240077

Currency
OUTLOOK
Macro Currency Strategy April 2009
QE, monetary conditions and the dollar

Our conclusion is that currencies of QE countries will tend to weaken against non-QE countries. However, we face a simple counter argument. This runs as follows QE countries will recover first and their currencies will rise. This view relies on the efficient and smooth running of capital markets, which is no longer the case. We would argue that the transmission mechanism has changed entirely. Policy makers are likely to err on the side of too much stimulus, rather than too little. Authorities will be more active in capital markets, possibly selling their equity stakes and controlling the rise in bond yields. Even if QE economies recover, it does not necessarily follow that their currencies will appreciate. FX Volumes down but not out There is much consternation in the FX market about the recent plunge measured in interbank volumes. Whilst customer volumes have definitely decreased a little, it is not on the same scale as the fall seen in the interbank market volumes. Those banks which have genuine customer business will be in the strongest position.
(pg 3)
Countries have varied widely in their views of the role of the currency in QE, but it is clearly part of the mechanism by which the policy is supposed to work. We review the policies being pursued in the QE countries, analyse possible future QE candidates and contrast this with countries that do not see QE as a necessary or appropriate policy.
The currency implications if QE works
Our conclusion that currencies of QE countries will tend to weaken against non-QE countries. However, we face a simple counter argument. This runs as follows QE countries will recover first and their currencies will rise. This view relies on the efficient and smooth running of capital markets, which is no longer the case. We would argue that the transmission mechanism has changed entirely. Policy makers are likely to err on the side of too much stimulus, rather than too little. Authorities will be more active in capital markets, possibly selling their equity stakes and controlling the rise in bond yields. Even if QE economies recover, it does not necessarily follow that their currencies will.
Gold investment robust but consumer demand crumbles (pg 16)

Gold prices are likely to remain volatile as investors assess the impact of the authorities efforts to combat the global recession. Ultimately we believe a lack of inflation will reduce the safe haven demand for gold.
FX Volumes down but not out
(pg 18)
There is much consternation in the FX market about the recent plunge measured in interbank volumes. Whilst customer volumes have definitely decreased a little, it is not on the same scale as the fall seen in the interbank market volumes. Those banks which have genuine customer business will be in the strongest position.
HSBC Volume-Weighted REERs
(pg 24)
It is common to look at Real Effective Exchange Rate (REER) indices when investigating changes in the value of a currency. These track the inflation-adjusted returns from being long a currency against a weighted basket of other currencies. The usual procedure is to weight the indices by trade weights. This is because the indices are often used to measure the likely impact of exchange rate moves on a countrys international trade performance.
The HSBC approach to REERs
Volumes of financial trade dwarf the volumes of physical trade. For this reason, the new HSBC VolumeWeighted REERs weight the basket by financial market volumes. We argue that if you are a financial market investor then the change in value of a currency you are likely to be exposed to is better represented by the new HSBC volume-weighted REERs than by traditional REERs.
Dollar Bloc
Canada QE a matter of time
(pg 33)
CAD is facing notable headwinds, and will continue to do so while the US economy continues to struggle. We acknowledge that the consolidation phase in USD-CAD could continue in the coming months, but view it as a prelude to an eventual break higher in the pair, not a precursor to a stronger CAD.
QE elsewhere helps the antipodeans

Australia a deserving case
The past month has seen AUD move higher on the back of risk appetite returning, but it is not known how long this sentiment will stay. Unlike most of the currencies benefiting from the change in market sentiment, Australias domestic situation warrants an appreciation in the AUD.
New Zealand regains some poise
The currency has bounced despite the domestic situation remaining relatively unchanged as the RBNZ struggles to release the economy from recession. When New Zealand is pulled out of recession, it will not be as fiscally stretched as others after riding on the coat tails of other G10 fiscal boosts.
Key events Date 10 April 15 April 21 April 22 April 23 April 25 April 29 April 30 April 4 May 5 May 5 May 7 May 7 May 13 May 14 May Central Bank policy rate forecasts Last USD EUR JPY GBP 0.00-0.25 1.25 0.10 0.50 May 09 (f) 0.00-0.25 1.00 0.00 0.50 August 09 (f) 0.00-0.25 0.75 0.00 0.50 Event Japan: BoJ publish minutes of 18 Mar meeting US: Fed release beige book Canada: BoC rate announcement UK: BoE to publish minutes of 8-9 April meeting EU: ECB Governing and General Council meeting Spring meeting of IMF and World Bank US: FOMC meeting & rate announcement New Zealand: RBNZ rate announcement EU: Eurogroup Finance Ministers meeting Australia: RBA rate announcement ECOFIN Council meeting UK: BoE MPC meeting & rate announcement EU: ECB rate announcement and news conference UK: BoE releases Quarterly Inflation Report EU: ECB publish monthly bulletin
Note: 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
Note: Consensus Forecasts February 2009
12 months 1.298 99.57 1.500 1.232 0.672 0.527
1.268 96.01 1.407 1.274 0.632 0.500

QE
We split our analysis into two parts. The first part is about QE itself and what policies are being adopted by different countries. The second part looks at the transmission mechanism of a possible QE recovery. In essence our conclusion is that currencies of QE countries will tend to weaken against non-QE countries. currencies of QE countries will tend to weaken against non-QE countries. We reiterate our view that the dollar will likely give back ground against the euro in coming months.
The US joins the QE club

The Fed announced its expanded and aggressive QE policy at the FOMC on 18th March. With Fed funds being kept at a range of zero to 0.25%, the Fed announced more aggressive quantitative easing initiatives than expected, worth an extra $1.15 trillion. The new developments include: (1) An extra $750bn of agency mortgage backed securities purchases over the rest of 2009, (2) $300bn in longer-term Treasuries to be bought over the next six months and, (3) An extra $100bn of agency debt over the rest of this year. Quantitative easing, of which a good chunk is what Bernanke prefers to call credit-ease, has already expanded the Feds balance sheet from $900billion to $1.9 trillion and doubled the monetary base since the failure of Lehman Brothers last September (chart 1). The Fed has already committed to do up to $1 trillion for the previously announced TALF, and one way or another up to an extra $1 trillion for the PublicPrivate Investment Fund. If fully utilized, this was already going to eventually take the Feds balance sheet to nearly $4 trillion over the next few quarters.
Part I QE the list of country grows

The Feds announcement on 18th March that it was moving to an aggressive quantitative easing (QE) drove the dollar substantially lower. The US has now fully joined a growing group of countries (UK, Switzerland, Japan) pursuing these policies. The ultimate objective of QE is to revive economic activity by easing monetary conditions further than is possible with conventional interest rate tools as the zero bound is approached. The mechanisms by which monetary conditions can be eased by QE are by lowering longer term interest rates, providing direct private sector access to funding not readily available through the banking system, and by currency depreciation. Countries have varied widely in their views of the role of the currency in QE, but it is clearly part of the mechanism by which the policy is supposed to work. We review the policies being pursued in the QE countries, analyse possible future QE candidates (Sweden, Canada), and contrast this with countries that do not see QE as a necessary or appropriate policy (Eurozone, Norway, Australia, New Zealand). Our conclusion is that
1. Feds balance sheet has already doubled to USD 1.9tr, and could reach USD 5tr
2. Sterling was hit hard by the original QE announcement

Cable from Jan 1 1.55 QE first announced 1.5
USD bn
2500
Fed balance sheet
USD bn
2500
2000
2000
1.45
1500
1500
1.4
1000
1000
1.35
500 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08
500
1.3 01-Jan 13-Jan 25-Jan 06-Feb 18-Feb 02-Mar 14-Mar
Source: Bloomberg, HSBC
With the new initiatives, we could eventually be looking at a Fed balance sheet of $5 trillion, or nearly six times its normal pre-crisis level. If this happened, it would take the Feds balance sheet to 36% of GDP (compared to a normal 6% of GDP). This would take it a bit higher than the Bank of Japans peak balance sheet of 30% of Japans GDP during its earlier quantitative easing policy between 1998 and 2005. Overall, the Fed is once again showing its intent in going to extremes in its once-in-a-century policy response to this once-in-a-century crisis, and a big part of it is to get private sector interest rates, and especially mortgage rates, to come down. As a direct result of these actions, we will soon be seeing a further large spike in mortgage refinancing applications, and with the various government housing initiatives in play, these applications should stand a better chance of being approved, although banking sector caution is still obviously an overall restraining factor.
qualifying debt, financed by the issuance of T-bills (and hence sterilised). On 5th March, the Bank of England announced that the fund will now be GBP 75bn (and GBP 150bn has been authorised) which will be financed entirely by newly created central bank money (resulting in an unsterilized increase in the money supply). The Bank can buy a maximum of GBP 50bn of private sector securities, but it can also be used to purchase medium-term and long maturity conventional gilts in the secondary market. The BoE has suggested that the majority of the overall purchases will be gilts. The GBP 75bn is a very large increase in the monetary base. Base money (notes and coins in circulation plus banks reserve accounts held at the BoE) will increase from GBP 93bn to GBP 168bn, a rise of more than 80%. Sterling was hit hard by the initial UK announcement of QE. Between 19th and 23rd January cable fell from 1.49 to a low of 1.35 (chart 2)
UK
The UK has been at the forefront of QE, with the Asset Purchase Facility (APF) originally announced on 19th January. As originally described, the GBP 50bn APF was established to buy corporate bonds, commercial paper and other
Switzerland
The SNB has been complaining about the strong CHF on numerous occasions, and yet managed to surprise markets by announcing currency intervention at their monetary policy assessment
on 12th March .The SNB is officially buying foreign currency, and they have not announced against which currencies they are selling. Given EUR-CHF is around 60% of the CHF trade weighted basket, it is very likely to be against the euro. CEE currencies, which have been depreciating aggressively against the CHF over the last months, should also benefit from the SNBs move, at least indirectly. Why so bold? The fact is that the CHF has been appreciating since August 2007(see chart 3), as the SNB states itself. As reference, back then EUR-CHF traded at 1.6500 and USD-CHF at 1.2100. So especially on EUR-CHF, that might be a level the SNB is eying. Interest rate cuts have had a limited impact. The nominal MCI (monetary conditions index, CHF 3 month LIBOR and nominal CHF trade weighted) has remained elevated. With the scope on interest rates exhausted, its now down to the currency. We do not believe the SNB will sterilise its currency buying, as excess liquidity is clearly its aim. If anything, the SNB could have trouble getting market rates down with its traditional money market tools. So again the intervention
will be helpful to loosen monetary conditions in Switzerland. From an international perspective, the fear now has to be that competitive currency devaluation to avert deflation takes place, though the SNB has repeatedly said that it only aims to prevent further currency appreciation. The SNB is also embarking on an outright credit easing. The SNB will buy CHF bonds issued by private sector borrowers, i.e. CHF corporate bonds. In the announcement, the SNB does not clarify whether there are any geographical restrictions on the issuer of corporate bonds. In any case, the major beneficiaries should be Swiss issuers, and its also likely that most of the holders of CHF bonds are Swiss institutions. The SNB has already been expanding its monetary base aggressively, but this is just another step to ease tensions in credit markets (chart 4).
Japan
The Japanese have the most experience with Quantitative Easing having pursued an explicit QE policy between 2001 and 2006. With nominal
4. The SNB has already been expanding the monetary base
Switzerland - monetary base
3. The CHF has been appreciating since 2007
CHF trade weighted 125 123 121 119 117 115 113 111 109 107 105 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09
125 123
90
90
80
80
121 119 117 115 113

50 50 60 60 70 70
111 109 107 105

30 Jan-00 Jul-01 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09 30 40 40
5. Japan had a QE policy between 2001 and 2005, and is moving in that direction again
JPY tr 40 35 30 25 20 15 10 5 0 May -00 Nov -01 May -03 Nov -04 May -06 Nov -07 BoJ Current Account Balances JPY tr 40 35 30
6. Canadian employment is falling fast

000s 150 C anada - m onthly em ploy m ent c hange 000s 150
100
100
50
50
25 20 15 10
-100 -100 0 0
-50
-50
5 0
-150 J an-00 J ul-01 J an-03 J ul-04 J an-06 J ul-07 J an-09 -150
interest rates again back at the zero bound, the BoJ has started moving back in the direction of a QE policy. In the earlier episode, the intermediate target of QE was a level of commercial bank balances held at the central bank. This was progressively increased from JPY 8tr to JPY 3035tr, in an attempt to getting credit flowing in the economy again (chart 5). Japanese QE met with only moderate success, at least in part because the banking industry was in no condition to start lending again, no matter how strong its liquidity position. The improvement in the Japanese economy between 2003 and 2007 was arguably more to do with strong growth in the rest of the world than to the QE policy. While the BoJ has not explicitly started on a new QE policy, it has announced an increase in its purchase of JGBs from JPY 1.4tr per month to JPY 1.8tr per month. Assuming this is not sterilised, this is very similar to the policies being pursued by the Fed and the BoE. The BoJ has also broadened the collateral it will accept on loans to banks in a way that is aimed at feeing up funds at regional banks. The Japanese authorities have not acted on the yen, despite the economy being heavily dependent on exports, probably because they do not want to risk retaliation from other countries.
The QE candidates Canada and Sweden

