Exchange rates vs USD

end period
Americas x x x x Western Europe Other Western Europe x x x x Emerging Europe x x x x Asia/Pacific x x x North Asia x x x x South Asia x x x x x Africa x x Canada (CAD) Mexico (MXN) Brazil (BRL) Argentina (ARS) x Eurozone (EUR*) x UK (GBP*) Sweden (SEK) Norway (NOK) Switzerland (CHF) x Russia (RUB) Poland (PLN) Hungary (HUF) Czech Republic (CZK) x Japan (JPY) Australia (AUD*) New Zealand (NZD*) x China (CNY) Hong Kong (HKD) Taiwan (TWD) South Korea (KRW) x India (INR) Indonesia (IDR) Malaysia (MYR) Philippines (PHP) Singapore (SGD) Thailand (THB) Vietnam (VND) x South Africa (ZAR) 2007 Q4 0.99 10.92 1.77 3.15 x 1.46 x 1.99 6.46 5.43 1.13 x 24.5 2.46 173 18.2 112 0.88 0.77 x 7.31 7.80 32.4 936 x 39.4 9393 3.31 41.3 1.44 33.7 16217 x 6.83 x 9.25 x 48.6 11027 3.46 47.5 1.43 34.9 16900 x 7.36 x 6.82 7.75 32.9 1263 x 46.4 9425 3.42 46.5 1.41 33.3 18200 x 7.34 x 29.4 2.96 191 19.3 91 0.70 0.58 x 6.83 7.80 32.1 1166 x 44.8 9090 3.26 45.2 1.40 32.3 19050 x 7.67 x 1.44 7.91 7.00 1.06 x 30.2 2.86 188 18.4 93 0.90 0.73 x 6.83 7.80 31.8 1133 x 46.4 9060 3.24 46.4 1.40 32.4 19000 x 6.97 x 1.39 x 1.61 7.14 5.78 1.03 x 29.4 2.85 196 18.8 93 0.92 0.71 x 6.78 7.80 32.3 1223 x 44.6 8925 3.09 43.9 1.31 30.4 19475 x 6.62 2008 Q4 1.23 13.81 2.31 3.45 x 1.43 x 1.52 7.20 5.94 1.05 x 31.2 3.38 233 21.0 88 0.84 0.69 x 6.69 7.80 31.2 1140 x 44.7 9010 3.08 43.6 1.28 30.1 19498 x 6.76 2009 Q4 1.05 13.08 1.74 3.80 x 1.35 x 1.50 7.78 6.50 1.08 x 30.4 2.91 203 18.0 84 0.97 0.74 x 6.59 7.80 30.4 1121 x 44.5 8708 3.03 43.5 1.26 30.2 20880 x 6.78 2010 Q1 1.01 12.36 1.78 3.87 x 1.22 x 1.58 6.73 5.86 0.98 x 30.5 2.95 207 18.7 81 1.03 0.78 x 6.55 7.80 29.4 1097 x 44.7 8577 3.02 43.3 1.23 30.7 20500 x 6.90 Q2 1.06 12.89 1.80 3.93 x 1.37 x 1.57 6.72 5.81 0.93 x 28.4 2.84 187 17.3 83 1.03 0.76 x 6.46 7.80 28.7 1067 x 43.5 8400 2.91 41.8 1.24 29.2 21500 x 6.80 Q3 1.03 12.62 1.69 3.96 x 1.34 x 1.60 6.31 5.53 0.91 x 28.1 2.75 183 16.8 81 1.07 0.83 x 6.40 7.80 28.5 1080 x 42.0 8300 2.88 41.0 1.23 28.6 21500 x 6.80 Q4 0.99 12.36 1.67 3.97 x 1.42 x 1.61 6.31 5.37 0.84 x 30.2 2.78 183 17.0 80 0.95 0.79 x 6.35 7.80 28.0 1070 x 42.0 8300 2.85 40.5 1.22 28.0 21500 x 6.80 2011 Q1 0.97 11.89 1.63 4.06 x 1.45 x 1.65 6.27 5.35 0.85 x 30.8 2.71 177 16.7 80 0.95 0.79 x 6.30 7.80 27.7 1060 x 42.0 8300 2.82 40.0 1.21 27.5 21500 Q2 0.97 11.71 1.56 4.11 x 1.42 x 1.66 6.11 5.21 0.87 x 28.4 2.71 177 16.7 80 0.95 0.79 x 6.25 7.80 27.4 1050 Q3f 0.95 11.45 1.54 4.12 x 1.44 x 1.66 6.04 5.17 0.90 x 30.8 2.71 177 16.7 80 0.90 0.79 Q4f 0.97 11.30 1.52 4.15 x 1.44 x 1.66 6.04 5.14 0.92 2012 Q1f 1.00 11.30 1.52 4.25 x 1.44 Q2f 1.00 11.30 1.52 4.34
Source: HSBC
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Exchange rates vs EUR & GBP

