Global FX Strategy

Global FX Strategy
November 24, 2009
Global FX Strategy 2010
John NormandAC
(44-20) 7325-5222
john.normand@jpmorgan.com
Paul Meggyesi
(44-20) 7859-6714
paul.meggyesi@jpmorgan.com
Ken Landon
(1-212) 834-2391
kenneth.landon@jpmorgan.com
Tohru Sasaki
(81-3) 6736-7717
tohru.sasaki@jpmorgan.com
Gabriel de Kock
(1-212) 834-4254
gabriel.s.de.kock@jpmorgan.com
Arindam Sandilya
(1-212) 834-2304
arindam.x.sandilya@jpmorgan.com
Niall O’Connor
(1-212) 834-5108
niall.oconnor@jpmorgan.com
Contents
Global FX Outlook 2010 3
Five global macro themes and top trades 11
Global FX Carry Trade Monitor 12
FX alpha strategies in 2010 14
Post-mortem: 2009 forecasts and trades 16
FX Derivatives 18
Long-term Technicals 24
JPY 34
EUR 40
GBP 46
CHF 52
SEK 57
Commodity currencies 62
Risk scenarios & hedging strategies 68
Event risk calendar for 2010 76
J.P. Morgan Forecasts
FX vs Forwards & Consensus 78
Rates, Credit, Equities & Commodities 79
Global Growth and Inflation 80
Global Central Bank Rates 81
www.morganmarkets.com/GlobalFXStrategy J.P. Morgan Securities Ltd.

The certifying analyst is indicated by an AC. See page 83 for analyst certification and important legal and regulatory disclosures.
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

J.P. Morgan Securities Ltd.
• Global FX Outlook 2010: New year, new lows (John Normand)

The dollar will turn in 2010, but not before marking new lows versus the euro (1.62), Swiss franc (0.91) and
possibly the yen (82). This move is more than a carry trade, given broad weakness in the balance of payments.
• Five global macro themes and top trades (Paul Meggyesi, John Normand)
The dollar will undershoot (worst-of basket on CHF, AUD, JPY); recover is discounted but exit strategies are
mispriced (GBP/CHF, AUD/NZD); the end of inflation targeting? (NZD/NOK); a CNY revaluation’s impact on
G-10 FX is overstated (EUR/JPY); and long-term valuation gaps to close in 2010 (EUR/SEK).
• FX Derivatives: A macro model for vol and strategy implications (Arindam Sandilya, Talis Bauer)
A macro model for implied volatility suggests that VXY (3-mo implieds) should range between 10% and 14%
in 2010, with spike risk more likely in Q3/Q4. Focus on vol carry for trading returns.
• Long-term Technicals: Major transition ahead (Niall O’Connor,Thomas Anthonj)
The dollar will undergo a major consolidation phase over the next two months before resuming its bear trend.
• Yen: What would push USD/JPY to all-time lows? (Tohru Sasaki, Junya Tanase, Yoonyi Kim)
USD/JPY can decline to 82 this year before rebounding. Even that level would not prompt BoJ intervention.
• Euro: Few obstacles to new highs (Paul Meggyesi)
The euro’s drivers are less idiosyncratic than other currencies, but it will still rise in an environment of broad
dollar weakness. Most counterarguments – export impact, China revaluation, euro break-up – are overstated.
• Sterling: Funding currency or investment vehicle? (Paul Meggyesi)
Sterling’s undervaluation limits the scope for further weakness, but it is premature to expect a rebound. The
trinity of deleveraging in the household, banking and public sectors remains a powerful obstacle.
• Swiss franc: Franc to rally as SNB steps off the brake (Paul Meggyesi)
Like the yen, the franc is transforming into a pro-cyclical currency in this post-crisis world of low global yields.
The currency will rally in 2010 as the SNB end its intervention (EUR/CHF to 1.46, USD/CHF to 0.91.)
• Swedish krona: The myth of krona undervaluaton (Kamal Sharma)
The krona is not as undervalued as most think, but it can still rally 7% in 2010.
• Commodity currencies: Where's the gold? (Gabriel de Kock, Matthew Franklin-Lyons)
NOK and AUD will lead the advance in 2010, driven by valuations and policy tightening. NOK is the valuation
champ, while AUD benefits from Asian growth. Policy disappointment and valuations hobble CAD and NZD.
• Risk scenarios and hedging strategies (Ken Landon)
An inflation surprise, a US funding crisis and US mid-term elections are three to hedge.
• FX Alpha Strategies in 2010 (John Normand, Matthew Franklin-Lyons)
Carry should deliver roughly 8% returns as volatility ranges but central banks tighten. Forward Carry returns
will moderate from 2009’s 10%. Simple price momentum will struggle in Q3/Q4 when the dollar turns.
• Global FX Carry Trade Monitor (Yoonyi Kim)
The carry trade has returned as it always does post-recession, but it is half as large as it seems. Currency
managers, global macro funds, CTAs and Japanese retail have moderate exposure. US and European have little.
• Post-mortem on 2009 forecasts and trade recommendations (John Normand, Kamal Sharma)
Forecasts were correct on direction but too conservative on magnitude. 60% of trades were profitable.
• FX Forecasts
EUR/USD targets raised to 1.62 by Q2 and 1.50 by Q4. USD/JPY should reach 82 by Q2 before rebounding to
89 at year-end. EUR/GBP should peak at 0.94 and AUD/USD at 1.02.
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Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

At its current pace of decline, the dollar will end this decade
Global FX Outlook 2010: New down 12% trade-weighted, its worst performance since
year, new lows Bretton Woods collapsed in the 1970s. As cold comfort, at
least the 2009 bear market has been comparatively mild.
The dollar has fallen only 5% trade-weighted this year and
• The dollar will end this decade with its worst against 75% of currencies globally, compared to proper
performance since the 1970s. 2010 will mark a routs in the early 1970s, late 1980s and early 2000s when
turning point, but not before the dollar approaches the dollar fell at least 8% and sometimes versus all
new lows versus the euro (1.62), the Swiss franc currencies (chart 1).
(0.91) and possibly the yen (82). Chart 1: Ranking USD bear markets: annual change in trade-
• Fed policy is partly to blame, since extreme rate weighted USD vs percentage of currencies against which USD rose
Based on annual spot movements of G-10 and emerging market currencies vs
environments have driven the dollar’s largest USD
over/undershoots of the past three decades. Even
though recovery is discounted and the dollar slightly 100% 25%
cheap, cash stockpiles are enormous for this rate % of currencies against which USD depreciated, lhs
environment. Another $300bn in drawdown could change in USD trade-weighted, rhs
15%
75%
occur, with the dollar still the chief casualty.
5%
• This move is more than a carry trade, however.
Other components of the US capital account are 50%
weak too (M&A/FDI, equity portfolio flows). -5%
• The dollar is not yet in bubble trouble. Currency 25%

-15%
markets do not meet the usual criteria for bubbles –
extreme valuation, momentum and leverage. Q1-Q2
0% -25%
also lacks the trigger for a reversal, namely a major
71 74 77 80 83 86 89 92 95 98 01 04 07
downside shock to growth or upside shock to rates.
Source: J.P. Morgan
• If the Bank of Japan’s exit from QE in 2006 is any
guide, this apparent stability could change in Q3 Naturally some think that the new year brings an inflection
2010 as the Fed initiates its exit strategy. This policy point, particularly since the dollar has become slightly
shift should be worth a 5-10% dollar rally in H2. cheap (4% trade-weighted on J.P.Morgan’s fair value
model1). The dollar will turn in 2010, but not before nearing
• Until then, implied volatility should range between all-time lows trade-weighted and surpassing old lows versus
10% and 14% (basis VXY for 3-mo implied), with the euro, Swiss franc and possibly the yen. The Fed’s rate
spikes more likely in Q3 – Q4. stance drives part of this move, but reducing the dollar to a
• Alpha strategies: This vol environment implies carry trade ignores much of the story. The US’s capital
returns of 8% on carry, which is less than 2009 but account leaks on several sides (direct investment, portfolio
still decent. Forward Carry returns will moderate equity) such that Fed policy may not drive a sustained
from 2009’s 10%. Simple price momentum will reversal unless the FOMC proves uncharacteristically
struggle in Q3/Q4 when the dollar turns. aggressive – or disruptive – with its exit strategy.
We extend the trough in USD weakness from Q1 2010 to
• Risks to the view: Corporates fail to spend; USD
Q2 and move targets to 1.62 on EUR/USD, 82 on
decline turns volatile, prompting intervention;
USD/JPY, 0.91 on USD/CHF and 1.02 on AUD/USD.
China revalues +10%; inflation resurfaces; US mid-
GBP/USD will benefit from EUR/USD’s rise (peak at
term elections impose fiscal discipline.
1.74 in June), but underperform due to EUR/GBP rally
• Five global macro themes and top trades: USD will to 0.94. These projections are more bearish than the USD
undershoot (worst-of basket on CHF, AUD, JPY); lows we published this summer when we expected
recovery is discounted but exit strategies are EUR/USD to peak at 1.50 and USD/JPY to trough at 89, but
mispriced (GBP/CHF, AUD/NZD); the end of three issues have arisen since then. The Fed is proving more
inflation targeting? (NZD/NOK); a CNY
revaluation’s impact on G-10 FX is overstated
1
(EUR/JPY); and long-term valuation gaps to close J.P.Morgan’s fair value framework is detailed in A new fair-value model
(EUR/SEK). for G-10 currencies, de Kock, September 6, 2008 and updated quarterly in
World Financial Markets.
3
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

comfortable with a zero rate environment than almost every bubble-like, carry trade. This statement is a half-truth.
other G-10 or emerging market central bank but the Bank of Shorts in low-yield currencies have revived as they always
England; cash positions (domestic and cross-border) remain do post-recession, but exposure has climbed to only half its
too high for the 2010 interest rate environment; and reserve pre- Lehman size when measured across the range of
diversification has accelerated to a record pace. Although investor-types such as dedicated currency managers, global
the structural arguments for a dollar collapse (even crisis) macro hedge funds, CTAs, Japanese retail and US retail
are less credible than the alarmists claim, cyclical dynamics (see Global FX Carry Trade Tracker on pages 12-13).3
are powerful enough to drive this overshoot of fair value, Balance of payments data on short-term capital flows (US
much like the late 1980s and in 2007/early 2008. T-bills, deposits and commercial paper) also suggests that
dollar selling this year has been substantial but has not fully
Since this move will occur within a low-inflation expansion,
unwound crisis-related dollar buying. As markets turned in
implied volatility should range between 10% and 14%
Q2, the US posted $90bn of net short-term capital outflows,
(basis J.P.Morgan’s VXY2 for 3-mo implied vol). Spike risk
an amount equivalent to a quarter of the $360bn of inflows
centers on late Q2/early Q3 when the Fed begins
from January 2008 to March 2009 as the credit crisis
implementing policy to reduce extraordinary liquidity, such
as altering the FOMC statement or undertaking repo Chart 2: Short-term capital flows: Most USD buying from the credit
operations, even though rates are on hold until 2011. The crisis has not been reversed
Net short-term capital flows (T-bills, CDs and commercial paper) on a quarterly
Bank of Japan’s experience in 2006 highlights that exits basis and as a four quarter rolling sum
from quantitative easing inject considerable uncertainty, 400
even when rate hikes are small or distant. This volatility four quarter rolling sum quarterly flow
environment implies that alpha strategies such as carry 300
will perform worse than in 2009 (predicted returns of 7% in 226
200
2010 vs 20% in 2009) but still benefit from the rise in cash
rates in the current high-yielders. Forward carry (trading on 100
rate momentum) also should perform worse in 2010(returns 0
of 10%) but still gain. Price momentum will struggle in H2
-100 -91
when the dollar turns again.
-200
The 2010 Outlook details these issues in six sections:
98 99 00 01 02 03 04 05 06 07 08 09 10
• global FX outlook outlining the case for a dollar Source: J.P. Morgan, BEA
overshoot, five global investment themes and the five
most compelling strategic trades; Chart 3: Foreign direct investment: Stronger US corporate profits
have revived net FDI outflows
• measures of the global FX carry trade based on S&P500 corporate profits growth year-on-year versus US net FDI flows. FDI shown
as four quarter rolling sum. Dotted line shows J.P.Morgan projections based on
public and proprietary data; JPM earnings forecasts and the historical relationship between profits and net FDI.
200 -40%
• a macro model for implied volatility and projections
for 2010 based on growth surprises, central bank 150 -30%
surprises and investor leverage. 100 -20%
50 -10%
• long-term technical outlook for G-10 and emerging
markets currencies; 0 0%
-50 10%
• research notes on the major currencies and
recommended strategic (12-month) trades/hedges; and -100 20%
-150 net FDI flows, $bn, 4 quarter sum, lhs 30%
• hedging strategies for three tail risks over the next Corporate profits growth, % oya, rhs
-200 40%
year–inflation surprise, a US funding crisis and US
90 93 96 99 02 05 08
mid-term elections.
Source: J.P. Morgan
The bearish case: it’s more than carry
Judging from market patter over the past several months,
the dollar’s decline simply reflects a burgeoning, even
3
Several weekly and daily indicators for tracking the carry trade’s size and
2
See Introducing J.P.Morgan’s VXYTM & EM-VXYTM, Normand and ownership are detailed in Keeping up with the Watanabes: Who drives the
Sandilya, December 2006. carry trade post-crisis?, Normand, May 15, 2009.
4
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

unfolded (chart 2). More recent data are unavailable, but The greater challenge in 2009 was pegging the timing and
judging from other cash indicators which correlate well strength of the recovery.
with balance of payments data (see chart 8 on page 6), it is
2010 dilemma: recovery discounted, USD cheap
unlikely that more than half of 2008’s inflows have been
but cash piles enormous
reversed.
The 2010 outlook is more challenging for two reasons:
Other components of the US capital account are
recovery is mostly discounted, and the dollar is already
outright negative, or less dollar-positive than headline
slightly cheap. The average investor expects US growth of
figures suggest. For example net FDI flows, which have
2.8% over the next four quarters, up significantly from the
been negative for most of the past decade, are deteriorating
0.5% expected six months ago. Forecasts for other
again. This development is cyclical: US corporates become
economies have risen significantly too and now stand at
more acquisitive internationally as profit growth improves,
1.2% for the Euro area, 1.4% for Japan, 5% for Emerging
and this recovery is proving no different from previous ones
Asia and 3.5% for Latin America. In theory a further dollar
(chart 3). Indeed, the pipeline of pending cross-border
decline should require another few quarters of upside
M&A deals (announced but not completed) now stands at -
growth surprises, since changes to growth expectations have
$40bn for the US compared to net inflows for the Euro area
been positively correlated with stock prices and negatively
($60bn), Australia ($20bn) and UK ($10bn)
correlated with the dollar this decade (charts 6 and 7).
One hopeful spot is net equity inflows, but foreign buying
Chart 4: The US’s net equity flows are weaker than Euro area’s but
is less dollar-bullish than it appears. Unlike the drain in stronger than Japan
equity capital that accompanied much of the 2002-2007 Net equity inflows, 3-month moving average
expansion, the US is now attracting equity portfolio flows 40 3
on a net basis. Net purchases are high outright ($9bn per 30
EUR20bn 2
month) and relative to Japan (¥300bn or $3.3bn per month), 20
but only a third of the €20bn ($30bn) per month which the USD9bn 1
10
Euro area gathers. Hence the negative correlation between
0 0
equity movement and the dollar: the US attracts less global
capital than other countries, even though flows are positive. -10 JPY0.3trn -1
-20
Central banks remain significant buyers of dollars but -2
-30 Euro area US Japan
there is mounting circumstantial evidence that they are
hedging their bets. Net official purchases of US securities -40 -3
run at roughly $50bn per month, which is high relative to 06 07 08 09 10
the US’s trade deficit (roughly $30bn per month) but low Source: J.P.Morgan, US Treasury (TIC), ECB and Ministry of Finance
compared to the nearly $100bn of forex reserves that Chart 5: Global reserve accumulation vs foreign official purchases of
emerging market central banks have been accruing monthly US securities, $bn, 3-month moving average basis
since June due to intervention (chart 5).4 The difference Global reserves calculated as sum for 15 emerging markets with reserves greater
suggests reserve diversification, which now runs at a record than $50bn, plus G-10 central banks which intervene (Japan, Australia, Norway
and Switzerland). Foreign official purchases is sum of weekly Fed custody holdings
pace (see Reserve diversification is back, FX Markets of Treasuries, bills and Agencies plus TIC-reported holdings of corporate bonds,
Weekly, Sept 18, 2009). equities and short-term USD deposits.
150 gap between reserve accumlation and US
If this story sounds familiar, it should. Similar capital
purchases is near record wide
account strains appeared after the 2001 recession when the
100
dollar was cyclically weak due to low rates and structurally
weak due to the current account’s size and its financing
mix. Since little has changed since 2001 – except that the 50
US current account deficit has dropped by half – dollar
bearish during a recovery was the obvious view (see Post- 0
mortem on 2009 forecasts and trade recommendations on Foreign official purchases of US securities
page 16). Expensive, low-yield assets of debtor countries -50
should typically fall in that environment either through Monthly reserve accumulation in EM
carry trades or the hedging of long-term capital inflows. -100
00 01 02 03 04 05 06 07 08 09 10
4 Source: J.P.Morgan, Federal Reserve and national central banks
This figure controls for the valuation effect on reserve from a weaker
dollar. We assume that central banks hold a roughly 25% allocation to
euros, per the IMF’s COFER estimates.
5
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

That move could occur next year because consensus Chart 6: Each percentage point increase in the consensus view on
forecasts are still low relative to the growth economies US growth generates a 10% move in stocks…
Monthly change in consensus forecasts on US growth vs monthly returns on the
typically achieve in the first year of a recovery.5 S&P500. Consensus projections based on monthly Blue Chip survey
10%
In practice, the bar for dollar depreciation isn’t so high y = 11.36x + 0.01
monthly change in S&P500

2
that it requires a growth upgrade. The reason is R = 0.54
5%
evidence of a still-sizable cash overweight. By now the
market impact of excess liquidity is well accepted; the only 0%
disagreement centres on whether this process is natural and -5%

positive, or engineered and sinister. Central bankers call the
move from cash to financial assets a “transmission -10%
mechanism” or “asset reflation” that stimulates growth -15%
through lower borrowing costs and positive wealth effects. -1.2% -1.0% -0.8% -0.6% -0.4% -0.2% 0.0% 0.2% 0.4%
Many investors characterise the switch more cynically as monthly change in consensus US growth forecast
the wall of money, as if the move is inexorable but also Source: J.P.Morgan
irrational. It is neither. The flow continues as long as the
growth and policy environment are stable, but not if they
Chart 7: …and -2.5% on USD trade-weighted
worsen. And the move is rational because investors tend to Monthly change in consensus forecasts on US growth vs monthly returns on USD.
seek assets offering the highest risk-adjusted return. During 5%
a recovery, this asset is not cash, nor a low-yield currency monthly change in USD trade-wtd
4%
of a debtor country. 3%
The critical issues for 2010 are (1) what is the 2%
appropriate cash allocation, and (2) can benign asset 1%
0%
reflation become a destabilising bubble. Chart 8 plots the
-1%
two concepts of cash relevant for the dollar – one cross- y = -2.79x - 0.00 -2%
border and one domestic. The cross-border series tracks US 2
R = 0.26 -3%
net short-term capital flows from the balance of payments,
-4%
comprising T-bills, certificates of deposit and commercial
-1.2% -1.0% -0.8% -0.6% -0.4% -0.2% 0.0% 0.2% 0.4%
paper (same series as chart 2 on page 4). Short-term capital
monthly change in consensus US growth forecast
inflows should rise if central banks are buying US assets for
Source: J.P.Morgan
reserve accumulation, if investors buy dollars during a
rising rate environment or if investors accumulate dollars
during a financial crisis due to short-covering or flight to Chart 8: Cross-border and domestic cash holdings of dollar still look
liquidity. The domestic series represents US household too high relative to the rate environment
USD billion, cumulative figures since January 1999 (starting point chosen by data
balances in retail money market funds, demand deposits or availability). Short-term capital flow data from US balance of payments data. US
checkable deposits. money market and demand deposit data from Federal Reserve.
600
The two series ran counter to one another after the 2001
recession because recovery pushed funds from money 500 short-term capital flows (US balance of payments)
markets into stocks (particularly international ones) and 400 US household cash
credit, while central banks purchased short-term USD assets
as part of their intervention policy. The two cash measures 300
converged during the crisis, reflecting the domestic switch 200
from stocks and credit into US cash, US investor
100
repatriation of non-US investments and foreign demand for
dollars as flight to liquidity. Short-term capital inflows 0
totalled $360bn from 2008 Q1 through 2009 Q1 while US -100
household cash holdings rose by roughly $250bn over the
-200
same period. Note that the figures are not additive, since
01 02 03 04 05 06 07 08 09 10
Source: J.P.Morgan, BEA, Federal Reserve
5
The first year of recovery brings growth twice the pace of the decline,
implying that the US should be expanding by at least 6% in 2010. So while
J.P.Morgan’s projections are more bullish than the consensus, they are
more bearish than the historical norm.
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Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

