MONTHLY Markets Adjust to FX OUTLOOK Reality of Lower ... · services group headquartered in Mexico and operating throughout Latin America, the US and Europe. As well as being one

MONTHLYFX OUTLOOKJune 2014

Markets Adjust toReality of LowerInterest Rates andSlower Growth for theLongrun

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Financial Markets ResearchEimear Daly - Head of Market Analysis

ABOUT MONEX

MONEX MONTHLY FX OUTLOOK 11 JUNE 2014 1 of 16

Monex Europe - Europe’s leading commercial foreignexchange specialist.

Based in the heart of the City of London, Monex Europeprovides confidential, same day spot and forwardforeign exchange contracts to a client base of FTSE-listed companies, large corporations, SMEs and financialinstitutions.

As a specialist foreign exchange company, our clientsbenefit from the highest quality of service, speed andflexibility. We couple this with the scale of a bank,which enables us to meet any FX need and constantlyexceed your expectations.

Monex Europe is the European arm of Monex Holding(also known as Monex Group), a global financialservices group headquartered in Mexico and operatingthroughout Latin America, the US and Europe.

As well as being one of the world’s largest commercialforeign exchange providers, Monex Group is also one ofthe most dynamic and fastest growing financial servicescompanies. Monex Group is listed on the Mexican stockexchange (BMV: MONEXB).

Monex Group is authorised to act in Mexico as a bank,broker dealer, mutual fund company and financialgroup; in the US as a broker dealer, investment advisorand money transmitter licensed to act in all states; andin the UK as a payment institution. The Group is afinancially regulated entity in all the countries in whichit operates.

EIMEARDALYHead of Market Analysis atEurope’s leadingcommercial foreignexchange broker,responsible for the tradingstrategy of over $125bn inFX turnover with a proventrack record of forecasting

accuracy. A familiar face to many as a regular onfinance TV including Bloomberg, CNBC and SkyNews and the go-to commentator for insight intothe G10 FX and money market space. Previouslypolled “fifth most accurate forecaster of G10 FX” byBloomberg, number three for euro-dollarforecasting and number seven for sterling-dollar.Appeared as FX Week’s number one forecaster forone month ahead and quarterly forecastingaccuracy.

RATINGS/AWARDS

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Source: Bloomberg as at 31 December 2013

CONTENTS3 Introduction

4 Sterling

7 Dollar

10 Australian Dollar

13 Realised Volatility

14 Market Positioning

15 Directory & Disclaimer

17 Contact



INTRODUCTIONA graph of the Federal Reserve benchmark Fed Fundsrate is a broad downtrend across its 33 year history. It isthe exact same story for the Bank of England interestrate, the Bank of Canada overnight lending rate and theRBA’s cash target rate. A series of downturns have beenfought with lower looser monetary policy but each timethe benchmark policy rate was never returned to pre-crisis levels. The developed world is slowing andbecoming ever more dependent on debt. This isnecessitating central banks to maintain ever lowerinterest rates just to support growth.

The Federal Reserve and Bank of England has bothintroduced outright guidance that when rateseventually do rise, the increase will be gradual and thetermination rate lower than the historical norm. Wheninterest rates should be based purely on the evolutionof the economy, particularly the trade-off betweeninflation and unemployment, we question how centralbanks can make this promise. The statement is justifiedby the reality that we are entering a slower growth era.It is now six years since the Great Financial Crisis andthe US is barely breaking 2% annualised growth. The UKjust reached the 3% annualised level but fundamentalweakness suggests slower growth may be on the futurehorizon. In the crises of the early 90’s and early 2000’s,the US economy was back growing at 3%-4% annualisedrate within 2 years of growth hitting its trough. For theUK, the economy managed to break above the 3%growth threshold within only 6 quarters of growthbottoming. This time around it took the UK sixteenquarters to scrape the 3% annualised output growth.

This has been an extremely slow recovery and whilethere is evidence of spare capacity across developedworld labour markets, the longer that spare capacityremains the more potential output is permanently lost.The longer the US grows at just 2% the harder it is tooargue that this is part of the recovery and not trendgrowth.

