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Major influence of monetary policy expectations

Generally, the FX market is subject to more long-term trends or regimes, where a specific factor has an impact on virtually all currencies in a particular way. Of course these trends will not explain all exchange rate fluctuations as currencies will also always be subject to other factors specific to each. Nevertheless, long-term trends are highly influential. Since 2003 three major regimes have governed the FX-market: the carry regime (2003-2008), the RORO (Risk On, Risk Off) regime (2008-2012) and the monetary policy expectations regime (2012--). Provided major central banks, particularly the Fed, continue to ease monetary policy the current regime is likely to persist as high currency valuations of those predominantly more hawkish have forced all central banks to try to steer expectations in a dovish direction. If a minor central bank tries to signal a tighter monetary policy it would probably have a drastic effect on its currency. We therefore believe the trigger for the next currency regime will be the Fed ending its monetary policy easing and signals that it intends to tighten its policy. These moves would probably enable smaller central banks to adopt more hawkish policies without any extreme effects on their currencies. Meanwhile others, including the BOJ and ECB, are likely to lag. With FX volatilities having already fallen to levels in line with those of the previous carry regime, it is not unlikely that widening rate differentials could trigger a return to a carry regime in 2015, under which both the euro and yen would probably suffer. More on page 4.


EDITOR Richard Falkenhll +46 8 506 231 33 CONTRIBUTORS Carl Hammer +46 8 506 231 28 Karl Steiner +46 8 506 231 04

THEMES: QUANT FOCUS: Extreme positioning among specs in GBP and JPY normalizes. Page 3 FX REGIMES: Monetary policy expectations influence FX. Page 4 SEK: SEK and the financial trilemma. Page 5

TRADING VIEWS SPOT: Sell EUR/SEK on rallies towards 8.90. SALES: Downside EUR/Scandies in focus. TECH: EUR/SEK neckline violation at 8.82 set target at 8.70. QUANT: Lower EUR/SEK supported by STFV and trend.
Next week FXR will be replaced by new Currency Strategy

You can also find our research materials at our website: www.mb.seb.se. This report is produced by Skandinaviska Enskilda Banken AB (publ) for institutional investors only. Information and opinions contained within this document are given in good faith and are based on sources believed to be reliable, we do not represent that they are accurate or complete. No liability is accepted for any direct or consequential loss resulting from reliance on this document. Changes may be made to opinions or information contained herein without notice.

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FX recommendations
EUR/USD 1y put spread NZD/NOK EUR/SEK Buy Sell Sell

0.20% 5.14 8.89

Price obj.
4.25 9


-1.1% -2.4% 0.7%

Start val / Start date

1.32% 4.87 9.00 28 May 19 Sep 10 Dec

May 28: Buy 1y 1.25-1.18 put spread. Cost 1.32% of notional. Sep 17: SEll NZD/NOK through 1y Risk reversal 4.65/5.05. Dec 10: Enter 1/2 short EUR/SEK, add 1/2 at high 8.90ies.

Track record since 2004 Profitable Non-prof. # of rec. avg return 122 1.65% 97 -1.25%

FX Forecasts
EUR/USD EUR/SEK EUR/NOK EUR/GBP EUR/CHF USD/JPY EUR/JPY USD/CAD GBP/USD AUD/USD USD/SEK USD/NOK NOK/SEK GBP/SEK EUR/PLN EUR/HUF USD/TRY RUB Basket USD/CNY USD/KRW USD/SGD 14-Jan 1.3657 8.8919 8.3717 0.8331 1.2314 103.47 141.3 1.0894 1.6393 0.9025 6.510 6.129 1.062 10.67 4.158 299.06 2.192 38.82 6.04 1059 1.268 1wk
SEB Forecasts 1mth Q1 14 1.36 1.34 8.95 8.80 8.45 8.40 0.84 0.84 1.23 1.23 104 106 141.4 142.0 1.08 1.08 1.63 1.59 0.90 0.88 6.58 6.57 6.21 6.27 1.059 1.048 10.69 10.44 4.16 4.15 299 298 2.20 2.20 38.6 38.8 6.08 6.02 1100 1080 1.24 1.28