Who will be next for QE? Of the other G10 countries, the two most likely candidates for QE policies over the next few months are Canada and Sweden.
Canada following the Fed?
Having cut rates from 2.50% to 0.50% since last December, the Bank of Canada is preparing to outline its own plans for QE in its next Monetary Policy Report on 23rd April (see also page 34). Bank of Canada Governor Carney has said that the Banks policy will be consistent with the approach of the Fed and the Bank of England. There seems little doubt that the speed of the economic deterioration seen in the US was a factor driving the aggressive move by the Fed. In the same way, the Bank of Canada is probably alarmed by the speed at which the Canadian economy is weakening, with employment falling way very sharply (chart 6). Some form of QE policy seems very likely to be announced (if not implemented) in April and it will probably be along the same lines as that announced in the US.
Sweden an exchange rate target?
Sweden has not announced any form of QE policy as yet, and it still has some room on conventional interest rate policy. However, should conditions
continue to deteriorate, it seems likely that Sweden will, like Switzerland, focus on the exchange rate as the intermediate target for QE. In a recent speech on monetary policy with a zero interest rate1, Deputy Riksbank Governor Svensson argued that in a deflationary environment, the exchange rate is a better policy tool than other unconventional methods. In order to get out of deflation this method entails a price level target where the currency is depreciated and the exchange rate held at a temporary exchange rate target until the price level target has been attained. This dramatic method is most efficient in creating expectations of a higher future price level and could provide sufficient stimulation to the real economy. I consider it very unlikely that this method would be needed in Sweden, but I believe it is good that it is available as a last resort. The policy would work in three stages: 1. A price level target is introduced in the form of a path that will generate the desired rate of inflation. In the event that unwelcome low
7. Sweden devalued in 1931 and avoided the worst of the depression
inflation or deflation has already arisen, the price level target can be set correspondingly higher than the current price level. 2. An exchange rate target that is consistent with the price level target is announced and the exchange rate is pegged to this exchange rate target until the price level target is attained. If, for example, the price level is to be raised by 10 per cent, the exchange rate target is set so that the currency depreciates by 10 per cent. 3. When the price level target has been attained, the currency is allowed to float and monetary policy returns to normal, either with the old inflation target or with the continued use of a price level target if this is deemed to be advantageous in the longer term. This policy idea was discussed at the most recent Riksbank meeting (details can be found in the minutes) and did not receive much support. However, with the SNB explicitly targeting the currency, the Riksbank may see this policy as a
U S D-S E K (a n n u a l a v e ra g e ) 5.50 5.30 5.10 4.90 4.70 4.50 4.30 4.10 3.90 3.70 3.50 1922
Source: HSBC
5.50 5.30 5.10 4.90 S E K b re a k s a w a y fro m th e G o ld S ta n d a rd in S e p te m b e r 1 9 3 1 U SD d e v a lu e s v e rs u s G o ld 4.50 4.30 4.10 3.90 3.70 3.50 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 4.70
See www.riksbank.com/templates/Page.asp?id=30660
8. Euro zone monetary conditions have eased, but not dramatically

3.0% E u ro z o n e M C I (Dec 2 0 0 0 = 0 ) MCI 2.0% R e a l rate s o n ly 2.0% 3.0%
1.0%
1.0%
0.0%
0.0%
-1 . 0 %
-1. 0%
-2 . 0 %
-2. 0%
-3 . 0 %
-3. 0%
-4 . 0 % De c -0 0
-4. 0% De c -0 1 De c -0 2 De c -0 3 De c -0 4 De c -0 5 De c -06 Dec -0 7 De c -0 8
more attractive option as Swedish inflation approaches zero. Sweden, like the UK, has some experience of the impact of currency weakness in an extremely weak economic environment. Both the UK and Sweden moved off the gold standard in September 1931, while the US maintained stability for the dollar against gold until 1933. This implied a devaluation of the krona of about 35% (see chart 7) and is widely perceived of helping Sweden avoid the worst of the depression. Given this historical experience, it is not surprising that Sweden might be considering a similar policy now.
(NOKprobably the best currency in the world, Currency Weekly, 23rd February 2009) is in the unusual and enviable position of having a relatively strong economy with little risk of deflation, and further room on conventional policy if necessary. In these circumstances, there is no need to consider QE, at least for now.
The Eurozone and QE

The most interesting case of the non-QE group is the Eurozone. Here there are clear signs that the economy is weakening sharply, with both domestic demand and exports hit hard. Interest rates have been cut sharply (to 1.25%) and the ECB has said that it would not be advisable to take rates as low as zero. The room for further conventional policies is now quite limited. There is no doubt that the market will start to expect some form of QE policy as the zero interest rate bound get closer. However, when asked about QE, ECB President Trichet emphasises that the ECB is already pursuing unconventional policy measures in its liquidity provision to commercial banks. He also argues that, unlike the UK and US, the monetary
The non-QE group

For the four remaining G10 economies, QE policy does not look likely in the foreseeable future. Australia (OCR 3.00%) and New Zealand (OCR 3.00%) still have room for manoeuvre on conventional policies. They also have room for further fiscal stimulus if necessary. In any case, given the size of their external liability position, they probably would be reluctant to pursue policies which could be seen as undermining their currencies. Norway, as we have previously argued
transmission mechanism in the Eurozone does not seem to have been badly impaired. In other words, the banking system is still functioning, and the steps the ECB has taken should be effective in supporting the economy. While not ruling anything out, ECB officials (and some Eurozone government officials) give the impression that they would strongly prefer not to follow the QE route taken by the US and others, but would rather wait to see how effective the existing policies will be. Monetary conditions in the Eurozone have been easing since late 2007, although they have not yet fully unwound the tightening seen between 2005 and 2007. Chart 8 shows a monetary conditions index (MCI) for the Eurozone. This measures the net effect (in basis points) of changes in real short term interest rates and the exchange rate from a given starting point. The easing over the past 18 months has been equivalent to about a 150bp cut in real interest rates.
Conclusion Part 1
While the risk for the Eurozone, and the euro, is that the economy continues to deteriorate and officials are forced into considering the use of QE policies, the risks for the QE group would seem to be at least as great. First, there is great uncertainty as to when or whether the QE policies will work. Second, there is the question of scale. Have the QE group done enough to support their economies, or have they done too much which could generate a different set of problems next year and beyond? Because QE policies have never been used in the same way before, there are very few indicators that can be used to measure success or failure or to guide on whether the scale of the operations is correct. In these circumstances, the FX market would seem likely to express a preference for currencies where policies remain conventional, even if the actual and prospective economic conditions in these countries are no better than in the QE group.
9. Non-QE currencies have begun to out-perform QE currencies recently

QE and non-QE currencies trade w eighted (Jan 1 2009=100) 106 106
104
104
102
102
100
100
98
98
96 QE currencies 94 01-Jan
96 non-QE currencies 94 15-Jan 29-Jan 12-Feb 26-Feb 12-Mar 26-Mar
10. SUMMARY OF QE POLICIES AND PROSPECTS FOR G10 COUNTRIES Country US QE? Yes Details Fed funds target remains at 0.00-0.25% 1. 2. 3. Purchase of up to USD 1.25tr of agency mortgage-backed securities this year Purchase of up USD 200bn in other agency debt Purchase of up to USD 300bn in longer date Treasuries over the next 6 months
Term Asset-Backed Securities Lending Facility (TALF) in place up to USD 1 tr, and Public-Private Investment Fund up to another USD 1tr. In total this could take the Feds balance sheet to USD 5tr (36% of GDP) UK Yes Bank Rate maintained at 0.5%. Asset Purchase Facility of GBP 75bn (up to GBP 150bn authorised) in private sector securities (up to GBP 50bn) and medium to long term gilts. Most of the purchases expected to be in gilts. This will increase the UK monetary base from GBP 93bn to GBP 168bn (80%) 3 month LIBOR target now 0.25%. Foreign exchange intervention to prevent further appreciation of the CHF against the euro, plus purchase of Swiss franc bonds issued by private sector borrowers. Amounts unspecified. Uncollateralised overnight call rate target maintained at 0.1%. Increase in BoJ purchases from JPy1.4tr per month to JPY 1.8tr per month. Broadening of collateral accepted by BoJ for loans. Bank Rate currently at 0.5%. Outline of QE policies to be given on April 23rd. Likely to be on similar lines to those seen in US and UK. Repo rate currently 1.0%. No QE policy as yet, but discussion of using the exchange rate as a policy tool to avoid deflation. Could possibly see a policy similar to Switzerland, with FX intervention and asset purchases. Overnight Cash Rate cut from 3.25% to 3.00% on April 7th. There is room for further conventional monetary policy easing if necessary. Official Cash rate cut by 50bp to 3.00% on March 12th. The accompanying statement said we do not expect to see in New Zealand the near-zero policy rates of some countries. Repo rate cut by 25bp to 1.25% in April. The ECB believes it is going far enough in terms of unconventional policies by its provision of large amounts of liquidity to the banking system. Lending rate cut by 50bp to 2.00% in March. The central bank signalled that rates could go to 1.00% but has not yet suggested QE type measures are on the cards.
Switzerland
Yes
Japan
Yes
Canada Sweden
From April? Not yet
Australia
No
New Zealand
No
Eurozone
No
Norway
No
Source: HSBC
There is some evidence that this is already happening. Chart 9 shows the performance of the average trade-weighted exchange rate indices of the QE group of currencies (USD, GBP, CHF, JPY) against the average indices of the non-QE group (AUD, NZD, EUR, NOK) since the beginning of the year. Since the end of January the non-QE group have been out-performing. Over the next few months the markets will be in the uncomfortable position of seeing the QE policies in place, but with little idea of when of whether they will work. At the same time global economic conditions seem very likely to stay very weak, or even worsen. With the increased uncertainty surrounding the implementation of QE, it seems likely investors will have a preference for currencies that are sticking to
conventional policies. We would therefore expect to see the NOK continues to strengthen, a relatively good performance from the AUD and NZD, and for the dollar to continue to give up ground against the euro. On the following page we provide a brief summary of the QE policies and prospects for each of the G10 countries.
Part II The currency implications: What if QE works?

We have argued that the QE currencies will under-perform. In suggesting this, we face a simple counter argument. This runs as follows QE countries will recover first and therefore their
10
currencies will rise. This view, however, relies on the efficient and smooth running of capital markets, which is no longer the case. We would argue that the transmission mechanism has changed entirely. Any QE driven recovery in nominal GDP is most likely to be dominated by rising inflation rather than real growth, because market mechanisms have been severely impaired. This may at first be viewed as signs of a recovery and be positive for the respective currency. However, authorities are most likely to take a wait and see approach, as they will not want to make the mistake of tightening too soon. Hence, concerns over inflation will ultimately dominate. The asset market reactions will be unclear as governments try to offload their equity holdings and officials stem the rise in long dated yields. When QE starts to work, it may be seen as a positive but as exit strategies get more difficult and inflation concerns increase, we believe it will be become a negative for a currency. The world of free markets dominated by an economic environment of steady growth and low inflation coupled with low volatility no longer exists. In the previous era higher rates meant a stronger currency this is no longer the case. The link between recovery and a stronger currency is
broken.
The pre-2008 world

The theology that strong economic growth translates into a stronger currency became enshrined during the last recovery. In essence the period from 2002 to 2007 was the sweet spot for carry and the link between strong growth and a strong currency. During this period we had stable inflation, reasonable growth and low volatility. When economic strength was met by higher rates, a currency would strengthen. This idea became more popular and powerful. And the returns from the carry trade became unsustainably strong. From 2002 to July 2007 the G10 carry basket had a Sharpe ratio of 1.65 (chart 11). To put this into context, a coin toss would have a Sharpe ratio of zero and equities before this crash were considered a good long-term investment because they had a Sharpe ratio of 0.5. A successful hedge fund would show a long-term Sharpe ratio of 1. So during this period the link between economic growth and currency performance became cemented in investors minds.
11. Astronomical returns strong growth meant a strong currency

% 6.0 5.5 5.0 94 4.5 4.0 3.5 3.0 100 2.5 Jan-94 Mar-94 May -94 Jul-94 Sep-94 Nov -94 96 Fed Funds rate (LHS) USD TWI (1994=100) Inv erted scale Index 90
12. 1994 higher rates and a falling dollar

% 6.0 100
92
Fed Funds rate (LHS)
USD TWI (1994=100)
Index
5.5 5.0 4.5 4.0 94 3.5 3.0 2.5 Jan-94 Mar-94 May -94 Jul-94 Sep-94 Nov -94 92 98
96
98
90
11
13. Cycling around a trend

Pre-2008 world
14. Stronger growth leads to a stronger currency
The conventional view
Nominal GDP
Recovery
Growth up Inflation up
Short rates & bond yields rise Equities rise
Currency rises
FDI Flows Portfolio flows
Source: HSBC
Source: HSBC
Low inflation and low volatility was the key

It was not always the case that strong growth implied a strong currency. Sometimes stronger growth and inflation was feared and the currency was sold. For example, in 1994 economic growth started picking up in the US after years of sub-par growth following the 1991 recession (chart 12). The Fed responded to stronger growth by raising rates from 3.0% to 5.5% in 1994. Through the course of 1994, the USD fell in trade-weighted terms (chart 12). At one point when the growth induced inflation scare was at its most intense, the USD was down nearly 10% on a trade-weighted basis. The idea of a strong economy and higher rates equating to a strong currency has its roots dug deep in the experience only of the last
economic cycle. To us, it is clear that once again the rules have changed and we would like to demonstrate this below.
The low inflation cycle