Global financial markets have been perplexed by the“goldilocks” era in financial markets – an equities bullmarket at the same time as bonds outperform. Theglobal economy is certainly heading in the rightdirection just slowly, hence the S&P 500 nabbing a newrecord high with only a 0.5% daily increase. At the sametime bond markets are coming to grips with this newlower interest rates world where central banks willpermanently maintain lower benchmark rates to try tosustain growth in the developed world.

G10 currency markets are still waiting for the firstleading central bank to hike interest rates. The carrytrade currencies are dangerously supported onexpectations of further easing from both the Bank ofJapan and ECB and may well struggle if further easingdoesn’t materialise. The euro will continue to defy logicand trade not on monetary policy divergence oreconomics but on where the currency has been. Globalinvestors will continue to favour the Eurozone on cheapvaluations, high liquidity and now low borrowing costs.

STERLING MacroeconomyThe UK economy grew by 0.8% on the quarter in Q1,securing its place as the fastest growing economy inthe developed world. Despite the UK breaking into 3%annual growth rates, output growth underwhelmed theBoE’s estimates and actually represented a pause ineconomic growth. Forward looking indicators and initialreadings suggest the UK picked up pace further into thesecond quarter. This puts the UK on course to not onlymeet but overshoot its pre-crisis GDP peak in thesecond quarter.

UK Growth Outpaces All Other G10 Economies

Source: Bloomberg, as at 11/06/2014

Consumer spending continues to be the most resilientfactor powering growth in the UK, expanding by 0.8% inthe first quarter. The trend looks only to acceleratefurther, with retail sales up 7.7% annually in May, thefastest pace of growth since April 2002. The exuberancein retail sales exceeds the rates of spending seen in therun up to the 2008 crisis. The rise has not been drivenby improving real wages however, but debt. Householddebt was up 4.5% on the year in March, a worryingfigure considering real wages have effectively declinedover the last six years. Median household income isdown by 3.8% between 2007/2008 and 2011/12.UKhouseholds have made some attempt to deleveragesince 2008, but the dangerous combination of recordhigh consumer confidence and record low interest ratesmeans debt could soon start rising again. UK householddebt to GDP stood at 143.3% at the end of 2012,compared to 80.53% in the US and 64.88% in Greece.

Another area of concern is the UK’s bubbling housingmarket. Annual house prices pushed into double digitgains in March, while supply growth declined andhousing demand sees no signs of relenting. Theintroduction of the Mortgage Market Review istightening up mortgage criteria for UK citizens and wehave seen an immediate drop off in the number ofmortgage approvals and some wobbles in monthlyhouse price gains but reports on the ground aren’tseeing any slowdown in the housing market. MarkCarney ultimately pinpointed the problem when he

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highlighted the large proportion of cash buyers in themarket. A lot of the transactions are paid for with cashbalances held in overseas financial systems. The UKhousing market has gained a global safe haven statusand there are numerous geopolitical risks culminatingto trigger safe haven buyers, whether it is to do withthe Russian/Ukraine tensions, a slowing China, as wellas election risk in Brazil and Indonesia. While to someextent the BoE is powerless to stop the housing boom,they are not blameless. £375 billion in asset purchasespushed up asset prices across Britain, and were at leastin part responsible for the quick recovery seen in UKhouse prices.

The UK labour market has been one of the biggestindicators of the UK recovery. After introducing aforward guidance pledge to consider rate rises onceunemployment fell below 7% in the UK, the Bank ofEngland were forced to reword their guidance whenemployment growth outpaced their expectations. Theunemployment rate dropped a total of 1.0% from mid-2013 to March 2014. However there were signs thatspare capacity was hidden in the high level of self-employed and part-time workers. Self-employedworkers accounted for 14% of all jobs created during2013, and part-time workers 22%. Weak wage growthalso hints at internal weakness in the jobs market.

The UK is currently running on hot air, though we haveto admit there is some rebalancing and reformoccurring beneath the surface. The most impressivesigns of a fundamental recovery beneath the stimulusare the significant rise in investments through 2013. UKinvestment is up 11.7% since the beginning of 2013. Toput this in context, investment is up only 18.81% since ittroughed in 2009. The UK’s beleaguered manufacturingsector has also staged a recovery since early 2013.However this hasn’t materialised into a recovery inexports and a more sustainable trade balance. The UKcontinues to be a net debtor to the rest of the worldand spend beyond its means.