some of the household cash increase probably reflected Chart 9: US retail cash positions have dropped this year more
repatriation of foreign equity investments. rapidly than after any recession of the past three decades
x-axis shows number of months before and after the recession ends, with zero
Nine months into the dollar’s decline, cash liquidations marking the last month of NBER-dated recessions. Y-axis shows US retail holdings
are very advanced relative to their pre-Lehman levels, of demand deposits, other checking accounts and money market funds indexed to
100 at t=0 (end of recession). Current series assume the 2008-09 recession ended
but balances are still too high for a zero-rate Jun 2009.
environment. US household cash has fallen by $250bn this 110
year, mostly to fund bond purchases. (US retail has average of 1980-2001 recessions
purchased $160bn of bonds, $65bn of credit but sold $21bn 105
of equities year-to-date). This is the fastest pace of cash current
liquidations post-recession in the past forty years (chart 9), 100
and more than reverses the cash hoarding which Lehman’s
bankruptcy inspired. But Lehman is the wrong anchor. 95
Because household cash balances track money market rates
with a lag, and since the funds rate is 200bp lower than it 90
was in September 2008, cash balances should fall well
below pre-Lehman levels. If the historical beta between 85
cash balances and money market rates holds, another -12 -9 -6 -3 0 3 6 9 12
$300bn could flow into asset markets over the next year Source: J.P.Morgan
(chart 10). Flows into US stocks would be dollar-neutral,
Chart 10: US household cash tracks Fed funds with a lag
but those into international equities, higher-yielding US household cash calculated as sum of retail money market funds, demand
government bond markets (particularly emerging markets) deposits and other checkable deposits (USD bn) plotted against Fed funds rate
or pure currency allocations (ETFs) obviously would be lagged one year.
USD negative. 2000 7%
US household cash, $bn, lhs
1900 6%
The path of cross-border short-term capital flows is harder Fed funds rate lagged 1yr, rhs
to predict because they do not track the funds rate nor US vs 1800
5%
rest-of-the-world spreads tightly. This disconnect reflects 1700
the offsetting sources of dollar demand in a low-rate 4%
1600
environment: private investors sell USD to fund non-US 3%
investments, but official investors recycle some of these 1500
flows into US T-bills and deposits as part of their 2%
1400
intervention practices. As a baseline we assume that the full 1300 1%
amount which entered post-Lehman ($360bn) will be
1200 0%
unwound. Only $90 was liquidated in Q2. Q3 data are not
yet available but the correlation between US household cash 00 01 02 03 04 05 06 07 08 09 10
and balance of payments flows (chart 8) suggests that the Source: J.P.Morgan
process has another two quarters and tens of billions left to
run. aggregate valuation reflects offsets from an expensive euro
(+6%) and yen (+10%) versus cheap sterling (-14%) and
Calibrating an undershoot fairly-valued commodity currencies. Purchasing power
Projecting how far the dollar could fall in this parity approaches suggest that the dollar is much cheaper
environment requires calibrating an undershoot, since (7% below its long-term average) but pure price-based
the dollar’s long-term drivers have not worsened materially. approaches to valuing currencies are flawed for reasons
Short-term cyclicals drive this move. Our long-term fair which are well-known: if an economy’s structure evolves
value model based on some of the standard, quarterly over time, the real exchange rate will trend rather than
variables – current account, net investment income, debt-to- mean-revert.
GDP levels and inflation – suggests that the dollar is only Deviations around fair value occur in every asset market. In
3% cheap in trade-weighted terms (chart 11), even though it FX they resurface each decade. Their duration is quite
has fallen 15 % trade weighted since March.6. This
December 2008 but is still cheap since current spreads (750bp)
6 overcompensate for the 4% default rate like this year. Equities are fairly
The same argument applies to credit and equities: markets are not valued despite a 65% rally from their March lows, since 2009 delivered
expensive because they have experienced an unprecedented rally from their earnings of $62 on an end-recession P/E of 16.5 implies an S&P target of
lows. Valuation must be judged relative to a market’s long-term drivers. 1010.
For example, high-yield credit has rallied 1100bp from its wides in
7
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

variable and they sometime bear no link the US business end when Japan emerged from deflation – a notable contrast
cycle. But they do share one commonality: overshoots tend to the Fed and Bank of England’s vagueness – the liquidity
to occur as a lagged response to an extreme policy withdrawal nonetheless sparked a 9% drop in USD/JPY and
environment (chart 12). In the mid-1980s the dollar’s a 2 point rise in implied volatility in 2006 Q2 as short yen
overvaluation reached 20% due to record interest rates positions were covered (chart 13 and 14). Those moves
under Volcker and record fiscal deficits under Reagan. In reversed within three months, but the analogy to dollar-
the late 1980s, the dollar’s undervaluation reached 7% funded carry by the time the Fed begins to withdraw
following the three–year easing cycle which accompanied liquidity next year should be obvious. Despite the best
Plaza Accord intervention. In 2001 the dollar’s efforts at transparency and signaling, the Fed’s exit is
overvaluation reached 10% as a lagged response to the US unlikely to be entirely graceful.
rate advantage that persisted until that year. In 2004 the
Chart 11: USD real effective exchange rate: Actual vs predicted
dollar undershot fair value by some 5% as the funds rate hit Predicted value based on J.P.Morgan estimates as outlined in A new fair-value
1%. The extension of that move to 12% cheapness in 2008 model for G-10 currencies, de Kock, September 6, 2008.
occurred alongside unilateral Fed easing. 160
Given the historical experience, 2010 looks like a year of 150

actual fair value
unfinished business as the dollar contends with the 140
lagged effects of an extreme rate environment. True, the
dollar’s current yield deficit versus the rest of the world (- 130
1% as a weighted average) has closed from the -3% extreme 120
of late 2008. But with two central banks having tightened in
2009 (RBA, Norges Bank), others to follow in 2010 (most 110
emerging markets) and some to simply turn more hawkish 100
(ECB), the rate deficit will widen over the next year. This
90
environment could produce an overshoot as large as the
80 84 88 92 96 00 04 08
typical ones, which delivered a dollar 10% cheap to fair
Source: J.P.Morgan
value in trade-weighted terms, some 7% weaker than
current levels. Normally such a move should be spread Chart 12: USD deviations from fair value have corresponded to
equally across the US’s major trading partners, but policy extremes of very tight or very loose Fed policy vs the rest of
emerging market intervention and subsequent reserve the world
USD deviations from fair value (positive indicates overvaluation) versus spread
diversification shifts more of the adjustment to G-10 between Fed funds rate and policy rates in the rest of the G-10 (weighted average).
currencies. For simplicity we assume G-10 currencies will 25% 8%
USD deviation from fair value model
appreciate roughly 8% by Q2 to 1.62 on EUR/USD, 82 for
6%
USD/JPY, 1.74 on GBP/USD, 1.02 on AUD/USD and 15% Fed funds spread to G-10 cash rates,
0.99 on USD/CAD (see full forecast profile on page 71). 4%
lagged 1 year
5% 2%
USD reversal in Q3: The Fed’s graceless exit from
QE may mirror the Bank of Japan’s in 2006 0%
-5% -2%
If extreme rate environments drive overshoots around
fair value, then normalisation should drive a reversal. -4%
-15%
That normalisation could come in late Q2/early Q3 as the -6%
Fed begins to exit from exceptionally low levels of policy -25% -8%
through some combination of FOMC statement changes and 80 84 88 92 96 00 04 08
repo operations to reduce excess reserves. Rate hikes should Source: J.P.Morgan
wait in 2010, but that patience does not guarantee tranquil
markets or a trend dollar decline through end-2010. The Three misconceptions about the dollar
resulting rise in volatility against a backdrop of much larger Dollar bulls will counter that an undershoot is unlikely due
dollar shorts could easily drive the dollar some 5-10% to three constraints: most investors are extremely bearish,
higher in Q3 and Q4. Indeed, the experience of Japan set the and therefore short; currency markets are experiencing an
precedent for a messy, albeit brief, QE exit. Ahead of its unsustainable bubble which will soon be punctured; and
first interest rate hike in mid-2006, the Bank of Japan began new lows on the dollar will motivate G-3 intervention. Each
reducing commercial banks’ target for current account is a misconception. We address each in turn.
balances (excess reserves) from a record ¥35trillion.
Although the BoJ had been explicit in stating that QE would 1. Everyone is bearish and therefore short. By the usual
cover story test – a trend reverses once it becomes a cover
8
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

story in the popular press – the dollar’s decline should have Chart 13: The end of Japanese QE in Q1 2006 prompted a spike in
ended this fall. But despite the bearish dollar patter, there is USD/JPY volatility…
Commercial banks current account balances with Bank of Japan versus USD/JPY
little evidence that views are so extreme or positions so 3-mo implied vol
short that they should impede the current bear trend. 35 13%
Consensus expectations are, in fact, dollar-bullish, with BoJ reduces reserve balance
30 targets 12%
end-2010 forecasts of 1.45 on EUR/USD, 98 on USD/JPY,
1.64 on GBP/USD, 0.88 on AUD/USD and 1.06 on 11%
25
USD/CAD. Even amongst the emerging market currencies, 10%
20
the only consensus bearish USD call comes against 9%
Emerging Asia (chart 15). Being non-consensus in this 15
8%
instance is no great shame, since the average forecaster has
10
been too conservative in anticipating USD weakness, even bank reserves, JPY trillion, lhs 7%
when they correctly predicted the dollar decline (chart 16). 5 USD/JPY 3-mo implied vol, rhs 6%
This conservatism usually corresponds to positions, which 0 5%
is why many of the indicators tracked on pages 13-14 01 02 03 04 05 06 07
(Global FX Carry Trade Monitor) continue to evidence
modest carry – and by extension short USD – exposure. Source: J.P. Morgan
Chart 14: …and a liquidation of yen-funded carry

2. Currencies are in bubble trouble. Related to the fear of IMM net speculative positions in JPY vs USD/JPY spot
excessive USD bearishness and USD shorts is the 50 BoJ reduces reserve 124
characterisation that currency markets are experiencing a balance targets
speculative bubble. The label has been applied to almost 0 120
every asset market this year except housing, since equities,
116
credit, some commodities and most high-yield currencies -50
have posted unprecedented gains since March. Identifying 112
asset bubbles ex ante is, of course, impossible. Many -100
marketsexhibit tremendous price rises, but the only ones 108
which earn the label of a bubble are those which crashed -150 IMM positions in JPY, thou contract, lhs
104
(Japanese real estate in the last 1980s, internet stocks in the
USD/JPY spot, rhs
late 1990s, housing in the 2000s). Thus we can only -200 100
distinguish bubbles from more ordinary bull markets ex Jan-05 Jun-05 Nov-05 Apr-06 Sep-06
post.
Source: J.P. Morgan
Markets that crashed shared three characteristics, however: Chart 15: Consensus expectations for currency movements versus
extreme valuation, extraordinary momentum and high USD over the next 12 months
leverage. 7 Applying this scratch test to currencies, the %, positive (negative) indicates that the consensus expects foreign currency to appreciate
(depreciate) versus the dollar by end-2010.
dollar flunks all sections. As noted earlier, the dollar is
cheap, but far from the extremes of 10% - 15% 12%
undervaluation (charts 11 and 12). Short dollar/long carry 9%
positions have risen quickly but only to about half their pre-
Lehman levels (see Global FX Carry Trade Monitor on 6%
page 14). And price momentum, measured as rolling 12- 3%
month returns, are far from the -10%to -15% annual moves
0%
which have marked turning points in the past (chart 17). By
Q2 2009 this scratch test could yield a different judgment, -3%
but for now, the currencies look like most other asset -6%
markets – heady but hardly bubble-like.
-9%
3. G-3 central banks would intervene at new lows for the
JPY
KRW
SEK
NOK
CHF
CNY
BRL
CAD
GBP
EUR
AUD
NZD
IDR
TWD
INR
MXN
TRY
ZAR
dollar. Intervention is standard practice for many emerging

markets central banks and some G-10 banks (SNB, RBA). Source: J.P. Morgan, Bloomberg
The intervention which drives the USD trend, however,
requires the Treasury, Bank of Japan and ECB. Our view on
7
See Are alternatives the next bubble?, Loeys, September 2006.
9
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

intervention during this dollar decline is the same as our Chart 16: Forecast errors: the consensus has been too conservative
view during the dollar’s 2008 rise: G-3 central banks will in forecasting USD weakness this decade
Consensus error on G-10 and emerging market FX forecasts vs USD, where error is calculated
not intervene in currency markets unless FX moves raise as difference between actual rate and forecast r ate over horizons of one quarter to two years.
volatility and drive other asset markets lower. The rationale A positive (negative) value indicates that the consensus underestimated (overestimated)
foreign currency strength vs USD.
is simple: G-3 policymakers know that intervention’s 12%
impact is fleeting without a sea change in monetary policy,
such as Fed hikes. Japan also faces considerable domestic 10%
opposition to further USD accumulation, as discussed in
8% G-10 FX EM FX
JPY: Can it reach new all-time lows? on page 34.
Where are we wrong? 6%
The most significant risks to the bearish view are the 4%

following:
2%
1. Corporates fail to spend bumper profits, leading to a
growth slowdown in early 2010. The dollar would 0%
appreciate as carry/cyclical trades are unwound. Current qtr 1 qtr ahead 2 qtrs ahead 1 yr ahead 2 yrs ahead
2. The dollar’s decline becomes volatile, possibly due to Source: J.P. Morgan
a US financing issue next year. The dollar would rise
Chart 17: Bubble test for excess momentum: USD’s move this year
versus the high-yield currencies and commodity currencies has not been excessive by historical measure
given the increase in volatility. The dollar would probably Annual returns on trade-weighted dollar and 2-sigma bands
fall versus the euro and Swiss franc since the underlying 30%
cause of the move is a US sovereign risk issue. Eventually
such a move could prompt G-3 intervention, but not before 20% average plus 2 sigmas
the dollar posts a sizable H1 fall. See Risk scenarios on
page 70 for the most efficient hedging strategy. 10%
3. A significant upturn in inflation. The consensus expect 0%

global inflation to turn higher in 2010, but to only 1.9% in
the US and 1% in Europe. Dollar weakness and resulting -10%
commodity price strength render that projection a moving average minus 2 sigmas
target, however, while the long-standing anxieties around -20%
fiscal policy and exit strategies raise questions about how 70 75 80 85 90 95 00 05
much inflation expectations can or should decline. Whether
Source: J.P. Morgan
inflation rises gradually (a low-volatility event) or abruptly
(a high-volatility event) drives the feedback to currencies as importance. US mid-term elections in November could
the CPI trend evolves. See Risk scenarios for the most result in a divided Congress, which may then result in more
efficient hedging strategy. conservative fiscal policy in 2011. Coming at a time when
expectations of Fed tightening are building, this electoral
4. China surprises with a +10% one-off revaluation of outcome could aid the dollar’s rebound late in the year. See
the yuan. The immediate reaction would be a lower euro, Risk scenario 3 .
since a stronger yuan would reduce China’s buying of non-
USD assets as part of its reserve diversification. We suspect We are not worried about premature tightening, or a
that such a policy move would be a low-probability event more meaningful shift to asset price targeting in the G-3
given China’s skepticism about the global recovery and its central banks that control global liquidity. Many smaller
lack of meaningful inflation. We continue to expect the central banks already have cited asset price inflation as
yuan to appreciate next year (forecast: USD/CNY at 6.58 by motivations for recent tightening, and the ECB has always
December 2010), but that baseline move is too modest and expressed more concern about excess liquidity than the Fed.
gradual to impact the euro. Only a significant- step-wise Even the most hawkish central banks, however, will avoid
appreciation (10% or more) would impact EUR/USD. See setting policy next year with asset prices in mind because
EUR: Few obstacles to new highs on page 38. few markets exhibit extreme overvaluation. Their comfort
level may change in 2011 if price trends continue at the
5. A divided USD government after mid-term elections. 2009 pace.
Politics is rarely a consistent G-10 FX influence, but when
fiscal policy is a central issue, elections assume greater
10
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 7859-6714

John Normand (44-20) 7325-5222
 Buy a 6-mo 1.60-1.50 GBP put/CHF call spread

Five global macro themes with a 1.45 RKI on the lower strike. Cost 1.35%.
and top trades  Buy a 6-mo 1.30 AUD call/NZD put, RKO 1.41.
Our short-term trade recommendations are outlined and Cost 0.68%.
marked to market each Friday in FX Markets Weekly. On
average we have held cash trades for three weeks and 3. The end of inflation targeting?
option trades for two months (see Table 1 in Post- Although central bank mandates are not officially under
mortem: 2009 forecasts and trade recommendations on review, they are certainly under legislators’ microscope.
page 16). This section focuses instead on five global New Zealand’s Labour Party has already withdrawn its
macro issues which we expect to define 2010, so support for inflation targeting, whilst the NZ Treasury is
accordingly the tenor is longer (6-12months) than the cognisant of the dangers of continued over-reliance on
types of trades we typically recommend in FX Markets anti-cyclical monetary policy. Norway by contrast is the
Weekly. only major country where unemployment is below its
long-term average, leaving the Norges Bank relatively
1. The dollar will undershoot.
free to normalise policy in pursuit of medium-term price
As detailed in the Outlook (pages 3-10), the dollar is
stability.
headed for another undershoot of fair value, even if it is
already slightly cheap. Low rates, weak long-term capital  Buy a 6-mo 3.90/3.60 NZD put/NOK ratio call
flows, high cash levels and EM intervention policy will spread in 1x1.5 notional. Cost 1.50%.
drive this move in Q1/Q2, with decent odds of a sharp
reversal only later in the year. 4. A CNY reval’s impact on G-10 FX is overstated
We focus fresh USD shorts in one of the few currencies As discussed in the euro section (page 40), we believe
to be undervalued vs. USD (CHF) and in a worst-of that the impact of CNY revaluation expectations on EUR
basket to benefit from de-correlation savings. The broad and JPY is overstated and that the broad dollar trend will
USD trend will dominate currency-specific factors, dominate these and other idiosyncratic factors. We
especially amongst the group of former funding expect EUR/JPY to remain rangebound as a result.
currencies (CHF and JPY) whose inverse correlation to  Buy a 6-mo 123-142 EUR/JPY range binary for
risk markets has/will break down, leaving USD as the 23.3%.
pre-eminent funding currency.
 Buy 6-mo 0.8900 USD/CHF one-touch for 16.7%. 5. Valuation gaps will close in the next year
Several currencies are misaligned on our fair value
 Buy a 6-mo USD put/worst-of basket call where model, with the most overvalued being JPY (+12%),
the basket comprises CHF, AUD and JPY. Strikes AUD (+6%) and EUR (+5%), and the most undervalued
are 0.9762, 0.9426 and 85.21 (35 delta). Cost 0.83% being GBP (-15%), NOK (-9%) and SEK (-5%). The
vs. 2.36% for the cheapest vanilla. obvious mean reversion trade would be to purchase
GBP/JPY, but since valuation gaps rarely close without a
2. Global recovery is discounted but country exit cyclical or policy trigger, this trade is premature.
strategies are mispriced. (Sterling’s re-rating requires Bank of England
The consensus has marked up its growth forecasts tightening.) Selling USD/NOK or EUR/NOK are
considerably over the past six months (page 7) and we candidates, but we hold these elsewhere. We therefore
have little quibble with current estimates. The more sell EUR/SEK through a ratio put spread, consistent with
significant mispricing, in our view, concerns exit the view that SEK’s undervaluation is smaller than
strategies. OIS curves imply almost 175bp of tightening presumed but still worth capturing (see SEK: The myth of
by the RBNZ over the next year, 140bp by the RBA, krona undervaluation on page 57).
60bp by the BoE and 25bp from the SNB. It seems
unlikely that the RBNZ would tighten more than the  Buy a 12-month EUR put/SEK ratio call spread
RBA given Bollard’s commitment to keeping rates on in 1x1.5 notional. Cost 0.88%.
hold through mid-year. BoE tightening in the next year is
at odds with a central bank still concerned enough about
the recovery to leave open the possibility of further QE
asset purchases. And the lack of term premium in the
Swiss curve is unusual for a country which suffered
relatively little damage from the Great Recession.
11
Global FX Strategy
November 24, 2009
Yoonyi Kim (81-3) 6736-7729