We look at simple growth trends to show our point that a QE led recovery does not necessarily mean a stronger currency. Chart 13 illustrates a simple cycle of nominal GDP growth around a given trend. Chart 14 shows what strong growth could mean for a currency via higher interest rates and capital flows and is representative of the type of thinking from 2002-2007 (chart 14).
15. Shock to the level and permanently higher debt

Structural break Higher debt levels into perpetuity even if we return to previous growth rate
x
16. Japans QE never got them back to the original path

Japan unable to get back to original path
Nominal GDP
Nominal GDP
Source: HSBC
Source: HSBC
12
The post-2008 world and QE

There is no doubt the world has completely changed compared to the 2002-2007 period. Now the problem we face is one of massive debts and the risk of deflation, which would increase the real values of those debts. Any economic depression would also put further pressure on the stretched finances of governments in other words what we need is higher nominal GDP growth. This would cut the real value of the debt stock. What we fear is not that the economy is cycling down and needs to be boosted as shown in chart 13 but that we have faced a massive downward shock to the level of nominal GDP (chart 15). This downward adjustment to the level of nominal GDP could have continuous and devastating consequences, even if we were to return to the old growth rates as in chart 15. Debt levels would remain permanently higher, as the level of nominal GDP would be depressed. In addition, governments will have to be cautious that they do not move into a Japan-type situation. That is, they must avoid the risk that they do not do enough to secure a recovery. Chart 16 shows a Japan-type scenario where nominal GDP is increased but not sufficiently to secure a sustained recovery. When Japans
government raised the consumption tax in 1997, they believed the recovery was self sustaining. This tax increase smashed the economy and it never fully recovered. Existing policy makers will be well aware of this and are likely to err on the side of allowing stronger nominal GDP growth before tightening policy.
Perfection is not what it used to be
In essence governments want us to get back to the original path or perhaps higher (chart 17). Here debt levels are the same in real terms compared to before the shock. The problem is that the recovery in nominal GDP growth is more likely to come from inflation rather than from real growth. This erodes debt levels but has a very different consequence for a currency. The quality of nominal GDP growth will matter. If it were to increase largely because of inflation, this should not be positive for the respective currency. Also if QE works how and when do we turn off the taps?
If QE works how do we shut off the taps?

Coming back to our earlier point, once the economy starts to grow through QE those economies that show a recovery first will see their respective currencies rise. It is now worth looking at this view from a different perspective. Once we
17. Perfection back to the original path
18. Attempts to get us back but taps remain open for too long
The ultimate aim of QE back to the original growth path

x
The concern is inflation will accelerate
NOMINAL GDP
Nominal GDP
Source: HSBC
Source: HSBC
13
start moving up the red path in Chart 18 that is strong growth in nominal GDP it is very possible that the knee-jerk reaction by the market will be to buy the recovery. However, the problems start to mount once nominal GDP growth starts to rise very aggressively, triggering inflation concerns. The issue of policy error is not a trivial one. Given Japans experience policymakers will not want to turn off the taps too soon as it may kill the recovery. In other words, it is in the interest of policymakers to err on the side of inflation and the erosion of debt levels. What we face is the concern that nominal GDP growth will start to rise massively through inflation as shown in chart 18. Under the low inflation, low volatility pre-2008 world, stronger growth saw interest rates and the equity markets rise, which in turn attracted FDI and portfolio flows. As a consequence, the currency rose. This is not necessarily the transmission mechanism that faces a QE type expansion. If there were concerns over rising inflation, the cost of capital at the long end would rise radically. If the bond market was left to its own devises, such a rise in the cost of capital would scupper the recovery. This would mean governments would have to keep buying the long end to ensure the rise in yields was controlled. In addition, any equity market strength would also give governments the ability to sell their newly acquired stakes, thereby hampering the equity rally. In addition, if the trade-off between inflation and growth has worsened. In other words nominal GDP growth is driven by inflation equities may out-perform government bonds but they are still not a great investment. The corporate sector is likely to have a permanently lower leverage ratio that is debt reduction. This means that the leverage for corporates into an expansion will be
lower than the historical norm. Hence we would see lower returns. Under such circumstances, portfolio inflows from overseas investors into equities would be limited. The respective currency should not outperform under these conditions.
Big government is back

The new world order is one of much bigger official intervention in capital markets, which will have a big impact on private capital flows. Greater regulation of markets, which is likely to limit capital flows, should hamper both direct investment and portfolio flows. Foreign direct investment (FDI) flows would certainly happen on a much smaller scale with a large lag as corporates remain very cautious and their access to capital would be restricted. Portfolio inflows are unlikely to pick up. In fact what the private sector is more likely to do is to rotate out of bonds into equities or credit rather than committing new money. It is hard to argue that a recovery with the authorities having to control the rise in bond yields whilst selling their equity stake will see a massive portfolio inflow by the private sector driving a currency up. This is certainly a much more complicated environment than the 20022007 period. One could legitimately argue that an expansion in nominal GDP growth through QE may drive a currency down through government bond outflows.
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19. If QE works, it does not necessarily mean a stronger currency
QE
Growth up Inflation up
Short rates may rise but bond yields controlled Equities?
Asset reaction uncertain Hard currencies outperform
Lack of free markets limit FDI Flows Portfolio flows
Officials could dominate market some moves
Source: HSBC
A QE driven recovery does not mean a stronger currency

It is worth exploring the definition of laissez-faire and asking whether these types of conditions are still with us. Laissez-faire is an economic philosophy, which advocates approximating completely free markets by mostly confining government intervention in economic matters to regulating against force and fraud among market participants. Hence, with government limited to a defensive role, government itself does not initiate actions in the marketplace beyond levying taxes in order to ensure the maintenance of the free marketplace. This is not the world of QE. One cannot expect the same reaction function to a recovery compared to the free market laissez-faire world that we previously witnessed. In short the free market, low inflation, steady growth, low volatility world of 2002-2007 where stronger growth was met with higher rates and drove currencies higher is not the world we are now in. A recovery through QE has many problems associated with it.
In particular the chances of a policy error are great, as policy makers err on the side of too much stimulus, rather then too little. In addition, the authorities will be much more active in capital markets, possibly selling equities and having to control the rise in bond yields. This will have a totally different impact on the markets compared to the 2002-2007 period. Even if QE economies recover, it does not necessarily follow that their currencies will appreciate. In fact a QE inspired recovery could see currencies fall, especially if the market thinks inflation will eventually get out of control. We advise selling QE currencies against the non-QE currencies now and even if a recovery in nominal GDP takes place.
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Gold investment is robust but consumer demand crumbles

As a traditional barometer of economic, financial and even geopolitical stress, gold remains well bid as investors continue to be suspicious of the inflationary consequences of quantitative easing and the health of the financial markets. Nowhere is this more evident than in the surge in demand for gold Exchange Traded Funds (ETF). Combined off-take in the seven largest ETFs is up an impressive 11.5moz from the beginning of the year to 49.5moz. This is equivalent to c1.5 times annual South African production. The expansion in ETF holdings has occurred against a backdrop of volatile net speculative long positions. An examination of the chart below shows that net speculative long positions on the Comex closely tracked fluctuations in the gold price, while ETF off-take has steadily grown. The centre of gravity
1. Gold net speculative positions
m oz S p e c . p o s itio n o n C o m e x (R H S ) 55 50
of gold investment appears to be shifting decisively away from the Comex and toward the ETFs. ETF demand has more than absorbed the decline in net speculative long positions, the fall in jewellery demand and increase in scrap supplies. So far the ETFs have exhibited a pronounced buy and hold mentality regardless of price volatility. However an investor exodus from the ETFs, should that occur, could result in significant amounts of bullion materializing on the market at short notice.
What about physical demand
James Steel Commodities research +1 212 525 6515 james.steel@us.hsbc.com
While the investment demand for gold is largely a function of investor risk sentiment, the demand for jewellery is more a function of price. Jewellery accounts for c70% of total gold consumption with India the worlds largest physical consumer and importer, accounting for as much as 30% of physical bullion demand in some years. Indian demand, in common with other
U S D oz
1100
G o ld in E T F s (R H S )
G o ld p ric e (L H S )
1000 45 40 35 30 700 25 20 15 10 400 5 0 J u l-0 3 J a n -0 4 A u g -0 4 F e b -0 5 A u g -0 5 M a r-0 6 S e p -0 6 A p r-0 7 O c t-0 7 M a y -0 8 N o v -0 8 300 600 900
800
500
Source: HSBC, Gold Bullion, iShares, CFTC
16
emerging economies, tends to be highly price elastic. Prices over USD900/oz have nearly crippled jewellery consumption in the Indian subcontinent, as well as other important emerging markets. After averaging 50t a month for the last two years, Indian imports dropped to less than 2t in January fell to almost zero in February, in response to high prices. Imports into Turkey a major jewellery manufacturer that supplies emerging markets in the Middle East and North America and Western Europe are also down on last year. The contraction in consumer income has also reduced jewellery demand even in more affluent Western markets.
Supply is upbut not from the mines
that prices are well above the marginal costs of production. Producers face a variety of obstacles in raising output that are relatively insensitive to price. These include declining ore grades, exhausted deposits, lack of reserve replacement and a paucity of new projects. It is our view that mine production is likely to contract c40t this year to below 2,400t. Also, central banks appear to have reduced their sales programs and withdrawn gold from the lending markets.
Outlook for gold

Gold prices are likely to remain volatile as investors assess the impact of the authorities efforts to combat the global recession but ultimately we believe a lack of inflation will reduce the safe haven demand for gold. Strong investor demand for coins, small bars, and gold ETFs will likely absorb surplus gold from increased scrap supplies and lower jewellery consumption. As a consequence supply/demand balances are likely to remain reasonably tight. Prices over USD1,000/oz may further choke off jewellery demand and encourage additional scrap supplies. We therefore forecast gold prices to average USD825/oz this year, with declines likely to accelerate in 2H as supplies become more burdensome.
In addition to a decline in jewellery demand, high prices have encouraged the mobilization of significant amounts of bullion via the scrap recycling market. Gold is held in varying amounts by millions of households worldwide. High prices have increased the rate at which holders of bullion are willing to turn in gold items for cash. In conversations with recyclers in the Middle East, India and Europe, it is clear that substantial amounts of gold are being recycled. We believe that so far this year, reprocessed gold has increased supply by several hundred tonnes. Other sources of supply, such as mine production, remain stagnant. Interestingly, the jump in prices has done little to increase output, despite the fact
2. Monthly Indian gold imports and prices
Monthly India Gold Imports (tonnes)
100 90 80
3. Annual Indian gold imports and prices

Yearly India Gold Imports Avg Gold Price in Rupiahs/oz 40,000
Avg Gold Price in Rupee/oz

50,000 45,000
700 800
35,000
40,000
70 60 50 40 30
35,000 30,000 25,000 20,000
600
30,000
500
25,000
400
20,000
20 10 0 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09
15,000 10,000
300
15,000
200 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
10,000
Source: Reuters HSBC
Source: Reuters HSBC
17
FX Volumes down but not out