STERLING Monetary PolicyBank of England Governor Carney admitted theeconomy’s shortcomings in his May inflation report.Setting out economic goals in the press conference wasakin to recognising the current flaws. Carney forecastthe recovery moving from one begun on householdspending to one sustained on business investment,from employment growth to productivity growth thatwill improve export competitiveness and to targetingrising real wages. Carney underlined that he won’t takerisks with this recovery and will rebalance growth tobusiness investment, productivity and real wages thatwill sustain this recovery. This is perhaps one reasonwhy Carney pre-committed to “slow and gradual” raterises once they do occur; guaranteeing that the BoE willstay decisively behind the curve once the recoverystrengthens. Carney essentially knows that this recoverywill built on stimulus not on any fundamentaladjustment or rebalancing and is concerned that oncepolicy begins to tighten, the hot air will gush out,leaving a deflated UK economy with all the same flawsas before.

Low Interest Rates Provide Little Suppose to BusinessInvestment While Household Debt Rises

Series 1: Bloomberg 11/06/14. Series 2: Bank of England 11/06/14.

However, previous rhetoric from the Bank of Englandhas uncovered that the consensus view may not beunanimous. The minutes of the May MPC meetingrevealed that the decision on interest rates was “morebalanced” for some members and the realisation that“the more gradual the intended rise in Bank Rate, theearlier it might be necessary to start tightening policy.”The minutes hinted at growing divisions within thecommittee with a “range of views” around the degree ofslack in the economy. It wasn’t long after the releasebefore the first hawk, metaphorically, stood up. MartinWeale, an external member of the MPC, called for aninterest rate increase “sooner rather than later”,admitting that he was behind the statement in theminutes that “slow and gradual” rate rises meant rateshad to rise sooner. He also expressed drasticallydifferent view on the economy and monetary policy. Hesaw less than 0.9% spare capacity in the economy

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versus the BoE consensus of 1-1.5%. For him “gradual”rate rises meant no more than 25bp a quarter while themarket is pricing in only a 180 basis points increase inthe next three years. With this sharp division the firstvote for a rate hike will come by September at thelatest.

The reality is the UK is getting very little benefit fromultra-low interest rates. Loans to businesses were down-4.2% on the year in March and that pace of contractionhas barely improved from 2012. Despite this businessinvestment is up materially as businesses draw down oncash balances and banks buffer up to meet newregulations. Even the Bank of England can’t put theirfinger on the reasons behind this disparity. We have toask what the point of keeping borrowing costs at ultra-low levels is if it isn’t playing any part in rebalancingthrough investment but accelerating a build-up inhousehold debt and providing support for a bubblinghousing market. With core inflation back to target, theUK cannot be remiss to the inflationary risks of the £375billion in QE they implemented. The question perhapsneeds to be rephrased instead of asking why hike rateswe should be asking why keep them at record lows.

We are expecting the first rate hike in late 2014 to Q12015 as the growing financial instabilities and highnominal growth rates naturally cause more and moreMPC member to vote for rate increases.


STERLING OutlookSterling-dollar trades directly in line with the UK-US 2year yield differential. Sterling dollar price action iseffectively a tug of war between which central bank willhike interest rates first. With the UK reaching 3% annualgrowth rates and the US ambling along at just 2%, theBank of England is now the front-runner to hike. Thisexplains sterling’s persistent appreciation against thedollar since the new year. However, appreciation hasbeen slow, with volatility at record lows. One reason isthat we are effectively arguing over a mere 25basispoints hikes one year from now. The market is alsoextremely long the pound, meaning trade is susceptibleto short term shake outs as sterling looks set to reversea substantial part of its post-2008 correction lower.

Sterling-Dollar Trades In Line with Yield Differential


The biggest risks to a stronger sterling-dollar is asharper than expected rebound in the US economy andUS inflation fears pricing in earlier rate hikes. The ECBaggressively easing policy could also pose a threat toshort term sterling appreciation, although most of thisis likely to be played out in the euro-sterling cross. Wehave to balance these concerns against gaining UKgrowth and the natural calls for higher interest rates asa result. As such we believe the overall direction forsterling-dollar is higher. We forecast $1.69, $1.72, $1.74and $1.73 for Q2, Q3, Q4 2014 and Q1 2015 respectively.

