January 18, 2011

FX Monthly – January 2011

John J. Hardy
Consulting FX Strategist
jjh@saxobank.com
+45 3977 4000

FX month(s) in review: Wild transition to the New Year

The two months since our November report saw remarkable developments in FX. The post QE2 announcement
environment saw a sharp reversal in some of the correlations we’ve been so used to, particularly the US
dollar’s correlation with risk and even correlations across markets in general. Other key developments included
a strong rise in interest rates and risk appetite into year end. Then to start the year, someone pressed the “all
change” button in FX and we’ve seen a sharp reversal in many of the trends that persisted into year-end –
particularly a sharp weakening in both the Swiss Franc and Australian dollar. Below are a few highlights of
what has transpired since our last report.

 What goes up must come down? We saw a sharp rally into year-end by both the Swiss Franc and the
Australian dollar, both (with some measure of 20-20 hindsight) clearly driven to some degree of fixing
interest or positioning squeezes aggravated by thin liquidity in the close of the year. The strong franc was
also driven by the renewed EuroZone sovereign debt pressures and the Australian dollar rally by the
commodity rally that ended the year with a flourish with copper, for example, trading to new all time
highs. Then, after the calendar rolled into 2011, these two currencies were the weakest of the G-10 by
mid-month, with Australia suffering from a commodity sell-off and a series of flood disasters and the franc
consolidating on European attempts (though somewhat feeble) to get ahead of the curve on its sovereign
debt crisis.

 Interest rates higher. At the time of our last report in mid-November, the US treasury market had
consolidated sharply from its heady gains going into the November 3 FOMC meeting – a move that was
clearly (with the wonderful aid of 20-20 hindsight) a buy-the-rumor, sell-the-fact reaction to the
confirmation that the Fed planned to move ahead with the QE2 policy of massive renewed bond purchases.
But in December, we were faced with a treasury sell-off that looked more like a rout than a mere
consolidation and this begs important questions for the USD and for major FX pairs. One the one hand,
higher interest rates in the US are a fundamental support for the currency on interest rate spread
comparisons, which in the past only favoured the USD when interest rates were falling because US rates
were almost as low as they could theoretically go and other countries’ rates generally fell faster. On the
other hand, if the higher interest rates are a reflection of bond buyers going on strike, we have an entirely
different scenario – one that is far more sensitive to the credit worthiness of the various nations and their
sovereign debt. The Japanese Yen could be particularly vulnerable in such a scenario.

 A USD/risk divergence. This is related to the point just above on interest rates. The market is a bit
confused as to what to do with the USD as interest rates in the US have risen faster than for some of the
other countries (at least at times – in the final days ahead of this report, some of this effect was fading).
This is a USD positive. But equity markets – at least in the US and Germany and a few other countries –
have marched to new highs for the cycle, which has time and time been associated with USD weakness
over the last couple of years or more of the USD carry trade. We’ve been so trained to see all markets as
one hyper-correlated mass that moves like a school of fish that this new divergence in the USD and risk
 January 18, 2011
FX Monthly – January 2011

appetite is a signal event we must pay close attention to in coming weeks. See more on the USD and risk
divergence in our Carry Trade Model article below.

Themes for 2011

As this is our first monthly of the New Year, we try to look at the bigger perspective and mull some of the
biggest issues that that the market will be chewing on this year:

To QE or not to QE? – It is abundantly clear from the latest batch of rhetoric that even the new purpoted
hawks among the voting FOMC members (Kocherlakota, Plosser, Fisher) expect for the QE2 program to run to
completion. The degree of dissent within the FOMC is so far less than we imagined would be the case, but the
more important question going forward is whether the Fed’s QE policies will end with QE2. If the economy
weakens again, Bernanke and company would likely feel the itch for another round of QE, perhaps aimed at
buttressing local and state finances, but we suspect that would be a political impossibility and that the Fed’s
maneuverability from here on out is extremely limited. Alternatively, if the US economy performs relatively
well, the Fed won’t find the justification for moving in the first place. We are expecting that this will eventually
support the USD, both because it is a sign that the Fed will be halted before it prints the greenback into
oblivion (just yet. anyway). We maintain the simultaneous assumption that growth expectations elsewhere
may fall relative to those for the US. These two factors, combined with at least a sideways if not falling risk
appetite in the months ahead are the preconditions for a stronger dollar.

Equity Markets since Fed QE2 Announcement

110

105

100

95

Shanghai Composite
90
US S&P500
MSCI Emerging Markets
85

Chart: Shanghai composite vs. MXEF vs. S&P500 – Since the QE2 announcement of early November, the
divergence in equity market performance around the world and correlations across markets in general has
been disrupted relative to the past couple of years. Are China and the emerging markets the leading indicator
here on risk?

China and Emerging Markets/Commodities: Here we throw a few themes together, but they are all
related. China is clearly grappling with problematic inflation levels from its property bubble and hot money
inflows aggravated by its dirty peg to the US dollar and the implications of hyper-easy Fed monetary policy.
Meanwhile, external demand is not growing at a rate sufficient to pass on strong price increases and domestic
consumers risk getting squeezed by commodity price rises and a high cost of rent from the property bubble.
 January 18, 2011
FX Monthly – January 2011

This margin squeeze for companies and on consumer is going to mean increasingly inferior growth rates with
every uptick in cost push inflation and every tightening of the screws on credit. In 2011, will China move more
forcefully to avert inflation risks by slowing credit markets and economic growth and overinvestment in real
estate projects? It will be tough for the country to engineer a soft landing and as China goes, so goes the EM
trade. Another issue for China and many other EM countries like Korea and Brazil is the inconveniently large
inflows of capital that are making life difficult, though these problems could quickly reverse a la late 2008 as
capital flows will take flight and could aggravate a sell-off.