FX volumes
The BIS recently reported2 that interbank FX volumes plunged in Q4 2008. They report that volumes on EBS, one of the two main interbank trading venues, roughly halved over this period. EBS report3 that the volume executed in January 2009 was 37% lower than the volume transacted in January 2008. Is this the end of the great volume expansion we have seen since the advent of the euro? Clearly there are many factors which will be working to reduce cross-border flows. The power of globalisation has diminished; the financial crisis is having a huge impact on global trade, portfolio flows and FDI. Government support of banks is designed to increase domestic rather than global lending. In addition to this, assets under management are down, as are leverage and risk appetite, all of which will result in lower speculative flows. In this section we investigate the relationship between customer trades and interbank volumes. We look into the various ways in which the interbank market can be more strongly impacted by the current financial crisis and suggest that a narrowing of spreads in the interbank FX market would be an indication that banks are beginning to trust each other again. Throughout this process, those banks which have genuine customer business will be in the strongest position.
Why are FX volumes so high?
Mark McDonald* FX Quant Strategist HSBC Bank plc +44 20 7991 5966 mark.mcdonald@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to NYSE and/ or NASD regulations
Figure 1 shows how volumes would be recorded on an exchange. If 200M EUR-USD were exchange-traded, a futures exchange would record this as being 400M EUR of open interest. Figure 2 gives a simple schematic of how things are recorded in the FX market. Here the total FX volume executed is 800M and we illustrate this in Figure 2. The most authoritative estimate of FX volumes is the BIS triennial survey. In this survey the BIS ask banks to report their executed volumes and to categorise the flow by counterparty type. Since deals between banks will be reported twice, the volume of these trades is halved so as to adjust for double-counting. As a result of this, the BIS would count the 400M done via the interbank market as a volume of only 200M. This means that we have two customer flows of 200M each and another 200M from the interbank market, making the total volume 600M. This raises the question of why the FX market has developed with this unusual structure. The way that FX trades have historically been done is that customers deal with their bank. Bank B1 will not know details of Bank B2s customer flow, and vice-versa. This could lead to the situation illustrated in Figure 3. Here A1 has sold 10M to its bank B1 at a price of 20 and A2 has bought 10M from its bank B2 at a price of 25. So B1 and B2 have offsetting positions which could be closed out at a profit to both banks. If the banks
Execution methods in foreign exchange markets BIS March 2009 Quarterly Review
3
http://www.icap.com/investor-relations/publications-
presentations-and-results/monthly-volume-data.aspx
18
1. On exchange, open interest would be 400M
2. In this case, volume measured by BIS is 600M
knew about this, the optimal solution would be for the two banks to cross their positions at the midprice (Figure 4). In this case they both make 2.5 points profit in 10M. This solution is impractical given the vast number of confidential customer deals with a large number of banks.
Intermediary Banks
However, what if there is an intermediary bank, I1, which is happy to buy at 21 and sell at 24? In this situation, B1 can sell at 21 with certainty, giving a 1-point profit. B2 can buy at 24 with certainty, resulting in a 1-point profit. And I1 gets to buy at 21 and sell at 24 giving a 3-point profit. So all counterparties in this chain are now dealing at profitable rates. This is the case shown in Figure 5. The intermediary bank is making a 3point profit here, despite not having to do the work of building up a customer base and maintaining client relations through an active
3. B1 and B2 do not know details of others customer flow
sales force. However, it is fair that I1 makes a profit from the transaction since they are providing a service. In the absence of counterparties such as I1, B1 and B2 might struggle to offset their positions. By providing short-term liquidity to the interbank market, I1 is enabling B1 and B2 to transact their business more efficiently. In this case, simple economics would teach us that, barring excessive barriers to entry, there will be increases in competition in I1s marketplace as other people attempt to achieve this profit. The increased competition will come because the barriers to entry in providing short-term liquidity to the interbank market are small compared to the barriers to entry of dealing with customer flow. Increased interbank market competition might lead to another intermediary bank, I2, to offer to buy at 22 and sell at 23 (Figure 6). From this
4. If they did, optimal solution would be to cross at mid-price
19
5. There is an incentive for intermediaries to offset the inventory risk of B1 and B2
simple example it is clear how it can be efficient for the FX market to be structured in this way since the competition drives spreads down. In reality, we are unlikely to be in the situation where different banks have simultaneous and exactly-offsetting customer flows. As a result of this, the profits made in Figure 6 by banks B1, B2 and I2 are not risk-free. These banks are providing short-term liquidity and the difference between
the bid price and the ask price is their payment for this service. Essentially, the expected profits from the business models of B1, B2 and I2 are payment for the market risk associated with holding the inevitable inventory which can build up as many customers trade with you in the same direction. Another result of this mismatch risk between bank inventories and arrival time of offsetting trades is that the relationship between flow from customers
6. Competition in the interbank market is likely to lead to compressed spreads
20
7. Offsetting inventory from customers in the interbank market multiplies volumes
and interbank flow is likely to be far more complicated than a simple 1-to-1 relationship. The inventory received from customers by bank B1 is liable to be passed around the market like a hotpotato, passing through many different intermediaries before being transferred to the ultimate end-users (customers of other banks). So the 200M customer flow into the interbank market in Figure 2 may well result in far more than 200M of trades between liquidity-providing banks in the interbank market. This means that the real situation with FX volumes is probably more accurately represented by Figure 7. The net effect of this is to drive interbank volumes up aggressively and spreads down.
Volatility
If we look at Figure 6, we can see that the intermediary bank I2 is offering a 1-point spread. This may well be an appropriate thing to do if markets are stable. However, as we have already mentioned, it is probable that most of the time we will not be in the situation where there are perfectly-offsetting and simultaneous flows. If we are in a volatile market then having such a tight spread might not be appropriate. For example, if B1 sells to I2 at 22, but then the market moves down aggressively before B2 needs to buy, then I2 will not be able to sell to B2 at 23. Either I2 must change the offer to sell to a lower price (and thus lose money on the transaction) or B2 will buy from someone else. This will lead to I2 holding on to the inventory received from B1, which was purchased at what is now a loss-making price. Thus, in volatile markets traders in the interbank market will not be able to compete by offering such tight spreads since those who attempt to do so will suffer severe loss. This incentivises them to stop providing liquidity in this way and works to reduce the number of active participants in the interbank market. Hence volumes go down and spreads start to widen. This is what we are currently witnessing.
Distrust, volatility and riskaversion

However, interbank volumes could also fall simply as a result of less trust between banks. We now consider this issue of interbank trust, as well as the confounding issues of high volatility and low risk appetite resulting from the financial turmoil.
21
Another possible impact of increased volatility on spreads is that it will make people attempting to transact business place more value on immediacy. If markets are relatively stable then someone buying might be tempted to join the best bid and hope that someone else sells to them. Doing this will save you the cost of crossing the spread. That is, if the best price in the market is 21 24 then placing a bid at 22 has the potential to save you 2 points and by placing a bid above the current best bid you can ensure that you are (at least for the moment) at the front of the queue. However, if the market is volatile then the certainty of trading with immediacy at a price of 24 might be considered preferable to the possibility of the bid at 22 not being filled and then subsequently having to trade at a much worse price once the market has moved against you. Increased volatility will clearly tend to increase the spread in the market. This means that high volatility will result in larger transaction costs for all market participants. A possible result of this will be a general reduction in trading interest since transaction costs will be so much higher. This will be particularly true for speculative traders.
will be curtailed. As a result of this, counterparties such as I2 either stop trading or they widen their spreads in effect becoming like I1. Hence, lower risk appetite will lead to larger spreads in the interbank market. This will in turn result in larger spreads to customers. Perhaps this extra cost could cause some of them to trade less and less frequently, thereby exacerbating the problem.
Fewer interbank participants

As well as some participants either changing their trading strategy or no longer competing in the same way, we have had some institutions fail who were very active in the interbank space. We believe that Lehman Brothers in particular was very active in streaming tight liquidity to the interbank market. As a result of the extreme market moves seen since Lehman collapsed, many institutions are reviewing the credit limits they offer to counterparties. This means that certain interbank participants might struggle to access all the liquidity in the market because they might have hit their credit limits with some counterparties. In addition to having a smaller number of banks, there are other participants in the interbank market who have exited the business. There are many non-banks who are primed onto the interbank market. This is where banks allow customers to trade on the interbank market under the banks name. This allows the customer access to the credit lines seen by the bank and thus offers the customer much better liquidity than they would otherwise have seen. The banks will ask customers to post collateral to insure themselves against the credit risk they incur through this process. As a result of a general reduction in credit limits and also because of the market stress and volatility we are currently witnessing banks are reassessing their prime brokerage programs. This will usually result in increased collateral being required. This will make some primed interbank market participants decide that the risk-
Reduced risk appetite

If the market was in a risk-loving mood then the higher volatility might not be a problem. When risk appetite is high there may well be some market participants who are prepared to take on the risk of offering tight liquidity and suffer the severe loss in an attempt to purchase market share. The usual argument would be that there are intangible future benefits which will result from having a larger market share and that it is worth incurring these losses since they are effectively the purchase cost of these future intangible goods. However, in the current economic climate all such arguments go out of the window. When banks are suffering financial distress there is a strong focus on cutting costs so loss-making strategies such as this
22
reward profile of their trading strategies is no longer appropriate. Finally, there are some participants in the interbank market who will not participate in the market once spreads get beyond a certain size. For example, trading strategies which are based on short-term trend strategies will not have a suitable risk-reward profile any more if the transaction costs (spreads) are too large. In general, higher frequency trading strategies will be more sensitive to transaction costs. The smaller number of active and aggressivelypriced participants in the interbank market will lead to a less liquid and less efficient market. This will put further upward pressure on spreads.
Conclusion
There is much consternation in the FX market at the moment about the recent plunge measured in interbank volumes. Whilst customer volumes have definitely decreased a little, we believe that the drop in customer volumes is not on the same scale as the fall seen in the interbank market volumes. In addition to this, current financial market conditions will have hit the interbank market particularly hard. Higher volatility and lower risk appetite will act as a disincentive from offering tight liquidity to the market. This in turn will lead to larger market spreads. The resulting higher transaction costs will lead to some market participants trading less frequently. Finally, the reduced trust between banks since the collapse of Lehman Brothers has led to a general tightening of credit conditions. Banks have reduced their credit lines with both other banks and with their customers and are demanding more collateral from their prime-brokerage clients. This tightening of credit conditions is a further reason why volumes have fallen and spreads have blown out. In conclusion, we note that these various conditions are not independent of each other. There is the possibility of a vicious cycle where these effects feed on each other. We believe that when we observe interbank FX market spreads narrowing again it might be the first signs of a return to normality in banks dealings with each other. Throughout this process, those banks which have genuine customer business will be in the strongest position.
Vicious cycle
These various factors are not independent of each other. For example, fewer interbank market participants will lead to a less-dense order book of resting liquidity. This will mean that the market impact of trades will increase, which will give higher volatility, particularly on a tick-by-tick level. Higher volatility will lead to larger spreads which can result in even fewer market participants. In this way it is possible to get a feedback loop between these various factors resulting in progressively larger spreads, higher volatility and lower volume.
23
HSBCs New Volume-Weighted REERs
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.
Accounting for inflation

How should we account for inflation when constructing the REER? Imagine that the USD and the CAD are at parity (ie USD-CAD=1). Imagine further that 1 USD will buy you 10 tomatoes in the US and that 1 CAD will buy you 10 tomatoes in Canada. If over the course of the following year USD-CAD moves to 1.1 are you better off if you are USD-based? At first glance it would appear so. However, if the price of tomatoes in CAD has risen significantly, and you are a heavy purchaser of tomatoes, then perhaps not. For example, if it now costs 2 CAD to buy 10 tomatoes in Canada, then hopping across the border with your 1 USD (=1.1 CAD) hoping to pick up 11 tomatoes is going to be a fruitless exercise. In fact, you will only get 5 tomatoes. This rather simple example highlights why people create REERs. If one is trying to estimate the change in value of a currency, inflation can have a non-trivial impact; particularly over long time frames. What one is really trying to do here is to measure the relative purchasing strength of different currencies. The best way to do this is open to debate however. Which measure of inflation should we consider in our REER? In the example above we have used the price of tomatoes to measure changes in value. However, this measure is irrelevant to someone who spends most of their income on other items. Thus we need to decide which measure of inflation we will use in constructing the HSBC REERs.
Mark McDonald* FX Strategist HSBC Bank plc +44 20 7991 5966 mark.mcdonald@hsbcib.com *Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to NYSE and/ or NASD regulations
24
There are many different types of inflation index, which measure price changes in different baskets of goods and services at different points in the production process. We clearly want an index which is produced in a timely fashion. Most countries release at least some inflation data on a monthly basis4. However, many countries produce a range of inflation indices at this frequency; so which one should we use? Perhaps the most comprehensive measure of inflation for a country would be the GDP deflator, which aims to measure the price changes across all national output. However, these are usually only produced on a quarterly basis. It is also desirable that the choice of inflation index is relatively consistent from country to country, something which is not the case for GDP deflators. Absolute consistency is clearly impossible; however, CPI indices are generally constructed in a relatively similar way from one country to the next, are mostly produced monthly, and are released in a timely manner. For this reason, using CPI as the inflation measurement for REERs is the most common choice [1] a convention which we follow in the construction of our indices. In the previous example it is clear that the high inflation in Canadian tomato prices has increased the real value of the CAD relative to the USD5, despite the nominal value of USD-CAD moving towards a weaker CAD. Higher inflation in one country than in another raises the real value of the currency of the first country relative to the currency of the second country.
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.
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. The rationale for using trade-weights can be found in [2], along with a detailed summary of the various problems with measuring accurate bilateral tradeweights. In Chart 1 we show the HSBC tradeweighted REER for the USD (grey line).
Australia and New Zealand do not.
At least from the point of view of a purchaser of tomatoes.
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1. Trade-Weighted and Volume-Weighted USD REERs

USD Trade-Weighted REER 160 USD Volume-Weighted REER 160
150
150
140
140
130
130
120
120
110
110
100
100
90
90
80 Apr-95
80 Apr-97 Apr-99 Apr-01 Apr-03 Apr-05 Apr-07 Apr-09
Source: HSBC
Volume Weights
The IMF publishes trade data in its direction of trade statistics (DoTS) [3]. From this, we can estimate that the sum of US imports from and exports to the rest of the world over April 2007 was approximately 250 billion USD. This is clearly quite a large number. However, it is dwarfed by the size of the turnover in the FX market. The BIS performs a triennial survey of the average daily volume of the FX market [4] in which they estimate the FX market average daily turnover for April 2007 to be 3.2 trillion USD every day! 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 considered in the index. However, these are not available. The volumes in the BIS survey [4] are only split into 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. The numbers given in [4] for the split by currency add up to 200% since each FX trade involves two exchange rates. To turn these percentage values into suitable weightings we use the following procedure. Let Pi be the percentage of all traded FX volume involving currency i. We calculate the weight that currency i has in the REER for currency X as
wiX
Pi Pj
jz X
This definition gives higher weighting to those currencies which are more highly traded and clearly satisfies
w
i
1.
26
In Chart 1 we also show the new HSBC volumeweighted REER for the USD (red line). Importers and exporters will, on aggregate, be exposed relatively cleanly to the trade-weighted index. However, participants in the financial markets are more likely to be exposed to the volume-weighted index. For example, many market participants simply use EUR-USD to look at USD strength (or weakness) because it is by far the most dominant exchange rate. The HSBC volume-weighted indices are an attempt to do this in a more systematic fashion. The comparison between the trade-weighted and the-volume weighted index is instructive. From Jan 1996 to Jan 2002 both USD indices show a significant increase. However, the increase for the volume-weighted index is much larger than for the trade-weighted index, moving up by almost 50% as opposed to the less than 30% increase in the trade-weighted index. This is because the value of the USD rose strongly against the JPY and the EUR (DEM in the pre-euro period), which are the most heavily traded currencies. We would argue that if you were a financial market investor during this period, the effective value of the USD you would have been exposed to is more accurately represented by the volume-weighted index rather than the trade-weighted index.
currencies varies over time so the volume weights must be variable as well.
Which basket of currencies should we use?