end period
Vs euro Americas x x Europe x x x x x x x x Asia/Pacific x x x Vs sterling Americas x x Europe x x x x x Asia/Pacific x x x x x US (USD) Canada (CAD) x UK (GBP) Sweden (SEK) Norway (NOK) Switzerland (CHF) Russia (RUB) Poland (PLN) Hungary (HUF) Czech Republic (CZK) x Japan (JPY) Australia (AUD) New Zealand (NZD) x x US (USD) Canada (CAD) x Eurozone (EUR) Sweden (SEK) Norway (NOK) Switzerland (CHF) x Japan (JPY) Australia (AUD) New Zealand (NZD) 2007 Q4 2008 Q4 2009 Q4 2010 Q1 Q2 Q3 Q4 2011 Q1 Q2 Q3f Q4f 2012 Q1f Q2f
1.46 1.44 0.73 9.45 7.94 1.66 35.9 3.60 253 26.6 x 163 1.67 1.90 x x 1.99 1.96 x 0.73 12.86 10.81 2.25 x 222 2.27 2.59
1.39 1.72 0.97 10.99 9.73 1.48 40.8 4.12 266 26.8 x 126 1.99 2.38 x x 1.44 1.77 x 0.97 11.37 10.07 1.53 x 130 2.06 2.46
1.43 1.50 0.89 10.24 8.29 1.48 43.4 4.11 270 26.4 x 134 1.60 1.97 x x 1.61 1.69 x 0.89 11.53 9.33 1.67 x 150 1.80 2.22
1.35 1.37 0.89 9.74 8.03 1.42 39.7 3.86 266 25.4 x 126 1.47 1.91 x x 1.52 1.54 x 0.89 10.92 9.00 1.60 x 142 1.65 2.14
1.22 1.30 0.82 9.53 7.97 1.32 38.2 4.14 285 25.7 x 108 1.45 1.78 x x 1.50 1.59 x 0.82 11.64 9.73 1.61 x 132 1.77 2.18
1.37 1.40 0.87 9.19 7.99 1.33 41.5 3.98 277 24.6 x 114 1.41 1.86 x x 1.58 1.62 x 0.87 10.61 9.23 1.54 x 132 1.63 2.14
1.34 1.33 0.86 9.02 7.80 1.25 40.9 3.96 278 25.1 x 109 1.31 1.72 x x 1.57 1.56 x 0.86 10.53 9.10 1.46 x 127 1.53 2.00
1.42 1.38 0.89 8.95 7.85 1.30 40.3 4.03 266 24.6 x 118 1.37 1.86 x x 1.60 1.56 x 0.89 10.11 8.87 1.47 x 133 1.55 2.10
1.45 1.40 0.90 9.15 7.78 1.22 40.7 3.98 266 24.3 x 117 1.35 1.76 x x 1.61 1.55 x 0.90 10.13 8.61 1.35 x 130 1.50 1.94
1.42 1.35 0.86 8.90 7.60 1.20 42.9 3.95 260 24.2 x 114 1.49 1.80 x x 1.65 1.57 x 0.86 10.33 8.82 1.39 x 132 1.73 2.09
1.44 1.40 0.87 8.80 7.50 1.25 44.4 3.90 255 24.0 x 115 1.52 1.82 x x 1.66 1.61 x 0.87 10.12 8.63 1.44 x 133 1.74 2.10
1.44 1.44 0.87 8.70 7.45 1.30 40.9 3.85 255 23.8 x 115 1.52 1.82 x x 1.66 1.66 x 0.87 10.01 8.57 1.50 x 133 1.74 2.10
1.44 1.44 0.87 8.70 7.40 1.32 44.4 3.80 260 23.7 x 115 1.60 1.82 x x 1.66 1.66 x 0.87 10.01 8.51 1.52 x 133 1.84 2.10
Source: HSBC
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Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: David Bloom, Clyde Wardle, Robert Lynch, Paul Mackel, Stacy Williams, Perry Kojodjojo, Marjorie Hernandez, Mark McDonald, Murat Toprak and Daniel Hui
Important Disclosures
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Additional disclosures
1 2 3
This report is dated as at 14 July 2011. All market data included in this report are dated as at close 13 July 2011, unless otherwise indicated in the report. HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner.
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Disclaimer
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Recipients in Singapore should contact a "Hongkong and Shanghai Banking Corporation Limited, Singapore Branch" representative in respect of any matters arising from, or in connection with this report. HSBC Mxico, S.A., Institucin de Banca Mltiple, Grupo Financiero HSBC is authorized and regulated by Secretara de Hacienda y Crdito Pblico and Comisin Nacional Bancaria y de Valores (CNBV). HSBC Bank (Panama) S.A. is regulated by Superintendencia de Bancos de Panama. Banco HSBC Honduras S.A. is regulated by Comisin Nacional de Bancos y Seguros (CNBS). Banco HSBC Salvadoreo, S.A. is regulated by Superintendencia del Sistema Financiero (SSF). HSBC Colombia S.A. is regulated by Superintendencia Financiera de Colombia. Banco HSBC Costa Rica S.A. is supervised by Superintendencia General de Entidades Financieras (SUGEF). Banistmo Nicaragua, S.A. is authorized and regulated by Superintendencia de Bancos y de Otras Instituciones Financieras (SIBOIF). The document is intended to be distributed in its entirety. Unless governing law permits otherwise, you must contact a HSBC Group member in your home jurisdiction if you wish to use HSBC Group services in effecting a transaction in any investment mentioned in this document. HSBC Bank plc is registered in England No 14259, is authorised and regulated by the Financial Services Authority and is a member of the London Stock Exchange. (070905) Copyright. HSBC Bank plc 2011, ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of HSBC Bank plc. MICA (P) 208/04/2011 and MICA (P) 040/04/2011