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DOLLAR MacroeconomyThe US is rebounding nicely after the winter freeze. Surveymeasures of the manufacturing and services sectors pointto the industries compensating for the first quarter’soutright contraction into the second quarter. Investmenthas also revived with April durable goods orderscontinuing to expand after a sharp bounce back in March.Factory orders also suggest business is back to normalfollowing the unusually cold winter weather. Consumptionseems to be reining in after it carried the economy in thefirst quarter. The US is set to put in a strong second quarterbut underlying growth remains in the 2% annualised range,below the 3% figure the Fed wants and leaving theeconomy susceptible to unforeseen shocks.

US Tapering Had A Direct Impact on The HousingSector


There are pocketed areas of weakness within theeconomy, one of which being the housing market. FedChairman Yellen specifically singled out this sector in herrecent testimony and listed it as the one domestic risk togrowth, an unorthodox move for a Fed Chairman. TheFed’s tapering of its Mortgage Backed Securities purchasescaused a significant rise in yields, tightening mortgageconditions and availability across the US. Although the rateof mortgage foreclosures continues to fall, the level ofhouse purchases and refinancing has plunged since MBSyields moved higher back in May 2013. US residentialinvestment flatlined across the last two quarters. Decliningaffordability and the memory of 2008 means manyAmericans are wary of taking on debt. This also explainsthe prevalence of multi-family apartment units at theexpense of single family homes, as America opt for rentingas opposed to home ownership. Average house prices arestill 12% below their 2007 peak and the uptrend in annualhouse price growth now appears to have peaked. Theredoes appear to be some stabilisation in house purchases ata low level but realistically the housing sector cannot beexpected to recover much further or be a key driver of theUS economy going forward, considering where we havecome from. The Great Recession appears to have caused astructural shift in American living, away fromhomeownership and hefty mortgages.

The US unemployment rate has fallen rapidly, evensurpassing the Fed’s expectations and causing them torewrite their forward guidance in March 2014. However therapid decline in the headline figure is being driven by theunexplained drop off in participation. Some analysts offerup an aging population as an easy excuse for the falloff

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Single Family Homes Sold (YoY) MBA Refinancing Index

however the co-ordination between the sharp drop off inlabour market participation and the Great Recession seemstoo much of a coincidence. The changing age structure ofthe US should have decreased overall participation by 0.2-0.3% a year from 2008. That means, abstracting for theGreat Recession, the participation rate should have been64.3% - it is currently 62.8%. What is more, prior to 2008the participation rate of older workers was on apronounced uptrend, as a rising Social Security retirementage, reduced pension packages, improved health andlongevity meant older workers worked longer. An agingpopulation doesn’t account for the sharp increase in socialsecurity disability claimants or the rise in studentenrolment. In fact, the biggest declines in participationduring the crisis came from among the youngest agegroup. The fast pace at which the long-term employedhave found jobs in the recovery suggests the decline in theparticipation rate is, to a large degree, cyclical. This meansAmericans will return to the labour market once therecovery improves and current declines in theunemployment rate are misleading.

The pace of jobs growth has also not been stellar. Since2008, there have been only 6 months when the 12-monthmoving average of jobs gains has been above 200K, theFed’s target level. The first period was in early 2012 and inlate 2013. This highlights the short business cycles the USeconomy is subject to.

Declining global commodity prices sparked deflationaryfears at the start of the year, enough for the central bankto re-anchor their forward guidance to the inflationoutlook. Although headline inflation has remained belowthe Bank’s 2% level for most of 2013, inflation is now risingrendering previous deflation fears premature. A reboundin utility and energy prices as well as strengtheningdemand pushed the annual inflation rate back to the 2%target in April. The corresponding increase in the core ratesuggests that the rising price level isn’t just the result ofhigher energy prices due to the winter freeze. Previousimport price declines bottomed out in November and nowtheir negative effect is falling out of the inflationcalculation. Rising producer prices show price growth isrebounding as rising import prices squeeze manufacturers’margins, an impact that is being passed up through theprice chain to consumers.