yoonyi.x.kim@jpmorgan.com
JPMorgan Chase Bank NA
Global FX Carry Trade Monitor

Chart 1: Japanese retail — market capitalisation of 100 largest FX- Chart 2: Japanese retail — aggregate retail margin shorts in JPY
denominated Its
¥trn; market capitalization of 100 largest investment trusts excluding funds ¥trn, Japanese retail measured by positions in USD, NZD, EUR, GBP and AUD
investing in equities; ranked in the order of total asset as of Nov 17th 09 on Tokyo Financial Exchange; positive indicates shorts in JPY
25 70 ¥8
Aggregate JPY shorts in Japanese margin accounts, JPY trn
80 ¥6
20
90 ¥4
100 ¥2
15
110 ¥0
Market cap of top 100 ITs, JPY trn, lhs
JPY trade-w td index , inv erted rhs
10 120 -¥2
06 07 08 09 10 06 06 07 08 08 09
Source: J.P. Morgan, Bloomberg Source: J.P. Morgan, TFE
• Japanese retail exposure to foreign currencies via investment • Despite fluctuations between long and short positions this
trusts has been rising since January at a moderate but year, Japanese margin traders have been building JPY shorts
consistent pace. The current level of ¥18.8trn is slightly less since August. The year to date peak in JPY shorts (¥4.1trn)
than the year-to-date high of ¥19.4trn reached in late October. marked in September is roughly 57% of the pre-Lehman peak
This year’s peak is 80% of the pre-Lehman high of ¥24.2trn of ¥7.1trn reached in Aug 2007. Current JPY shorts at ¥3.0trn
reached in August 2008. (Nov 19) is 74% of the year-to-date peak.
Chart 3: Japanese retail — margin shorts in JPY vs USD, GBP, Chart 4: Global retail — issuance of FX-linked structured notes
AUD
bn local currency. positive indicates long in local currency/short in JPY $bn, region is where the note was issued
USD
30
Asia ex Japan
25 GBP 25 Latin America
20 AUD North America
20 Europe
15
10 15
5 10
0
-5 5
-10 0
-15 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
08 08 08 09 09 09
Source: J.P. Morgan, TFE Source: J.P. Morgan
• Japanese retail margin shorts in JPY against USD, GBP, and • Total issuance in FX structured notes globally reached $21bn
AUD recorded new historical peak in the later half of 2009. in 2009, which is roughly 80% of the record 2008 issuance of
USD/JPY longs and GBP/JPY longs each reached a historical $27bn. Issuance in Latin America doubled from last year,
peak at $27.3bn in Oct and £8.5bn in September, while reaching a record high at $7.6bn whilst issuance elsewhere
AUD/JPY longs marked a new record peak most recently on declined sharply. Issuance in Europe, North America and Asia
Nov.19 at A$16.7bn, eclipsing the previous record in July. As ex Japan this year stands at 36%, 76% and 69% of their
of November 19, longs in USD and GBP stands at $4.8bn and respective peaks reached in 2008 for Europe and Asia ex-
£3.3bn, equivalent to 18% and 38% of their historical highs. Japan and in 2007 for North America.
12
Global FX Strategy
November 24, 2009
Yoonyi Kim (81-3) 6736-7729

yoonyi.x.kim@jpmorgan.com
Chart 5: CTAs — aggregate IMM shorts in USD Chart 6: US retail — market capitalization of US-listed FX ETFs
$ bn as the sum of net speculative positions on the IMM in AUD, NZD, CAD, $bn. Positive value indicates longs in foreign currency, shorts in USD
EUR, GBP, JPY, CHF and MXN.
$20 5 75
Aggregate USD shorts on IMM, $ bn, lhs
$10
4 80
$0
3 85
-$10
2 90
-$20
1 95
-$30 Market cap of US-listed FX ETFs, $bn, lhs
USD trade-w td index , inv erted, rhs
0 100
-$40
00 02 04 06 08 10 06 07 08 09 10
Source: J.P. Morgan, CME Source: J.P. Morgan, Bloomberg
• Since turning flat in May, CTAs have been rebuilding USD • US retail exposure to foreign currencies via ETFs enjoyed a
shorts with aggregate IMM position rising to year to date peak moderate but consistent up-trend since the equity market rally
at $22bn in October, which is equivalent to 60% of the pre- in March. USD short positions reached a year to date peak at
Lehman peak at $36bn in Nov 07. While the current level of $3.7bn in October, which is 70% of the pre-Lehman peak in
USD shorts has fallen to $18bn or 15% off from the recent August 08 at $5.0bn. Most recent data shows the current
peak, CTAs continue to hold a large stake in USD carry trade. position at $3.1bn, roughly 15% down from the recent peak.
Chart 7: Currency managers and global macro hedge funds — beta Chart 8. Currency managers and global macro hedge funds — Beta
with G-10 carry strategies with emerging markets carry strategies
Positive beta implies a long in carry, a short in dollars HFR used for global macro Positive beta implies a long in carry, a short in dollars HFR used for global macro
hedge funds. Barclay BTOP Index and Parker Blacktree Index used for currency hedge funds. Barclay BTOP Index and Parker Blacktree Index used for currency
managers. managers.
2.5 2.0
Currency managers Global macro hedge funds
2.0
1.5
1.5
1.0 1.0
0.5
0.5
0.0
-0.5 0.0
-1.0
-0.5
-1.5 Currency managers Global macro hedge funds
-2.0 -1.0
05 06 07 08 09 05 06 07 08 09
Source: J.P. Morgan Source: J.P. Morgan
• Currency manager and macro hedge fund exposure to G-10 • Betas for currency managers and macro funds with respect to
carry, as proxied by their return beta with a carry basket, has emerging markets carry baskets has alone been rising steadily
trended higher throughout the year. But with betas of 0.2 to but is well off the 2007-2008 peaks. Current betas of 0.3 to
0.5, exposure appears to be a fraction of the highs reached in 0.4 are well below the pre-Lehman peaks of 1.8 for global
2007-2008. Prior to the Lehman shock, hedge funds betas macro funds and 1.1 for currency managers.
peaked at 2.5 while those of currency managers peaked at 1.3.
13
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

Matthew Franklin-Lyons (1-212) 834-4565
J.P. Morgan Securities Ltd., JPMorgan Chase Bank NA
If historical betas hold, then carry returns could reach

FX alpha strategies in 2010 8%, which is higher than average but lower than this year’s
returns. We assume that implied volatility will range
After the carry trade’s appalling performance in 2008, most between 10% and 14% in 2010 (see FX Derivatives section
model-driven strategies staged a comeback in 2009, on page 19), which limits the upside on carry relative to
delivering higher absolute and risk-adjusted performance 2009’s unprecedented decline in volatility. The average
than many industry composites (table 1). Standard carry carry on G-10 and emerging markets baskets will rise by
strategies delivered returns of 20% on a G-10 basket and about 150bp due to monetary tightening, thus raising the
9.5% on emerging markets (table 1). Forward carry, which running yield.
trades currencies based on momentum in interest rate
spreads, returned 10%, roughly equivalent to last year’s Econometric models for predicting the returns to
performance of 12%. (See next page for descriptions of forward carry and price momentum are less robust.
J.P.Morgan’s rule-based strategies.) More qualitatively, we suspect returns to both strategies will
be average in 2010. For forward carry, interest rate markets
Simple price momentum performed the worst this year, will deliver less powerful signals in 2010 since a major
losing 10% year-to-date. We expected as much: medium- repricing has already occurred – this year’s shift in front-
term price momentum models almost always underperform end rates to imply more aggressive tightening in most
at turning points because the lookback period used to countries relative to the US. The strategy would only
generate signals places too much weight on a mature trend. deliver above-average returns if central banks surprise
An alternative to simple price momentum, which we call meaningfully next year, which is unlikely in the current
Forward Momentum Overlay because it uses the short- inflation environment.
term rate signal from Forward Carry to confirm price
momentum, performed relatively better. It lost only 0.4% Simple price momentum should perform better in early
because rate signals often contradicted medium-term price 2010 than in 2009 since lookback periods now incorporate a
momentum, which until mid-year was still recommending bearish dollar trend. But these models are vulnerable in the
to buy dollars because of the currencies strong performance second half of the year because price signals alone will not
in late 2008. warn of an impending dollar turn in H2 as the Fed begins
withdrawing excess liquidity and volatility rises. The
Previous J.P.Morgan research has explored the issue of Forward Momentum Overlay model, which uses short-term
forecasting returns from various alpha strategies, since interest rate expectations to confirm price signals, is
excess returns tend be regime-dependent (see Currency preferred in such an environment. Any move in rate spreads
manager returns, trading styles and Fed cycles, Normand, in the dollar’s favour around mid-year would neutralise
August 2006 and FX in a world with less leverage and more bearish dollar signals from medium-term price momentum
regulation, Normand and Sandilya, January 2009). Carry and thus induce the model to take profits on dollar shorts.
performs best when volatility is declining but policy rates
increasing, thereby boosting the rate advantage of high- The performance and signals from each models are reported
yielders. Forward Carry tends to perform best when central weekly in the FX Alpha Strategies section of FX Markets
bank cycles are unsynchronised, thus causing rate spreads to Weekly.
trend for several months. Price momentum tends to perform
best in periods of declining interest rates, probably because
such an environment drives long-term bear markets for the
dollar.
14
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

J.P. Morgan Securities Ltd., JPMorgan Chase Bank NA
Table 1: Performance of rule-based FX alpha strategies, currency managers and global macro hedge funds, 1999 - 2009
Betas are calculated between monthly returns on strategies/manager composites and the level of volatility/interest rates.
Alpha strategies Manager performance
Forward Momentum Overlay HFR global

Forward Carry (rate Price (price momentum plus Barclay Currency Barclay Group Parker macro hedge
G-10 carry EM carry spread momentum) momentum Forward Carry) Traders Index BTOP FX Blacktree CMI funds
2009 YTD
Avg annual return 20.0% 9.4% 10.4% -10.4% -0.4% 0.7% 0.9% 0.1% 3.3%
Std dev 11.7% 5.8% 10.8% 11.5% 7.2% 1.6% 1.0% 1.6% 4.7%
IR 1.7 1.6 1.0 -0.9 -0.1 0.4 0.9 0.1 0.7
Beta with respect to
Equity vol (VIX) -0.13 -0.07 -0.11 0.01 -0.05 -0.01 -0.01 0.01 -0.05
Rate vol (MOVE) -0.03 -0.03 0.01 0.00 0.00 0.00 0.00 0.01 0.01
FX vol (VXY) -0.62 -0.37 -0.44 0.15 -0.14 -0.01 0.00 0.09 -0.08
UST 2-yr -3.42 -2.34 0.72 2.42 2.21 -0.86 0.07 0.00 -1.35
2004 - 2008 (5 years)

Avg annual return -3.2% 9.5% 7.0% 2.0% 4.4% 1.4% 0.7% 4.3% 7.1%
Std dev 12.0% 15.7% 7.0% 7.2% 4.8% 2.0% 1.5% 1.6% 2.7%
IR -0.3 0.6 1.0 0.3 0.9 0.7 0.5 2.6 2.7
Equity vol (VIX) -0.15 -0.18 0.00 0.09 0.05 0.01 -0.01 0.00 -0.01
Rate vol (MOVE) -0.03 -0.04 0.00 0.02 0.01 0.00 0.00 0.00 0.00
FX vol (VXY) -0.42 -0.51 -0.05 0.22 0.09 0.04 -0.01 -0.01 -0.02
UST 2-yr 0.61 0.41 0.00 -0.26 -0.14 -0.05 0.03 -0.02 0.08
1999 - 2008 (10 years)

Avg annual return 2.9% 10.4% 5.5% 4.5% 5.0% 3.4% NA NA 8.9%
Std dev 10.8% 16.2% 5.4% 7.8% 4.8% 3.4% NA NA 6.1%
IR 0.3 0.6 1.0 0.6 1.0 1.0 NA NA 1.5
Equity vol (VIX) -0.06 -0.11 0.00 0.04 0.02 0.02 NA NA -0.01
Rate vol (MOVE) -0.02 -0.03 0.00 0.01 0.01 0.00 NA NA 0.00
FX vol (VXY) -0.20 -0.38 -0.04 0.09 0.02 0.08 NA NA -0.02
UST 2-yr -0.01 -0.17 -0.07 -0.04 -0.06 -0.09 NA NA -0.06
Strategy descriptions
G-10 and Emerging Markets Carry strategies select four Forward Momentum Overlay only buys currencies which
currencies with highest ratio of carry (1 mo rate differential) have appreciated in spot terms and are experiencing rising
to volatility (annualized spot vol over past 30 days). rate expectations relative to another currency. Thus it
Forward Carry buys the currency in whose favor rate combines the standard price momentum framework with
expectations have moved over the past month. Expectations Forward Carry.
are based on 1mo rates 3mos forward. All strategies are described in Alternatives to Standard
Forward Carry Overlay only buys high yield currencies if Carry and Momentum in FX (Normand and Ghia, August 8,
rate expectations are also moving in that currency’s favor, 2008).
so combines standard carry and Forward Carry concepts.
15
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

Kamal Sharma (44-20) 7777-1729
Table 1: J.P.Morgan and consensus forecasts in January 2009

Post-mortem: 2009 forecasts Spot on Jan
Forecasts for
and trade recommendations 1, 2009 Q1 09 Q2 09 Q3 09 Q4 09

This time last year we expected deleveraging to push the EUR/USD
dollar higher versus all currencies but the yen in Q1 JPM 1.35 1.28 1.30 1.35 1.37
2009, following by dollar weakness as the recovery Consensus 1.35 1.33 1.32 1.33 1.33
unfolded. This view was shared partially by the Actual 1.35 1.33 1.40 1.46 1.48
consensus, although J.P.Morgan forecast for dollar
weakness was broader and more aggressive than the USD/JPY
average forecast. We expected EUR/USD to fall to 1.28 JPM 90 88 85 85 90
by end Q1 from 1.35 at the start of the year. In the event, Consensus 90 92 94 96 97
EUR/USD ended Q1 at 1.33, equivalent to the consensus
Actual 90 99 96 90 89
forecast.
From Q2 onwards, however, we projected a much AUD/USD
stronger recovery – and therefore dollar sell-off – than JPM 0.71 0.60 0.64 0.70 0.76
the consensus, so forecast 7% EUR/USD appreciation Consensus 0.71 0.65 0.65 0.66 0.68
through year-end. The consensus forecast was flat around
Actual 0.71 0.69 0.81 0.88 0.91
1.33. The euro well exceeded both, rallying over 12% Source: JP Morgan
from Q2 to Q4 (chart 1).
Chart 1: JP Morgan forecasts for EUR/USD versus consensus
Our forecast profile for USD/JPY assumed that the
1.50 JPM
dollar would weaken in the first half of the year before
Consensus
recovering modestly towards the end of 2009. The
1.45 Actual
consensus was much more bullish, expecting continuous
USD/JPY appreciation through Q4. We were wrong in 1.40
Q1 as USD/JPY rallied following a collapse in Japanese
growth and the country’s trade surplus. By year-end, 1.35
however, our forecast was much closer to the mark than
the consensus (JPM 90, consensus 97). 1.30
As with our forecasts for EUR/USD, we overestimated
the Q1 decline and the Q2 recovery in commodity 1.25
currencies, even though we pegged the turning point 01 Jan 09 Q1 09 Q2 09 Q3 09 Q4 09
correctly. For example with AUD/USD, we expected 7% Source: JP Morgan
appreciation in Q2 but AUD/ USD rallied by over 16%.
Given the lower starting point of our forecast by end Q1, Chart 2: JP Morgan forecasts for USD/JPY versus consensus
our projections trailed actual AUD/USD moves by an 100 JPM
average of 22%. This compares to an average miss of Consensus
98
Actual
24% by the consensus. However, from Q1 to Q4 we had 96
correctly forecasted the degree of the AUD/USD 94
recovery. From end Q1 to Q4 2009, our forecasts had 92
looked for a 27% appreciation in AUD/USD which 90
compares favorably to the 31% actual appreciation. The 88
consensus lagged well behind, forecasting only a 4% 86
appreciation over the same period. 84
82
01 Jan 09 Q1 09 Q2 09 Q3 09 Q4 09
Source: JP Morgan
16
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

Kamal Sharma (44-20) 7777-1729
Trade recommendations are detailed each Friday in FX Table 1. Performance statistics 2008 – 2009
Markets Weekly and are classified as macro directional 2008-2009
2009 YTD 2008 weighted avg
trades (cash and options); derivatives relative value I. Trade Recommendations portfolio
and technical trades. Cash
# of trades 59 85 144
I. Macro trade recommendations
Success rate 63% 59% 61%
This year we recommended fewer cash trades (59) than Average return per trade (%, unweighted) 1.0% 2.0% 1.6%
in 2008 (85). Nonetheless, our success rate was higher, at Average holding period (days) 18 31 26
63% compared to 59% in 2008. The average return per Derivatives (non-digital)
trade was 1% compared to 2% in 2008. In weighted # of trades 19 3 22
terms, our trades have delivered a 61% success rate over Success rate 63% 0% 55%
Average return per trade (bp, unweighted) 0.6% -0.6% 0
2008-2009, whilst weighted average returns were 1.6%
Average holding period (days) 57 66 58
over the same period.
Derivatives (digital)
In 2009 we issued more derivatives trades than in # of trades 18 5 23
2008:19 non-digitals (vs 3 in 2008) and 18 digitals (vs 5 Success rate 44% 20% 39%
in 2008). Success rates were high (63%) and average Average return per trade (%, unweighted) -3.5% -3.6% -3.5%
returns per trade decent (0.6%) for non-digitals, but not Average holding period (days) 56 54 56
for digitals (success rate of 44% and average loss of - II. FX Derivatives portfolio (relative value)
3.5%). Non-digital
# of trades 28 13 41
II. Relative value derivatives recommendations Success rate 68% 77% 71%
Average return per trade (%, unweighted) 0.1% 0.6% 0
In 2009, our relative value recommendations focused on
Average holding period (days) 75 53 68
non-digitals. The number of recommendations more than
doubled to 28, whilst the success rate was marginally Digital
lower at 68% (from 77% in 2008). The average return # of trades NA 3 3
Success rate NA 33% 33%
was 0.5% lower than in 2008 at 0.1%.
Average return per trade (%, unweighted) NA 8% 8%
III. Technical trade recommendations Average holding period (days) NA 33 33
III. Technical Strategy portfolio

In 2009, we recommended half the number of technical
# of trades 44 87 131
trades as we had done in 2008, at 44. Nonetheless, our
Success rate 55% 43% 47%
success rate improved by over 10% to 55%. However, Average return per trade (%, unweighted) 0.0% 0.2% 0.1%
the average return on each trade was close to flat versus Average holding period (days) 9 9 9
+0.2% in 2008.
Source: J.P. Morgan
Chart 1: 2008-2009 performance summary: Average returns per
trade Chart 2: 2008-2009 Performance summary: Success rate by type
of trade
2009 1.0%
Cash
2.0% Cash 63% 2009
2008 59%
0.6% 2008
Non-digital
-0.6% 63%
Non-digital
0%
-3.5%
Digital
-3.6% 44%
Digital
0.1% 20%
RV (non-digital)
0.6% 68%
RV (non-digital)
0.0% 77%
Technical
0.2%
55%
Technical
43%
-5% -4% -3% -2% -1% 0% 1% 2% 3%
Source: J.P. Morgan 0% 20% 40% 60% 80% 100%
Source: J.P. Morgan
17
Global FX Strategy
November 24, 2009
Arindam Sandilya (1-212) 834-2304

Talis Bauer (44-20) 7777-5276
Chart 1. The decline in volatility across asset classes in 2009 was

FX Derivatives: A macro nothing short of dramatic, and G10 FX was no exception
3M ATM implied volatilities in equities (S&P 500), US interest rates (2Y and 10Y
model for volatility and tails), FX (VXY G7) and commodities (gold and copper), indexed to 100 as of 01-
Jan-09.
strategy implications 140
Index S&P
US 3M10Y
US 3M2Y
Gold
Copper VXY G7
• The unexpectedly strong economic recovery in 2009
sponsored a dramatic decline in volatility across 120
asset classes and proved our forecasts too cautious.
100
• We conceptualize volatility at a fundamental level as
the product of the supply of macroeconomic 80
surprises and the vulnerability of markets to such
surprises, as measured by leverage. 60
• We envision growth surprises to be fairly muted in

40
2010 as the recovery matures, but some shocks in
monetary policy could lie in store towards the latter Jan-09 Mar-09 May -09 Jul-09 Sep-09 Nov -09
half of the year as exit from QE and the trajectory Source: J.P. Morgan
of the Fed hiking cycle assume centrestage.
Chart 2. 2009 was a stellar year for gamma selling
• Currency relevant leverage resides in two pockets – Short gamma returns calculated as the P/L from selling a basket of 3M delta
the overhang of dollar shorts among investors, and hedged ATM straddles, with the basket composition mimicking that of JPMorgan’s
VXY G7 index. Options are re-struck at the start of the month, and assume no
the massive build up of public sector debt. transaction costs.
(bp USD) AUD EUR GBP NZD CAD CHF JPY NOK SEK Basket
• Our model linking currency volatility to leverage
Ann. Return 506 754 400 230 439 376 432 162 -138 554
and surprise factors finds current VXY levels close
IR 0.7 1.7 0.5 0.3 1.0 0.7 0.7 0.2 -0.2 1.3
to fair value. Our economic forecasts lead us to
5% Tail Loss* -73 -26 -70 -70 -30 -43 -80 -59 -67 -41
believe that VXY should stay within a 10-14 range
Max Loss* -100 -83 -214 -234 -46 -115 -112 -229 -190 -79
in 2010, with upside risks in H2.
* Weekly stats
• Lack of any real directional momentum in vols is
bp USD bp USD
likely to reduce the efficacy of gamma trading 100 500
strategies. Focus on vol carry – for instance the 80
premium (discount) of forward vols to spot vols – as 60 400
a more reliable generator of trading returns. Own 40 300
long-dated EUR and CHF vols as portfolio hedges. 20
0 200
Back from the brink -20
100
-40
After the annus horribilis that was 2008, most market -60
participants would have settled for a 2009 that offered little Weekly short gamma P/L(LHS) 0
-80 Cumulativ e short gamma P/L(RHS)
more than a modicum of stability. As it turned out, the -100 -100
strength of the economic recovery caught a very cash-
Jan-09 Mar-09 Jun-09 Aug-09 Nov -09
overweight market by surprise, and sponsored a decline in
volatility across asset classes that was nothing short of Source: J.P. Morgan
dramatic (chart 1). Such multiple vega annual declines in
euphoria cost us full-blown participation in the gamma
financial market volatility have not been the norm in post-
selling fest that followed (chart 2). Lower vol is however a
recession years over the past two decades, but the depth of
favorable environment for relative value trading styles, and
the latest recession compared to those in the recent past and
many of our RV trade recommendations benefited indirectly
the pace of the rebound that followed rendered such
from the reduced uncertainty in the macro environment. In
historical calculus irrelevant. We were admittedly in the
the sections that follow, we outline our framework for
cautious camp as far as vol forecasts went, expecting a 3-4
analyzing currency volatility and draw some conclusions on
vol decline in the VXY from the unsustainable early 2009
the likely trajectory of vol next year.
highs based on usual normalization dynamics around
recessions, and our underestimation of the post-QE
18
Global FX Strategy
November 24, 2009