Euro PIGS crisis – our forecasts for the Euro generally suggest that the Euro crisis will come to a head sooner
rather than later in 2011. A crisis meeting will apparently be held by EU leadership in February to discuss ways
in which to get ahead of the curve on the sovereign debt problem as it is widely agreed that a Spanish default
would be too large for the current rescue funds and EFSF to handle. There have been signs of a softening
stance from Germany on the idea of expanding EU commitments, but the efforts thus far from EU leadership
have underwhelmed and the German politicians are fully aware of the political suicide that awaits any carte
blanche approach to bailing out the periphery.

One of the next key events will be the Irish election, possibly as early as late March. Ireland has no incentive
to live with its current bailout arrangement other than pride and the inertia of the EuroZone experiment and
the political opposition in Ireland is virtually guaranteed a victory. Will Ireland reschedule its debt already by
mid-year or even threaten to leave the EuroZone somewhere down the line? Credit default swaps on Irish
sovereign debt are trading higher and higher as the markets ponder this question – they were in the high 600’s
at the time of this writing compared to sub-300 levels last summer and are sharply higher even since the
EU/IMF arrangement was agreed on back in late November. (see a chart in the Forecast section for the Euro
below).

Carry Trade Model – coming unhinged

This time around, we note that the market correlations seem to be shifting more profoundly than we have seen
in some time – at least the kneejerk correlation in the USD and risk appetite. Our model clearly shows that risk
appetite remains very strong globally, but that the USD has failed to fall to new lows. There are a couple of
explanations or potential predictions we can try to extract from this:

The USD is no longer the ideal funding currency – this is a bit of a tough one to argue for. As long as risk
appetite remains robust (which favours being long carry trades), there is plenty of evidence to argue that the
US currency is an ideal funding currency, considering that it still has a very low interest rate, that the market
expects it to move very slowly to raise rates considering that the Fed is still in quantitative easing mode while
other banks have been raising rates for some time, and due to its lack of fiscal discipline. Still, US interest
rates have jumped sufficiently higher to improve its standing in spreads versus some of the other major
currencies, and this has clearly been instrumental in some of the USD’s relative resilience in this market. Also,
US economic fundamentals have perked up somewhat. Theoretically, if the US recovery blossoms from here,
then the popularity of using the USD as a funding currency could fade and other currencies, potentially the
Japanese Yen or Swiss franc could become more popular funding currencies if interest rates head higher.

The stronger USD is a leading indicator on the direction of risk - When we say “stronger USD” here, we
merely mean relative to its past correlation with risk appetite, as the USD has yet to consistently rally versus
the market, though it has been relatively stable while risk appetite has gone into overdrive (at least in the
developed equity markets – some divergences exist elsewhere). Since the Fed’s easy money policies have
provided the liquidity for a good portion of the rally in risk appetite since the anticipation of QE2 set in, one
 January 18, 2011
FX Monthly – January 2011

could argue that the anticipated withdrawal of that liquidity as June approaches means a stronger USD and
lower risk appetite and the unwinding of some of the huge short USD/long risk trades out there.

The weak Euro is grabbing the spotlight – this is one of the more likely explanations for the relative USD
strength and certainly explains some if not all of the greenback’s relative resilience. Flows into the Euro have
doubtless slowed from the largest potential buyers – central banks, who are likely having a hard time justifying
Euro purchases as the continent is racked with its sovereign debt convulsions. The Euro has been the only
plausible alternative to the USD as a major reserve currency, so any Euro weakness will inevitably be
expressed to some degree as USD strength.

Carry Trade Outlook – the cart leading the horse?

Again, we wonder here whether the USD has become a leading indicator on risk appetite. We would suggest
that to some degree it has, as the Fed’s very loose monetary policies have been a key element in keeping
global risk appetite at the boil - particularly in the last huge rally from late August of last year, when it became
clear that QE2 was on the way – and now that it is rather clear that the Fed plans on carrying the debt
monetization program to completion. Eventually, however, the market will move on to focus on other drivers of
global risk. While the USD still plays a prominent part in setting the agenda, commodity prices and interest
rates will exercise increasing influence if they continue to head higher from here as risk appetite can’t possibly
like the thought of a margin squeeze and decrease in liquidity.

If, on the other hand, commodity and interest rate prices fail to head higher, it is likely due to an increasing
worry that China will suffer a setback and that global growth will disappoint on weak end demand. If those
themes begin to dominate, carry trades will likely suffer steep losses, since they are generally a pro-cyclical
barometer to begin with. There are signs that worries in China are growing, but major equity markets and
many of our risk appetite measures have failed to pick up on this consistently. This scenario is USD bullish if no
sovereign debt worries come into play. The truly chaotic scenario would be risk aversion combined with
sovereign debt worries, a scenario that is less USD bullish if those worries affect the assessment of the US’
ability to ever pay back its debts.

As for the components of the carry trade model, all of them are in relatively risk-willing territory – not a huge
surprise considering the very positive reading for the carry trade index. There are a couple of laggards, though,
including a emerging market bond spreads, which are well off the lows of the recent range, and FX volatility,
which has decreased somewhat, but not to the kind of extremely low levels we are seeing in equity market
volatility indicators
 January 18, 2011
FX Monthly – January 2011

Saxo Bank Carry Trade Model Chart

Saxo Bank Carry Trade Model

3 115

2 110

105
1
100
0
95
-1
90
-2
85
-3
80

-4 Carry Trade Index

75
USD no carry added
-5 70

Chart: Saxo Bank Carry Trade Model- Longer term view. This time around, we decided to display the
longer term perspective, which shows that global risk appetite, as measured by our Carry Trade Index, is
still very much in risk hungry terrain. The last time it was near this high was in March-April of this year,
which preceded the May 6 “flash crash” and weak equity market of the early summer. (The Sample US
Carry Trade shows the carry-less performance of a basket of 7 currencies (AUD, NZD, PLN, TRY, MXN,
IDR, BRL) vs. the USD and JPY.) Chart derived from data from Bloomberg.
 January 18, 2011
FX Monthly – January 2011

Central Bank Watch: Expectations shifting higher

Central Bank Rate Expectations

6.00%
Rate Now (17 Jan. 2011)
5.00%
1-yr. Forward Exp.