Q2 14 1.31 8.80 8.40 0.85 1.24 106 138.9 1.09 1.55 0.88 6.72 6.41 1.048 10.41 4.10 295 2.22 39.0 5.98 1070 1.26

Q3 14 1.30 8.65 8.45 0.85 1.25 109 141.7 1.10 1.53 0.87 6.65 6.50 1.024 10.18 4.08 295 2.24 39.3 5.94 1060 1.24

Q4 14 1.28 8.50 8.55 0.84 1.26 112 143.4 1.12 1.52 0.85 6.64 6.68 0.994 10.09 4.05 295 2.25 39.5 5.90 1050 1.22

Recommendations total track record 2004 22.3% 2005 18.9% 2006 -16.6% 2007 12.1% 2008 5.8% 2009 9.6% 2010 19.3% 2011 3.5% 2012 5.7% 2013 0.4% 2014 -1.6%

Central Bank forecasts

Sweden Base rate Next meeting Action expected Next change Direction 0.75% 13-Feb unch Apr-15 +25 bps Norway 1.50% 27-Mar unch Mar-15 +25 bps USA 0-0.25% 29-Jan unch EMU 0.25% 06-Feb unch Japan 0.10% 22-Jan unch UK 0.50% 06-Feb unch Canada 1.00% 22-Jan unch Switzerland 0-0.25% 20-Mar unch

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Quantitative focus: GBP/USD ready for a correction lower

Two currencies stand out this week: GBP and JPY. Short GBP/USD looks attractive to us as we expect further normalization of the excessively bullish speculative position and as the short-term fair value model indicates a probable correction lower. JPY on the other hand is mainly standing out due to the on-going positioning normalization and a short USD/JPY based on this feels a bit too aggressive as we expect only a minor correction of the longer uptrend. Positioning According to the latest CFTCs Commitment of Traders report European currencies were in general out of favour with speculators. The net long EUR position was cut in half and positioning fell back to the average level seen over the past year. USD on the other hand was in favour and the aggregated net long position increased. GBP, for which positioning became excessively bullish in the previous report, normalized slightly from the 96th to the 92nd percentile but as normalizations tend to carry th on to at least around the 75 percentile we believe that a continued normalization could continue to weigh on the currency. JPY, for which positioning have been excessively bearish for quite some time, also normalized, bringing it from the 2nd to the 10th percentile. Looking at the JPY positioning there seems to be reasons why specs could continue to reduce their net short: (1) Currently they are not getting paid (past gains are booked on 2013), (2) the aggregated speculative basked consists to 70% of long USD vs. JPY this is usually viewed as far too high an individual currency exposure where e.g. 35% would be a common maximum and this lack of diversification/crowdedness should make specs concerned if price action continues to be disappointing for a long USD/JPY.
Speculative positioning (COT)
Net non-commercial positions Percentile ranks Current Previous Change Current Change -56,852 -57,414 1% 31 68 -60,542 -57,956 -4% 16 42 4,727 10,889 -57% 71 9 14,498 30,589 -53% 53 19 18,178 22,781 -20% 92 34 -128,868 -135,228 5% 10 74 17,607 15,605 13% 41 68 7,866 6,707 17% 39 66 183,386 164,027 12% 78 68
0-25th percentile 50-75th percentile

Short-term fair value The largest misvaluations according to our STFV models are currently found in NZD/USD which closed 2.0 standard deviations above its STFV yesterday and in EUR/CHF which closed 3.0 standard deviations below. EUR/NOK is 0.3 standard deviations below a quite flat STFV. EUR/SEK is 0.7 standard deviations below its STFV which is sloping downward and with todays higher than expected Swedish CPI STFV will most probably continue lower. GBP/USD corrected lower towards its STFV yesterday and as its STFV is in a downward slope there seems to be further GBP weakness in the cards.



Market sentiment Our risk appetite index has spent the past week consolidating the sharp gain past the 17th of December.
Risk appetite index

25-50th percentile 75-100th percentile Source: CFTC. Percentile ranks calculated using data one year back.