Another variable in the construction of effective exchange rate indices is the choice of which currencies to include in the basket. Since this is an arbitrary choice, we wanted to have a rationale for the selection. For this reason we choose to include currencies only if they were in the group of currencies for which the BIS report volume data in [4].
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. Doing this also raises the question of whether inflation happens over calendar time, or market time. For example, if we have inflation spread out every day, does the inflation between Friday and Monday count as three times the inflation from Monday to Tuesday, or is it the same? Since, in the extreme limit of hyper-inflation, price-rises can clearly happen at the weekend, we choose to spread the inflation equally over each calendar day, rather than each work day. This choice of data-frequency is a significant departure from REERs calculated by other institutions. While it will make only a small difference in periods where inflation rates are generally low and similar across countries, the
Variable Weights
As shown in the technical appendix, if the weights of the basket constituents are constant over time then the formula for calculating the REER is much simpler. Sadly, it is not appropriate to have fixed weights in constructing such indices. In the case of trade-weighting, the importance of trading partners varies significantly over time. Tradeweights which were calculated over a decade ago would seriously underestimate the importance of emerging market countries and, as such, would underweight their currencies in the index. Similarly, the FX market share of different
27
difference will become more significant if we enter a period where inflation rates are higher and more variable across countries. Given the huge amount of monetary and fiscal stimulus being injected into various economies at the moment, it is possible that higher and more variable inflation rates may be seen in coming years, in which case the new approach will prove valuable.
28
References
[1] Luci Ellis. Measuring the real exchange rate: Pitfalls and practicalities. Reserve Bank of Australia, 2001. Available from http://www.rba.gov.au/rdp/RDP2001-04.pdf [2] M. Klau and Fung S. S. The new BIS effective exchange rate indices. Bank for International Settlements, March 2006. Available from http://www.bis.org/publ/qtrpdf/r_qt0603e.pdf [3] Direction of trade statistics. International Monetary Fund. Available from http://www.imfstatistics.org/dot/ or from Datastream [4] Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2007. Bank for International Settlements. Full details are available from http://www.bis.org/press/p071219.htm
Appendix
Return on a weighted basket of currencies
If Xi(t) is the price of currency X in currency i at time t, then the return6 from holding one unit of X and being short Xi(t) units of i from time t to time W W is
X (t Gt ) ln i . X i (t )
(1)
If we consider the performance of currency X against a range of k currencies i {1,2,3...k } , this can be generalised to
w (t ) ln
i i
X i (t Gt ) , X ( t ) i
which is the same as

wi ( t ) X i (t Gt ) ln , X i (t ) i
Returns can be calculated as log-returns, rl (as we have here), or they can be defined as proportional returns, rp. For proportional returns X (t Gt ) X (t )(1 rp (t )) . For log-returns X (t Gt ) X (t ) exp(rl (t )) . Log-returns are symmetrical since if Y=1/X then rlY rl X . This desirable property does not hold for proportional returns. For this reason, log returns are used in the construction of exchange rate indices.
29
where wi is the proportion held in currency pair X/i and currency X being defined as
w (t )
i i
t .This leads to the NEER for a
N X (t )
wi ( t0 ( n 1)Gt ) X i (t 0 nGt ) . N X (t 0 ) n i X i (t 0 ( n 1)Gt )
In the case where the weights wi are constant over time, this simplifies to
N X (t )
wi X i (t ) N X (t 0 ) . i X i (t 0 )
Adjusting for inflation

We extend formula (1) to the following:
X (t Gt ) I X (t Gt ) I i (t ) ln i , X ( t ) I ( t ) I ( t t ) G i X i
where IX(t) is the value of the inflation index in the country with currency X at time t and similarly for Ii(t). If one rebases all the inflation indices at time t so that I i (t ) 100 I X (t ) t then this simplifies to:
X (t Gt ) I X (t Gt ) ln i X i (t ) I i (t Gt )
Thus, the REER for a currency X is calculated as
wi ( t0 ( n 1)Gt ) X i (t0 nGt ) I X (t0 nGt ) . RX (t0 ) n i X i (t 0 ( n 1)Gt ) I i (t 0 nGt )
RX (t )
As with the equation for NEERs on the previous page, we can simplify the equation in the case where the weights wi are constant
R X (t )
wi X i (t ) I X (t ) R X (t 0 ) . i X i (t 0 ) I i (t )
30
HSBC Volume-Weighted REERs

USD REER index
USD Trade-Weighted REER 1996=100 160 USD Market-Weighted REER 1996=100 160
1 996=1 00
EUR REER index

EUR Market-Weighted REER 120 EUR Trade-Weighted REER
1 996=1 00
120
140
140
105
105
120
120
90
90
100
100
75 75
80 Jun-94 Jun-98 Jun-02 Jun-06
80 Jun-10
60 Jun-94 Jun-98 Jun-02 Jun-06 60 Jun-10
Source: HSBC
Source: HSBC
JPY REER index

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

1996=100 140 GBP Trade-Weighted REER GBP Market-Weighted REER 1996=100 140
105
105
125
125
90
90
110
110
75
75
95
95
60 Jun-10
80 Jun-10
Source: HSBC
Source: HSBC
31
CAD REER index

CAD Trade-Weighted REER 1996=100 150 140 130 120 110 100 90 80 Jun-94 Jun-98 Jun-02 Jun-06 CAD Market-Weighted REER 1996=100 150 140
CHF REER index

CHF Market-Weighted REER 1996=100 110 CHF Trade-Weighted REER 1996=100 110
100
100
130 120 110 100

70 70 90 90
80
80
90 80 Jun-10
60 Jun-94 Jun-98 Jun-02 Jun-06 60 Jun-10
Source: HSBC
Source: HSBC
AUD REER index

AUD Trade-Weighted REER 1996=100 140 AUD Market-Weighted REER 1996=100 140
NZD REER index

NZD Market-Weighted REER 1996=100 140 NZD Trade-Weighted REER 1996=100 140
120
120
120
120
100
100
100
100
80
80
80
80
60 Jun-10
60 Jun-10
Source: HSBC
Source: HSBC
SEK REER index

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

NOK Trade-Weighted REER 1996=100 130 120 NOK Market-Weighted REER 1996=100 130 120 110 100 90 80 70 60 Jun-98 Jun-02 Jun-06 Jun-10
100
100
110
90
90
100 90 80
80
80
70
70
70 60 Jun-94
60 Jun-10
Source: HSBC
Source: HSBC
32
Canada QE a matter of time

Most of the economic news out of and impacting Canada in the past month has been disappointing. Domestic economic data has been weaker than expected more often than not, while the continued deterioration of key inputs from the US, such as the labor market, or auto company news, suggests the spillover from south of the border will continue to present a considerable drag on Canada. These developments reinforce our long standing view that the CAD is set to fall further this year. To briefly review, the past month brought a plunge in housing starts (-12.3% m/m in February), an 82K decline in employment, a whopping five-tenths jump in the unemployment rate to 7.7%, and a widening of the trade deficit to C$1bn from $650m in December. So much for trade surpluses; we looked at data going back to 1971 and could not find two consecutive months where Canada posted trade deficits. In addition, Capacity use fell to 74.7% in Q4 from 78.1% in Q3, and the accompanying chart shows how capacity utilisation has fallen off a cliff. Not only does that widen the output gap, but it may also impact the Bank of Canadas assessment of when the gap will close and what actions may be needed now to address that condition (we discuss the BoC outlook below). Along those same lines, manufacturing shipments continued to fall, down 5.4% in January, and marking the longest consecutive streak of monthly contractions (six) since at least 1992. And just to round out the bottom, leading indicators fell 1.1% in February, the lowest reading since 1981.
1. Capacity utilisation plunges
Capacity Utilization (% ) 90 88 86 84 82 80 78 76 74 1987 90 88 86 84 82 80 78 76 74 1990 1993 1996 1999 2002 2005 2008
All of those reports were worse than expected. But there were some releases that met or even exceeded expectations. CPI rose 0.7% m/m overall and 0.5% at the core level, higher than expected but clearly contrary to the broader trend of lower inflation readings for a number of months and at this stage not an issue for the CAD. Retail sales jumped 1.9% in January, also better than expected but it only reversed a limited portion of the 5.2% decline in December. And the reality is that the dramatic weakening in the labor market, the contraction in manufacturing and even the lower level of energy prices suggest domestic demand will remain suppressed for the foreseeable future. Monthly GDP fell 0.7% in January, a poor reading to be sure but in fact right in line with market expectations and actually representing an improvement from the 1% contraction in December.
33
To no ones surprise, the mix of data in the past month has done nothing to improve the bleak economic outlook in Canada and frankly, were not expecting anything better from upcoming data releases. So for the CAD, the issue may be more one of degreeshow much worse will things get and then how will Canada stack up against other currenciesand the policy response. On the latter, the Bank of Canada has already cut the overnight target rate to 0.5%, and pledged to keep it at low levels, or even lower, for an extended period (until there are clear signs that excess supply in the economy is being taken up, in the BoCs language).
QE on the way
central banks which have recently moved to QE (the Bank of England, Swiss National Bank and Federal Reserve). That said; recall that the declines in GBP and the USD proved temporary following the respective BoE and Fed QE announcements (large, but temporary). A surprise move to QE by the BoC this month would likely generate tactical gains in USD-CAD, it might not mark the beginning of a new, sustained rally in the currency pair. The CHF has thus far remained at generally weaker levels following the SNBs QE announcement, but they augmented their efforts by including direct FX intervention into the mix, rather than focusing more specifically on credit easing. We would not expect the Bank of Canada to include FX intervention in its QE efforts at this stage. The current stresses in Canada are not related to the CAD exchange rate, Canada signed onto the G20 Communiqu which pledged to refrain from competitive currency devaluations and even without that, Canadian authoritiesas much as any in the G10typically side with allowing market forces, rather than officials, to dictate exchange rate movements.
Crude rally an opposite force
With the policy rate already at stretched levels, the focus now shifts to quantitative easing (QE). The Bank said it will outline a framework for the possible use of credit and quantitative easing in the next Monetary Policy Report, due April 23. That does not preclude an announcement of such measures at the scheduled April 21 interest rate announcement, but it does not appear that financial market and/or economic conditions have not deteriorated further in a manner that would warrant such actions just yet. Furthermore, the recent rebound in risk appetite might provide policy makers with some breathing room. At this stage, we think the BoC keeps its powder dry (i.e. no QE) for another month or two. If the BoC sticks to plan and only outlines possible QE plans in the future, rather than enacting them immediately, the impact on the CAD should be limited. But if they accelerate the process (not out of the question, given the aggressive QE moves of other central banks as well as the BoCs own actions in cutting the overnight target rate more quickly than many had expected), the initial implications for the CAD are likely to be quite bearish, similar to the sharp declines experienced by the currencies of those
As noted previously, all of the inputs in exchange rate determination rarely point in the same direction simultaneously. Moreover, some inputs clearly carry more weight than others. For the CAD, there is no underestimating the impact of energy prices. Oil prices rose roughly $20 from mid-February through March, a development that certainly provided some help to the CAD. Indeed, USD-CAD had briefly rallied above the 1.3000 threshold on March 9, its highest level since the summer of 2004. But those gainsand the CADs weaknesswere not sustained, due in part to the recovery in crude oil prices during the period.
34
2. Rally in crude helps the CAD