Talis Bauer (44-20) 7777-5276
Volatility = Surprise X Leverage Chart 3. Growth surprises in the US are highly correlated to the
business cycle…..
Previous JPMorgan research has conceptualized volatility at Growth surprises defined as the rolling 12M standard deviation of monthly changes
a fundamental level as the product of the supply of surprises in the 1-year ahead consensus expectations for US growth. Shaded areas
and the vulnerability of markets to these surprises (see represent NBER recessions. Exit from the current recession assumed to be Jun’09.
% Grow th YoY change in US %
Volatility, Leverage and Returns, Loeys and Panigirtzoglou, 0.6 4.5
Surprise Unemploy ment
October 2005). This approach aims to link views on 3.8
0.5
volatility to the macroeconomic reading of financial 3.0
markets, and is different from the dominant time-series 0.4
2.3
approaches to forecasting volatility that is best represented
by the GARCH class of models. In this framework, shocks 0.3 1.5
or surprises in the form of news or unexpected events 0.2
0.8
prompt revisions in expectations of cashflows from an asset, 0.0
leading to variability in its price. The magnitude of this 0.1
-0.8
variability also depends on the degree of wrong-footedness F'cast
0.0 -1.5
of the market in absorbing these revisions – in other words
Dec-90 Dec-94 Dec-98 Dec-02 Dec-06 Dec-10
leverage. Larger the surprise and more levered the market,
the greater should be the resulting volatility. The outlook Source: J.P. Morgan, Blue Chip Indicators
for FX vol next year therefore rests on two key questions:
Chart 4. ….as are monetary policy surprises
• Where can currency-relevant surprises spring Monetary policy surprises defined as the rolling 12M standard deviation of monthly
changes in 2Y US swap rates. Shaded areas represent NBER recessions. Exit
from? from the current recession assumed to be Jun’09
bp %
• Where does leverage reside in the system? 60
Monetary Policy YoY change in US
Surprise Unemploy ment 4
Surprises – where from?
50 3
One can think of surprises as the supply of market relevant 3
exogenous events or news, either in the form of unexpected 40 2
developments in macroeconomic variables such as growth 1
or inflation, and unanticipated policy actions by the 30
0
government. Along the lines of Loeys et al, we focus on the -1
20
macroeconomic forces of the “surprise production function” -1
to project changes in the supply of these surprises. Charts 3 10 -2
and 4 depict these surprise production functions for US
Jun-91 Feb-95 Oct-98 Jun-02 Feb-06 Oct-09
growth and monetary policy by looking at the impact of
Source: J.P. Morgan
monthly flow of information on market expectations over
the coming year. Given the linkages of the rest of the world Chart 5. Currency managers and global macro hedge funds have
to the business cycle in the US, these US-based measures increased their holdings of pro-cyclical FX post-QE, but positions
are likely a good proxy for economic surprises even for are still only half the size of those at the height of 2007 frenzy
Rolling 30-day betas from regressing daily returns for i) a composite of 25
world markets. Ideally, one would like to record surprises in dedicated currency funds compiled by JPMorgan and ii) HFR global macro hedge
real time as we do for monetary policy expectations in chart funds on returns from JPMorgan’s IncomeFX and IncomeEM carry baskets.
4, using standard deviation of monthly changes in 2-yr 2.5 Currency Managers
Global Macro Hedge Funds
treasury yields. In the absence of a liquid real time market 2.0 S i 3 Fed announces
for growth expectations however, we rely on Blue Chip QE
consensus forecasts instead in chart 3. 1.5
1.0
Broadly speaking, both surprise functions exhibit
reasonable correlation to the business cycle. The sample 0.5
period includes three recessions – 1991, 2001 and the
0.0
current one – which seem to define the peaks in growth and
monetary policy surprises. Entering into the second year of -0.5
recovery, our economists remain upbeat on growth forecasts -1.0
and anticipate US labor markets to stabilize by the end of Feb-05 Jan-06 Jan-07 Dec-07 Nov -08 Nov -09
the year, with the unemployment rate falling from 10.2% Source: J.P. Morgan, Bloomberg
19
Global FX Strategy
November 24, 2009

Talis Bauer (44-20) 7777-5276
currently to 9.8% by YE 2010. Judging from the historical Chart 6. Neither Japanese retail nor CTAs have enthusiastically sold
relationships in charts 3 and 4, this suggests that the supply JPY and CHF in 2009; instead, USD shorts have funded the bulk of
of growth shocks next year is likely to be muted, but the recovery trade, and represent the most significant position
developments on the monetary policy front could surprise overhang facing currency markets in 2010
Retail holdings based on total retail positions on the Tokyo Financial Exchange
markets given the uncertainty around the timing of exit $ billion ¥ trillion
from QE, the trajectory of eventual Fed hikes, as well as the 20 IMM USD positions 4
room for such surprises to play catch up with business cycle IMM JPY and CHF positions
10 2
indicators even at current levels.
Leverage – where is it? 0 0
Leverage within the investor community in FX carry trades -10 -2

– defined here as outright positions in high-yield currencies
-20 -4
held by dedicated currency managers, global macro hedge
funds, CTAs or Japanese retail – has increased in 2009 -30 -6
judging from the upturn in their return betas with our carry JPY retail positions
strategy indices (chart 5), with the turning point coinciding -40 -8
with the Fed’s QE announcement in March. Not Jan-06 Oct-06 Jul-07 Apr-08 Feb-09 Nov -09
surprisingly, much of the move was funded in dollars rather Source: J.P. Morgan, TFE, CME
than in traditional low yielders such as yen or Swiss francs. Chart 7. Corporate balance sheets are not a source of leverage
Neither Japanese retail nor other leveraged investors such as Financing gap defined as capital spending less internal funds for non-financial
CTAs have displayed their pre-crisis penchant for selling corporates in the US
Long-term debt as a
JPY and CHF. As chart 6 shows, net yen retail positions 4% Financing 50%
share of total credit
currently stand at ¥870 billion, not very far from the gap
3% 45%
¥560bn where they began the year. CTAs have been net
buyers of JPY and CHF for almost the entire year based on 2% 40%
IMM net speculative positions, a far cry from the $30bn 1% 35%
short in the heydays of the carry boom. Instead, the USD
has picked up the funding slack, with net outstanding IMM 0% 30%
shorts at $18 bn (chart 6). While still only half the size of -1% 25%
holdings in mid-2007, dollar shorts represent the most
-2% 20%
substantial position overhang facing currency markets in
2010. -3% 15%
Corporates and households look fairly tame from a gearing Feb-90 Dec-93 Nov -97 Sep-01 Aug-05 Jun-09
standpoint. After extensive deleveraging throughout 2008 Source: J.P. Morgan
and most of this year, the financing gap for US corporates— Chart 8. Public sectors have geared up massively even as the
the gap between internal funds and that needed to finance private sector has retrenched over the past two years
fixed investment and inventories—had turned to a financing Average debt /GDP and budget balance/GDP ratios across US, EU, Japan and UK
% %
surplus by 2Q09 (chart 7), and this surplus is likely to 100 Debt/GDP Ratio Budget Balance/ 4
expand again this quarter given the forecast of strong profit GDP Ratio
growth, a modest decline in fixed investment, and reduced 2
but still sizable inventory liquidation. Balance sheets have 80
also taken a more conservative turn as firms have shifted 0
out of short-term financing to longer term debt, and sharply 60
improved their liquidity ratios (chart 7). Consumers in the -2
US and UK have cut spending sharply this year, allowing
savings rates to rise (3.3% in the US, 5.6% in the UK). The 40
-4
process should stabilize around the turn of the year in the
US, but is incomplete in the UK, where the size of the 20 -6
balance sheet repair has been small relative to the Dec-90 Aug-95 Mar-00 Oct-04 May -09 Dec-13
outstanding debt stock. Net-net, we estimate that a large Source: J.P. Morgan, Bloomberg
part of corporate and household retrenchment is already
20
Global FX Strategy
November 24, 2009

Talis Bauer (44-20) 7777-5276
behind us, and save in a few pockets, 2010 should begin to Chart 9. VXY current looks about fair given the investor leverage
see an upturn in the leverage cycle. stock and the supply of surprises
Growth surprises as defined in Chart 3; Monetary policy surprises as defined in
As private sectors retrenched violently over the past two Chart 4; Investor leverage taken to be the average beta of CSFB Tremont hedge
years, public sectors have of course done the opposite. With fund index on JPMorgan’s IncomeFX and IncomeEM carry baskets
Coefficient t-stat p-v alue
rates at or close to zero, Central banks resorted to
Intercept 2.06 2.60 0.01
unconventional measures such as quantitative easing
Monetary Policy Surprise 0.16 6.36 0.00
(US,UK) and governments virtually everywhere
Grow th Surprsise 4.63 2.56 0.01
supplemented these efforts through looser fiscal policy. As
Inv estor Lev erage 3.42 8.25 0.00
a result, public sector leverage has balooned across the
25
developed world (chart 8), with US and UK being the VXY Actual
biggest culprits. Financing this massive government debt is VXY Model = 2.06 + 0.16*Monetary Policy Surprise +
not a problem as long as weak loan demand maintains the 20 4.63*Grow th Surprise + 3.42*Inv estor Lev erage
commercial bank bid for government paper, foreign central +/- 1 Std. Error Bands
banks remain committed to reserve accumulation and
15 Adj R 2 = 51%
deflation remains the reality for next year. However an
inflation scare could be a game changer as financing costs
rise and rollover risks come to the forefront. Broad money 10
supply growth and inflation expectations therefore merit
close tracking to gauge the risks of such an event unfolding.
5
A Macro Model for FX Volatility Jul-96 Mar-99 Nov -01 Jun-04 Feb-07 Sep-09
Source: J.P. Morgan
Chart 8 presents a regression model linking the VXY to the
surprise and leverage factors discussed earlier. All variables Table 1. Our expectations for modest US unemployment in 2010 lead
are statistically significant, have intuitive signs and the us to a forecast for nearly unchanged VXY levels by next year
All variables as defined in Chart 9. The monetary policy surprise forecast assumes
adjusted R2 is more than acceptable in the context of that the 18 bp current dislocation from levels justified by unemployment figures will
econometric models in academic literature that attempt to correct over the course of 2010.
capture the macroeconomic/financial market volatility link. Growth Surprises vs. Unemployment
At current levels, VXY looks fair to modestly rich to Coefficient t-stat p-v alue
model fair value, but the deviation is insignificant given Intercept 0.14 35.9 0.00
the standard error around the estimate. Note that the YoY Unemploy ment 0.08 21.2 0.00
leverage variable used in the model suffers from two
handicaps: Monetary Policy Surprises vs. Unemployment
Coefficient t-stat p-v alue
(a) it measures only investor leverage, ignoring the fiscal
Intercept 0.14 35.9 0.00
leverage buildup altogether– largely because public sector
leverage measures are too low frequency compared to other YoY Unemploy ment 0.08 21.2 0.00
inputs, and too slow moving to be a signficant explanatory Forecasts
variable in a G7 context.8 Umeploy - YoY Grow th Monetary Policy Inv estor
VXY
(b) the measure of investor leverage is not a currency ment (%) Unemp. (%) Surprise (%) Surprise (bp) Lev erage
specific metric like those outlined in chart 5, but rather the 9.8 -0.4 0.11 42 0.93 12.3
broad beta of the entire universe of hedge funds (proxied by Source: J.P. Morgan
the CSFB Tremont Hedge Fund return index) to FX carry,
once again necessitated by the lack of a longer history of signficant in the context of the current environment and
currency manager return data. likely biases model fair value estimates lower.
The latter is less of an issue since it only forces the With these model parameters, it is possible to run vol
regression coefficient of the leverage variable to capture projections using our base case growth and policy forecasts.
spillover effects from other asset markets – not in itself This is a two stage process, involving first quantifying the
terrible given the one-factor nature of most portfolios at surprises vs. business cycle relationship depicted in charts 3
present – but the omission of public sector leverage is and 4 to predict the extent of macro-surprises in store next
year, and then plugging in those surprise readings into the
vol model described in chart 8. Table 1 tells the story in a
nutshell: our economic forecasts translate into muted
8
Unlike in an EM setting where external vulnerability has been well growth surprises next year and some pickup in
documented to be key factor in past crises
21
Global FX Strategy
November 24, 2009

Talis Bauer (44-20) 7777-5276
monetary policy surprises, and together with an Scenarios section) and long-dated vols in both slide
unchanged leverage factor point towards a VXY positively along inverted vol curves. In addition, the tail risk
forecast for YE 2010 at 12.3, with sizeable +/- 1 std. scenario mentioned above is likely to involve a decoupling
error tolerance of 2 vol pts – in other words roughly a 10 of the dollar and US rates as foreign holdings of US assets
– 14 vol range for the vol index. No doubt this is a bland are liquidated en masse (stocks, bonds and currency). Such
outcome given that VXY is currently trading close to those decorrelation between FX and rates is positive for long-
levels, but not unreasonable that the sizeable correction in dated vols as it increases the volatility of forwards; further
vol levels from late 2008 highs is already behind us, and out in tenor the forward, higher the impact9. The
that large vol moves are unlikely from levels that are not far combination of positive slide, thin supply and sensitivity to
from long-term averages (15-year average close to 11). a disorderly dollar decline make long-dated vols attractive
portfolio hedges for 2010.
If we are correct on the VXY, “beta” vol trading strategies
like outright short-gamma will have a hard time delivering Chart 10. Short-dated volatility strategies are likely to find 2010
the stellar returns that they did this year, and even more challenging, as the lack of vol momentum acts as a drag on usual
market-neutral trading styles are likely to find 2010 trading styles
Average yearly P/L from outright short gamma and long/short gamma strategies
challenging. Our analysis of strategy returns in various vol contingent on the magnitude of the YoY change in VXY. Outright short gamma
regimes shows that the lack of vol momentum tends to act returns computed as the P/L from selling a basket of 3M delta hedged ATM
as drag on these trading styles, rendering stable vol straddles, with the basket composition mimicking that of JPMorgan’s VXY G7
environments unfriendly towards gamma trading (Chart 10). index. Long/short relative value returns computed as the P/L from buying 3M delta
hedged ATM straddles in the two best long gamma currency pairs among the G10
Granted that the long/short gamma trading scheme used as majors and selling3M delta hedged ATM straddles in the two best short gamma
proxy for relative value vol trading returns is too simplistic candidates. Good gamma sells (buys) defined as those that rank high (low) on a
for style analysis, but the broad conclusion from the chart – composite metric given by rolling 1-yr z-score of 3M implied vol * 3M implied vol /
that gamma trading strategies irrespective of flavor tend to realized vol ratio. Options are re-struck at the start of the month, and assume no
transaction costs.
yield low absolute returns when vol is rangebound, but that
RV tends to underperform short gamma in vol sell-offs and v ol pts.
20 Short gamma
outperform in vol rallies – probably holds.
15 Relativ e Value
However if vol levels do not shift radically, vol carry trades
10
likely stand to perform resaonbly well. A typical example of
earning carry in vol space is to be short (long) forward 5
volatility on steeply upward sloping (inverted) vol curves – 0
investors stand to pocket the premium (discount) of forward
-5
vols to spot implied vols if vol curves remain unchanged
over the trade horizon. Vol curves in G10 are currently -10
close to historic highs in steepness, and while some of this -15
is doubtless attributable to portfolio protection driven
-20 <-10 -10 to -6 -6 to -2 -2 to 2 2 to 6 6 to 10 >10
demand for long-dated dollar calls that is likely to reverse
next year, we do not view a deluge of long-end vol supply Source: J.P. Morgan
to the street as likely given the market’s memory of the Chart 11. Positive slide at the back-end of vol curves, coupled with
havoc that the past two years wrought. Coupled with likely lack of vol supply, makes long-dated EUR and CHF vols
anchored front-end vols, this likely means that vol curves attractive to own as portfolio hedges
are likely to retain their upward sloping shape next Vols (%)
year, making short FVA a likely source of alpha for 14 EUR/USD
currency option portfolios. USD/CHF
13
Finally, the twin themes of earning positive vol carry and
lack of back-end vol supply dovetail nicely to suggest 12
value in owning long-dated (10-year) EUR/USD and
11
USD/CHF vols. EUR and CHF are the two currencies that
are most responsive to a dollar crisis scenario (see Risk 10
9
From the standard forward – spot relationship: F = S *exp (-rate diff)*T, 9
one can write the variance equation as: σF2 = σS2 + σrate diff2T2– 2 σS σrate Tenor (Y)
8
diff T ρS,rate diff. From the equation, it is clear that lower ρS,rate diff leads to
higher σF. Also, the presence of the T term in the equation means that 1 3 5 6 8 10
longer tenor vols benefit more than shorter-dated vols from higher rate vol Source: J.P. Morgan
and a de-correlation between spot and rates.
22
Global FX Strategy
November 24, 2009

Talis Bauer (44-20) 7777-5276
Post-mortem: 2009 FX
Derivatives Trade
Recommendations
Table 1. Performance statistics 2008 – 2009
Trade performance in 2009 resulted in a lower hit rate than 2008-09
in 2008 as well as a lower average trade P/L (table 1), 2009 YTD 2008 w eighted av g
although the number of trades increased. The number of Vanilla Options
trades rose as liquidity conditions began to improve in the # of trades 27 13 40
latter half of 2009, making transaction costs less prohibitive Success rate 63% 77% 68%
for relative value positions. Nonetheless, we end the year Av erage return per trade (bp, unw eighted) 10 60 26
with a hit rate above 63% and an average of over 10bp on Vol Products*
our vanilla trades. We have a slightly better hit rate on our # of trades 3 N/A 3
vol product trades (which include FVAs and vol swaps) but Success rate 67% N/A 67%
with an average of -0.6 points per trade. However, vol Av erage return per trade (v ol pts, unw eighted) -0.6 N/A -0.6
products have made up only 10% of our total portfolio. Digital
# of trades N/A 3 3
Positions that were initiated in 2008 and unwound in 2009 Success rate N/A 33% 33%
suffered as the correlations that made the trades attractive at Av erage return per trade (%, unw eighted) N/A 8% 0.1
the time broke down, and this resulted in sizable losses. If *Vol products include volatility swaps and Forward Volatility Agreements (FVAs)
we exclude these P/Ls from our 2009 summary, i.e. Source: J.P. Morgan
counting only those trades initiated and unwound in 2009,
our average P/L is 25 bp for vanillas (chart 1) and 1.3 points Chart 1: 2008-2009 Performance summary: Success rate by type of
for vol products, versus only 9 bp and -0.6, respectively, trade (average P/L)
when we include the positions initiated in 2008 but held Vanilla Options
2009**
until 2009 (all of these trades were initiated pre-Lehman).
The jump risk around an event such as the collapse of 2009
Lehman or the U.S. announcement of quantitative easing
proved problematic for delta-hedged straddles (as opposed 2008
to a flat gamma product such as a volatility swap). For
instance, in our long GBP/USD 3M vol versus short 0 10 20 30 40 50 60
bp
USD/JPY 3M vol trade, realized volatility outperformed our
implied entry level, yet the trade lost money as spot drifted
from strike in both currencies; the jump in USD/JPY at the 2009**
time of the announcement proved particularly problematic Vol Products
for a position being delta-hedged on only a daily basis. 2009
As liquidity returned to the options market in the second

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5
half of 2009, we have been able to successfully make use of Vol points
vol swaps, enabling us to cleanly monetize implied-realized
vol mispricings. The two vol swaps that have been closed ** Does not include trades initiated in 2008 (all of which were prior to mid-September 2008 i.e.,
out have both ended up being profitable, with an average pre-Lehman)
P/L of 1.3 vol points. We currently have three vol swap Source: J.P. Morgan
positions still open, all of which are profitable.
Our tactical entry into cross-asset trades, short FX vol
versus long SPX vol, both proved profitable, as has our
short gold vol versus long silver vol trade, which is still
open.
23
Global FX Strategy
November 24, 2009
Niall O’Connor (212) 834-5108

Thomas Anthonj (44-207) 742-7850
JPMorgan Chase Bank NA, J.P. Morgan Securities Ltd.
retracement, it does not guarantee a sustained shift in trend.