The US economy is consistently described as “moderate”by officials and that in itself is the problem. There is nostrong drive behind this recovery and the stalling housingmarket and low levels of job market participation suggestthe economy is still embattled with problems from thesub-prime mortgage crisis. The shale gas boom andreduction in front loaded austerity will provide somemomentum but overall the US recovery lacks gusto. TheUS economy is heading in the right direction but issusceptible to unforeseen negative shocks. An inflationcomeback may mean policymakers have a limitedtimeframe to wait for growth to get into gear beforetightening policy.



DOLLAR Monetary PolicyThe unusual phenomenon of the US 10 year yield stuckat the 2.5% level has gained significant market attention.The reality is that the yield is tracking the outlook formonetary policy. The US 10 year yield fluctuated wildlylast year when the Fed suggested winding down theirasset purchases, as market expectations for imminentpolicy tightening greatly overshot the Fed’s intentions.Into 2014 US yields were pinned lower and manymarket participants got burned as Treasuriesoutperformed when the Fed went on a communicationdefensive. There are now three points to the FederalReserve’s forward guidance. The outlook for the FedFunds rate is data based, specifically relating to theoutlook for inflation and employment; the low level ofthe Fed Funds rate will be maintained for a considerableperiod after tapering ends, especially if inflation stillruns below target; and even when employment andinflation are near mandate levels, interest rates may stillneed to be below historically normal levels. Effectivelythe Fed still insists the interest rate is based on the databut the first rate hike has been pushed out and whenrates do rise the magnitude will be far less than thehistorical norm. This iron clad market communicationexplains the low volatility in the 10 year and the ratebumping along the bottom of a new lower range. Asthe Fed themselves’ have said when rates do rise, theterminal rate will be below normal level, closer to 2%than the historical norm of 4%.

Inflationary Pressures Re-emerge


The Fed’s staff projections continue to project a“moderate” recovery and a “gradual” improvement inthe labour market. This uninspiring outlook explains theFed’s forward guidance, as a failure of growth to moveinto a higher gear means the economy will requiremore support and for longer. Without acceleratinggrowth, the US economy won’t be ready for higherinterest rates until late 2015. The majority of Fed hawksaren’t calling for sooner rate hikes based on economicperformance but the risks of financial instability. Wewould argue a re-emergence of inflationary pressurewould also spark further calls for the first rate hike. Ourbaseline view is that the Fed will first hike the interestrate in Q3 2015, not based on economicoutperformance but concerns over inflation and assetbubbles. The Fed funds rate is likely to end 2015 at0.75%.

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Import Price(YoY) Core PCE (YoY)

DOLLAR OutlookThe underperformance of US yields is in line with theweaker dollar seen since February this year. The outlookfor the dollar is now heavily reliant on marketexpectations for the Fed Funds rate. Considering theFed tapered asset purchases at their March meetingwhen the US economy was undergoing a severecontraction, it shows that despite what the Fed says,tapering is on a pre-set course and it would takeeconomic Armageddon for it to miss a cut in assetpurchases.

Euro Weakness Is Dependent on the Return of aStronger Dollar


The Fed has already included a discussion of thetechnicalities of raising the Fed funds rate in its Marchminutes to little market reaction. This suggests thatafter the tapering hysteria of last year, dollar bulls arehesitant to get burned twice. While there is a generalconsensus that the dollar is undervalued, the dollarindex is only 19% below its long-term average.Considering the size of the Fed balance sheet and thefact that it’s still growing, this level is not unjustified.The dollar will only receive a slight lift on improvedeconomic data but overall it will take a clearer steer onthe first Fed funds hike to get dollar bulls back into themarket. The Fed may begin to include more guidanceon how rates will be raised and the projected outlookfor rate hikes into 2015, giving the dollar a long-awaitedleg higher.