4.00% Expected Change

3.00%

2.00%

1.00%

0.00%
USD EUR JPY GBP CHF AUD CAD NZD NOK SEK

Chart: Central Bank expectations have certainly shifted higher since our last couple of reports, with the
market beginning to price in non-trivial moves from a number of banks – even the ECB, after Trichet
turned hawkish on inflation despite all of the sovereign debt woes facing the Euro Zone.

G-10 CB Rates and Expectations

1600
1200 1500

1400
1000
1300
800 1200

1100
600
1000
400 900

800
200 Forward CB Expectations 1-yr. (bps - left axis)
G-10 Total CB Overnight Rates (bps - right axis) 700

0 600

Chart: G-10 CB rates and rate expectations in aggregate: We’re seeing a sizable increase in
expectations for the G-10 central banks in aggregate as the blue line above indicates. The market is
looking for some 500 bps of rate hikes in aggregate for the year forward on top of recent hikes. Charts
above derived from data from Bloomberg
 January 18, 2011
FX Monthly – January 2011

Saxo Bank G-10 FX Forecasts

Base Case: Our basic premise that the post QE2 announcement would see a continued retrenchment in risk
appetite was more or less wrong, as the adjustment higher in interest rates and the US dollar rally after the
announcement proved indecisive and as risk appetite charged higher once again (with a couple of notable
exceptions – especially China, which is a critical driver of the future of global growth). China should be getting
a lot of focus now and in the months ahead, as the regime is trying to engineer a soft landing in the country’s
overheating, inflation-ridden economy. China is the lynchpin of the emerging market trade, and the US dollar
as well, due to carry positions and capital flows out of the US and into emerging markets. As China slows and
grapples with its economic imbalances, this could severely affect the trajectory of risk appetite as it impinges
upon the major currencies. A weaker EM trade would like be USD supportive. Also USD supportive would be a
significant consolidation in risk appetite in general – something we have yet to see since last summer. Such a
development is overdue. The question, as always, is one of timing.

Alternative Scenario(s): The alternative scenario is that we have an incipient bubble in equities and
particularly in commodities in progress and that we may have reached a point where the market boils over into
a full-blown bubble mentality of price gains feeding further price gains. In this kind of market, all attempts to
fight the trend are futile and this could go on for another one week, one month, or three months. The
persistence in the price action in US equities of late argues in favour of this view. It must be noted that the
climax and reversal off of such non-consolidating rallies is often spectacular, if not fearsome. Until the
EM/Commodity/major equity markets consolidate more convincingly, the USD will have a hard time achieving
any altitude and most of the alternative scenarios below for each currency discuss the potential for the existing
market environment to persist for a time.

Table: Saxo Bank G-10 FX Forecasts

Currency Pair 1M 3M 12M Alternative (1-2M)

EURUSD 1.3000 1.1800 1.1400 1.3400

USDJPY 85.00 89.00 100.00 80.00

EURJPY 111.00 105.00 114.00 107.00

EURGBP 0.8500 0.8000 0.7800 0.8650

GBPUSD 1.5700 1.4800 1.4600 1.5500

EURCHF 1.3000 1.3400 1.3700 1.2400
USDCHF 1.0000 1.1400 1.2000 0.9300

AUDUSD 0.9300 0.8200 0.7500 1.0200

AUDJPY 79.00 73.00 75.00 82.00

AUDNZD 1.2700 1.2600 1.2100 1.3100

NZDUSD 0.7200 0.6400 0.5800 0.7800

USDCAD 1.0200 1.1000 1.1500 0.9600

EURNOK 8.00 7.75 8.00 7.50

EURSEK 9.00 9.25 9.00 8.75
 January 18, 2011
FX Monthly – January 2011

Currency Pair 1M 3M 12M Alternative (1-2M)

EURPLN 4.00 4.50 4.75 3.75

USDZAR 7.00 7.50 8.00 6.75

Saxo Bank G-10 FX Outlook

Note that all of the charts below show the currencies versus an evenly weighted basket of the remainder of the
G-10 currencies with an Index of 100 approximately 10 years before the present date. All chart content is
derived from Bloomberg data

USD – US Dollar
USD
90
USD
85
200 SMA

80

75

70

65

60

In the post QE2 environment of November, the USD saw a relief bounce. Since then the USD
has been largely mixed – still a relatively strong performance as we have also seen a
continued surge in risk appetite, suggesting that the market is giving the rising interest
rates in the US some credibility and that the use of the USD as a funding currency for carry
trades is waning in popularity.

Over the last couple of months, the USD’s behaviour versus other markets has changed drastically. That is at
least partially due to some signs of improvement in US data and a strong move higher in US interest rates all
along the yield curve, a move that has outpaced the moves higher in interest rates in some of the other major
economies, which improves the appeal of the greenback against their currencies. Among the G-3, the USD has
more or less won out in recent weeks as the Euro is mired in yet another spasm of sovereign debt worries, and
the JPY has a hard time maintaining any measure of credibility when interest rates are on the rise.