Currency weight in an aggregated speculative FX portfolio

80% 70% 60% 50% 40% 30% 20% 10% 0% 10% 20% JPY CAD AUD CHF NZD EUR MXN GBP

Karl Steiner

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Week ahead: FX regimes: Monetary policy exp. key for FX.

Long-term FX regimes
Monetary policy expectations influence FX. But whats next?
Generally, the FX market is subject to long-term trends, which impact almost all currencies in a specific way. While of course these developments will not explain all exchange rate fluctuations as each currency will also always be subject to more specific factors, long-term trends remain very influential. The chart below shows different currency regimes since around 2006. The RORO-regime This started in mid-2008 and continued until mid-2012 and is illustrated in the chart above by a high positive correlation between the AUD/USD exchange rate and general risk appetite. Under the RORO regime most currencies possessed very strong positive (former highyield currencies) or negative (high liquidity currencies) correlations with changes in general risk appetite. The correlation could be as strong as 0.7-0.8 based on daily changes between currencies and a proxy for variations in general risk appetite. In this market it was very simple to predict how specific currencies would react to a given event. If it was positive for general risk appetite it would support some currencies, such as the AUD, and weaken others an in particular the USD. Under these market conditions, the difficult task was to forecast what would happen to general risk appetite. This regime continued until summer 2012, when we entered what we regard as the present system - the monetary policy expectations regime. The monetary policy expectations regime In mid-2012 several developments occurred simultaneously which proved very important for the FX market. In July 2012 the ECB launched its OMT programme to convince financial markets that the ECB would save the euro. Moreover, the Fed initiated the first stage of QE3, which further added to global liquidity. At the same time, there were increasing signs that the BOJ would adopt a more aggressive monetary policy as one cornerstone in Abenomics to break once and for all the countrys devastating price-deflation trend. Several smaller currencies had also become overvalued due to increasing risk appetite, strong economic fundamentals and a less dovish monetary policy. At this juncture several of these currencies smaller central banks began to respond through verbal or de facto interventions and by lowering rates to prevent continuing currency appreciation, which undermined their competitiveness. Therefore, monetary policy expectations became the key FX market driver, with currencies backed by more neutral or even hawkish central banks receiving support while those with dovish central banks depreciated. This is where we stand today. Monetary policy appears to remain the key driver for FX markets and exchange rates fluctuate with market expectations on monetary policy. As a result, currencies are supported when expectations on monetary policy become more hawkish but weaken when expectations become more dovish, which also involves an increased focus on growth and inflation. Given its major focus on monetary policy expectations and with the general global trend still indicating even easier monetary policy near-term from major central

Over the last decade we observe three different longterm drivers affecting the FX market. Firstly, the carry market regime began in around 2003 when the global economy began to recover after the equity bubble burst with central banks possibly too cautious on tightening monetary policy. The carry regime As may be remembered, this regime was characterized by low and falling volatilities with tail-risks priced too cheaply. With volatility low, investors were able to generate a positive return from interest rate differentials between currencies, buying high and shorting lower yield (i.e. JPY and CHF) currencies. This generated strong trends in the FX market with, particularly, low yielding currencies depreciating and high yield currencies appreciating. Moreover, it created large FX market positions as speculative investors generally held very similar exposures, which later turned out to be an important factor in explaining the shift in FX regime that occurred with the financial crisis in 2008. After the Lehman crash, FX volatility increased sharply. As a result, carry exposures became unattractive as their success was based on low volatilities. Investors began widespread closures of such exposures, which initially exerted pressure on high yield currencies while supporting undervalued low yield currencies, which acquired safe-haven status based on its superior liquidity. The FX market had begun the RORO regime (RORO Risk On Risk Off).

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banks as the BOJ and the ECB. the current regime looks likely to persist for some time yet.

So what will the next regime be like? Naturally, answering this question requires considerable speculation. However, as we expect the current regime to continue until the Fed, or another large central bank, announces a more hawkish monetary policy, this will also cause rate differentials between currencies to widen. Moreover, several central banks will probably remain on hold for longer, such as the BOJ and the ECB, due to the particular situation in their respective regions. Consequently, increasing rate differentials will once again improve the return on carry exposures (eventually) just as they did 10 years ago. However, to produce a new carry regime, FX volatilities must be low enough to avoid wholly eliminating the return from rate differentials. FX volatilities have fallen substantially in recent years, seemingly to around pre-financial crisis levels.