A stronger dollar is extremely important for the euro asthe central bank struggles to set the common currencyon a lower trajectory. We believe a weaker euro-dollaris now in the hands of the Fed as the euro continues toattract capital inflow despite a raft of policy action fromthe ECB. We see euro-dollar moving higher in the nearterm as aggressive talk from the ECB and their firstventure into outright QE, albeit retroactively, continueto attract investment capital without the offsettingeasing. We see the dollar remaining range-bound overthe summer months around the $1.38 level, ending theyear around $1.39/1.40 level. Euro-dollar will break clearabove $1.40 into Q1, ending the three months around

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EUR/USD USD Index

$1.41. The dollar should make a comeback into mid2015 as the Fed begins to lay out their plans for hikingthe Fed Funds rate. Euro-dollar is likely to approach$1.38 by mid-year.


AUSTRALIAN DOLLAR MacroeconomyThe Australian economy didn’t implode in 2014 despiteconsensus views that a slowing China and a peakingmining investment boom would prove a lethalcombination for the economy. In fact growth picked upsince late 2013, bolstered by strong exports, risingconsumption and dwelling investment. Employmentgrowth surged with the unemployment rate finallyfalling in March after been on an upward trajectorysince early 2012. Despite concerns that a weaker Aussiedollar and the lowest level of interest rates on recordwould stoke inflation, annual price growth was less thanmarkets expected leaving the rate just within the RBA’starget range.

Moderating Housing Sector Growth


Australia’s exports have remained resilient despite aslowing China and further deterioration in the country’sterms of trade. Quarterly export growth has averaged1.34% in the last two years, higher than the 10 yearaverage of 1.0%. Australia’s trade surplus with Chinaeven increased in March, though it remained belowlevels seen in late 2013. A surge in exports to Japan inMarch ahead of the nation’s sales tax hike helped tobolster exports growth. Declines in the annual exportgrowth are worrying signs that the economy will beunable to sustain its rate of exports as China slows orstabilises. The deviation between the value and volumeof Australia’s commodity exports suggests the decline interms of trade is already having adverse effects. Thuswhile export growth remains resilient, we cannot expectthe sector to continue to be an area of growth in future.

Recent indicators suggest some of the air is being letout of Australia’s bubbly housing market. Monthlybuilding approvals fell -5.4% in February and continuedto decline in March. The official measure of houseprices fell sharply in Q1 and a fall in annual loan growthsuggest the downturn could continue. While thesedevelopments show macro-prudential measures arehaving some affect and will ease concerns of financialinstability, it also means housing will be one less sectorto offset the peaking mining investment boom. Despite

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Series 1(House Price (QoQ))

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ultra-low interest rates, non-mining investment has stillfailed to counterbalance the decline in resource sectorinvestment.

Employment growth has put in a spectacularperformance since the start of the year. The economycreated 106.5 thousand jobs in the year to date, leadingto the biggest single drop in the unemployment rate inMarch since late 2010. This corresponded with anincrease in labour participation, which had been on abroad down trend since mid-2010. We are seeing theevolution of a two tier labour market in Australiabetween part-time and full-time workers. Part-timeworkers have accounted for 26% of all jobs created yearto date. The pace of jobs growth will also be unable tokeep pace with the influx of immigrants into theeconomy, suggesting labour force participation willcontinue to decline and there will be limited pressureon wage growth as increased supply outstrips demand.Australia’s wage cost index has declined steeply sinceQ4 2012, illustrating the significant spare capacity in theeconomy despite the stronger growth in the last twoquarters.

We view Australia’s recent budget as a positive for thenation’s long-term growth. The austerity budget doesnot prescribe front-loaded austerity but medium-termconsolidation. As Treasurer Hockey noted the budgetends the “corporate welfare system” by abolishingindustry assistance programmes worth $845 million.This is balanced by abolishing carbon and mining taxes,reducing the tax burden by 1.5% for 800,000companies. The treasury is cutting government outlayswhile increasing spending on investment with long-term benefits. What it means for Australians’ wallet is anincrease in the top marginal rate of income tax by 2%for people earning more than A$180,000. Eligibilitycriteria will also be applied to state pensions, based onasset holdings and income test thresholds. Consumerconfidence survey figures immediately fell in theaftermath of the budget suggesting a short-termdownturn in consumption is likely. However this budgetimplies a light fiscal drag and overall reinforces thefiscal sustainability of the government and its triple Arating. The budget should return Australia to having thelowest debt level in the G10.