Still, strong risk appetite has been almost as much of a drag on the US currency as higher interest rates have
supported the currency’s case. (see our monthly look at our Carry Trade Model for more on this) For the
greenback to escape new multi-year lows here, we will need to continue to see an improvement in US
fundamentals relative to other countries, or we will need to see a strong bout of risk aversion that sees the
 January 18, 2011
FX Monthly – January 2011

market unwind still very large outstanding USD shorts. In the past, our outlook has favoured USD strength
through risk aversion, but the merciless charge of the bulls has made that proposition appear hopeless for the
time being. Going forward, however, we wonder how long the market can continue to bid commodities and
equities higher simultaneously, especially in an environment of rising interest rates. At some point, the
pressure of a rise in commodity prices will be felt in margins and in end demand – particularly in the emerging
market trades – many of which are funded in part with short USD positions.

Outlook

We assume the economic trajectory for the US will look better than that of the G-3 and perhaps better than
many other countries as well after the Obama administration primed the pump even further with the extension
of jobless benefits and the payroll tax exemption, not to mention the extension of the Bush tax cuts that would
otherwise have expired. By the same token, those latter measures make us worry about the longer term
prospects for the USD when the federal government has failed to show the least whiff of the kind of austerity
we are seeing Europe attempt (although this is happening at the local and state level in the US by necessity in
many instances). This has us adjusting our USD forecasts for the longer term a bit lower than they were
previously.

Ahead of 2011, we speculated that the Fed would find more dissent within its ranks than it saw previously with
the yearly shuffle in voting member composition. But so far, the rhetoric from two of the expected hawks is far
more cooperative than we imagined, with even Plosser saying that he was all for keeping QE2 on schedule
even though he is not sure that it will help. So the only apparent forces keeping the Fed from moving again to
keep the liquidity gravy train rolling will be the new Congress just convened on Capitol Hill and positive
economic data. Even without major dissent within the Fed, we suspect the political environment will keep the
Fed more sidelined than the market is counting on, even if the US economy proves weaker than currently
expected.

The other major force acting on the USD is the direction of risk appetite – which has only been up, up, up since
last summer. Our assumption is that a more two-way market for risk develops soon at minimum as the market
is getting ahead of itself with interest rates on the rise and margins getting squeezed.

Next FOMC Meeting: January 26

Alternative scenario: the USD makes a serious attempt at its lows for the cycle amid an attempt by the
market to get back on the rally train as the risk bulls and growth Pollyannas talk up global growth prospects
 January 18, 2011
FX Monthly – January 2011

EUR – Euro
EUR
130

125

120

115

110
EUR
105
200 SMA

100

The Euro dropped to the lowest level vs. a basket of the rest of the G-10 since 2002 before
rallying strongly in the wake of a couple of “successful” sovereign debt auctions from
Portugal and Spain. Has the market priced in too much pain in the short term for the single
currency?

The Euro weakened anew in recent weeks on “Take Three” of the PIGS debt crisis as we have progressed from
Greece to Ireland and now Portugal, which is in the throes of rumors on whether it will also require a bailout
sooner rather than later. While the situation in Euroland looks dire and sovereign debt spreads and default risk
measures are at close to their widest ever, there are a few rays of light for the Euro in mid-January. After very
little progress from EU leadership on addressing the issues back in December, we have a few signs that
Germany’s stance on the idea of expanding the rescue facility is softening. We also have the odd couple of
China and Japan willing to sink funds into the Titanic of PIGS sovereign debt. This will not end well further
down the road (as we discuss below), but the question, considering where Euro is trading in some of the
crosses (particularly EUR/commodity currencies, EUR/SEK, etc.) is how much pain is already priced in and
whether we might have enough positive news in the short term to at least put a floor under the Euro for a
while. Indeed, in the final days of our preparation of this report, the Euro was sharply stronger across the
board. Another round of broad Euro weakness may have to wait another couple of months, depending on the
news flow.

While growth is struggling in Europe at the periphery as austerity measures bite on the need to confront the
public debt situation, the growth in Germany continues to astound – to such a degree that further upside
surprise from current activity levels and survey readings will be hard to come by from here on out.
 January 18, 2011
FX Monthly – January 2011

Ireland Debt Spreads vs. CDS Prices

8
Ireland/Germany 10-year 700
7
spread 600
6 Ireland CDS Price
500
5
400
4
3 300

2 200

1 100
0 0

An intriguing divergence: while German-Irish debt spreads appear somewhat under control
in mid-January as the ECB and possibly China and Japan prop up the debt “market” for Irish
debt, the fear in the CDS market is clearly that the risk of an Irish default remains on the
rise. CDS prices may be a better measure of Euro sovereign debt stress than interest rate
spreads.

Outlook

We continue to expect that the longer term solution for Europe to its sovereign debt challenges – whether it’s a
massive increase in bailout funds combined with new ECB easing, or we see PIGS countries themselves
throwing up their hands and demanding a restructuring of their debt – will mean either easier monetary
conditions in Europe relative to the US or chaos – effectively a lose/lose situation for the Euro regardless of the
path taken. Outside the EURUSD cross, we also expect EURGBP to fall in coming months for the same reason.
But against the more pro-risk currencies, we wonder if most of the downside potential for the short to medium
term is fully priced in. Only a really chaotic scenario for the Euro combined with an extension of this very long-
toothed rally in risk appetite would justify a further stretching of valuations in crosses like EUR/AUD, EUR/NZD,
EUR/SEK and possibly even EUR/CHF.

While the EU leadership may manage to move ahead with a new and bigger bailout package in the weeks to
come (which could give the Euro some very temporary relief), we have to ponder the concrete risk from a Irish
election (possibly as early as late March) and its potential to produce a new government and political process
that aims at throwing the yoke of the Euro and the impossible burden of public debt (much of it bad debts
unwisely transferred from the private sector topped off now with high interest-bearing EU/IMF bailout-related
debt). If the Irish move to default, it is quite possible that the other PIGS countries – and perhaps even Italy –
eventually begin to look at Ireland with envy and consider the wisdom of a EuroZone exit themselves.