Crude Oil (LHS) 150 USD-CAD (RHS) inverted 0.90
CAD headwinds remain

The point is that the CAD is facing notable headwinds, and will continue to do so while the US economy continues to struggle, as the spillover effects on Canada will remain considerable. We acknowledge that the consolidation phase in USD-CAD could continue in the coming months, but we view that as a prelude to an eventual break higher in the currency pair, not a precursor to a stronger CAD.
125
1.00
100
1.10
75 1.20 50 1.30 25 Mar-08
May-08
Jul-08
Sep-08
Nov-08
Jan-09
Mar-09
We thought USD-CADs break higher in March would mark the end of its near-six-month consolidation period but we obviously jumped the gun. The rally in oil and the USDs abrupt selloff following the Feds QE announcement March 18 combined to put significant downward pressure on USD-CAD. Hence, the broader consolidation phase persists, but we continue to recommend using corrections towards the bottom of that range (1.2000-1.2200) to establish medium-term, long USD-CAD positions. Note too that swings in risk appetite continue to exert considerable pressure on the FX market broadly, including the CAD. Hence, the recent recovery in global equity prices has seen notable declines in the JPY and USD, with the CAD benefitting against both of those currencies. But looking a bit more broadly, since the low close in the S&P 500 on March 9, almost every other G10 currency has appreciated against the CAD, from the meager rise of the EUR, to the more sizeable gain in the AUD, the SEK and the NZD. Aside from the USD and JPY as noted above, the CHF is the only other G10 currency to lose ground to the CAD over that same period. In that instance, the CHF was impacted by the threat of additional SNB FX intervention and higher risk appetite, rather than a positive reassessment of the CADs prospects.
35
QE elsewhere helps the antipodeans

Australia a deserving case
The past month has seen AUD move higher on the back of risk appetite returning, but it is not known how long this sentiment will stay. Unlike most of the currencies benefiting from the change in market sentiment, Australias domestic situation warrants an appreciation in the AUD. Australian policy makers seem determined to ensure a recession is avoided with the RBA easing the cash rate further on April 7th 2009. At 3.0% the cash rate is already 175 basis points below the lowest point it reached in Australia's recession of the early 90s, and 125 points below the level it briefly reached in the abrupt and short lived downturn at the beginning of this decade.
This is in addition to the government legislating for a fiscal package of 4% of GDP to support consumption and jobs through 2009. The deep AUD depreciation since the middle of last year is also helping its economy, offsetting much of the decline in US dollar commodity prices. While Australia has not been able to evade the global slump things are looking up for the economy The balance of reports from China (a major trading partner), including fixed asset investment, retail sales, residential construction and (spectacularly) bank lending, have all suggested the switch to expansionary policies is working. The global economy is a very long way from an upswing, but with China having one of the largest stimulus packages they are likely to lead the world out of recession. Even after excluding a big gold shipment, exports were up around 1% in February, braking the steep fall from October of last
year. Much of that fall was in iron ore exports to China and coal exports to Japan, Taiwan and Korea. The improvement in iron ore suggests the dislocation of the China market in the fourth quarter of last year has not persisted into this year. The flattening out of coal exports suggests the destocking of raw materials in Japan, Korea and Taiwan may also be slowing.
By the end of this year around one million new home loans for owner occupation will have been issued since the rate cuts began last September, almost all of them at a variable rate and at the lowest rate in over three decades.
Output will falter in the first half of 2009. By the second half, however, we expect some of the decline in exports and business investment will be offset by stronger household consumption, an upswing in residential construction, and government infrastructure spending. We have revised down our 2009 year-average growth forecast to just above zero -- not a bad outcome, given the dire global circumstances.
Quite how the RBA handles the return of the cash rate towards a neutral setting around twice as high as it is now, in circumstances like these, is something we will begin to discover sometime next year. But with the Australian growth outlook looking better than most interest rates in Australia may be able to rise earlier than elsewhere. If this were to transpire the AUD would get a major boost.
NZD regains some poise

There has been a spectacular recovery in the NZD after touching a 6 year low. It has risen to levels not seen since January 2008. The currency has bounced despite the situation in New Zealand remaining relatively unchanged as the RBNZ struggles to release the economy from the grips of
36
a long but shallow recession. However, Central bankers elsewhere have begun quantitative easing (See page 3). The risk of QE in New Zealand seems unlikely and is a factor behind the NZDs appreciation.
1. Rising, but not on its own merit
NZD-USD 0.6 0.58 Fed announce plans to buy $300bn treasuries 0.56 0.54 0.52 0.56 0.54 Geithner announces 0.52 fresh financial 0.5 0.48 16-Feb-09 02-Mar-09 16-Mar-09 30-Mar-09 bailout plans 0.5 0.48 0.6 0.58
stabilisers (declining revenues and higher spending) than a discretionary response. This is unlike other members of the G10 who are putting their sovereign debt ratings - albeit higher ratings - into jeopardy with huge stimulus packages
Less stretched, but less control

When New Zealand is pulled out of this recession, it will not be as fiscally stretched as others as it has been riding on the coat tails of other G10 members fiscal boosts. In addition its financial system is largely unscathed. Its biggest exports are food products, which have been less affected by the global downturn. Its biggest export market is Australia, which is doing better than most. But despite these relative positives, the economy is still at least two quarters away from a recovery, and the timing and strength of the upswing will be dependent on the strength of recovery elsewhere. Against the AUD we maintain our expectation of depreciation, with the RBNZs cash rate expected to fall further below the RBAs. Furthermore Australias economy is expected to begin growth sooner than New Zealands. So we prefer the nonQE currencies to the QE currencies. Within the two antipodean non-QE currencies we still prefer the AUD to the NZD.
Risk appetite rising...for now
In addition to the quantitative easing measures, more financial bailouts have been announced along with G20 meeting announcing additional funds for the IMF. These measures have boosted sentiment with commodities and global stock indices rising around the world. This has also led to higher risk currencies like the NZD making significant gains on the month. It is not known how long this turnaround will last but when it ends and risk appetite dissipates it is inevitable the NZD will suffer but for now it is one of the stars of the show.
Stimulation is coming from elsewhere
On paper the effects of the RBNZs cut in the cash rate by a cumulative 525bp between July 2008 and March 2009, with one or two more 25bp cuts yet to go would be expected to be huge. But unlike the Australians, New Zealanders mostly lock into fixed rate mortgages, and the impact of lower cash rates is accordingly less direct. In addition, its fiscal policy is expansionary, though largely through the impact of the automatic
37
MXN/USD
Mexico: A brighter outlook The MXN has recovered close to 15% since the rally in US equities begun in early March. While the first phase of the recovery was driven by improved risk appetite, we see a shift in the technical position of the MXN that should extend the recovery over the next few weeks. To begin, Mexico was the first EM country to apply for an FCL (for USD47bn) with the IMF, and while it does not intend to activate the loan yet, the agreement allows the authorities to increase foreign reserves at a low cost at any time. In our view, this should help to cap MXN weakness ahead. Moreover, Banxico activated its USD30bn swap line with the Fed and, as such, will initiate dollars auctions to local banks on 21 April for up to USD4bn to facilitate dollar financing for local corporations, thereby reducing rollover risks. We think that the markets positive reaction is more than a knee-jerk reaction and look for USDMXN to move to a 13.00-13.50 range, as onshore supply of dollars increases.
15.75 14.75 13.75 12.75 11.75 10.75 9.75 8.75 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
15.75 14.75 13.75 12.75 11.75 10.75 9.75 8.75
Source: Thomson Financial Datastream
BRL/USD
Brazil: The reversal of the flight to quality trade
4.00 3.50 3.00 2.50 2.00 1.50 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
4.00 3.50 3.00 2.50 2.00 1.50
We see improved technicals in BRL where net foreign speculative positions have fallen from a high of USD13.3bn in February to USD6.2bn by the end of March. Furthermore, we find evidence in the BCBs decision to roll over only USD4bn of the USD7.9bn in swaps that expired on 1 April as evidence that demand for dollars onshore has waned. To some extent, demand for dollars has waned as inflows into local equities have resumed on a reversal of the flight to quality flow. Recent data also shows encouraging signs with the trade balance over the last two months showing improvements. All in all, BRL looks well poised to move towards 2.10/USD, in our view, though global market sentiment will continue to prevail.
ARS/USD
Argentina: A weaker ARS, but after the elections
4.0 3.6 3.2 2.8 2.4 2.0 1.6 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
4.0 3.6 3.2 2.8 2.4 2.0 1.6
Dollar demand has increased fourfold over the past month despite the governments efforts to repress wholesale investors. As such, throughout March, the exchange rate weakened at the fastest pace since last October, rising 4.4% to ARS3.72/USD. Nevertheless, given the proximity of midterm elections (which the government moved forward from 24 October to 28 June), we believe that the monetary authority will be keen on avoiding any discrete jump in the exchange rate in the near term. This effectively means keeping controls in place to curb wholesale demand while using reserves to accommodate retail investors. Moreover, BCRA dollar sales along the onshore NDF curve amid thin volumes is widening the offshore-onshore spread, with implied yields in the offshore market climbing further as USD demand increase and offers become scarcer. This threatens to further undermine liquidity and price action in the offshore market.
38
CHF/EUR
1.70 1.66 1.62 1.58 1.54 1.50 1.46 1.42 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90
Switzerland: QE through the exchange rate The intervention by the Swiss authorities saw euro-CHF jump substantially. However, the Swiss have made it quite clear that they are attempting to stop CHF appreciation rather than cause CHF weakness. In other words they do not want to be accused of causing a competitive devaluation thereby sparking a beggar they-neighbour quarrel with the EU. This cautious line by the Swiss authorities has seem EUR-CHF stabilise at around the 1.52 level. On top of the issue of intervention the Swiss have been in the news regarding how they operate their banking system with respect to private clients. All in all we believe the CHF has lost its historical strategic advantage in a time of financial stress.
euro-sw iss (LHS)