AUSTRALIAN DOLLAR Monetary PolicyMarket expectations for the RBA’s next policy movehave swung wildly since the beginning of the year asemployment growth outpaced expectations and theweaker Aussie dollar stoked inflation concerns. Marketsmoved from pricing in further cash rate cuts at the startof the year to pricing in rate hikes as inflation risk tookcentre stage and robust economic growth allied fears ofa long-term downtrend. First quarter inflation printingbelow consensus in April instantly priced out some hikeexpectations, though the Aussie bond market suggests17 basis points of rate hikes over the next two years arestill priced in.

Australian Inflation is a Balancing Act of DomesticDeflation Pressures and Imported Inflation


Australian inflation is a confluence of factors. Theweaker Aussie dollar is exacerbating inflationarypressures, evident in 3.3% increase in tradable inflationsince mid-2013. In contrast, non-tradable inflation,which reflects domestic inflationary factors alone, hasfallen 1.2% since mid-2013 as economic slack,

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particularly in the labour market, presses down on pricegrowth. This has led to a relative tug of war which hasleft inflation rates within the RBA’s target range. Withthe Aussie’s exchange rate stabilising since August, theinflationary effect of a weaker Aussie dollar shouldbegin to fall out of the annual calculation fromSeptember, revealing a much weaker underlyinginflation rate.

We maintain that at this juncture the RBA is more likelyto ease than hike. There are significant threats toAustralia’s economic outlook emanating from China,lower global commodity prices and a peaking mininginvestment boom. Considering the positive evolution ofhousing sector imbalances and the softer outlook forinflation, the RBA lacks an economic case to hike rates.A weaker Chinese yuan gives the RBA another reason tokeep policy on hold, to try to retain its competitivenessto the Chinese market.

Our base scenario remains that the RBA will keep policyon hold given that it currently doesn’t have theeconomic case to lower rates either. However we don’tsee the RBA hiking rates until Q1 2016, making it one ofthe last G10 central banks to hike.

AUSTRALIAN DOLLAR OutlookThe risks are lined up for the Aussie, the reality of aslower China, lower global commodity prices, the needto reinvent itself following the mining investment boomand the tail risk that the RBA could cut the cash targetgiven a deterioration in the growth outlook. Despite thiswe believe the near term direction of the AUD is higher.Simply put we are in a carry trade environment and theAussie is triple A carry. Investors are prepared tooverlook any fundamental flaws for the high yield theAussie offers. Aussie has the other benefit of one of thefew triple A currency which is reinforced by the recentTreasury budget.

AUD Remains Supported in the Current CarryEnvironment


The Aussie dollar is up 5.53% since the beginning ofFebruary, in line with a recovery in a number of carrycurrencies including the Brazilian real, Turkish lira andSouth African rand. The Aussie’s oblivion tofundamentals is further reinforced by a recentdecoupling from the China trade. The Aussie wastraditionally how investors took on exposure to China,as close trade links meant the Aussie dollar waseffectively a freely floating Chinese yuan. The Aussienow appears to be impervious to the China risk asevidenced by a breakdown in the correlation betweenAUDUSD and copper. We believe the Aussie dollar willcontinue to find support until an external factor puts anend to the current carry trade environment. Twopossible catalysts include expectations for tighter USmonetary policy or the ECB failing to announce QE. Thetimeline of markets returning to the carry trade asspeculation of ECB QE first emerged suggest ECB assetpurchases may have directly addressed investors’ fearsabout a slowdown is US asset purchases.

We see the Aussie trading to $0.94 by the end of Q2.The currency will likely come under pressure throughthe rest of the year as either one of the two scenariosevolve. AUDUSD will trade towards $0.88, $0.86 and$0.85 by the end of Q3, Q4 and Q1 respectively.