Next ECB Meeting: March 3

Alternative scenario: With the involvement of China and Japan in propping up public debt markets across
Europe, the bearish bets on the Euro and its debt are squeezed mercilessly and EUR rallies strongly across the
board in the shorter term.
 January 18, 2011
FX Monthly – January 2011

JPY – Japanese Yen

JPY
120

110

100

90

JPY
80
200 SMA

70

The JPY is on a road to nowhere, which is actually a fairly strong performance, considering
the degree to which interest rates have risen in the US and elsewhere and the strong
continued rise in risk appetite (mostly concentrated in the US, we must note). The direction
in interest rates may dominate the JPY outlook going forward.

US interest rates rose sharply in late November and into December, but have since range traded – and in
USDJPY this has resulted in a solid bounce off a throwback sell-off toward the 80 level. Elsewhere, the JPY has
largely been a passive participant in the currency market and hardly cut a profile as the market has failed to
find any strong new Japanese theme.

The economic outlook for Japan is not particularly encouraging, with deflation still in full swing while higher
commodity prices and a still fairly strong currency are crimping Japanese profits. With China on a policy
warpath aimed at breaking the back of the inflation threat and the property bubble, the outlook for Japan and
its export economy aren’t particularly encouraging. Unlike the US Fed, which may find itself facing increasing
headwinds on further action from an irate Congress in the coming year, the Bank of Japan would be happy to
throw another log on the QE fire after already having practiced a round of unsterilized currency intervention
and other easing measures. The political environment in Japan is also so shaky that at some point, if the
economy dips again, we can’t rule out more drastic measures. Meanwhile, the debt continues to accumulate on
an already world-beating debt load with no credible program for bringing public sector revenues in line with
costs. When do we get the wake-up call? Credit default swaps on Japanese public debt are rising in price, but
not to a sufficient degree to show up on the market’s radar screen. Watch for this possible eventuality by the
end of this year.

Outlook

Japan’s debt is a time bomb with an unknown trigger date – a date that will move closer if interest rates
continue to rise from here and that will be delayed if interest rates fall again. Higher rates even bring the risk
of a disorderly decline in the JPY under the right circumstances as loss of confidence can be a sudden thing, as
we experienced back in the fall of 2008. In the longer term perspective, the government has soaked up as
much of the country’s domestic savings as it can and new debt will have to be printed into existence or funded
 January 18, 2011
FX Monthly – January 2011

from beyond Japan’s borders. This does not add up to a bullish scenario for the country’s currency. Any
strength in the currency will likely be relatively fleeting, even if we can’t rule out one more sizable surge in the
JPY if we see a government bond rally sometime this year as the world goes into risk aversion mode and
possibly unwinds some of its bets on emerging markets. The repatriation trade could provide a temporary
resuscitation of the JPY before it heads weaker.

Next BoJ Meeting: January 25

Alternative scenario: Bonds make a strong stand while risk appetite shows signs of rolling over into a major
consolidation. This kind of scenario could see the JPY make one more dash to the strong side and USDJPY
headed below its all-time low in 1995 of 79.95.

GBP – British Pound

GBP
100
GBP
95
200 SMA

90

85

80

75

70

After dipping yet again to an all time low heading into 2011, sterling has since risen very
sharply, driven by a combination of tighter liquidity conditions perhaps as well as a “good
thing it’s not the EuroZone” mentality. Has the currency finally put in a real low for the
cycle?

The pound was sharply weaker heading into year-end for no particular apparent reason, but has since
rebounded. A couple of possible reasons included far tighter liquidity conditions for the currency relative to
recent moves elsewhere as 2-year interest rates have increased more sharply than for any other currency in
recent months. Some of that has to go down to the apparent tightening in bank credit. As well, the renewed
woes in the EuroZone meant that the pound found strength in the important EURGBP pair. Finally, many of the
new austerity measures are set to take effect this year, and the market is perhaps rewarding the currency for
the government’s fiscal probity. The latter is an important feature missing in the US picture.

On the negative side, the ugly trade balance numbers keep getting uglier and mean that the UK will have to
find a way to attract capital flows to offset such a large trade deficit. After the implosion of the UK financial
services sector and so many of the nation’s banks, will the country ever be able to rebuild what it once had?
These are important questions for the longer haul, as is the question of whether the paradox of savings means
 January 18, 2011
FX Monthly – January 2011

that austerity measures end up meaning a shortfall in tax revenue and fail to improve the country’s fiscal
imbalances. Also pulling to the negative side are signs that consumers are increasingly negative on the future
and that housing faces gathering declines.

GBPUSD vs. CDS Spread

10 1.65

0
1.6

-10
1.55
-20
1.5
-30

CDS Spread 1.45

-40
GBPUSD
-50 1.4

Charting GBPUSD versus the spread of the UK vs. the US CDS prices shows us an interesting
divergence of late – a divergence explained in part by interest rate spreads widening as
well in favour of the UK. The 2-year swap spread favors GBP by almost 90 basis points – the
most since January of 2009. Which development wins out?

Outlook
Our assumption is that the pound will continue to trade more or less in correlation with the USD due to the
similar themes the two currencies face (twin deficits, post bubble banking sector, lower interest rates and
relatively active central banks). The currency may find a tailwind this year due to its very cheap valuation and
as the EuroZone must work its way through a sovereign debt crisis. The highest volatility may be seen in
crosses like GBP/AUD and GBP/NZD if the commodities rally comes undone at some point during the year. If
risk aversion strikes especially hard, however, the pound will have a hard time keeping up with the US dollar.