Long-term Technical Strategy: We still see a growing risk that a corrective phase can
Major transition ahead develop into year-end and during Q1, but it will likely be
a short term development as the current technical setup
does not yet support a sustainable USD recovery. In that
• The USD bear trend is expected to continue into
regard, this short term correction should eventually lead to
2010, but not without an initial consolidation phase
new lows, with a recovery and more formal basing process
as short-term risk factors increase.
developing later in 2010.
• Still, the medium term setup suggests EUR/USD can For the medium term view, we see potential for the USD to
seek the 1.60 area, if not higher while the Dollar retest if not break the 2008 cycle lows. This should allow
Index targets 73/71 and AUD/USD extends to for EUR/USD to push into the 1.60/1.63 zone, while the
.98/1.00. Dollar Index targets the 73/71 zone. Also, AUD/USD
• New USD lows should complete the final leg down should seek a retest, if not break of the 2008 high near
for the bear trend leading to a more sustained USD .9800 with deeper targets near 1.00.
recovery later in 2010. Chart 1: Dollar Index– Weekly Chart – Momentum indicators suggest
a deep oversold setup, but the overall trend remains intact
• EUR/USD sees important support in the 1.45/1.4250
zone which should continue to hold if new cycle
highs can develop.
• GBP has the potential to outperform within G10 by
the end of 2010; CAD seems to be at or close to an
exhaustion point, implying an underperformance in
2010.
• Scandinavian currencies face stronger setbacks in
2010 but the uptrends are incomplete.
• We see a mixed setup for JPY given the range bias
over multiple timeframes. Cross JPY presents a
more intriguing setup given the potential to extend
medium term trends.
• EM currencies maintain the medium term bullish
bias and should continue to outperform in 2010. From this point, we sense the USD will be vulnerable to a
more sustained correction particularly given the completion
• MXN is in position to play catch up; EUR/MXN is of long term Elliott patterns, as well as the more entrenched
vulnerable to a deeper correction; patterns in oversold setup. As such, we will be more inclined to look
CAD/MXN and USD/MXN confirm the bullish for opportunities to establish long USD positions at that
MXN view. time.
• The bullish setup for CE-3 remains intact led by A focus on levels and equities
PLN and HUF; CZK expected to lag.
In line with the oversold setup, the current trends are
• Trade strategy: Sell EUR/MXN; await better
struggling to extend through a number of important USD
location to buy AUD/USD, EUR/CAD and
supports/targets. The highlight of this setup is the
GBP/CAD; also look to sell EUR/AUD, USD/MXN,
consolidation below the critical 1.50/1.5165 and 1.5300
USD/KRW and USD/INR at better levels.
resistance areas for EUR/USD which includes the 76.4%
retracement from the 2008 cycle high. Also, the Dollar
Major transition ahead Index faces an important test at the 75/74.30 support zone
As 2009 draws to a close and the broad-based USD bear which also represents the 76.4% retracement from the 2008
trend continues to develop, the key question for 2010 is cycle low. The ability to sustain through these important
whether there is any hope for a USD rebound. By most USD supports should be a difficult task for the short term
technical measures the USD is deeply oversold and due for view, but we are also aware that an extension through these
a correction (chart 1). However, while an overbought or levels would imply a greater risk that prices should
oversold extreme is usually a condition for a potential eventually test, if not break the 2008 USD low.
24
Global FX Strategy
November 24, 2009

With correlations between risky assets and currencies still at We see a similar story from an Elliott wave perspective
a high level and expected to continue into the 1H 2010, a (chart 3). The USD likely completed a third wave decline
consolidation phase for the equity markets should position from the March highs and typically suggests an oversold
the USD for a Q1 corrective phase. In that regard, we do see extreme which points to a consolidation phase (fourth
some potential short term negative risks for equities as most wave). As this setup usually precedes a corrective process,
indicators point to a trend that is stretched, but not broken. it also implies that the overall trend is incomplete.
Chart 2: S&P500 Index - Daily Chart – Approaching key resistance in Chart 4: Dollar Index - Weekly Chart –Moving average signals have
the 1110/1135 zone; short term bias suggests a pause. defined medium term trends; current signal remains bearish.
Given the overbought setup, the short term risks suggest the The quality of any retracement will be telling, as it should
S&P Index should struggle against the key 1110/1135 help define whether the USD shifts into a range, or stages a
resistance zone (chart 2). Our Fixed Income technical deeper reversal. For now, we see the range view as the
analysts, Michael Krauss and Jason Hunter who cover the likely scenario. The outcome would suggest a correction
back to the 78/80.00 zone for the Dollar Index, while
Chart 3: EUR/USD– Daily Chart – The Elliott wave count suggests a
short term corrective phase before new highs. EUR/USD can retrace to the 1.45/1.4230 zone. Similarly,
AUD/USD has potential to pull back into the .8700/.8600
area, if not the .8300/.8200 zone. Importantly, these levels
should be a maximum for this corrective phase and lead to a
return to the underlying trend. Moreover, these levels will
likely define where we are wrong on our view for new USD
lows. Violations would suggest a more important USD low
is in place and a deeper corrective phase underway.
With regards to the medium term view, we still point to the
bearish USD setup for many of our medium term trend
indicators. In that regard, our moving average system which
has been bearish the USD since June remains intact (chart
4). Note that this indicator has been an effective tool in
confirming the broad trends as seen during the USD bull
trend in 2008, as well as the cyclical decline from the 2006
peak.
S&P500 Index suggest the market is losing upward Encouraging signs apparent that the battered
momentum against these key levels. Moreover, our chief British Pound has discounted most of its bad
market strategist Jan Loeys points out that equities news but medium-term risks persist
historically consolidate for several weeks during this stage Since the British Pound hit an all-time low around the year-
of an economic recovery. With that in mind, we sense the turn 2008/2009 it showed a remarkable recovery
USD can transition into a consolidation phase during Q1 to particularly against USD and JPY where 5-wave structures
alleviate part of the oversold condition. up have formed against the long-term downtrend. Similar
25
Global FX Strategy
November 24, 2009

pictures are displayed in GBP/CHF and in GBP/CAD would deliver the final evidence that a long-term trend
which gives further support to the idea that we are at least reversal has taken place at 0.9803
going to see more of the same in form of a bigger C-wave
Chart 6: EUR/GBP - Weekly Chart –Above key-support at 0.8639 and
up in the 2nd half of 2010. at 0.8249 a resumption of the uptrend can not be excluded yet.
The short-to medium-term picture though (1st half of 2010)
looks critical as the market is still missing a stronger
countertrend 3-step decline which is either going to form
the so-called B-wave down within a broader A-B-C up-
consolidation or a 2nd wave low in case a new up-trend is
unfolding. In terms of shape and extent that does not make a 0.8639
difference as both scenarios would look for a 3-step decline
which retraces roughly 76.4 % (1.4339) of the preceding 5- 0.8249
wave advance. This could well dominate the first half of
2010 before a stronger recovery (wave C or Wave 3) can be
expected again.
Chart 5: GBP/USD– Weekly Chart –Looking constructive long-term,
but medium-term a stronger setback is still looming.
In terms of monetizing these described scenarios we suggest

being a GBP seller towards 1.7332 in GBP/USD and/or on
a trend line break (currently at 1.6080) to bet on a medium-
term B/2nd wave decline or towards the key-supports at
1 or A 1.7332 0.8639 and at 0.8249 in EUR/GBP with respective stops
opposite these barriers to bet on a potential resumption of
the bull-trend. Once in the trade GBP would of course offer
a perfect risk-reward to reverse existing short positions
towards the previously described 76.4 % retracements (i.e.
towards 1.4339 in GBP/USD) with a rather wide stop there
under to finally bet on what is assumed to constitute the
1.4339 2 or B GBP out performance in the 2nd half of 2010.
A story of relative underperformance within G10
Only the decisive break below the equivalent 76.4 % could be forming in CAD where shown setups
retracement’s (i.e.1.4339 in GBP/USD,129.33 in GBP/JPY, favor a much broader setback
1.6629 in GBP/CAD or 1.5833 in GBP/CHF) would resume
The best example in this context is probably USD/CAD
the GBP bear-trend in favor of new all-time lows.
where the market displays a 5-wave structured rally (wave
The only outstanding market in terms of displayed A) from the 0.9059 low in Nov.07 up to the 1.3063 top in
structures is EUR/GBP as the GBP recovery from the all- March this year. Given this almost textbook structure the
time high at 0.9803 can only be described as complex. following and still ongoing decline is perceived to be a
Concerning the main question though whether we might countertrend B-wave decline only which usually retraces
have seen a long-term turnaround at 0.9803 or whether the 76.4 % of the preceding Wave A. That said there is a very
long-term up-trend is still intact the market is giving a clear good chance that the market is forming a 2nd higher base in
answer in providing two major T-junctions which are at the 1.0004 handle (B-wave). As part of this bottoming
0.8639 (int. 76.4 %) and at 0.8249 (38.2 % on higher scale). process the market might well trade a range between
The defense of the former would support a triangle 1.1127/64 (previous top/int. 38.2 %) and 1.0004 (76.4 %)
consolidation whereas a decline to 0.8249 and the defense over the coming months as shown in the chart picture below
of it would potentially form the C-leg down of a double- before the strong C-wave rally up is expected to materialize.
zigzag 4th wave consolidation. In both scenarios we’d be A break above daily trend line resistance at 1.0785 would in
missing the final 5th wave up with new price extremes in this context indicate a test of the upper range boundary
the parity region. A decisive break below 0.8249 though whereas a break below 1.0362 (int. 76.4 %) would finally
challenge the bigger T-junction at 1.0004. Allowing a bit of
26
Global FX Strategy
November 24, 2009

slippage and as the 76.4 % is more a target zone than a strict So as long as 1.6629 is not broken decisively the odds
support a decisive break of the latter would only be remain in favor of a stronger recovery up to 1.9038 (int.
indicated on a break below 0.9711 (pivot). Such a break 38.2 %) and most likely towards the big T-junction at
would eliminate this whole scenario in favor of a re-test of 1.9697/1.9763 (38.2 % on higher scales).
the Nov.07 low at 0.9059.
The ideal risk-rewards to bet on a stronger CAD setback
Chart 7: USD/CAD - Weekly Chart – Above 1.0004 the odds are in throughout 2010 would of course be given around the
favor of a strong CAD setback. 76.4% retracement’s which are at 1.0004 in USD/CAD and
at 1.6629 in GBP/CAD whereas stops should be place at
least 3 full points below in order to allow some
overshooting. In case the market fails to come anywhere
close it would be worth going with the break above daily
trend line resistance in USD/CAD (currently at 1.0785).
After a strong 2009, Scandis are risking broader
setbacks in 2010 whereas NOK is expected to
under perform SEK.
Having had an incredible run throughout the whole of 2009
NOK and SEK have both reached key-resistance levels in
B 1.0004 form of 76.4 % retracement’s (i.e. 5.5036 in USD/NOK,
6.6489 in USD/SEK, 8.2270 in EUR/NOK ) or in form of a
61.8 % retracement (i.e., 10.0210 in EUR/SEK).
That said these markets face an increased risk of at least
The structures in EUR/CAD are comparably a lot less running into a stronger rebound if not into a countertrend
rally of much larger scale. A deeper investigation unveiled
exciting but as long as minor Fib.-support at 1.5414 (int.
the key-T-junctions to distinguish between the two
76.4 %) is not taken out thee door for a stronger up-swing
into 1.6960/72 (int. 76.4 %/old top) and maybe even up to scenarios in form of internal 38.2 % retracement’s (i.e.
8.5904 in EUR/NOK, 7.2476 in USD/SEK, 5.9303 in
1.8654 (76.4 % on big scale) remains wide open.
USD/NOK) and trend line resistance at 10.4465 in
Another market which supports the idea of a stronger CAD
Chart 9: USD/NOK - Weekly Chart –Market sitting on Key-support
setback within 2010 is GBP/CAD where the dynamics of from where a broader consolidation is expected to unfold.
the latest rebound suggest that a much broader recovery has
already been started. Short-to medium term though, there is
a risk of forming the right shoulder of a potential inverted H
& S pattern towards 1.6872 or 1.6629 (int. 61.8/76.4 %).
Chart 8: GBP/CAD - Weekly Chart –Above 1.6629 the odds are in
favor of a stronger recovery in the course of 2010
6.1936
5.9303
1.9697/1.9763
1.9038 5.5036
EUR/SEK. Remaining below these resistance levels the

long-term trends are assumed to be still intact whereas
decisive breaks above the just-mentioned resistance barriers
1.6629 would end the dominance of the Scandis in favor of a much
broader depreciation.
27
Global FX Strategy
November 24, 2009

To dissolve the risk of a major rebound in favor of a countertrend rally (B-wave) within an even broader A-B-C
resumption of the still prevailing trends it would on the down consolidation. If such a break would occur though,
other hand require decisive breaks below key-Fib.-support
Chart 11: EUR/USD - Weekly Chart –Up-trend seen intact but below
at 8.2270 in EUR/NOK, at 5.5036 in USD/NOK and at 1.5164 the risk of a stronger setback persists
10.0711 (trend line) in EUR/SEK.
A break above 5.9303 as shown in chart 9 would call for a
much broader up-consolidation but as long as the last T-
junction at 6.1936 is not taken out we are missing the final 1.5164
evidence of an even broader countertrend rally unfolding
what would imply that the original up-trend in Scandis is
still missing one leg after the initially expected setback to
complete the whole cycle.
1.4232
Chart 10: USD/SEK - Weekly Chart –Market sitting on Key-support
from where a broader consolidation is expected to unfold.
we’d have to be prepared for a new down-trend (C-wave)

7.5126 unfolding with a potential price target of 1.1640. A 1.5300
print would eliminate this risk in favor of an extended 3rd
7.2476
wave rally into the 1.6241/1.6326 handle where a long-term
topping pattern is expected to be formed.
Chart 12: EUR/AUD - Weekly Chart –Market sitting on Key-support
6.6489 from where a broader consolidation is expected to unfold.
Assuming that the long-term up-trends for NOK and SEK

are still intact as long as the decisive Fib’s are not taken out,
it probably offers the best risk-reward to not try to catch the
anyway choppy up-swing but to buy NOK or SEK at the
key 38.2 % retracement levels (i.e. 5.9303 and 6.1936 in 1.7888
USD/NOK, 7.2476 and 7.5126 in USD/SEK) with 1.7646
respective stops above. Provided the higher Fib’s are not
taken out at least one new price extreme (wave 5) towards
the 2008 lows can be expected.
G10 in brief: EUR
Apart from the 3 key-themes just described one of the main
questions left is of course what’s going to happen in
More or less the reverse picture is unfolding when we look
EUR/USD? Fundamentals support an extension within the
at EUR/AUD where the EUR has been under tremendous
overall USD bear trend but from a technical perspective
pressure throughout 2009. In terms of cycles though this
there is one key-barrier at 1.5164 (76.4 %) in the way which
market is also trading very close to key-support between
could prove to be tricky. As long as it is not broken
1.5926 and 1.5793 (old low/weekly trend line) from where
decisively, say by a 1.5300 print, the market is running the
an internal 4th wave recovery into the 1.7646 to 1.7888
risk of a setback into key-support at 1.4232 (int. 38.2 %)
handle (int. 38.2 % on two different scales) could unfold.
which can be seen as the key-T-junction on bigger scale.
These levels would offer a perfect risk-reward to bet on the
The defense of the latter is absolutely crucial in order to
missing 5th leg down towards the 2007 low at 1.5477. A
avoid the risk of having only performed a huge 3-step
28
Global FX Strategy
November 24, 2009

straight break below 1.5793 would reversely delay the be looking for a setup to establish long positions for the
expected recovery and challenge 1.5477 immediately. extension. In turn, we see potential for the rally to retest
of the 2008 cycle highs near .9850 with some risk for a
CHF
Chart 14: Gold – Monthly Log Chart – Still trending higher following
A rather mixed picture is on the other hand given in most of the breakout while demonstrating a potential five-wave pattern from
the CHF crosses but with a general consensus that the the 1970 low.
strong appreciation of the Swiss Franc we have observed
through 2008 and 2009 is still due for further consolidation
in 2010. A clear indication that CHF is due for a stronger
setback would clearly be given once trend line resistance at
1.5309 in EUR/CHF and/or Fib.-resistance at 1.0380 in
USD/CHF would be taken out. Below these levels though,
the downside remains open and could be extended first
before CHF is due for a stronger consolidation.
AUD
AUD has been the best performer in G-10 this year as the
bullish cyclical shift and steady improvement in risk
sentiment led to a one-way advance from the February/
March lows. Note that a November close at current levels
Chart 13: AUD/USD - Weekly Chart –Short term corrective phase
should ultimately lead to a test, if not break of the 2008 high. closer test of 1.00. In that regard, our medium term trend
filters continue to point to further upside. Note that our
basic moving average system which is used to define the
medium term trend maintains the current Buy signal from
.8265
late-March.
.8568
NZD
NZD follows AUD in the standings for best performer for
2009. While the trends are still intact, our short term view
for the USD opens the window for a corrective phase.
However, this bias is still viewed within the context of the
medium term uptrend. The struggles to sustain above the
next line of key targets/resistance levels (76.4% retracement
at .7430) in line with the loss of upward momentum and the
Chart 15: NZD/USD - Daily Chart –The failure below the October high
points to the short term corrective phase and underperformance;
still viewed within the context of the medium term advance.
would confirm an unprecedented ten consecutive higher
monthly closes for AUD/USD. Moreover, this uptrend
violated a previous month’s low just once during that
timeframe. While a simplistic explanation of the price
.6445 .7082
action, it demonstrates the strength of the overall trend.
Moreover, the sustained rally in commodities and in
particular precious metals contributed to the favorable setup
highlighted by the breakout and acceleration to new all-time
highs for Gold. Despite the medium term bullish setup, we
still sense the short term framework can allow for a
consolidation phase into year-end and into the early-part of
2010. This is in line with the loss of upward momentum and
the approach of macro targets closer to the 2008 highs. The
.8860 support zone will be key as breaks would suggest a
deeper pullback is possible into the .8500 area, if not lower.
Still, the medium term setup calls for new highs and we will
29
Global FX Strategy
November 24, 2009

recent failure below the October high are consistent with the As such, the action in the JPY crosses has the potential to
setup for a short term correction. Support near .7000 is be a more interesting trade for next year. Similar to the
important for this view and will likely define whether a USD trends, cross JPY does appear vulnerable to a short
deeper pullback can develop into the .6700 area and ideal term consolidation phase particularly as a number of pairs
basing zone for continuation of the medium term rally have struggled to extend through the next line of important
phase. As such, we see medium term targets in the resistance levels highlighted by the important 139 resistance
.8000/.8200 zone. The concern for NZD is the relative zone for EUR/JPY. However, the overall trends remain
weakness that has developed over the past month which intact and we sense additional upside will likely develop
points to a potential underperformance bias into 2010. In beyond any corrective phase that may develop in Q1. Still,
that regard, basing patterns are developing in the likes of we note that the 127 support area should continue to hold to
EUR/NZD and GBP/NZD following the bullish reversals in maintain the potential upside bias for new highs and a C-
October. Also, one of our favorite trades is bullish wave into the 145 zone. Similarly, AUD/JPY fell short of
AUD/NZD as we sense the cross can retest, if not through the key 86/88 resistance zone, as the short term risks grow.
the important 1.30 medium term range highs. In turn, while With the potential to correct lower we see good support in
we see potential for NZD/USD to resume the bull trend the 76/74 zone. Prices are expected to base here for the next
beyond this short term corrective phase, we sense the leg up into the 92/95 area.
upward path will be more of a grind given the patterns in
Chart 17: EUR/JPY - Daily Chart – The range below the 139.14 area
the crosses. Also, a violation of the key .6600 area (38.2% suggests a bullish bias/C-wave; support at 127.00 is critical.
retracement from March and July breakout zone) would
question whether prices can extend to new highs.
JPY
The technical case for JPY shows several cross currents
raising the risk that JPY will be more range-bound into
2010 particularly against the USD. As we recognize the 139.14
extended trend that has developed from the 2009 high, as
well as the 2007 peak, there is still little evidence of a
reversal at this point. However, much of the medium term
technical view will depend on the important 87.15 support 127.00
zone which includes the lows from December 2008 and
January 2009. Breaks here should define whether an
Chart 16: USD/JPY - Daily Chart – Expected to be range-bound in
2010; critical test at 87.15 support and 92.50/93.30 resistance levels.
EM: the bullish case is intact

While we see risk that a consolidation can develop
particularly against the USD during the early-part of 2010,
the broad EM trends remain intact and are expected to
continue into the new year. Moreover, while the action in
the USD may be more two-sided, we see several compelling
developments for the crosses which suggest the bullish case
for EM can persist in 2010.
For the Latams, a key focus will be on MXN. As the
currency has lagged the performance of other Latams for
87.15 most of 2009, we sense a catch up trade will be seen in
2010. The patterns and trends that have developed over the
past year now seem mature and suggest a growing risk of a
extension can develop towards deeper targets located near bullish shift not only against the USD but also on the
86.00 and then the 84.50/83.50 ideal basing zone. crosses. For USD/MXN, we continue to view the April-
Alternately, the 92.50/93.30 resistance zone and recent November range as a consolidation phase before the
range highs will imply whether a deeper retracement back medium term downtrend that began in March resumes. For
to the 94.85 and 97.50 trendlines (April 2009 and 2007). the short term setup, this range may persist particularly
30
Global FX Strategy
November 24, 2009

given the potential for some retracement in risk during the the medium term advance is over, but the cross does appear
early part of this year. Still, the 13.80/13.85 area should primed for a MXN catch up trade which could take prices
continue to act as key resistance and maintain the downside back to the 6.85/6.75 zone. This is where we would expect
bias. Importantly, a break of the critical 12.77/12.80 support price to base for another run at the highs, if not new highs.
zone should allow for an extension into the 12.00 area, if
Our long standing bullish view on Asia FX remains intact,
not lower.
but like most markets a short term consolidation is likely
Chart 17: USD/MXN - Daily Chart – The range below the 13.8470 area due. As we monitor the action in the ADXY Index, we note
suggests a bullish bias/C-wave; support at 12.77 is critical. the advance from the 2009 lows is entering important
resistance/target zone in the 110.50/11.75 area which
includes the 61.8% retracement from the 20008 cycle highs.
This view seems consistent with the pattern from the July
low which seems close to completing a five-wave advance.
13.8470
We also see this development in the individual USD pairs,
as a number of medium-term targets have been met amid a
deep, oversold framework. Still, we sense this short term
12.77 corrective phase will ultimately lead to renewed
outperformance. A key focus for 2010 will be KRW and
INR.
Chart 18: USD/KRW - Daily Chart – Short term setup can allow for a
corrective phase against the 1120/1100 support area, but medium
term trend points lower..
The rally in EUR/MXN from the April low, as well as the