May 2011 May 2012 May 2013 May 2014

0.80

0.85

0.90

0.95

1.00

1.05

1.10

0.40

0.45

0.50

0.55

0.60

0.65

Series 1(AUDUSD) Series 2(BRLUSD) Series 3(TRYUSD)


REALISED VOLATILITY


EUR/USD

Jun 2012 Sep 2012 Dec 2012 Mar 2013 Jun 2013 Sep 2013 Dec 2013 Mar 2014 Jun 2014

1.20

1.22

1.24

1.26

1.28

1.30

1.32

1.34

1.36

1.38

1.40

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

9.00

9.50

10.00

CAD/USD


0.96

0.98

1.00

1.02

1.04

1.06

1.08

1.10

1.12

1.14

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

GBP/USD


1.45

1.50

1.55

1.60

1.65

1.70

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

9.00

CHF/USD


0.86

0.88

0.90

0.92

0.94

0.96

0.98

1.00

5.00

6.00

7.00

8.00

9.00

10.00

11.00

12.00

NZD/USD


0.76

0.78

0.80

0.82

0.84

0.86

0.88

7.00

8.00

9.00

10.00

11.00

12.00

13.00

14.00

15.00

16.00

GBP/EUR


0.76

0.78

0.80

0.82

0.84

0.86

0.88

4.00

5.00

6.00

7.00

8.00

9.00

10.00

AUD/USD


0.86

0.88

0.90

0.92

0.94

0.96

0.98

1.00

1.02

1.04

1.06

6.00

7.00

8.00

9.00

10.00

11.00

12.00

13.00

14.00

15.00

JYP/USD


75.00

80.00

85.00

90.00

95.00

100.00

105.00

110.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

Realised volatility reflects the actual volatility derived from a time series of currency spot prices. The measure iscalculated using the annualised standard deviation of daily returns over a three month period.

– Currency (LHS) – Realised Volatility - 3 months (RHS)

Source: Bloomberg data as at 11.06.2014

MARKET POSITIONING


EUR/USD

Jun 2012 Dec 2012 Jun 2013 Dec 2013 Jun 2014

1.20

1.22

1.24

1.26

1.28

1.30

1.32

-250,000.00

-200,000.00

-150,000.00

-100,000.00

-50,000.00

0.00

50,000.00

100,000.00

CAD/USD


78.00

79.00

80.00

81.00

82.00

83.00

84.00

85.00

-20,000.00

-10,000.00

0.00

10,000.00

20,000.00

30,000.00

40,000.00

50,000.00

60,000.00

GBP/USD


1.53

1.54

1.55

1.56

1.57

1.58

1.59

1.60

1.61

1.62

1.63

-80,000.00

-60,000.00

-40,000.00

-20,000.00

0.00

20,000.00

40,000.00

60,000.00

CHF/USD


1.00

1.01

1.02

1.03

1.04

1.05

1.06

1.07

1.08

-40,000.00

-30,000.00

-20,000.00

-10,000.00

0.00

10,000.00

20,000.00

NZD/USD


0.97

0.98

0.99

1.00

1.01

1.02

1.03

1.04

1.05

1.06

-80,000.00

-60,000.00

-40,000.00

-20,000.00

0.00

20,000.00

40,000.00

60,000.00

80,000.00

100,000.00

120,000.00

GBP/EUR


0.02

0.02

0.02

0.02

0.02

0.02

0.02

0.02

0.02

0.02

-160,000.00

-140,000.00

-120,000.00

-100,000.00

-80,000.00

-60,000.00

-40,000.00

-20,000.00

0.00

20,000.00

40,000.00

AUD/USD


0.96

0.97

0.98

0.99

1.00

1.01

1.02

1.03

1.04

-80,000.00

-60,000.00

-40,000.00

-20,000.00

0.00

20,000.00

40,000.00

60,000.00

80,000.00

100,000.00

120,000.00

JYP/USD


0.75

0.76

0.77

0.78

0.79

0.80

0.81

0.82

0.83

0.84

-10,000.00

-5,000.00

0.00

5,000.00

10,000.00

15,000.00

20,000.00

25,000.00

30,000.00

35,000.00

The US Commodity Futures Trading Commission releases a snapshot of traders positioning on a weekly basis. Thenet non-commercial positioning provides a proxy for broader speculative activity in the FX market and as suchreflects market sentiment regarding individual currencies and can signal overstretched market positions.

– Currency (LHS) – Realised Volatility - 3 months (RHS)

Source: Bloomberg data as at 11.06.2014

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