The currency is entering an important period as the world waits and watches to see how deeply austerity
measures, tighter control of bank credit, and a rise in the VAT affect the country’s growth and markets.
Considering where the currency is coming from, it is tough to find a downside scenario unless the wild global
bullishness continues unabated or the sovereign debt theme becomes applied more generally.

Next BoE Meeting: March 10

Alternative scenario: Wild bullishness keeps up a head of steam, which sees the market looking elsewhere
for better yield.
 January 18, 2011
FX Monthly – January 2011

CHF – Swiss Franc

CHF
140

CHF
135
200 SMA

130

125

120

115

The Swiss Franc saw a spectacular spike into year-end with the renewal of the EuroZone
PIGS and EURCHF selling as well as USDCHF selling, possibly on the fiscal profligacy of the
new stimulus measures from the Obama administration. But the franc has started the year
on a very weak footing – perhaps due to excessive valuation and higher interest rates
elsewhere moving against the franc’s favour?

The Swiss franc outperformed until the beginning of the year, when it went from profound strength to profound
weakness. Some of the move lower was in the days before this report, when the Euro was also surging, as the
CHF seems to trade as a kind of anti-Euro, trading exceptionally weak when the Euro is strong and vice versa.

That “Anti-Euro” trade seems to be the main theme going for the franc, though we wonder if some measure of
its weakness in the beginning of the year may be on the realization that it yields virtually nothing and interest
rates and commodity prices have been heading higher, giving it the appearance of a tempting funding
currency. Also, at some point, a currency’s strength becomes an economy’s weakness, particularly an economy
that is highly reliant on exports.

Outlook

The highs may be in now for the Swiss franc versus the broader market. While another round of the Euro crisis
could potentially see the EURCHF pair to new lows, we have technical signs of trend exhaustion in the crosses
like USDCHF and GBPCHF, which may have now put in significant lows. For EURCHF, the move back higher (a
couple of days before this report was published) through 1.2765 is promising for those looking for a reversal,
though eventually the pair needs to work north of the 200-day moving average (currently around 1.3475) as a
stronger indication that the franc’s strength is fading against the single currency as well.

The Swiss government has expressed profound concern about the level of the currency’s strength, though
recent history suggests there is little the government can do about it as the market has overwhelmed previous
attempts by the SNB to manage the currency. Rather, the natural forces of the market may be the only thing
that can see the franc weaker in the months ahead. It’s behaviour certainly seems to suggest that it is far from
 January 18, 2011
FX Monthly – January 2011

being the safe haven currency of yore – we suspect that any potential for risk aversion will do little to help the
currency in coming cycles.

Next SNB Meeting: March 17

Alternate scenario: EURCHF collapses back towards the lows on renewed PIGS sovereign debt worries and
CHF heads to a new high versus the G-10.

AUD – Australian Dollar

AUD
145

AUD
135
200 SMA

125

115

105

95

The Aussie outdid itself with a new all-time peak right at year-end. But with the transition
to the New Year, the currency is struggling from a batch of weak data and a flooding
disaster. Has the miracle currency had its last hurrah?

AUD defied gravity yet again, riding the enthusiasm for precious metals and other industrial commodities and
risk appetite into year-end. The currency touched a new multi-decade high against the USD and the EUR. A
good portion of the strength has faded since the beginning of the year, however, as commodity market
performance has turned patchy, but also as a number of Australian economic activity surveys (the AiG surveys
for Manufacturing, Services and Construction) suggest a strongly slowing non-mining economy. Finally, after a
string of very positive employment reports, the December employment report showed virtually no payroll
growth.

The catastrophic Queensland floods are a one-off development that risk warping data both ways in coming
months (to the downside due to interruptions and then possibly some measure of upside activity down the
road on rebuilding). The worst damage besides the immediate human and residential costs are that key mining
areas for coal and iron ore have been affected. This could even have implications for Chinese growth if coal
prices spike further as the country is a huge consumer of these Australian imports.

On the housing front, which is one of the country’s main vulnerabilities (outside of potential for commodity
price drops), activity remains sluggish with very high, but stagnating prices, a classic sign of a peaking market.
The RBA has been removing accommodation for 15 months now and may nudge the rate to 5.00% at its
February meeting.
 January 18, 2011
FX Monthly – January 2011

Outlook
After the ramp up into year-end and subsequent drop (the most significant drop in the Aussie since last
summer), it appears we have a significant area of resistance for the currency. We can buttress this argument
with clear evidence that yield expectations for Australia are beginning to underperform a majority of other G-
10 currencies.

Going forward, there are two main threats to the Australian economy: a correction in commodity prices, which
is inevitably a question of Chinese demand, and the threat of an unwinding in the Australia housing bubble,
which by itself could see the country’s banks in sufficiently dire straits to require the RBA to change course
(and if the RBA does not change course, it could be because of high inflation elsewhere, making the threat one
of sharply inferior growth). Either way, the currency is still priced for perfection, and only a sharp renewal in
commodity prices and risk appetite would see the AUD making another ascent to the strong levels at which it
closed 2010. (We argue elsewhere in this publication that at some point not terribly far from where we are now
in energy prices in particular, a rally in both commodities and risk appetite are incompatible on the implications
for margins from cost-push inflation).

In China, authorities are concerned about recent inflation rates and are cracking down on credit and bank
reserve requirements, both to cool inflation and the risks of a housing bubble (too late, actually, but zero cost
of carry on Chinese apartments and local officials neck deep in a personal financial interest in keeping the
bubble alive will make the price discovery mechanism very tricky indeed). The Chinese regime is also
concerned with keeping their economy growing strongly at all costs and shifting growth over to the consumer,
which it will be hard pressed to do with consumers handing over an increasing percentage of their earnings to
food and rent. Australia trades like a China derivative in many ways.