2008 cycle low is mature and now appears vulnerable to a
reversal. The short term view is consistent with this setup
given the potential double top near 20.00, while also
suggesting the diagonal ending pattern from the 2008 low is
likely complete. A break of the 19.17/20 support zone
1120
would suggest an increased risk that a corrective phase is
underway. We see risk of a retracement back to the
18.20/18.00 zone and quite possibly to the 16.60/15.75
levels deeper into 2010. Also, given our view for CAD
underperformance into next year, we see a similar pattern
for CAD/MXN as the trends are mature and vulnerable to a
deeper correction. In turn, we are closely monitoring the
12.05 support level as breaks would confirm a deeper For USD/KRW, the steady decline during 2009 has led to a
retracement into the 11.65/11.30 levels. test of medium term support in the 1165/1145 zone. While
We maintain an overall bullish bias for BRL, but do sense there is still little evidence of a base, or sustained reversal
that a short term corrective phase is likely to develop we note that the short term trends appear mature particularly
particularly as both USD/BRL and EUR/BRL are holding given the decline from the July high. As such, we sense that
important support levels amid a deep oversold setup. Still, sustained downside from current levels will be a tall order.
we sense any corrective phase is likely to retain a range bias However, beyond a short term corrective phase, we will be
before the outperformance resumes. Moreover, any looking for a better setup and location to establish short
extended retracement from current levels will be viewed as term positions as we sense the overall trend is incomplete.
an opportunity to re-establish BRL long positions for the In turn, we see deeper targets in the 1050/1000 zone.
next leg down. We also note that BRL/MXN appears The medium term bearish setup remains compelling for
vulnerable to a corrective phase as well, but a break of the USD/INR in 2010 as the broad topping pattern continues to
7.34/7.29 support zone is necessary to confirm the short develop. Again, this head and shoulders pattern points to
term retracement phase, if not larger consolidation below additional INR strength next year beyond any short term
the recent highs. Importantly, we do not sense just yet that corrective phase that may form in early-2010. While we
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Global FX Strategy
November 24, 2009

note the breakdown below the important 46.50/75 support Chart 20: EUR/PLN - Daily Chart – A series of lower highs and lows
zone has thus far failed to elicit a trending bias, the pattern suggests another leg down into 2010.
and the corrective nature of the price action from the recent
lows argue for a continuation of the decline from March.
This suggests the downtrend has potential to test medium
term targets starting in the 44.10/43.65 zone which include
the 61.8% retracement from the 2007 cycle low and equal
swing target from the March peak. The case for a deeper
decline into the 42.00 area (76.4% retracement) can also be
made.
Chart 19: USD/INR - Weekly Chart – Head and shoulders topping
pattern argues for continued downside into 2010.
Trade Recommendation
• Strategy: Sell EUR/MXN at market, target 16.70 &
15.50, stop at 20.30
Chart 21: EUR/MXN - Weekly Chart –An upward sloping converging

triangle signals the end of a multi-year up-cycle
In CEEMEA a primary focus will be on CE-3. We note the

recent outperformance in the likes of PLN and HUF point
to a renewed trending bias. And this setup is in line with the
bullish action from the 2009 cycle lows. Again, like the
broad risk view, we are monitoring for some consolidation
during the early-part of 2010 particularly as a number of
key retracement levels have held including those for 16.6032
EUR/PLN and EUR/HUF. However, the overall bullish
action is expected to continue led by PLN. In that regard,
we see potential for EUR/PLN to extend this decline into
the key 3.80/3.86 support/target zone as the next leg of the
downtrend develops. Similarly, EUR/HUF has the potential 14.7410
to stage another push lower for this decline from the 2009
high which seems consistent with the broad, head and • EUR/MXN shows an impressive uptrend since the
shoulders pattern from late-2008. We see targets in the 1980’s whereas the 7.56 bottom in 2001 looks like the 4th
255/247 area. The setup in CZK is less favorable and there wave low of bigger scale. The latter implies that the
is a growing risk for underperformance on the crosses. In market has been performing a 5th wave impulse since
that regard, the decline from the 2009 high has failed to which is already looking pretty stretched.
make the case for a sustained break of the critical 25.00 • But what really caught our attention is the upward sloping
support area. converging triangle which has formed over the last year
and regularly constitutes a major topping pattern.
• Given the latest failure at upper triangle resistance
(20.1457) and the very dynamic sell-off there after we see
strong evidence given that a major top is already in place.
32
Global FX Strategy
November 24, 2009

Downside Potential: A broad down-consolidation towards

at least 16.6030 (last bottom) and potentially even to
15.30/14.74 (int. 38.2 %/old bottom)
Risk: A recovery exceeding triangle resistance at 20.1457
as this could trigger another extension higher.
Watch list
As the expected short term corrective phase takes hold, we
will be monitoring for a better setup and location to re-
establish short USD positions for the next leg of the bear
trend. Our primary focus will be on AUD/USD for final 5th
wave up within the prevailing trend. Similarly, we will be
looking for a setup to establish short positions in
EUR/AUD for that final leg down to new lows.
Also, in line with our view for CAD to struggle, we sense
EUR/CAD and GBP/CAD will present excellent
risk/reward buying opportunities beyond a short term
corrective phase. Moreover, we will monitor for
opportunities in AUD/CAD for a continuation of the
medium term rally phase.
As we expect MXN to outperform, we will look for
opportunities to set short positions in USD/MXN for a
breakdown of the medium term range below 12.77/12.80
support. Similarly, short positions in CAD/MXN will
ultimately make sense for a deeper correction of the rally
from the 2008 low.
Finally, short term corrections in USD/KRW and
USD/INR should present a setup to enter short positions for
the next leg down of the EM outperformance trends, as the
broad trends continue to point lower.
33
Global FX Strategy
November 24, 2009
Tohru Sasaki (81-3) 6736-7717

Junya Tanase (81-3) 6736-7718
Yoonyi Kim (81-3) 6736-7729
Research Note reached our target of 90, set at the beginning of the year;
however, it was mainly due to USD weakness and JPY
JPY: What would push remained weaker in general than we had anticipated with
EUR/JPY still trading around higher than our previous
USD/JPY to all-time lows? target of 123.
Chart 1: Yen real effective exchange rate
• Since March 2009 the yen has declined against all
major currencies but the dollar as the recovery 2000=100
130
trade gained traction. The yen’s current level is
neutral from the perspective of purchasing power 120 av erage since 1970 (86.4)
parity (PPP). 110
100
• In 2010 several factors conspire to push USD/JPY
lower in Q1 and Q2. 90
80
• Upward pressure on Japan’s long-term yields may
rise given concerns over Japanese fiscal condition. 70
This move would accelerate repatriation flows and 60
strengthen the yen. Jan-70 Jan-76 Jan-82 Jan-88 Jan-94 Jan-00 Jan-06
• Foreign central banks, who are extremely Source: J.P.Morgan
underweight yen, may raise Japan’s weight once the

yen and Japan’s long-term yields start rising. We expect USD weakness to persist into until mid-2010.
With regards to the yen, however, we expect the currency to
• Japan’s Homeland Investment Act (HIA) and strengthen given the following upside factors including (1)
foreign purchases of Japanese stocks are other a possible rise in Japan’s long-term yields, (2) foreign
possible factors supporting JPY. We expect purchases of Japanese stocks, partly due to Japanese
USD/JPY to decline to 82 by mid-next year and see corporates’ public offerings, (3) JPY purchases by foreign
risk of USD/JPY testing the historical low marked central banks, (4) JPY purchases stemming from Japan’s
in April 1995. Homeland Investment Act (HIA) and (5) the Fed’s low-for-
long policy. If our view is correct, USD/JPY will extend its
• Even at that level, MoF intervention is unlikely.
downside with the combination of “weak dollar and strong
• Risk factors to our bullish view on JPY include de- yen” in 1H 2010. Therefore, we expect USD/JPY to decline
hedging of foreign bond investments by Japanese to 82 by mid-next year while keeping an eye on further risk
institutional investors and re-acceleration in of USD/JPY testing the record low at 79.75 marked in April
Japanese foreign investments. 1995. We believe that yen-selling intervention by Japanese
MoF would still be highly unlikely even if USD/JPY breaks
• Trade: Buy a 6-mo 123-142 EUR/JPY range binary the historical low. Meanwhile, heading into 2H10, we
to position for an equal USD decline within the G-3 expect to see a modest rebound in USD/JPY, as the market
pairs. will start pricing in the normalization of the Fed’s monetary
policy.
Upside risk to JPY to heighten in 2010
As markets dragged on the aftermath of global de- The yen is still not so strong
leveraging, equity markets across the world traded on a As many people clearly remember the sharp yen
weak tone between the beginning of the year and early appreciation after the Lehman shock on September 2008
March in 2009 while the yen traded firmly over the period. (JPY’s NEER estimated by J.P.Morgan rose 31% between
Since then, however, as concerns over the systemic risk of Sep. 12, 2008, which was one business day before Lehman
global financial system began to recede and investors across Brothers filed for Chapter 11, and Jan.21, 2009, where JPY
the world started to observe global economic recovery NEER marked the recent peak) and USD/JPY is trading
underway, the recovery trade got back on track and JPY well below 100, the recent level of JPY seems to be
started declining against the majors, excluding USD. perceived as strong by majority of the people. However, we
Examining relative performances in the G-10 currencies believe such recognition is not necessarily correct.
since early March, we can find a pattern of both JPY and
USD weakening whilst JPY-cross rates generally trading For example, if we see REER estimated by J.P. Morgan,
higher when investors’ risk appetites improve. USD/JPY JPY declined to a historical low level on June 2007 and
after then, sharply rose to slightly above the long-term
34
Global FX Strategy
November 24, 2009
Tohru Sasaki (81-3) 6736-7717

Junya Tanase (81-3) 6736-7718
Yoonyi Kim (81-3) 6736-7729
average. JPY REER is now trading around slightly below Chart 2: Inflation and currency performance in the major countries
the long-term average level (chart 1). Therefore, JPY % %
currency mov ement -60
movements after the Lehman shock should not be seen as a 80
Grow th rate of CPI since Jan. 1990
against JPY
process of the yen overvaluation; it should rather be seen as -50
a corrective move of the extremely weak JPY to a more 60 -40

neutral level. In other words, these moves should be -30
40
perceived as a normalization process of “JPY-weakness
-20
bubble”. JPY’s REER suggests that the level seen in 1995 20
certainly represented a “super strong” yen. However, even -10
if USD/JPY declines by 10% from the current level and 0 0
reaches the historical low marked in 1995, JPY’s REER USD AUD GBP EUR NZD NOK SEK CAD CHF JPY
should not match the 1995’s high (JPY REER needs to rise Source: J.P.Morgan
by about 40% to match the historical high). It means that
even if USD/JPY hits 79.75 now, JPY should still be Factors suggesting JPY strength in 2010
considered much weaker than in 1995 when USD/JPY was The theory of purchasing power parity takes very long time
at 79.75. to realize and is not useful in forecasting FX moves within
The most important factor in explaining the divergence in 1-2 years. As the current level of the yen is close to neutral
the extent of JPY strength between 1995 and now, is the in the context of PPP, upside risks and downside risks to
difference in inflation trend between the US and Japan. If JPY look more balanced. However, we believe that factors
exchange rates move towards the direction which offset the listed below will lead to a strong JPY in 2010.
divergence in purchasing power between two countries, the 1. Possible rise in Japan’s long-term yields
currency for lower inflation country should appreciate
against the currency for higher inflation country. This idea We expect Japanese fiscal condition to deteriorate further.
is called as the “Purchasing Power Parity (PPP)”. Japan’s J.P. Morgan expects Japanese public debt to rise to about
headline consumer price index has stayed close to flat 200% of GDP in 2010 and to reach 300% in 2019 without
between 1995 and now, while the headline CPI in the US any hike in consumer tax rate. Under such condition, JGB
has risen by 40% over the period. Therefore, 1 dollar=79.75 issuance amount for FY2009 is expected to exceed ¥50
yen in 1995 is now equivalent to 1.4 dollar =79.75 yen (1 trillion (11% of GDP).
dollar = 57 yen) from the perspective of the PPP. So far, increases in JGB issuances have not necessarily led
Chart 2 shows the change in CPI since January 1990 in the to any rises in Japanese long-term yields, due to (1) ample
major countries and changes in FX rates for these countries domestic savings, (2) strong home bias amongst Japanese
over the same period. The chart suggests that, in the long- investors and (3) well contained domestic inflation
run, currencies for higher inflation countries tend to weaken expectations. However, these factors are likely to change
and vice versa, in line with the PPP theory. We have heard over time. Regarding (1), in particular, as we expect Japan’s
some arguments that exchange rate should reflect the power demographic change to result in lower household saving
of each country and downward trend in population in Japan rate and it’s unlikely that saving rate in corporate sector will
suggests a long-term JPY weakness. However, these factors rise significantly, Japan at one point will fall into a situation
have had little impact on the long-term trend in exchange where the government cannot finance its deficit by domestic
rate. Meanwhile, relative growth rate in inflation is the savings only and will be forced to depend on foreign money
dominant factor for the strength of currencies. Needless to to finance the deficit. Under such condition, JGB yields will
say, central banks’ monetary policy aims to achieve stable need to rise to attract foreign investors those who seek for
inflation rate to realize stable value of currency. The main higher risk premium.
reason behind the long-term upward trend in JPY is the We do not expect such condition will materialize over the
prolonged deflation in Japan. next year (we expect Japanese current account balance to
Obviously, relative inflation is not the only factor driving turn deficit in 2014). If concerns over this scenario heighten
the FX trend, particularly in the short to medium term. further, however, upward pressure on JGB yields should
Indeed, our fair-value model, which takes the terms of elevate. When JGB yields start going higher with
trade, government debt and current account etc. into amounting concerns on financing difficulties for public
account on top of inflation level, suggests that the current debt, what should happen in the FX markets?
level in JPY is overvalued by more than 10%. At least from It seems typical to take any rise in JGB yields stemming
the perspective of the PPP, however, the current level of from fiscal concerns as JPY-negative. However, as more
JPY is still not considered strong. than 90% of JGB outstanding is held by domestic players
35
Global FX Strategy
November 24, 2009
Tohru Sasaki (81-3) 6736-7717

Junya Tanase (81-3) 6736-7718
Yoonyi Kim (81-3) 6736-7729
(where more than half is held by public sector), selling in 2Q this year (chart 4). If we assume JPY holdings by
pressure on JPY due to JGB selling should be limited. foreign central banks will rise to as high as the latest peak
level, we will see ¥2.8 trillion of JPY purchases by foreign
In addition, while Japanese government borrows a large
central banks.
amount of money from domestic investors, Japan as a
country is the world’s largest net creditor. Japan’s net Chart 3: International investment positions of major countries
foreign asset stood at ¥225 trillion as of the end 2008. It JPY trillion
300
accounts for 41% of total JGB outstanding and 27% of total
public debt where ¥108 trillion of ¥225 trillion comes from 200
foreign bond investments by private sector (chart 3). Under 100

such circumstances, if JGBs grow more attractive with 0
higher yields, it is possible for domestic players to start
-100
repatriating their foreign asset investments to invest in JGBs
instead. Such discussion should also take into account -200
moves in overseas interest rates given their impact on yield -300

spreads. We expect 10-year US Treasury yield to rise to -400
4.50% by the end-2010, leading to a modest widening in JPN CHN GER Sw iss HK FRN CAD UK RUB ITA USA
US-Japan 10-year spread. For Japanese institutional Source: J.P.Morgan
investors (for lifers in particular), however, absolute level of
JGB yields is more important than spreads. As they are Chart 4: JPY held by central banks as foreign reserve
obliged to pay certain returns, once JGB yields reach the JPY trillion
level close to this, they will be unwilling to take any FX- 16
risk. Indeed, in the long-run, there has been a stronger 15
correlation between JPY’s REER and 10-year JGB yield 14
(0.45 since 1986) than between USD/JPY and US-Japan 10- 13
year spread (-0.08 over the same period). 12
11
Therefore, we believe that an impact of higher JGB yields 10
on JPY should be positive, as long as Japan maintains 9
ample foreign assets and enjoys current account surplus. As 8
it should take several years to turn Japanese current account 2002/Q1 2003/Q1 2004/Q1 2005/Q1 2006/Q1 2007/Q1 2008/Q1 2009/Q1
balance into deficit, if JGB yields start rising next year, this Source: IMF, J.P.Morgan
should imply strong JPY.
2. Foreign purchase of Japanese stocks Currently, JPY accounts for only 3% of foreign reserves
held by global central banks. If this increases to 6%, the
Although foreign investors aggressively bought Japanese level seen in 1999 to 2000, we will see more than ¥10
stocks between 2004 and 2007, JPY continued to decline trillion of JPY-purchases. Furthermore, if we take the share
over the period. We think this was because most part of of JGBs in the global bond market capital into account, 6%
foreign investors’ Japanese stock investments was FX- still looks extremely underweighted. If the main reasons
hedged with the relatively wide interest rate spreads behind the underweighted JPY lie in extremely low level in
between Japan and major countries. At this time, however, JGB yields and continuous JPY weakness until mid-2007,
FX-hedged Japanese stock investments have become less as yield disadvantage has been diminishing and JPY has
attractive with shrinking yield spreads. Therefore, we been trading firmly, it’s likely that central banks will raise
believe majority of foreign investments in Japanese stocks the weight of JPY in their foreign reserves.
since April this year should be without FX-hedges. In
particular, as some cases had been announced already, 4. Japanese Homeland Investment Act (HIA)
public offering by domestic financial institutions and J.P. Morgan expects a tax relief introduced in April this
corporates should accelerate in coming quarters. Since a year to generate about ¥4 trillion of repatriation of overseas
certain part of such offering is usually allocated for foreign retained earnings by Japanese corporates. Against our view,
investors, relevant flows could be JPY-supportive. repatriation flows have been quite limited so far (table 1).
3.JPY-buying from central banks But this means that there remains a room for more
repatriation flows supporting on JPY to take place in over
According to the IMF data, although JPY held in the foreign the next year.
reserves by global central banks had declined after marking
the latest peak at ¥15.5 trillion in 2Q08, it increased slightly
36
Global FX Strategy
November 24, 2009
Tohru Sasaki (81-3) 6736-7717

Junya Tanase (81-3) 6736-7718
Yoonyi Kim (81-3) 6736-7729
Table 1: Repatriation of overseas retained earnings by Japanese 6). Domestically, as Japan already has a huge short-JPY
corporates carry trade positions, which accounts for 18% of GDP in the
JPY billion
FX special accounts (fund used for JPY-selling intervention
Average
2006 2007 2008 2009
(06-08)
is financed by issuance of FBs), Japanese officials seem
Jan 52 56 72 76 60 unwilling to accumulate FX reserve further. Also, both in
Feb 93 77 84 50 85 cases of massive JPY-selling intervention in mid-1990s and
Mar 459 492 542 798 497 2003-2004, JPY stopped its appreciation only after the MoF
Apr 242 419 167 196 276 stopped JPY-selling intervention. These bitter experiences
May 129 242 254 262 208 should have been enough to make the MoF to be more
Jun 217 315 319 407 284 cautious about intervention. Therefore, we believe that JPY-
Jul 149 211 222 251 194 selling intervention is highly unlikely even if USD/JPY
Aug 122 130 164 112 139
breaks the historical low. Note that, our view on
Sep 215 340 286 312 280
intervention is not a factor supporting our forecast for
Oct 67 166 72 102
USD/JPY declining to 82. In fact, if intervention is
Nov 48 105 49 67
Dec 279 329 188 265 conducted against our view, history tells us that decline in
Source:BoJ USD/JPY is likely to be sharper and stubborn and the
bottom of USD/JPY could be much lower than it would be
5. The Fed’s low-for-long policy without intervention.
There has been a good correlation between the difference in Chart 6: FX intervention by Japan’s MoF
US-Japan policy rate outlooks and USD/JPY. As we expect JPY billion
the Fed’s first hike to take place in 2011 at the earliest, 8,000 150
relative outlooks for policy rates in the US and Japan will USD/JPY
140
6,000
continue to weigh on USD/JPY, at least until 1H10. Spread
130
between US and Japan in 3-month LIBOR has fallen into 4,000
negative territory and this reverse in yield differential is 2,000
120
now extending into 6-month yield. Note that, from 1990 to 110
1993 where the US-Japan 3-month LIBOR spread stood at 0
100
around zero or negative territory, USD/JPY declined -2,000 intervention amount 90
sharply (chart 5).
-4,000 80
Chart 5: US-Japan 3-month LIBOR spread and USD/JPY Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09
% points Soruce: MoF, Bloomberg
8 US3M-JP3M USD/JPY 180
7
6 160 Risk factors to our JPY-bullish view
5
4 140 As discussed above, we expect JPY to trade firmly against
3 the majors during next year and to see a relatively large
120
2 upside against USD in particular. However, it should be
1 100 worth pointing out some risk factors against our JPY-bullish
0
-1
view.
80
-2 1. Earlier hike by the Fed
-3 60
Jan-90 Jan-93 Feb-96 Mar-99 Apr-02 May -05 May -08 As there has been a strong correlation between the
Source: Bloomberg, J.P.Morgan
difference in US-Japan policy rate outlooks and USD/JPY,
if expectations for earlier Fed hikes heighten, it could lead
JPY-selling intervention remains highly unlikely to an earlier bottoming out of USD/JPY than we expect.
Also, rising hopes for Fed hikes should lead to flattening of
In the past few years, J.P.Morgan has maintained the strong
the US yield curves. Under such condition, domestic
view that FX intervention by Japanese MoF is highly
institutional investors, those who have invested in US bonds
unlikely due to both international /domestic reasons.
with FX-hedging, could buy USD and sell JPY to take out
Regarding the international backdrop, the fact that the G7 FX-hedging and these flows could push USD/JPY higher.
publicly started criticizing China’s rigid FX policy in 2003 However, as these moves mean that Japanese institutional
to 2004 has made Japan’s intervention more difficult. investors will newly take FX risks, to materialize these
Indeed, Japan stopped FX intervention March 2004 (chart moves, a notable rally in the Nikkei index, which could
37
Global FX Strategy
November 24, 2009
Tohru Sasaki (81-3) 6736-7717