dollar-sw iss (R HS)
NOK/EUR
Norway: NOK still a favourite
10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
10.50 10.00 9.50 9.00 8.50 8.00 7.50 7.00
The NOK has moved lower following the latest central bank meeting on 25 March. The Norges Bank reduced its key rate by 50bps to 2.00% but suggested further rate cuts were on the cards. It added that the key rate could reach 1.00% by autumn. Despite the dovish tone by the Norges Bank, we maintain a positive outlook on the currency. The interest advantage that it has compared to others has not really been a key driver behind our positive view for the next 18 months. The NOK has a backdrop where the current account is still high, even though the oil price has moved lower, and sovereign risk is comparably small to the other G10 countries. The one feature that detracts from the NOK being considered a safe haven currency is its relatively lower liquidity premium compared to other currencies such as the EUR. However this lower liquidity profile is not enough to change our optimistic view on the NOK.
SEK/EUR
Sweden: ... SEK stronger but not out of the woods
12.00 11.60 11.20 10.80 10.40 10.00 9.60 9.20 8.80 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
12.00 11.60 11.20 10.80 10.40 10.00 9.60 9.20 8.80
The SEK has corrected higher in recent weeks, as some of the contagion risk from Central Europe has dissipated. That said, this contagion risk has not been totally removed, which suggests the SEK could struggle to make significant headway from here. The Riksbanks next monetary policy meeting is on 20 April. The key rate stands at 1.00% but the risk is that another rate cut comes through and the central bank announces some unconventional measures. The language by the Riksbank members is very important, as some of the board members have suggested aggressive measures to reflate the economy may be needed. In particular, some of the Riksbank members have discussed the idea of purposely devaluing the SEK to help achieve their inflation target. It is a low probability scenario but the fact that this idea has been discussed in public indicates aggressive policy measures cannot be ruled out.
39
TRY/USD
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-07 Jan-08 Jan-09
1.90 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10
Turkey: IMF deal supports TRY in short-term Following local elections on March 29th and with fairly respectable victory, the Turkish government has renewed its focus on long-awaited new IMF arrangement. In the meantime, G-20s strong support to IMF and significant boost to its lending capacity have also reflected well in local Turkish markets, fuelling expectations that the deal size with Turkey could be larger than original $15-25bn expectations. Thus, TRY may remain stable in near term. In the medium-to-long term, though, its all about economic growth and risk-adjusted return offered to TRY investors. This depends a lot on European economy. As HSBC foresees sharp contraction in Eurozone economy this year and the next, there are considerable downside risks to Turkish economic activity as well. Hence, while a credible and sizable IMF program is expected to shield Turkey somewhat in the short-term, there remain medium-term risks.
Source: Thomson Financial Datastream,
RON/EUR
4.5 4.0 3.5 3.0 2.5 2.0 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
4.5 4.0 3.5 3.0 2.5 2.0
Romania: IMF to ease pressure on the leu Romanian leu has embarked on an appreciation cycle in late March after securing a EUR20bn loan package financed by IMF/EU/WB/EBRD. The positive sentiment is boosted further by the elevated appetite for risk after G-20 summit. Accordingly, the funds from the package will be used to finance whopping budget deficit (5.2% of GDP in 2008), ease balance of payment requirements (C/A deficit at 12.1% as of 2008) and support reserves of National Bank Romania (NBR). Although the financial support will alleviate the roll-over risk on Romanias massive external debt service this year (EUR 33.7bn), it is unlikely to prevent growth from falling into negative territory. In short-term, leus appreciation is likely to continue with the enhanced investor confidence following IMF deal, nevertheless RON remains hostage to global/regional turmoil despite NBRs covert FX interventions and high cost of shorting the currency (policy rate at 10.0%, highest in EU).
ILS/USD
5.10 4.70 4.30 3.90 3.50 3.10 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
5.10 4.70 4.30 3.90 3.50 3.10
Israel: ILS will remain sensitive to EUR-USD Although the ILS has weakened since the beginning of the year, it continues to outperform most EM currencies, due to strong macro fundamentals, including a C/A surplus, positive net FDI, and a small external debt. Monetary policy has contributed to a weaker ILS both through aggressive rates cuts and daily FX purchases by the Bank of Israel (BoI), at an annual pace of USD20bn, or 11% of GDP. So far, the BoI has sterilized both FX and FI intervention, but has hinted that some form of quantitative easing will be the next monetary tool, a policy which is negative for the ILS. Politics are not expected to have a serious impact on the ILS, although a credible fiscal policy by the new Netanyahu coalition should be ILS-positive. The ILSUSD is expected to trade in the 4.15-4.25 range through mid-2009, fluctuating with shifts in the EUR-USD rate.
40
CNY/USD
China: Spot to remain stable The renminbi spot rate will remain stable for the time being. However, we continue to expect the NDF to show increasing premium. Recently the NDF curve flipped back to discount as Chinas credible domestic policy response and strong verbal commitment to a stable USD CNY have held other forces in check. However, we expect Chinas external sector to continue to deteriorate, even as policymakers successfully support growth from the domestic side. Certainly some monthly trade deficits seem possible over coming months, FDI is likely to continue to shrink, and we continue to expect local savers to reduce their heavy CNY overweight. Against this backdrop, the strong appreciation in Chinas real exchange rate is likely to be of increased focus. While a weaker currency is unlikely to noticeably boost exports, we doubt that any country will remain comfortable with an overly strong real exchange either when global growth remains constrained.
8.30 8.10 7.90 7.70 7.50 7.30 7.10 6.90 6.70 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jul-05 Jul-06 Jul-07 Jul-08
8.30 8.10 7.90 7.70 7.50 7.30 7.10 6.90 6.70
HKD/USD
Hong Kong: HKD to remain robust
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
7.86 7.84 7.82 7.80 7.78 7.76 7.74 7.72 7.70
The HKD has two crucial supports that other currencies in EM Asia lack. The first is that Hong Kong is one of the few countries with a private sector stock of net foreign assets. Secondly, Hong Kong residents are quite comfortable holding their wealth in HKDs (there are also emerging anecdotes of Mainland flows into the HKD). These two forces together imply that ongoing global balance sheet adjustments, and the associated capital repatriation, will result in a net repatriation of assets back to Hong Kong, suggesting the HKD will remain robust. To this point, the HKMA has been comfortably able to resist any pressure on the HKD peg simply through intervention. Certainly we do not expect any constraints on intervention to emerge this year, nor do we expect any shift in the peg arrangement at any time.
PHP/USD
57 53 49 45 41 37 33 29 25 97 99 01 03 05 07 09
57 53 49 45 41 37 33 29 25
Philippines: PHP weakness to come Our expectation of sharply declining remittance flows remains the key reason for our bullish USD-PHP view. Unlike the previous crisis, the current one has spared few economies and industries. According to IMF estimates, 2009 will mark the weakest year for global trade in over 60 years. With 15% of remittances coming from sea-based workers, aggregate flows are likely to be affected quite substantially. In addition, the ongoing weakness in the Middle East not only means a sizeable contraction in demand for Filipino workers, but also the likely transfer of some current workers back home. The ongoing credit deterioration is also another concern of ours. Officials have unveiled an ambitious Economic Recovery Program, comprising tax and spending of up to 4% of GDP which is likely to see the fiscal deficit widen to 3.3% of GDP this year.
41
THB/USD
Thailand: THB weakness persist
55 50 45 40 35 30 25 20 97 99 01 03 05 07 09
55 50 45 40 35 30 25 20
The THB is set to remain on a modest depreciation trend, but it lacks any of the obvious pressure points seen in some of the other Asian countries. Thailand, unlike its peers, saw a significant withdrawal of portfolio capital after 2006 due to the introduction of capital controls and ongoing political uncertainty. However, this has had the benefit of keeping FX volatility low during a period of volatile risk environment. Moreover, Thailand lacks any significant external short term debt compared to its Asian peers. Having said that, the ongoing leakage, weakening FDI inflows and poor sovereign credit situation should keep USD-THB well-bid. Moreover from a trade weighted valuation perspective, Thailand remains expensive compared to the rest of the region. As such, the BOT is likely to continue supporting a competitive THB.
SGD/USD
Singapore: A more aggressive MAS?
1.90 1.80 1.70 1.60 1.50 1.40 1.30 97 99 01 03 05 07 09
1.90 1.80 1.70 1.60 1.50 1.40 1.30
At the time of writing, the MAS is very close to its biannual policy-setting meeting. We are looking for a 200-300 recentering weaker in the S$NEER midpoint, which would be a historically aggressive easing move by the MAS. As Asias smallest and most externally dependent economy, Singapore is more vulnerable than most to the global recession, already having recently printed historically large declines in activity including headline real GDP, and with inflation set to turn negative. This has lead Singapore to announce one of the most aggressive fiscal stimulus packages in the region, and we expect a response of similar magnitude from the MAS. Even though the risk environment has improved in the past month or so, it has improved because policymakers have become unconventionally aggressive and we expect MAS to be in-line with this.
TWD/USD
Taiwan: TWD not a preferred short From a fundamental macro perspective the TWD outlook seems straightforward. As a specialized export-sensitive economy with little innate domestic demand, adjusting to structurally lower western export demand should entail a structurally undervalued real exchange rate. The wrinkle, however, is that the currency is quite cheap, and our strong impressions from onshore are that FX policy may support depreciation less aggressively going forward. Accordingly, TWD is not one of our preferred shorts in Asia, even though we believe TWD depreciation has further to run. A deeper than cursory look at the external accounts leaves us with a view that the balance of payments is broadly negative for the currency. In the first instance, the current account in Taiwans case is a misleading as a source of TWD demand. For example, the most recent data from the CBC suggest that, while Taiwan continues to run a trade surplus, the trade sector is actually a net seller of TWDs. At the end of the day, it is difficult to see Taiwans outflow of local savings coming to an end.
36 34 32 30 28 26 97 99 01 03 05 07 09
36 34 32 30 28 26
Source: Bloomberg
42
Euro dollar vs forwards

USD/EUR 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 Forward Forecast USD/EUR 1.60 1.50 1.40 1.30
Euro Swiss vs forwards

CHF/EUR 1.75 1.70 1.65 1.60 1.20 1.10 1.00 0.90 1.55 1.50 1.45 1.55 1.50 1.45 Forward Forecast CHF/EUR 1.75 1.70 1.65 1.60
0.80 0.80 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
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 Forward Forecast USD/GBP 2.10 2.00 1.90 1.80 1.70 1.60 1.50 1.40
Euro sterling vs forwards

GBP/EUR 1.00 0.97 0.94 0.91 0.88 0.85 0.82 0.79 0.76 0.73 0.70 0.67 0.64 0.61 0.58 0.55 Jan00 Forward Forecast GBP/EUR 1.00 0.97 0.94 0.91 0.88 0.85 0.82 0.79 0.76 0.73 0.70 0.67 0.64 0.61 0.58 0.55 Jan10
Jan01
Jan02
Jan03
Jan04
Jan05
Jan06
Jan07
Jan08
Jan09
Dollar yen vs forwards

Forward Forecast JPY/USD JPY/USD 140 140 135 135 130 130 125 125 120 120 115 115 110 110 105 105 100 100 95 95 90 90 85 85 80 80 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Euro yen vs forwards

JPY/EUR 175 165 155 145 135 125 115 105 95 85 Jan00 Forward Forecast JPY/EUR 175 165 155 145 135 125 115 105 95 85 Jan01 Jan02 Jan03 Jan04 Jan05 Jan06 Jan07 Jan08 Jan09 Jan10
43
3 Month Money End period North America US (USD) Canada (CAD) Latin America Mexico (MXN) Brazil (BRL) Argentina (ARS)* Chile (CLP)* Western Europe Euro-15 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
2005 Q4 4.5 3.4 8.0 17.4 4.8 4.5 2.5 4.6 2.0 1.0 2.6 6.3 4.6 5.9 13.8 6.6 7.0 0.1 5.8 7.7 1.7 4.2 6.3 12.8 3.2 5.2 3.3 4.0 1.6 4.5
2006 Q4 5.3 4.2 7.2 12.8 7.1 5.3 3.7 5.3 3.3 2.1 3.9 8.1 4.2 5.9 17.6 7.6 9.2 0.6 6.5 7.7 1.8 3.9 8.2 9.5 3.7 4.8 3.4 4.8 1.8 5.3
2007 2008 Q4 Q2 4.7 4.5 7.3 11.2 10.0 6.5 4.6 5.9 4.7 2.8 5.9 7.6 5.1 6.3 16.0 6.6 11.3 0.9 7.3 8.9 3.3 3.5 8.0 7.8 3.6 3.7 2.4 5.7 2.2 3.9 2.8 3.4 7.6 12.7 10.7 7.9 4.9 5.9 5.0 2.8 6.6 8.8 6.7 5.4 19.3 16.4 12.4 1.0 7.8 8.7 3.3 2.3 9.4 9.2 3.7 6.0 1.3 5.4 2.2 3.7
Q3 4.5 4.1 8.3 14.0 11.5 8.5 5.3 6.3 5.5 3.0 7.7 8.7 6.6 8.3 19.1 18.0 12.1 1.1 7.3 8.0 3.3 3.7 11.0 9.9 3.7 5.7 1.9 5.8 2.3 4.0
Q4 1.4 1.9 8.2 13.0 15.7 8.3 2.9 2.8 2.5 0.6 4.0 10.0 5.9 20.6 15.5 20.0 11.4 1.0 4.1 6.0 1.7 1.0 8.5 12.0 3.4 6.1 1.0 4.7 1.0 3.0
2009 Q1 1.4 1.0 6.4 10.5 12.9 2.3 1.6 1.6 1.1 0.6 3.0 9.5 4.3 15.0 12.5 16.0 9.8 0.7 3.2 3.8 1.3 1.0 7.1 9.3 2.0 4.5 0.6 2.2 0.2 1.8
Q2f 1.2 0.4 5.7 9.0 14.7 1.6 1.2 1.5 0.8 0.4 2.5 8.5 3.5 13.5 13.0 15.0 8.3 0.6 3.0 3.4 1.0 0.9 6.3 8.0 1.3 5.0 0.6 1.7 0.1 1.1
Q3f 1.0 0.4 5.2 8.8 14.9 1.6 1.0 1.4 0.5 0.4 2.5 7.5 3.0 13.5 14.0 15.0 7.8 0.6 3.2 3.3 1.0 0.8 6.1 7.8 1.3 5.0 0.6 1.7 0.2 1.1
Q4f 1.0 0.4 5.1 9.1 15.3 1.6 1.1 1.4 0.5 0.4 2.5 7.5 3.3 13.5 14.5 18.0 7.8 0.6 3.6 3.3 1.0 0.7 6.0 7.5 1.3 6.0 0.7 1.7 0.3 1.1
Q1f 0.9 0.4 5.1 8.8 15.3 1.6 1.3 1.5 0.5 0.4 2.5 7.0 3.3 11.5 15.0 12.0 7.8 0.6 4.6 3.5 1.0 0.6 5.7 7.3 1.3 6.0 0.8 2.0 0.4 1.1
Q2f 0.9 0.5 5.1 8.7 15.1 1.9 1.5 1.7 0.8 0.7 2.5 6.5 3.3 11.0 15.5 12.0 7.9 0.6 4.7 3.5 1.0 0.6 5.9 7.2 1.3 6.0 0.9 2.2 0.3 1.1
Important note
This table represents three month money rates. Due to the dislocation in the three month money markets, these rates may not give a good indication of policy rates.
44
8-Apr-09 last
2008 Q1 x x 3.17 1.75 437 10.64 1831 2.80 2.15 Q4 x 3.45 2.34 639 13.81 2248 3.13 2.15
2009 Q1 x 3.71 2.31 584 14.21 2539 3.15 2.80 Q2f x 3.80 2.35 625 15.35 2750 3.22 2.80 Q3f x 4.01 2.35 650 15.00 2828 3.30 2.80 Q4f x 4.20 2.45 650 15.00 2775 3.45 2.80
2010 Q1f x 4.40 2.40 650 14.80 2750 3.35 3.60 Q2f x 4.61 2.35 650 14.75 2700 3.35 3.60 Q3f x 4.82 2.35 650 14.60 2700 3.35 3.60 Q4f x 5.05 2.35 650 14.40 2700 3.35 3.60
Latin America vs USD

Argentina (ARS) Brazil (BRL) Chile (CLP) Mex ico (MXN) Columbia (COP) Peru (PEN) Venezuala (VEF)
x 3.67 2.22 579 13.56 2419 3.10 2.14
Eastern Europe vs EUR

Czech Republic (CZK) Hungary (HUF) Russia v s USD (RUB) Romanian (RON) Turkey v s USD (TRY)
S imple rate
x 26.59 297 33.76 3.17 1.61 4.49 x 5.62 4.14
x 25.21 3.75 260 8.00 23.52 3.75 1.33 3.52 5.75
x 26.85 2.25 266 10.00 29.38 4.03 1.54 4.12 5.00 x 5.52 3.78 4.0
x 27.45 309 34.01 4.24 1.66 4.67 x 5.63 4.15 4.3
x 27.50 295 34.00 4.35 1.65 4.20 x 5.65 4.20 4.5
x 27.00 290 31.50 4.30 1.68 4.00 x 5.75 4.18
x 26.00 285 33.50 4.25 1.71 3.80 x 5.65 4.15
x 25.50 280 33.50 4.00 1.63 3.70 x 5.60 4.10
x 25.00 280 33.50 3.90 1.60 3.60 x 5.55 4.10
x 24.50 275 33.50 3.80 1.60 3.50 x 5.55 4.05
x 24.00 270 36.80 3.80 1.60 3.40 x 5.55 4.00
Poland (PLN)
Middle East vs USD