Next RBA Meeting: February 1

Alternative scenario: The goldilocks scenario for Aussie continues and it has another go at its highs as
natural resource prices arch higher again.
 January 18, 2011
FX Monthly – January 2011

CAD – Canadian Dollar

CAD
120

CAD
115
200 SMA

110

105

100

95

The broad comeback in CAD faltered somewhat just ahead of this report, perhaps as the
rally in the US dollar also failed to follow through by mid January. The currency may keep
its weak correlation with the USD, outperforming other commodity currencies when the
USD is strong and underperforming when the USD is weak.

The fundamental position of the Canadian currency looks rather strong, with its strong mix of commodities
(energy in particular) in an environment of strong commodity price increases and with the much touted
“world’s most solid banks”. These qualities as well as the improvement in some of the US data has seen the
currency tracking generally higher for the last few months versus the broader market, though it has seen a bit
of a swoon by mid January on the spike in European currencies after the January ECB meeting. Against the
USD, the currency was able to take out the parity level and USDCAD remained below that psychological
threshold for a number of days ahead of this report. An additional factor in favour of the currency includes the
pro-business plan to ratchet corporate tax rates lower in coming years, already starting this process with a
drop in corporate tax rates to 16.5% this year from 18%. Compare that to 35% in the US.

While most factors look positive for Canada and its currency if current conditions continue, particularly if crude
oil prices can rally and stay above 100 dollars per barrel, we are concerned about a number of factors that may
see the currency lower versus the USD and other currencies in coming months. Eventually, the commodity rally
will become self-correcting on the destruction of demand from higher prices (and we are particularly concerned
about China’s potential for a rough ride in coming months as authorities there try to engineer a soft landing).

In addition, while the Canadian government has been very prudent since its fiscal crisis of the 90’s and its
public debt loads are very modest by US and other standards, the private sector in Canada is the world’s most
leveraged, as a housing bubble has taken house prices into extremely unaffordable territory and private debt
loads are very heavy from housing and other types of consumer credit. Any bump in the road on real estate
prices and suddenly the “world’s most solid banks” will appear far less sturdy. It is remarkable that the housing
market is already showing signs of topping out and correcting despite Canadian interest rates having only been
hiked to 1.00% . On the downside of a housing bubble, this also shows how little easing the BoC will have to
work with compared to the US, where the Fed was able to drop rates 500 basis points to ease the pain. (In the
 January 18, 2011
FX Monthly – January 2011

day head of this reports publication, the government announced important new measures aimed at reducing
mortgage credit and we are reminded that the CMHC is much like the US’ Fannie Mae, meaning that price
declines on the order of those in the US after its housing bubble could suddenly make the entire country’s
balance sheet look completely different in a year’s time).

Outlook
Previously, we expected that the Canadian dollar would be unlikely to trade as a particularly high beta currency
on the expectation that it would tend to follow the lead of the US dollar. But the extreme swings in the Euro
and a sudden reassessment of Canadian fundamentals in light of the continued strength in risk appetite and
commodity prices has seen plenty of volatility and USDCAD has headed below parity again.

We would still expect that the Canadian dollar has more middle-of-the pack potential going forward: it’s
overvaluation versus the market is less stark than that for Australia (AUDCAD shorts are an interesting idea on
this theme and have shown a lot of traction over the last month) and its exposure to China is far less direct,
but an eventual correction in the bubble-like commodities markets (an eventual expectation) would weigh
heavily on the currency, as would the threat of an unwind of the country’s housing bubble. The market is
expecting more than 80 basis points of tightening from the Bank of Canada – so if conditions fail to continue to
improve to the degree expected, USDCAD’s stay below parity could prove a short one.

Next BoC Meeting: March 1

Alternative scenario: Oil goes to 110 dollars a barrel and the market believes that this won’t lead to any risk
of a slowdown as CAD rallies sharply across the board.

NZD – New Zealand Dollar

NZD
140
NZD

200 SMA
130

120

110

100

NZD has pulled higher once again versus the broader market on still buoyant expectations
for RBNZ rates and the commodities (particularly food commodities) rally has helped boost
the currency. But should we really be closing in on an all time high for the currency
considering the potential risks out there?
 January 18, 2011
FX Monthly – January 2011

The kiwi had a roller coaster ride since our November report – weaker for a time perhaps on the New Zealand
drought and a muted view on the potential for the RBNZ to hike going forward, but then stronger as
commodity prices – and particularly milk prices - have rebounded strongly and risk appetite has maintained a
strong head of steam in to mid January. AUDNZD flows may have also heavily influenced the currency’s overall
level, as a strong new high in that pair in December above 1.35 was roundly rejected as Australia hit a few
speed bumps to start the year.

The domestic economy is not performing particularly strongly, but the market may not be focusing much on
the basic growth data as it is on commodity prices – particularly for foodstuffs, which have risen to high
enough levels to trigger riots in some food insecure countries like Tunisia and Jordan. This may mean that the
currency is becoming a bit one-dimensional in its behaviour and may correlate with food commodity prices
going forward – for better or worse. Elsewhere in the economy, house prices are in a persistent, if slowly
grinding, downtrend, and could continue to weigh on growth, as will the currency’s strength.

Outlook
NZD and AUD look overvalued, but both will require a more persistent correction in risk and perhaps on top of
that, signs of a real slowdown in China before any lasting sell-off can develop. In the kiwi’s case, a slowdown in
key food commodity prices will also be a necessary component of a further search for lower valuation. We
stated back in mid-November that “the NZD may act as a kind of lower beta version of the Aussie – the one G-
10 currency it is likely to appreciate against if risk appetite/competitive devaluation trades beat a hasty retreat
due to the Aussie’s poster child status in this market” Since then, the NZD weakened a bit against the Aussie
into December, but then came storming back due to problems special to Australia, but also possibly because of
the increased focus on food prices, which are so important in New Zealand’s export mix. From here on out,
NZD may continue to outperform the Aussie for the same reason. Elsewhere, the currency is overvalued and
may be set for a fall once food prices hopefully revert back to the mean.