Junya Tanase (81-3) 6736-7718
Yoonyi Kim (81-3) 6736-7729
result in an improvement in investors’ risk appetite, will US long-term yields on the back of widening
also be needed along with heightening speculation for the deposit/lending gap in the banking system. If this realizes, it
Fed’s hikes. More specifically, we think if the Nikkei index should be an additional factor supporting JPY strength
rises to above 12000 along with heightening hopes for the given the strong negative correlation between JPY and the
Fed’s rate hike, USD/JPY buying from Japanese US long term yields. Furthermore, if China allows greater
institutional investors will push USD/JPY above 100. CNY appreciation than we now expect (we expect
However, we believe the probability of such scenario USD/CNY to decline to 6.50 until the end of 2010), it could
coming true, at least in 1H10, is quite low. result in a broad appreciation in Asian currencies, elevating
an upward pressure on JPY as well. Taking into account the
2. Acceleration in Japanese overseas investments
fact that the next G20 summit will be headed by Korea in
Since 2Q this year, Japanese retail investors have resumed 2010, it may be natural to think that Korea and China will
their investments in foreign assets as concerns over try to take leadership roles taking bold steps towards
systemic risks for financial system receded and global resolving global imbalances. If this happens or even just
economic recovery came back into their radar screen. Net expectations for such movement were to heighten, market
purchases of foreign bonds and stocks by Japanese retail participants are likely to sell USD/JPY as a proxy trade.
investors through investment trusts have amounted to ¥2.9
With our bearish view on USD, upside risks to JPY give
trillion between January and October this year; which is
more reasons to believe in possible sharp decline in
more than triple the net purchases last year (Note, however,
USD/JPY. Unless we are faced with rising expectations
that it is still about 50% of total net purchases in 2006 and
over earlier Fed hikes and rallies in the Nikkei to above
2007). If these trends continue, relevant flows could weigh
12000, USD/JPY is likely to decline to 82 by mid-2010,
on JPY.
before modestly rebounding towards 2H10 along with an
However, flows stemming from FX margin accounts which expected rise in hopes for the Fed’s policy normalization. If
had contributed to JPY weakness until mid-2007 are not a USD/JPY reaches our target at 82, we should watch out for
factor necessarily suggesting JPY weakness for this time. risk of USD/JPY making a further decline, as the market
This is because risk-taking activities by FX margin accounts will keenly want to test the historical low at 79.75. In that
have become more two-sided one compared with that until sense, we should not rule out the possibility of USD/JPY
mid-2007 and as a result, we rarely observe any sharp trading below the historical low at least temporarily.
accumulation in positions - typically in JPY shorts. These
Again, however, it is important to note that this still should
developments reflect that short JPY carry trades have
not be perceived as a significantly high level for JPY, when
become less attractive with shrinking yield spreads between
taking the relative inflation trend into account; if we look at
Japan and other major countries amidst rising FX volatility.
the “real” (price-adjusted) USD/JPY rates, USD/JPY at
Moreover, while we can expect yield gap with some
79.75 now should be equivalent to USD/JPY at around 105
countries to widen next year, starting from August 2010,
in November 1999 (chart 7).
there will be a restriction limiting leverage to 50 times.
Therefore, by the time yield differentials recover to Chart 7: Real USD/JPY rate
attractive levels, retail traders will only be able to take 180
smaller amount of positions. Price-adjusted (real)
160
Separately, foreign direct investments by Japanese
corporate have been relatively solid this year. Although the 140
pace of relevant outflows this year (¥6.3 trillion, annualized
figure between January and September) has been smaller 120
than that in 2008 where the FDI-related outflows recorded a
historical high at ¥10.7 trillion, it’s still comparable with 100
outflows in 2006 and 2007. If JPY strength continues, it’s actual
possible that the FDI outflows will be accelerated further. 80
We target USD/JPY 82 with seeing downside risk Feb-90 Feb-94 Feb-98 Feb-02 Feb-06
Source: J.P.Morgan
Aside from the JPY bullish factors mentioned above, there
are other upside risks for the yen which are not necessarily
in line with J.P.Morgan’s official view. One risk is a
possible decline in the U.S. long-term yield. Japan’s past
experience suggests possible risk for significant decline in
38
Global FX Strategy
November 24, 2009
Tohru Sasaki (81-3) 6736-7717

Junya Tanase (81-3) 6736-7718
Yoonyi Kim (81-3) 6736-7729
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39
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 7859-6714

J.P. Morgan Securities Ltd
Research Note How much have central banks distorted

EUR/USD?
EUR: Few obstacles to new On our estimates EUR remains moderately overvalued
highs (+5%) relative to its equilibrium value. The most popular
explanation for this apparent richness in the euro is the
distortive effect of the de-facto Bretton-Woods II
• J.P. Morgan’s forecast for new highs in EUR/USD arrangement of (soft) dollar pegging in the Asian countries.
reflects USD bearishness, ongoing reserve This, the argument runs, prevents USD from appreciating
diversification and the absence of euro-specific against the fundamentally cheap surplus currencies in Asia
headwinds. A commonly perceived risk to the euro and instead channels dollar depreciation through the path of
from faster CNY revaluation is overstated, as is the least resistance in G10 floating exchange rates. EUR bears a
threat to the region’s trade and capital flows from disproportionate burden of this USD depreciation due to the
the euro’s valuation. Fears of EUR break-up are no demand for EUR from Asian and other central banks
longer credible. diversifying their USD reserves. This hypothesis is
illustrated by charts 1 & 2 that compare the deviation of
• Reserve diversification is the factor most often cited EUR/USD from fair value against the level of global FX
as a cause of EUR’s persistent overvaluation in reserves. The two are highly correlated – 85% in level terms
recent years. The empirical evidence has not been and 70% in change terms since 1999.
overwhelming until recently.
Chart 1: EUR overshooting vs. fair-value appears related to global
FX reserves, both in level terms…
• EUR is typically weakest when central bank 30% Dev iation of EUR/USD from equilibrium, % lhs 8000
demand for EUR is strongest, suggesting that CB
7000
portfolio rebalancing has dominated. Such portfolio 20% Global FX reserv es, $ bn, rhs
6000
rebalancing has served to cap rather than 10%
exacerbate EUR strength and to limit EUR 5000
pullbacks. There was evidence from Q2, however, 0% 4000
that diversification is becoming more aggressive, 3000
-10%
which could justify sustained EUR appreciation. 2000
-20%
1000
• Reserve accumulation is one facet of a broader-
-30% 0
explanation for “excess” upward pressure on EUR,
namely the continued fixing of Asian exchange rates 00Q1 02Q1 04Q1 06Q1 08Q1
and the resultant re-channeling of USD-deprecation Source: IMF; J.P.Morgan
through floating currencies. The flaw in this
explanation is the persistent positive correlation Chart 2: …and in change terms
Change in EUR/USD ov er/underv aluation, % oy a, lhs
between EUR and CNY – there is no evidence that
changing expectations about the pace and extent of 20% Change in FX reserv es, oy a, $bn, rhs 2000
CNY revaluation affect EUR on a sustained basis. 10% 1500
Fade the inevitable EUR weakness should China
escalate the pace of CNY revaluation. 0% 1000
-10% 500
• There is no evidence that FX valuation is depressing -20% 0
either trade or investment flows to the Euro area.
-30% -500
External flows offer no resistance to new highs.
-40% -1000
• Fears of a structural crisis are as long-standing as
00Q2 02Q2 04Q2 06Q2 08Q2
they are misplaced. What many feared would
undermine cohesion – a severe and asymmetric Source: IMF; J.P. Morgan
recession – has actually served to reinforce it. This circumstantial evidence appears to support the
• Trade: buy a 6-mo 123-142 EUR/JPY range binary hypothesis that reserve accumulation and diversification has
to leverage the lack of domestic drama in the Euro been instrumental in driving the euro’s overvaluation,
area. especially as EUR moved into overvalued territory only at
the time that reserve accumulation really got into gear in the
40
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 7859-6714

middle of the decade. But correlation does not imply volume change in EUR reserves versus the change in
causation. The hypothesis would be more compelling if EUR/USD). One quarter does not constitute a trend and Q2
there were also a strong positive relationship between the could yet prove to be a fluke. But if central banks do switch
deviation of EUR/USD from fair-value and central bank more from portfolio rebalancing towards momentum
demand for EUR itself. investing, the impact would be to boost both EUR/USD
spot and volatility.
Unfortunately the data appears to show precisely the
opposite – EUR is strongest relative to fundamentals when Chart 4: Record EUR reserve accumulation in Q2, in price and
central bank demand for euros is weakest and vice versa. volume terms
Quarterly change in EUR FX reserves, $bn
Such an analysis is subject to the unavoidable limitations of
the IMF’s Composition of Foreign Exchange Reserves 150 Actual
(COFER) data, which provides a currency breakdown for FX-adjusted
only 2/3 of global reserves and omits certain key players, 100
most notably China. Nonetheless, chart 3 plots the change
in EUR/USD against the reported accumulation of EUR 50
reserves minus USD reserves (volume terms). As is clear,
0
there is a strong negative (-65%) correlation between these
two series. In other words, central banks physical -50
accumulation of EUR reserves is greater when EUR is
weaker, and vice versa. -100
Chart 3: EUR strength is inversely related to the relative demand for 2002 2004 2006 2008
EUR FX reserves Source: IMF; J.P.Morgan
Change EUR/USD ov er/underv aluation, % oy a, lhs
Chart 5: An end to CB reserve rebalancing in Q2?
20% EUR-USD reserv e accumulation, FX adjusted, 4Q sum, 300
$bn 200 80
Change in EUR FX reserves, FX
10%
100 60 09Q2
0%
0
adjusted, $bn
40
-10%
-100
-20% 20
-200
0
-30% -300
09Q1 -20
-40% -400
99Q3 01Q3 03Q3 05Q3 07Q3 09Q3 -40
-10% -5% 0% 5% 10% 15%
Source: IMF; J.P.Morgan
EUR/USD, QoQ change, %
Rather than reserve diversification influencing the exchange
rate, it seems that exchange rate changes influence reserve Source: IMF; J.P. Morgan
diversification, at least over short-medium term horizons, as
Unraveling the EUR-CNY nexus
centrals banks rebalance their reserves to maintain broadly
steady reserve ratios in the face of fluctuating exchange Another way of considering whether Asian FX fixing has
rates. Rather than over-inflating the value of the euro, the artificially distorted EUR/USD is to examine the market
activities of reserve managers may have served to compress based evidence, in particular the relationship between
its variability in both directions. Reserve management may EUR/USD and USD/CNY. If China’s currency pegging has
have been more bearish for EUR/USD vol than it was indeed forced excessive USD depreciation onto EUR/USD,
bullish for EUR/USD spot. the reality or expectation of CNY appreciation should be
expected to alleviate upward pressure on EUR/USD. Under
This is not to deny of course that more active diversification this Bretton Woods II hypothesis, one would expect there to
into EUR could yet generate a more substantial overshoot in be a negative correlation between EUR and expected CNY
EUR/USD. There was some evidence of just such a shift in appreciation, or at the very least that the correlation
central bank behavior in Q2. EUR/USD appreciated during between the two should decline as CNY flexibility
the quarter, yet according to the COFER data, central banks increased. This proposition is of course testable, given that
accumulated a record volume of EUR reserves. In addition, we have four years in which USD/CNY has been allowed to
they accumulated more EUR than USD reserves. (Chart 4 depreciate to varying degrees.
plots the quarterly change in EUR reserves, chart 5 the
41
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 7859-6714

Once again the evidence does not appear to support the Chart 7: Aside from a brief period in 2006/2007, EUR has been
hypothesis. To illustrate this, chart 6 plots EUR/USD positively correlated with expected CNY appreciation
Correlation between EUR/USD and 1Y implied CNY appreciation vs. USD, levels,
against the appreciation in CNY vs. USD implied by the 1Y 1Y rolling window
NDF. Chart 7 plots the correlation between these two. Aside 1.0
from a brief period in mid-2006 to 2007, the level of
EUR/USD has been positively correlated with the expected
degree of CNY appreciation vs. USD, the exact opposite of 0.5
the Bretton Woods II distortion hypothesis. In addition, the
correlation of daily changes in EUR and CNY has actually 0.0
increased, not decreased, over the past few years (chart 8).
Chart 6: EUR/USD and expected CNY appreciation are positively -0.5
correlated
EUR/USD
1.7 12% -1.0
1.6 Nov -01 Nov -03 Nov -05 Nov -07
CNY - 1Y appreciaiton v s USD implied by 9%
1.5 NDF, %, rhs
Source: J.P. Morgan
1.4 6%
1.3
3%
Chart 8: The positive correlation between EUR and CNY (has
1.2 increased, not decreased. There is little evidence of directional
1.1 0% decoupling of EUR and CNY
1.0 Correlation between EUR and CNY via USD, daily % changes, 1Y window
-3% 40%
0.9 CNY spot
0.8 -6%
30% CNY 1Y fw d
Nov -00 Nov -02 Nov -04 Nov -06 Nov -08
20%
Source: J.P. Morgan 10%
The experience of the last few years tends to contradict the 0%
notion that Asian inflexibility has led to an artificial
-10%
appreciation in EUR/USD. In reality there has been one
dollar trend and the fact that the positive correlation -20%
between EUR and CNY has increased through periods of Nov -01 Nov -03 Nov -05 Nov -07 Nov -09
both fast and slow CNY offers little prospect that this
correlation will collapse or turn negative should Asian Source: J.P. Morgan
policymakers do the unexpected and sanction a much faster
Where’s the domestic drama?
pace of local FX appreciation. There is little doubt that the
knee-jerk reaction to either a step adjustment in USD/CNY What, if any, are the idiosyncratic Euro factors that could
or a faster rate of crawl would be a sell-off in EUR/USD, impede, or indeed reinforce, the uptrend in EUR/USD
more so in EUR/JPY. That after all was the response to the resulting from the general USD downtrend? In recent years
initial de-pegging in July 2005. As in 2005, however, we EUR has been devoid of domestic dramas, which in a sense
would expect this response to be quickly reversed as the could be viewed as one of the single currency’s major
market reverted to the singular dollar trend. A directional attributes, as this has left the euro free to function as a core
decoupling of EUR and CNY remains a distant prospect. anti-dollar currency. The market has on occasions fretted
about local risks to the euro – hidden losses at Euro area
banks and fears of euro break-up being the two most
obvious. But these concerns have generally come to nothing
and the euro remains a stand-out strong currency.
The most obvious question-mark surrounding the forecast
of a new high in EUR/USD is whether the economy would
be able to withstand the hit to external demand. In addition,
there is a natural concern that the apparent richness in the
euro could damage investment flows to the region. In short,
can the region’s balance of payments withstand a continued
appreciation in the currency to new record highs?
42
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 7859-6714

Exchange rate appreciation is certainly a drag on Euro area Chart 9: The Euro area’s relative export performance is inversely
exports. Chart 9 shows that the inverse relationship between related to the level of the euro
the region’s relative export performance and the exchange EUR REER
160 Dev eloped/Euro area ex ports, 1999=100 130
rate is exceptionally strong. The exchange rate is a key
determinant of export market share. But the consequences 150 120
of this for the absolute export performance, which is what 140
110
matters for economic growth and presumably also for 130
policymakers, should be more than offset by the boost to 100
120
exports from global economic recovery (chart 10). A recent 90
analysis by our chief Euro area economist (See Currency 110
unlikely to prevent strong Euro area export growth, 100 80
Mackie, October 2009) found the dominant driver of export 90 70
growth to be foreign demand (i.e. global growth) rather than
relative price (i.e. the exchange rate). A 1% change in Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09
global growth results in a 2.1% change in Euro area exports. Source: J.P. Morgan
A similar effect from the exchange rate requires a sizeable
6% trade-weighted adjustment in the euro. Given our Chart 10: But the global business cycle is the key driver of exports
forecasts for global growth next year it is not a stretch to get 40 Global IP, % oy a Euro area ex ports, % oy a
to 8% growth in Euro area exports even with a stronger 30
EUR. And due to the still low level of exports (20% below 20
their peak) the risk is for even stronger growth.
10
Recent trade numbers tend to confirm this analysis and
0
support the outlook for an extended euro uptrend through at
least H1 next year. Chart 11 shows the region’s trade and -10
current account balances. After falling sharply as global -20
trade imploded last year, the trade balance has returned to a -30
reasonable surplus. The current account, meanwhile, has
Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08
returned to balance for the first time since late 2007. The
unprecedented collapse in the region’s surplus last year no Source: J.P. Morgan
doubt exacerbated the deleveraging-led collapse in the euro
Chart 11: Healing in the Euro area’s external accounts
in late 2008; since then the turnaround in the external Euro area external balances, 3mo moving average, EUR bn
accounts has contributed to the euro’s rehabilitation. 15 Current account Trade balance
Capital flows offer no solace to Euro skeptics 10
What of capital flows? The overall portfolio flow position is 5

extremely strong. Indeed, net portfolio flows over the past 0
year have approached a record €500bn, primarily due to a
-5
surge in debt inflows (€440bn). The relationship between
the currency and net portfolio flows is however inconsistent -10
(chart 12), as one would expect given the conflicting nature -15
of bond and equity flows. For the bulk of the life of the -20
single currency strong and rising net portfolio inflows were
associated with EUR appreciation, and vice versa (1999- Jan-99 Jul-00 Jan-02 Jul-03 Jan-05 Jul-06 Jan-08 Jul-09
2007). Since then, however, the relationship has flipped, not Source: J.P. Morgan
surprising given the unprecedented flight to quality demand
for bonds in the face of near economic and financial
collapse, a collapse which itself also undermined the euro.
43
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 7859-6714

Chart 12: Euro area portfolio inflows at a record high, but the Chart 13: Foreign investors were quick to sell EUR equity, and quick
relationship to EUR is inconsistent to reinvest
Euro area equity flows, 12m sum, EUR bn
Net Euroarea portfolio inflow s, 12m sum, EUR bn, lhs
600 20% Foreign purchases EUR equity
EUR NEER, % oy a
15% 400
Euroarea purchases foreign equity
400 10% 300
200
5%
200 100
0%
0
0 -5%
-100
-10%
-200
-200 -15%
-300
Source: J.P. Morgan
Source: J.P. Morgan
From the perspective of assessing whether EUR valuation is Chart 14: Combined demand for EUR from the current account, net
adversely affecting investors’ perception of the region’s equity and FDI flow has surged to a record high in recent months.
growth prospects and therefore the real rate of return on Euro area current account, net equity and FDI flow, monthly average, EUR bn
euro investments, it makes sense to consider equity and FDI 40
flows in isolation. The message here is not particularly
worrisome for the single currency. That said, neither does 20
this support any form of outperformance from the euro
versus non-USD currencies. 0
Equity flows turned sharply negative during the crisis as
foreign investors sold nearly €250bn of local equities. They -20
have since reinvested 45% of this, a reinvestment rate that 3m 12m
exceeds that of the US. There is no evidence here that -40
currency valuation has adversely affected foreign demand
for EUR investments. That said it would be unrealistic to -60
expect equity flows to drive a sharp EUR appreciation from Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
here. The reason is that Euro area equity investors, who
were quick to repatriate overseas equities last year, have Source: J.P. Morgan
been exceptionally slow to reinvest. Of the €142bn of
foreign equities that were sold between Sep 2008-Apr 2009, The overall state of the Euro area’s balance of payments in
only €1bn has been reinvested. Putting local and foreign so far as it drives demand/supply for EUR can best be
equity flows together, 90% of the equity capital that left the summarized by a broad basic-balance concept that
region during the crisis has already been reinvested. EUR aggregates the current account, net equity and net FDI
may well appreciate to new highs but most likely not on a flows. As chart 14 highlights, the basic balance collapsed
wall of equity money. during 2008/early 2009 but has since recovered sharply, so
much so that the combined surplus over the past 3 months is
FDI flows, meanwhile, are still negative (EUR 134bn over at a record high. The surplus is not sustainable at these
the past year) but the bulk of these flows are now accounted levels, not least because equity re-investment will wind-
for by intercompany loans rather than fresh outward down. Nonetheless, it confirms that there is no obvious
investment by Euro area companies. It remains to be seen balance of payments headwind for the euro, even at these
whether genuine M&A outflows from the Euro area will seemingly expensive levels.
resume in the face of the global upswing. For now M&A
activity looks to be a broadly neutral factor for EUR/USD. What price EUR break-up risk now?
Ever since its inception EUR has attracted a group of hard-
core skeptics, unconvinced that the Euro area constituted an
optimal currency area and that cohesion of the single
currency area would be severely tested, and potentially even
broken, by the first severe recession or asymmetric shock to
44
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 7859-6714

hit the region. It is not particularly obvious that these Chart 15: Growth divergence within the Euro area has increased, but
structural reservations have had any negative bearing on remains with historic norms
Dispersion of intra-Euro area GDP growth rates (% oya, 4q MAV). Calculations use
EUR’s average valuation in recent years; nonetheless the current composition of the euro area for consistency
doubts about cohesion of the single currency have been the 4% 20%
Standard dev iation, lhs Max -min, rhs
basis for intermittent bouts of pessimism towards the
currency. Break-up risk has been the euro’s ultimate
domestic drama. 15%
3%
Such skepticism towards the long-run viability of the euro
10%
looks ever more unjustified in the light of recent events.
Rather than exposing economic and political fault-lines in 2%
the Euro area, the crisis has served to reinforce the political 5%
attachment towards the euro, especially as a source of
stability for smaller countries, both current and aspiring 1% 0%
members. More objectively, it is not obvious that the Feb-96 Feb-98 Feb-00 Feb-02 Feb-04 Feb-06 Feb-08
recession has resulted in a potentially fatal divergence in
economic performance amongst Euro area members, one Source: J.P. Morgan
that would raise more valid doubts about countries’ Chart 16: The divergence in unemployment is more pronounced
continued participation in the single currency. Charts 15, 16 Dispersion of intra-Euro area unemployment rates (% oya, 4q MAV).
and 17 illustrate this with a time series of the standard 6 19
deviation of GDP growth, unemployment rates and fiscal 17
deficits throughout the Euro area. 5
15
If the worst recession of the post-war period has been 4 13
incapable of undermining EUR cohesion, one has to
question what potentially could. One of the lasting legacies 3 11
of this crisis may therefore be to end the intermittent Standard dev iation, lhs 9
speculation of EUR break-up, either as an economic 2
Max -min, rhs 7
inevitability or a political possibility.
1 5
Source: J.P. Morgan
Chart 17: Fiscal cohesion has not been threatened

Dispersion of intra-Euro area GDP public sector deficits (% GDP).
Standard dev iation, lhs
5 20
Max -min, rhs
4 15
3 10
2 5
Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08
Source: J.P. Morgan
45
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 8769-1906

Paul.meggyesi@jpmorgan.com
Research Note clearly traded as an investment currency during this period.