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52
Main Contributors
David Bloom Global Head of FX Research +44 20 7991 5969 david.bloom@hsbcib.com David is Global Head of FX Research for HSBC. He has been with the Group since 1992. Before taking up his current post, specialising in currencies and market strategies, David was the US economist for the Bank. He also has work experience within equity markets and analysing the UK economy.
Paul Mackel Director of Currency Strategy +44 207 991 5968 paul.mackel@hsbcib.com Paul is a senior currency strategist covering the G10 currency markets. He joined HSBC in June 2006 and is based in London, working alongside David Bloom. Prior to joining HSBC, Paul worked in a similar role for other financial institutions.
Stacy Williams Head of FX Quantitative Strategy +44 20 7991 5967 stacy.williams@hsbcgroup.com Stacy is responsible for FX quantitative research, advising the global client base on the development of currency overlay programs and the construction of bespoke hedging strategies. He is also responsible for proprietary model trading systems and developing the banks academic collaborations, principally with the University of Oxford, where he read physics.
Mark McDonald FX Quantitative Strategist +44 20 7991 5966 mark.mcdonald@hsbcib.com Mark is a quantitative FX strategist based in London. He joined HSBC in 2005. Before joining the company, he obtained a DPhil from Oxford University, researching in collaboration with the HSBC FX Strategy team. Mark has an MPhys in Physics, also from Oxford University.
Daniel Hui FX Strategist, Asia +852 2822 4340 danielpyhui@hsbc.com.hk Daniel is a Hong Kong-based FX strategist covering Asia. Prior to joining HSBC in 2007, he worked as an economist covering Southeast Asia and Greater China. Daniel received his masters degree from Johns Hopkins University, with a concentration in international economics and Asian economic development.
Perry Kojodjojo FX Strategist, Asia +852 2996 6568 perrykojodjojo@hsbc.com.hk Perry joined HSBC in 2005 as part of the global FX strategy team. He is based in Hong Kong and covers Asia. Perry received his masters degree in finance from Imperial College London.
Robert Lynch Head of G10 FX Strategy, Americas +1 212 525 3159 robert.lynch@us.hsbc.com Robert is the Head of G10 currency strategy for HSBC in New York. He has over 10 years of experience as a currency analyst and, in conjunction with the rest of the FX Strategy group, is responsible for helping to formulate the FX Strategy groups views and forecasts for major currencies.
Clyde Wardle Emerging Markets Currency Strategist +1 212 525 3345 clyde.wardle@us.hsbc.com Clyde is a New York-based emerging markets currency strategist, focusing mainly on Latin America. He also provides emerging market risk management advice to HSBCs global client base. He has been with the bank for eleven years.
Marjorie Hernandez FX Strategist, Latin America +1 212 525 4109 marjorie.hernandez@us.hsbc.com Marjorie is a New York-based FX strategist covering Latin America. She was formerly part of HSBCs global emerging market research team as an economist focusing on the Andean region. She joined HSBC in 2005.