On the interest rate front, the RBNZ is clearly uncomfortable with the strong currency and complained strongly
about it strength preventing a “rebalancing” of the economy back toward stronger exports. As long as the
currency continues to see the kind of strength we have seen lately, the bank is unlikely to change its tune
much on a cautious approach to further rate rises, and if rate expectations head lower (regardless of the
currency level), that would likely only be on fears of slower economic growth generally, usually a kiwi-negative.

Next RBNZ Meeting: January 26

Alternative scenario: Food prices continue to ratchet higher and equity markets arch to new highs, taking
NZD to a marginal new high versus the rest of the G-10 currencies.
 January 18, 2011
FX Monthly – January 2011

NOK – Norwegian Krone

NOK
120

115

110

105

NOK
100
200 SMA

95

The Norwegian krone greeted its new central bank chief (who took office at the first of the
year) with its weakest levels since late 2008, but the currency has since rallied on the
strength in crude oil prices and renewed projections that the Norges Bank leadership may
move again to raise rates.

The Norwegian krone finally bottomed out around the time of our last report and has been generally stronger
since then. The persistent rise in oil prices back to 90 dollars per barrel has been the critical factor in that
renewed strength, as well as perhaps a focus on its solidity relative to the fragility of other European
sovereigns at the EuroZone periphery. Important as well, interest rate expectations from Norges Bank have
moved from a near complete lack of expectations for the last several months to now looking for slightly more
than 50 basis points of tightening in the coming 12 months. The expectation is that strength in the economy
and the continued risk of overheating in the housing market will mean that Norges Bank may raise rates
despite EURNOK trading close to its lowest levels of the last five years (in the past NB chief Olsen has stated
that the currency’s strength or weakness would be instrumental in setting interest rate policy. Watch the next
Norges Bank meeting for any follow up on that rhetoric or lack thereof.)

Outlook
Now that the Norwegian krone has rebounded from levels we considered undervalued the last time around, our
outlook is a bit more neutral. We are still generally positive on the currency as the only significant downside
scenario for the krone is a market in which risk appetite and commodity prices are collapsing in an absence of
sovereign debt worries. Such a scenario will be difficult to come by in this world of enormous debt public debt
burdens. On the upside potential, we have to consider what happens if oil goes to well over 100 dollars per
barrel.

Perhaps the most interesting scenario for NOK is an investment environment in which the market worries about
sovereign credit ratings again, in which case NOK has few peers. At the extreme, an out-and-out global
sovereign debt crisis could mean that JPY and NOK become the two poles of the G-10 universe - NOK on the
strong side and JPY on the weak.
 January 18, 2011
FX Monthly – January 2011

We reiterate our view that long NOK versus the most overvalued corners of the market – particularly Aussie,
but possibly also NZD and SEK, could be an interesting way to trade relative valuation. We mentioned this idea
two months ago and the NOK was weaker still against these currencies into December but now seems to have
turned the corner – quite significantly in the case of AUDNOK. NOK still looks relatively attractively valued
versus the pro-risk currencies almost regardless of whether things turn out well or poorly down the road.

Next Norges Bank Meeting: January 26

Alternative scenario: oil accelerates to well over 100 dollars per barrel and the market starts to heavily
favour any currency with a positive correlation with energy prices.

SEK – Swedish Krona

SEK
110

105

100

95 SEK

200 SMA

90

The krona was back on the up-and-up with a steady stream of robust data, a central bank
that continues to hike rates, and on renewed Euro woes. As well, the krona’s general
positive correlation with risk appetite has seen the currency remain relatively strong while
major global equity markets have been very strong. But is it reaching the top of its
potential against the rest of the major currencies?

After a period of consolidation against the broader market late last year, the krona regained its legs and has
rallied back towards its 2010 highs against the rest of the G-10 currencies. Against the very weak Euro, the
currency touched its strongest level in almost 10 years. The country is in a remarkably strong position relative
to the weaker countries of the EuroZone periphery and almost has the fundamentals of booming Germany, but
with better demographics and lower debt levels. Also, the Riksbank is looking to continue its hiking ways due
to the strength in the economy and in housing prices in particular.

Outlook
Everything looks great for the Swedish krona at present, but this is more or less fully priced into the currency
now that it has rallied back to the top of the longer term range – particularly in light of its valuation against the
Euro, which is at longer term highs. Down the road, the risk of a weaker European economy has to rate as one
of the larger risks to continued strength in the currency due to potential implications for the exports.
 January 18, 2011
FX Monthly – January 2011

Eventually, as well, the country will need to confront its housing bubble, though the question is how much
more accommodation (or alternative policies aimed at clamping down on credit related to real estate
purchases) will need to be removed before this really bites into home prices. Another potential overhang is the
selling of the country’s currency by the Swedish National Debt Office, which acquired billions of SEK in an effort
to smooth the currency’s decline during the 2008-09 crisis. The currency will likely find a more permanent top
around the time the Euro finds a bottom and/or when risk appetite goes at least sideways and stops its
seemingly ever-upward spiral.

Next Riksbank Meeting: February 15.

Alternative scenario: if Europe manages to stave off sovereign debt worries for another quarter or two and
equity markets fail to blink, the currency could post new highs versus the rest of the G-10 currencies before
fading again.
 January 18, 2011
FX Monthly – January 2011

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