Egy pt (EGP) Israel (ILS)
x 5.45 3.45 4.0
Africa vs USD
South Africa (ZAR) Interest rates
x 9.23
x 8.13 10.60
x 7.83 11.90
x 9.51 12.20
x 11.00 11.35
x 11.25 0.00
x 11.50 0.00
x 12.00 7.80
x 12.50 7.80
x 12.75 0.00
x 13.00 0.00
45
end period
x Canada (CAD) Mex ico (MXN) Brazil (BRL) Argentina (ARS) x Eurozone (EUR*) Other Western Europe x x UK (GBP*) x Sw eden (SEK) x Norw ay (NOK) x Sw itzerland (CHF) Emerging Europe x x Russia (RUB) x Poland (PLN) x Hungary (HUF) x Czech Republic (CZK) Asia/Pacific x x Japan (JPY) x Australia (AUD*) x New Zealand (NZD*) x North Asia x China (CNY) x Hong Kong (HKD) x Taiw an (TWD) x South Korea (KRW) x South Asia India (INR) x Indonesia (IDR) x Malay sia (MYR) x Philippines (PHP) x Singapore (SGD) x Thailand (THB) Africa x Vietnam (VND) x South Africa (ZAR) Americas x x x x Western Europe x
2006 Q4 1.16 10.80 2.14 3.06 x 1.32 x 1.96 6.84 6.23 1.22 x 26.4 2.90 191 20.9 119 0.79 0.71 x 7.81 7.77 32.6 930 x 44.2 8996 3.53 49.1 1.53 36.0 16050 x 7.05 x x x x x x
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
2008 Q2 1.01 10.31 1.59 3.02 x 1.58 x 1.99 6.02 5.09 1.02 x 23.5 2.13 149 15.2 106 0.96 0.76 x 6.86 7.80 30.4 1048 x 43.0 9218 3.26 44.8 1.36 33.5 16110 x 7.83
Q3 1.06 10.95 1.91 3.13 x 1.40 x 1.78 6.97 5.91 1.12 x 25.2 2.41 172 17.4 106 0.79 0.67 x 6.85 7.77 32.1 1207 x 47.0 9469 3.45 47.2 1.44 34.0 16800 x 8.28
Q4 1.23 13.81 2.34 3.45 x 1.39 x 1.44 7.91 7.00 1.06 x 29.4 2.96 191 19.3 91 0.70 0.58 x 6.82 7.75 32.9 1263 x 48.6 11027 3.46 47.5 1.43 34.9 16900 x 9.25
2009 Q1 1.26 14.21 2.31 3.71 x 1.33 x 1.43 8.27 6.75 1.14 x 34.0 3.52 232 20.7 99 0.69 0.57 x 6.83 7.75 33.9 1375 x 50.6 11550 3.65 48.3 1.52 35.5 17776 x 9.51
Q2f 1.40 15.35 2.35 3.80 x 1.40 x 1.50 8.39 6.21 1.11 x 34.0 3.00 211 19.6 100 0.70 0.58 x 6.80 7.80 36.0 1400 x 54.0 13000 3.80 51.0 1.60 36.5 17900 x 11.00
Q3f 1.40 15.00 2.35 4.01 x 1.45 x 1.56 8.28 5.86 1.08 x 31.5 2.76 200 18.6 100 0.72 0.59 x 6.80 7.80 36.0 1400 x 54.0 13500 3.90 52.0 1.62 38.0 18050 x 11.25
Q4f 1.40 15.00 2.45 4.20 x 1.50 x 1.61 8.00 5.67 1.05 x 33.5 2.53 190 17.3 105 0.74 0.60 x 6.80 7.80 36.0 1200 x 54.0 13500 4.00 53.0 1.64 38.5 18200 x 11.50
2010 Q1f 1.35 14.80 2.40 4.40 x 1.50 x 1.61 8.00 5.33 1.07 x 33.5 2.47 187 17.0 105 0.76 0.60 x 6.80 7.80 36.0 1200 x 54.0 13500 4.10 53.0 1.64 38.5 18200 x 12.00
Q2f 1.30 14.75 2.35 4.61 x 1.50 x 1.61 8.00 5.33 1.07 x 33.5 2.40 187 16.7 105 0.76 0.60 x 6.80 7.80 36.0 1200 x 54.0 13500 4.10 53.0 1.64 38.5 18200 x 12.50
Q3f 1.30 14.60 2.35 4.82 x 1.50 x 1.61 8.00 5.33 1.07 x 33.5 2.33 183 16.3 105 0.76 0.60 x 6.80 7.80 36.0 1200 x 54.0 13500 4.10 53.0 1.64 38.5 18200 x 12.75
Q4f 1.30 14.40 2.35 5.05 1.50 1.61 8.00 5.33 1.07 36.8 2.27 180 16.0 105 0.76 0.60 6.80 7.80 36.0 1200 54.0 13500 4.10 53.0 1.64 38.5 18200 13.00
46
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
sourceHS BC
2006 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) Q4 x x 1.32 1.53 0.67 9.02 8.21 1.61 34.8 3.83 251 27.5 x 157 1.67 1.87 x x 1.96 2.28 x 0.67 13.39 12.19 2.39 x 233 2.48 2.78
2007 Q4
2008 Q2 Q3 Q4
2009 Q1 Q2f Q3f Q4f
2010 Q1f Q2f Q3f Q4f
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
1.58 1.60 0.79 9.48 8.02 1.60 37.0 3.35 235 23.9 x 167 1.64 2.07 x x 1.99 2.02 x 0.79 11.97 10.14 2.03 x 211 2.07 2.61
1.40 1.49 0.79 9.79 8.30 1.57 35.5 3.39 242 24.5 x 149 1.78 2.10 x x 1.78 1.90 x 0.79 12.43 10.54 2.00 x 189 2.26 2.67
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
1.33 1.67 0.93 10.98 8.96 1.51 45.2 4.67 309 27.4 x 131 1.91 2.33 x x 1.43 1.80 x 0.93 11.85 9.68 1.63 x 142 2.06 2.51
1.40 1.96 0.93 11.75 8.70 1.55 47.6 4.20 295 27.5 x 140 2.00 2.41 x x 1.50 2.10 x 0.93 12.62 9.34 1.66 x 150 2.15 2.59
1.45 2.03 0.93 12.00 8.50 1.57 45.7 4.00 290 27.0 x 145 2.01 2.46 x x 1.56 2.18 x 0.93 12.88 9.13 1.69 x 156 2.16 2.64
1.50 2.10 0.93 12.00 8.50 1.57 50.3 3.80 285 26.0 x 158 2.03 2.50 x x 1.61 2.25 x 0.93 12.88 9.13 1.69 x 169 2.18 2.68
1.50 2.03 0.93 12.00 8.00 1.60 50.3 3.70 280 25.5 x 158 1.97 2.50 x x 1.61 2.17 x 0.93 12.88 8.59 1.72 x 169 2.12 2.68
1.50 1.95 0.93 12.00 8.00 1.60 50.3 3.60 280 25.0 x 158 1.97 2.50 x x 1.61 2.09 x 0.93 12.88 8.59 1.72 x 169 2.12 2.68
1.50 1.95 0.93 12.00 8.00 1.60 50.3 3.50 275 24.5 x 158 1.97 2.50 x x 1.61 2.09 x 0.93 12.88 8.59 1.72 x 169 2.12 2.68
1.50 1.95 0.93 12.00 8.00 1.60 55.2 3.40 270 24.0 x 158 1.97 2.50 x x 1.61 2.09 x 0.93 12.88 8.59 1.72 x 169 2.12 2.68
47
48
49
Analyst certification
The following analyst(s), who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and 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, Paul Mackel, Clyde Wardle, Richard Yetsenga, Robert Lynch and Juliet Sampson This report is designed for, and should only be utilised by, institutional investors. Furthermore, HSBC believes an investors decision to make an investment should depend on individual circumstances such as the investors existing holdings and other considerations. Analysts are paid in part by reference to the profitability of HSBC which includes investment banking revenues. For disclosures in respect of any company, please see the most recently published report on that company available at www.hsbcnet.com/research. * HSBC Legal Entities are listed in the Disclaimer below.
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50
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[240077]
51
Global Currency Strategy Research Team
Global
David Bloom Global Head of Currency +44 20 7991 5969 david.bloom@hsbcib.com
Precious Metals
James Steel +1 212 525 6515 james.steel@us.hsbc.com
Global Emerging Markets Asia

Richard Yetsenga +852 2996 6565 Perry Kojodjojo +852 2996 6568 Daniel Hui +852 2822 4340 richard.yetsenga@hsbc.com.hk perrykojodjojo@hsbc.com.hk danielpyhui@hsbc.com.hk Juliet Sampson +44 20 7991 5651 juliet.sampson@hsbcib.com
United Kingdom
Paul Mackel +44 20 7991 5968 Stacy Williams +44 20 7991 5967 Mark McDonald +44 20 7991 5966 Mark Austin Consultant paul.mackel@hsbcib.com stacy.williams@hsbcgroup.com mark.mcdonald@hsbcib.com
United States
Robert Lynch +1 212 525 3159 Clyde Wardle +1 212 525 3345 robert.lynch@us.hsbc.com clyde.wardle@us.hsbc.com
Marjorie Hernandez +1 212 525 4109 marjorie.hernandez@us.hsbc.com
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.
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 group's views and forecasts for major currencies.
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.
Juliet Sampson Chief Economist, Emerging EMEA juliet.sampson@hsbcib.com +44 20 7991 5651 Juliet Sampson is Senior Economist covering Central Europe and South Africa. She joined HSBC in 2005 and has over 10 years experience in emerging markets as a currency and debt strategist.
Clyde Wardle Emerging Markets Currency Strategist clyde.wardle@us.hsbc.com +1 212 525 3345 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.
Richard Yetsenga Asian Regional FX Strategist richard.yetsenga@hsbc.com.hk +852 2996 6565 Richard is a Hong Kong-based member of HSBCs global emerging markets FX research team covering Asia. Prior to joining HSBC in 2004, he worked in currencies and economics research, including four years with the Australian government.
Stacy Williams Director of FX Quantitative Strategy stacy.williams@hsbcgroup.com +44 20 7991 5967 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 bank's academic collaborations, principally with the University of Oxford, where he read physics.

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Currency

Macro Currency Strategy April 2009

QE, monetary conditions and the dollar

Macro Currency Strategy April 2009

QE, monetary conditions and the dollar

Gold investment robust but consumer demand crumbles (pg 16)

FX Volumes down but not out

HSBC Volume-Weighted REERs

Macro Currency Strategy April 2009

QE elsewhere helps the antipodeans

12 months 1.298 99.57 1.500 1.232 0.672 0.527

1.268 96.01 1.407 1.274 0.632 0.500

Macro Currency Strategy April 2009

QE, monetary conditions and the dollar

The US joins the QE club

Part I QE the list of country grows

Macro Currency Strategy April 2009

2. Sterling was hit hard by the original QE announcement

Fed balance sheet

500 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08

Source: Bloomberg, HSBC

Source: Bloomberg, HSBC

Macro Currency Strategy April 2009

3. The CHF has been appreciating since 2007

121 119 117 115 113

111 109 107 105

Source: Bloomberg, HSBC

Macro Currency Strategy April 2009

6. Canadian employment is falling fast

Source: Bloomberg, HSBC

Source: Bloomberg, HSBC

The QE candidates Canada and Sweden

Macro Currency Strategy April 2009

Macro Currency Strategy April 2009

8. Euro zone monetary conditions have eased, but not dramatically

-4. 0% De c -0 1 De c -0 2 De c -0 3 De c -0 4 De c -0 5 De c -06 Dec -0 7 De c -0 8

The Eurozone and QE

The non-QE group

Macro Currency Strategy April 2009

9. Non-QE currencies have begun to out-perform QE currencies recently

96 non-QE currencies 94 15-Jan 29-Jan 12-Feb 26-Feb 12-Mar 26-Mar

Macro Currency Strategy April 2009

From April? Not yet

Part II The currency implications: What if QE works?

Macro Currency Strategy April 2009

The pre-2008 world

11. Astronomical returns strong growth meant a strong currency

12. 1994 higher rates and a falling dollar

Fed Funds rate (LHS)

USD TWI (1994=100)

Source: Bloomberg, HSBC

Source: Bloomberg, HSBC

Macro Currency Strategy April 2009

13. Cycling around a trend

14. Stronger growth leads to a stronger currency

The conventional view

Short rates & bond yields rise Equities rise

FDI Flows Portfolio flows

Low inflation and low volatility was the key

The low inflation cycle

15. Shock to the level and permanently higher debt

16. Japans QE never got them back to the original path

Macro Currency Strategy April 2009

The post-2008 world and QE

wi ( t0 ( n 1)Gt ) X i (t 0 nGt ) . N X (t 0 ) n i X i (t 0 ( n 1)Gt )