Of course, it is difficult to state exactly when the FX market will become subject to another regime or what the key currency driver might be under it. However, the present set-up is likely to persist until at least one or several major central banks start to signal a tighter monetary policy. Given current very low general inflation, due to pressure from global deleveraging, this appears unlikely to occur before 2015. Provided major central banks continue to ease monetary policy, they will probably also stop smaller central banks from taking steps to tighten monetary policy as this would mostly subject their own currencies to further pressure to appreciate. Therefore, the trigger for the next currency regime will most likely concern Fed monetary policy with a complete cessation of asset purchases and signaling of higher rates, which would also make it possible for smaller central banks to move ahead with tightening monetary policy as well.

In that case, at its current levels, FX volatility would probably not obstruct a new carry regime if rate differentials began to widen. In this sense therefore, a new carry regime appears a credible assessment. Richard Falkenhll

SEK & the financial trilemma

Could CPI surprise on the downside 2014?
In the Riksbank Minutes presented last week, Karolina Ekholm again raised the important question of global capital flows, independent central bank policy and foreign exchange movements. In her opinion, should Riksbank deviate too much from international (dovish) monetary policy (as the risk is still with the current repo path see graph below vs. our own projection for ECB refi rate) SEK will undoubtedly appreciate. Riksbank also continues to project a gradually stronger krona based on the repo rate divergence in 2015/16 targeting KIX back to 101 (today 103.50).

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inflation is now the biggest concern for the Swedish central bank. Furthermore, with lower European risk premia (lower sovereign interest rate spreads) the demand for so called safe-haven currencies such as Sweden has decreased. One could hence argue that the importance of this dilemma (of international capital flows at adds with national monetary policy) is perhaps less valid going forward given that financial flows will play a less significant role in determining the value of currencies. Our outlook for 2014 is also based on SEK again being traded as a pro-cyclical currency dependent on the outlook for growth and inflation. With no domestic house price correction likely to take place near-term (which is the biggest risk to the current high foreign ownership rate of Swedish equities and bonds), growth and inflation will be eagerly watched by FX traders. We hold a neutral/upside bias to growth (barometers) but a downside risk to inflation (failure to reach the Riksbank inflation target in the coming 2-3 years). International inflation surprises have continued to land below market estimates (see graph below). This adds to the risk for continued low Swedish CPI in the near-term. This morning however Swedish CPI for December surprised on the upside: CPIF landed at 0.8% y/y vs Riksbank forecast at 0.6% y/y. We are looking to add to our short EUR/SEK recommendation on moves towards 9.00 (first entered just below 9.00), short-term we dont expect EUR/SEK to move below 8.80 given continued dovish monetary policy.

The academic literature has long raised the concept of the impossible trinity: it is unattainable to have a fixed exchange rate, sovereign monetary policy and free capital movement (absence of capital controls). This concept was explored further last year when Helene Rey (Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence) presented a paper at the annual IMF conference in Jackson Hole which points out that despite the acceptance of only being able to control the repo rate (and let the currency float), international capital movements have a cycle of its own and its agenda is set by the core countries (obviously) rather than small peripheral economics like Sweden. Global financial cycles are associated with surges and retrenchments in capital flows and boom and busts in asset prices and crises. Consequently, local financial conditions are hence determined internationally through capital flows, exchange rate- and interest rate movements by factors decided elsewhere as there is a potent global financial cycle in gross capital flows, credit creation and asset prices, which has tight connections with fluctuations in uncertainty and risk aversion. (Please see the front text / WAFX above for some criticism of this view as the Risk-on and Risk-off market has finally shown signs of breaking down). A coordination of global monetary policy would ease the strains but is impossible to implement. Independent monetary policies are (hence) possible if and only if the capital account is managed directly or indirectly. Capital controls could solve this problem but are not likely in developed economies. The recommendation is instead to deal with the issues that peripheral economies end up with, such as excessive credit growth, through Macroprudential polices. This is also the road Riksbank has chosen as the rate cut in December clearly shows

Carl Hammer