HSBC Euro Break

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HSBC Euro Break

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Currency

Macro Currency Strategy July 2011

GBP: between a rock and a hard place

Macro Currency Strategy July 2011

EUR and CHF: Where core EUR might have been

Will a new tax holiday boost the USD?

NOK has beauty, but not everyone sees it

Macro Currency Strategy July 2011

12 months 1.405 87.85 1.664 0.986 0.988 0.752

1.429 83.14 1.628 0.968 1.043 0.774

Macro Currency Strategy July 2011

GBP between a rock and a hard place

110 105 100 95 90 85 80 75 70

Macro Currency Strategy July 2011

Arise Sir Sterling!...Not...

GBPs diffusion illusion

25 . 0 M a y-0 9 S e p -09 J an -1 0 M a y-1 0 S e p -1 0 J an -1 1 M ay -11

Source: HSBC, Bloomberg

Macro Currency Strategy July 2011

3. US and UK activity surprise indices trending down

4. US and UK inflation surprises trending up

60.0 -25.0 50.0

-40.0 -50.0 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11

Source: HSBC, Bloomberg

Source: HSBC, Bloomberg

Flip flopping on UK interest rates

5. The market is no longer expecting BoE rate increases this year

0.5 Jan-11 Feb-11 Mar-11 Apr-11 May -11

Source: HSBC, ICAP, Bloomberg

Macro Currency Strategy July 2011

6. Interest rate differentials suggest GBP-USD should be lower

1.42 Aug-10 O ct-10 Dec-10 Feb-11 A pr-11 Jun-11

GBP is not immune to Eurozone concerns

Macro Currency Strategy July 2011

Ireland 30 118 10 14 135 51 462

Spain 141 182 18 107 47 709

Italy 393 163 31 18 66 37 867

BRICs Eurozone EU-27

17.5 125.4 141.8

6.6 47.3 53.5

Macro Currency Strategy July 2011

What could see GBP escape the trap?

Macro Currency Strategy July 2011

EUR and CHF: where core EUR might have been

Currency performance is the key

1. ECB and SNB policies have historically moved together

EUR and CHF Policy Rates

Source: Bloomberg, HSBC

Macro Currency Strategy July 2011

2. Swiss and Eurozone inflation has diverged

Swiss and Eurozone Inflation YoY Swiss Eurozone

% y-o-y 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0

3. EUR-CHF stability broke down in 2010

Source: Bloomberg, HSBC

Macro Currency Strategy July 2011

100% 90% 80% 70% 60% 50% 40% 30% Jun-99

EUR-USD and USD-CHF - 6m rolling correlation

100% 90% 80% 70% 60% 50% 40% 30% Jun-11

Source: Bloomberg, HSBC

Monetary Conditions Index

5. EUR-CHF implied volatility is now above the European average

Macro Currency Strategy July 2011

6. Swiss monetary conditions have tightened sharply because of currency appreciation