The relationship between GBP and equity markets has been
GBP: Funding currency or more mixed since stocks turned around in March. In the
early part of the rally, and also over the past month, GBP
investment vehicle? and stocks moved higher in tandem – GBP continued to
perform as an investment currency. But for a three month
• GBP has defied the doomsters this year, posting a period between July and September the correlation between
4% trade-weighted appreciation so far. Is this a GBP and the stock market flipped as traders started to use
confirmation that GBP remains an inherently pro- GBP as the funding currency counterpart to their reflation
cyclical currency whose undervaluation sets the trades. This distinction between GBP as funding or
stage for an extended appreciation next year as the investment currency remains pivotal to how one thinks
global recovery unfolds? about GBP’s prospects next year. Should GBP be regarded
as an investment currency, which stands to benefit from a
continued healing in the global economy and financial
• We are not convinced. GBP’s undervaluation may
markets, or is sterling’s future now defined as one of that
limit the scope for a renewed sharp depreciation,
select group of funding currencies (primarily USD) whose
but the relative headwind to the UK economy from
fortunes are inversely related to that of the global economy
a trinity of deleveraging in the household, banking
and asset prices?
and public sectors remains a powerful obstacle to a
sustained cyclical rebound in GBP. The UK is Chart 1: GBP’s correlation to equity markets rose to a multi-decade
poised for its greatest economic underperformance high during the crisis,
in the last two decades. Correlation between daily changes in GBP NEER and S&P500, 1Y rolling window
30%
25% 20Y average
• The issue of unresolved balance sheet leverage
20%
questions the prospects for a quick normalization in
15%
interest rates and as such it is doubtful whether
10%
GBP can regain its former high-yield status.
5%
Without this GBP’s positive correlation to risk
0%
markets is liable to weaken substantially.
-5%
• The structural state of public finances is -10%
particularly hostile for GBP. The currency end- -15%
game from this is either slow-burning pressure on -20%
GBP due to an adverse shift in the fiscal/monetary Jul-90 Jul-93 Jul-96 Jul-99 Jul-02 Jul-05 Jul-08
policy mix should policymakers undertake fiscal Source: J.P.Morgan
consolidation (a la Canada in the mid 1990s) or a GBP’s future as a funding currency?
faster depreciation should policymakers sidestep the
problem and risk a loss of foreign investor What determines a currency’s status as a funding or
confidence. investment currency is the expected rate of return on its
assets vis-à-vis international counterparts. Exchange rate
• Trade: Buy a 6-mo 1.60 – 1.50 GBP put/CHF call valuation provides one component of this expected return,
spread with a 1.45 RKI on the lower strike, since the and in this sense GBP’s current undervaluation versus
market is too optimistic on the UK’s exit from QE equilibrium exchange rate models is one factor which has
and not keen enough on Switzerland’s. the potential to support demand for GBP should investors
anticipate capital gains from a reversion to long-run fair
GBP’s history as an investment currency value. But beyond this, the expected rate of return on UK
assets will be determined primarily by the UK’s relative
One of the key issues for GBP throughout this year has been economic performance and the resultant trajectory for
its relationship to the global business cycle and asset prices. relative interest rates.
At a simplistic level the UK was positioned near the
epicenter of the housing, banking and credit market How GBP behaves relative to risk markets reduces to the
collapses in 2007/2008, an uncomfortable proximity which GBP’s rate advantage – the higher GBP’s carry, the more
caused GBP to slump as stock markets went south. In the effectively it should function as an investment currency and
process the correlation between GBP and risk markets the higher its correlation to risk markets. A lower level of
surged to its highest level in recent decades (chart 1). GBP carry should reduce GBP’s sensitivity to risk markets, with
46
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 8769-1906

the correlation turning negative in the extreme case in the UK is lagging the global recovery is worrying enough;
which GBP offers negligible or even negative carry and is that it is doing so despite the advantage of a competitive
transformed into a funding currency. As chart 2 details, this currency and more aggressive monetary stimulus than
relationship between GBP’s yield pick-up and its sensitivity elsewhere is even more concerning. Now the relationship
to risk markets has held well over the past decade, with the between relative UK growth and GBP’s performance may
notable exception of the past year, when the correlation to be rather weak (chart 4); nonetheless, it is difficult to see
risk markets rose to a new high even though the carry on sterling appreciating for the second consecutive year in the
GBP collapsed to a multi-decade low. face of the second consecutive year of sub-par growth.
Positioning can explain this divergence as stock markets Chart 3: UK is faced with the sharpest growth underperformance
melted down last year – the carry on GBP may have since the late 1980s/early 1990s
UK minus developed world GDP growth, % oya. 2009 and 2010 are JPM forecasts
collapsed but investors nonetheless had an accumulated
3%
overhang of long GBP positions which were unwound as
stock markets went south. But there is no symmetric reason 2%
to suppose that GBP should rally just because stocks are 1%
now rebounding. Investors will not be squeezed back into
0%
GBP in the same way they were squeezed out last year
barring an interest rate justification for them to reload on -1%
GBP longs. As chart 2 makes clear, the average carry on -2%
GBP is at its lowest level in over a decade, a fact which
-3%
should depress appetite for GBP as a carry trade and put
downward pressure on GBP’s correlation to risk markets. In -4%
the extreme, as happened briefly in the summer, there is the Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05
potential for this correlation to turn negative should the Source: J.P.Morgan
paltry level of UK rates encourage a broader use of GBP as
Chart 4: There is a positive, albeit weak, relationship between
a funding currency.
relative UK growth and GBP’s trade-weighted performance
Chart 2: GBP is a now a low-yielding currency, which justices a The scatter diagram plots the growth gap between the UK and the developed world
much lower or even negative correlation to risk markets on the horizontal axis and the annual change in GBP’s REER on the vertical axis.
1975-1979 1980s 1990s 2000s
3.0 UK-G7 2Y sw ap differential, %, lhs 0.3 30%
1Y rolling correlation betw een GBP and S&P500
2.5 20%
0.2
2.0 10%
2009
0.1
0%
1.5
0 -10%
1.0
-20% 2008
0.5 -0.1
-30%
0.0 -0.2 -4% -3% -2% -1% 0% 1% 2% 3%
Aug-99 Aug-02 Aug-05 Aug-08 Source: J.P.Morgan
Source: J.P.Morgan A Beaufort scale for balance sheet headwinds
Growth outperformance turns to underpeformance Pivotal to GBP’s prospects as the global recovery unfolds is
So much for the current trivial level of spreads – does the the number and magnitude of unresolved balance sheet
UK have the capacity to deliver above average growth in tensions in the UK economy. The UK was in the vanguard of
the next few years and in doing so to re-establish GBP as a the global housing bubble and as a consequence its household
higher-yielding investment currency? The omens for this and banking sectors are amongst the most levered in the world.
are not good. Chart 3 compares the difference between GDP In addition, UK public finances have unraveled at a faster rate
growth in the UK and the rest of the developed world. The than anywhere else in the developed world, as a structurally
UK broadly outperformed over the last decade, albeit more large deficit has been further stretched by an outsize banking
noticeably in the first half of the decade than in the second, crisis and the attendant economic recession. In a worse case
but this year and next JPMorgan expects the UK to deliver scenario the UK is faced with the need for a simultaneous
its sharpest growth underperformance since the ERM- deleveraging by the household, banking and public sectors, a
housing related recession in the late 1980s/early 1990s. That trinity of deleveraging that threatens to depress relative UK
47
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 8769-1906

growth prospects vis-à-vis those countries where private and Chart 6: The larger the banks, the larger the losses
public balance sheets are less stretched. Balance sheet issues Bank losses, % of GDP
25%
may have taken something of a backseat in recent months,
partly because ultra-low interest rates have alleviated their 20% Additional ex pected
debt-servicing symptoms, but without a meaningful reduction
Q2 2009
in leverage it is difficult to see how the UK can recapture its 15%
former status as a higher growth/higher yield economy. Given
the importance of these balance sheet issues it is worthwhile 10%
considering them in slightly more detail.
5%
Headwinds from the banks
At the start of the crisis, the UK had the second largest 0%
banking system out of the major countries. As chart 5 US UK Euro area
details, little has changed in the intervening period. The Source: IMF- Global Financial Stability Report, October 2009
banking sector has contracted but the extent of the
deleveraging is relatively small, with total bank liabilities as Chart 7 The resultant credit crunch is more severe in the UK
IMF’s estimate of the credit shortfall, as % of GDP. This is the difference between
a % of GDP falling from 500% of GDP to 470%. In the potential domestic supply of credit and the domestic demand for credit.
Switzerland, by contrast, the banking system has shrunk 0
from 670% of GDP to 580%. UK banks are still 75% larger
as a proportion of the economy than they were a decade
-5
ago.
Chart 5: The UK had an outsize banking system, and still does 2009
-10
Banking sector liabilities, as % GDP.
2010
800%
-15
600%
2007
-20
400% 2008
US Euro UK
2009
200% Source: IMF Global Financial Stability Report, October 2009
Chart 6 compares the IMF’s estimate for banks losses,

0%
expressed a percentage of GDP – it is a quite striking that
UK bank losses are estimated to be three times as large as in
ea
UK
US
lia
da
n
d
pa
e
n
tra
ar
na
ed
rla
the US or Euro area. The resultant credit gap – the

Ja
s
Ca
ro
Sw
ize
Au
Eu
Sw
difference between the domestic supply of credit and the

Source: National central banks, J.P.Morgan
domestic demand for credit – is shown in Chart 7. This
The disproportionate size of the banking system matters for credit gap can in some senses be regarded as a measure of
two reasons. Firstly it has increased the cost to the taxpayer the severity of the credit crunch, and in the UK this is six
of stabilizing the banking system, thereby worsening the times as large as the US this year and nearly four times
UK’s fiscal positions (more on this later). Secondly, the greater than in the Euro area. The credit shortfall is
outsize losses faced by UK banks compromises their expected to decline next year but will remain near 10% of
relative ability to create credit – in short, the larger the GDP compared to less than 1% in the US and 3% in the
banking system, the worse the resultant credit crunch. Euro area. Given this disproportionate inability of the UK
banking system to create credit, is it any wonder that the
The IMF in its recent Global Financial Stability Report
BoE has had to undertake such aggressive QE, providing
attempted to quantify the relative extent of the credit crunch
monetary financing to the government worth some 15% of
in the major economies. To do this it first calculated the
GDP, or ¾ of the credit gap, this year?
potential supply of new credit from financial systems in the
US, Euro area and UK, derived from an estimate of bank Headwinds from household leverage
losses adjusted by an estimate for new bank capital and
The extent of household leverage is another potential
bank profits. The IMF then compared this potential supply
relative headwind for the UK economy. UK consumers
of credit with the ex-ante demand for credit.
were not the most voracious borrowers during the credit
boom– that dubious honor falls to Ireland where household
48
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 8769-1906

debt as a percent of GDP rose by 54% between 2001 and convincing basis for a resumption of UK economic
2008 – nor do they have the highest debt/GDP ratio outperformance nor a renaissance of GBP as a carry
(Australia tops this list at 106% with the UK in third place currency.
at 100%). Nonetheless, household leverage in the UK is
Chart 10: Balance sheet problems translate to outright credit
high both by international standards and relative to UK contraction in the UK
history (chart 8), a fact which threatens to depress UK Bank lending to individuals and non-financial corporations, % oya
growth relative to many other counttries should consumers 16% Current
seek to delever more aggressively. The impact of such a Pre-crisis av erage
process on relative economic performance is already being 12%
felt this year. As chart 9 highlights, the severity of a
8%
country’s recession is inversely related to the scale of
leverage in its household sector. 4%
Chart 8 UK household debt is high relative to history and
0%
international peers
120%
Australia -4%
Household debt/GDP ratio, %
UK Ireland
100% US
Canada NZ -8%
80% Norw ay Sw eden USD GBP EUR AUD NZD JPY CHF SEK NOK
60% Japan Source:J.P.Morgan
Germany France
40% The drag from public finances
Italy
20%
Excess leverage in the UK is not confined to the private
0% sector. As a result of the structural expansion in the size of
-20% 0% 20% 40% 60% 80% the public sector in recent years, the recession and the bank
bail-outs, the UK is suffering the worst deterioration in
Household deb/GDP ratio v s. 10Y av erage public finances of any major country. Chart 11 shows the
Source:OECD; J.P.Morgan
deficit position in 2009/10, chart 12 the projected increase
in public debt between now and 2014.
Chart 9: Leverage depresses growth on the way down in the same
way it boosts growth on the way up Chart 11: The UK runs the largest fiscal deficit this year and the
2% second largest next year
Australia Public sector financial position, % GDP
2009 GDP growth, % oya
0% 10
Norw ay NZ 2010 2014
-2% France US 5
Canada Sw eden
-4%
-
Germany UK
-6% Italy
Japan -5
-8%
Ireland
-10
-10%
-15
-20% 0% 20% 40% 60% 80%
dia
ne a
rw il
Ja UK
Fr US
Au Ita 0
M hin a
ge ea
na Z
T u alia
In n
str ly
rm ica
C da
sia
Ge Af r n
Household debt/GDP ratio v s. 10Y av erage

G- e
Ar Kor a
R uxic o
y
So Sw rkey
ay
N o raz
do in
2
pa
ut ede
c
Ca N
an
i
ss
an
In nt
B
e
h
Source:OECD; J.P.Morgan
In summary, balance sheet problems in both the banking Source: IMF

system and household sectors threaten to impair credit
growth to varying degrees in the main economies. The more
severe the balance sheet strains, the weaker the outlook for
credit expansion and by extension overall economic
performance. On both fronts the UK is relatively exposed
and as such it should be no surprise to learn that UK credit
growth is virtually the weakest of all the major countries
(chart 10), with bank credit to the private sector now falling
quite sharply in outright terms. This hardly constitutes a
49
Global FX Strategy
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Paul Meggyesi (44-20) 8769-1906

Chart 12: The explosion in UK public sector debt in coming years is Chart 13:Debt stabilization is a high hurdle for the UK
exceeded only by Japan Required improvement in primary fiscal balance between 2010-2020 to stabilize
Projected change in gross public sector debt, 2014-2007, % GDP public debt/GDP ratios at either 60%, if currently above 60%, or at end-2011 levels
60 if currently below 60%.
16
40 14
12
20 10
8
0 6
4
-20 2
0
-40 -2
ne a
rw a
N o ntin l
UK
Ge r an S
st 0
na a
R u ina
NZ
T u ralia
n
M f rica
ly
C h da
Ar Bra ia
hA n
ge zi
rm ce
I n In ia
K o
y
Be nce l
So Sw rkey
S nd
Gr pain
ce
nd
I re U K
US
r 0
ay
do di
Au um
nm ea
ed Z
ia
k
Ge rlan ia
I ce I taly
n
F r t uga
F i ada
N e Aus land
D e Kor n
rm ds
Au G-2
C a ore
pa
C a any
ut ede
F U
an
Ita
s
ic
Po G-2
ar
pa
ss
e
Sw N
s tr
l
la
the tra
ee
nla
ex
Ja
lgi
Ja
n
a
Source: IMF Source: IMF
The BoE may be fully monetizing this deficit for now but A fiscal lesson from Canada
whichever Party wins the General Election next year faces
the substantial task of stabilising public finances. Various Public sector delevering is not the only balance sheet issue
forecasts such as the IMF’s have UK public debt rising to facing the UK but it the one that will capture much of the
100%, a level at which ratings agencies may struggle to market’s attention in the run up to the General Election
justify a continued AAA rating. The state of public finances (which has to be held by 3 June 2010). A number of
is likely to adversely influence GBP, either because the new countries have undertaken sizable fiscal consolidation in the
government addresses the imbalances, with the attendant past but one that is often mentioned when discussing the
pressure this will place on both growth and monetary likely impact on GBP is that of Canada in the mid 1990s.
policy, or because it neglects the problem and precipitates Canada substantially expanded the size of its public sector
some form of financing crisis (debt downgrade, foreign through the 1980s and early 1990s, with public expenditure
central bank selling etc.). The UK may not be alone in as a share of GDP rising from 42% in 1989 to a peak of
having sacrificed its public finances in the interests of 53% in 1993. The deficit peaked at 9% of GDP in 1992
sustaining economic growth. Nonetheless, as the above while public debt exploded from 46% in 1980 to 102% in
figures demonstrate, the scale of the damage, and the 1995. At this stage Canada was facing real issues of debt
resultant need for remedial action, is greater in the UK than servicing and crowding out, with debt-servicing costs
most other countries. Deleveraging by the public sector is absorbing neatly 40% of tax revenues at the peak. Debt
unavoidable in coming years, a reality that is likely to have servicing may be far less of an issue for the UK currently
a major bearing on the all-important fiscal/monetary policy (debt servicing absorbs only 5% of tax revenues);
mix in the UK vis-à-vis other economies where the financial nonetheless in many other regards the deterioration in the
collapse and recession has left less of a mark on the public UK’s public finances mirrors that of Canada. For instance,
balance sheet. the UK public expenditure/GDP ratio is currently at 52%
The scale of the task facing the new government can compared to 37% in 2000, while the deficit is 13% of GDP
perhaps best be appreciated by recognizing that the bulk of and debt on course to rise to nearly 100% of GDP by 2014
the UK’s deficit is actually structural in nature and will not compared to a trough of 40% in 2001.
be cured automatically by a resumption of economic growth What then did Canada do to stabilize its finances and what
(the IMF puts the structural primary deficit at 8% of GDP effect did this have on the exchange rate? The deficit
compared to a G20 average of 3%). Given this, there is a peaked in 1992 but the real turning point was the 1995
pressing need for discretionary fiscal tightening in coming budget, two years after which the government had managed
years of a scale exceeded only in Japan. Based on IMF to balance its books. That Canada eliminated a double-digit
analysis, the UK will need to improve its primary budget deficit in a matter of just a few years provides some
balance by 13% of GDP per annum by 2020 to ensure reassurance not to panic over the UK position; nonetheless
stabilization in debt/GDP at 60% by 2030. By comparison, it also demonstrates the importance of political will to take
the required tightening is 9% of GDP in the US, 6% in painful measures and the risk should the UK election fail to
France and 3% in Germany. deliver a government with a strong majority and mandate to
act. To note, the vast bulk of the improvement in Canada’s
deficit came from a hefty reduction in government spending
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Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 8769-1906

rather than an increase in taxes, with Canadian government History rhymes rather than repeats. Nonetheless, the
spending as a percent of GDP slumping by just over 10 Canadian experience provides a useful template for thinking
percentage points in a decade. about the end-game for GBP from current fiscal excesses in
the UK. Throw in the additional headwinds from delevering
The impact of this on Canada’s financial markets can best
in the banking and household sectors and the likelihood of
be explained with reference to chart 14, which plots the
GBP recapturing its high yield status in the coming few
relative fiscal and monetary position in Canada versus other
years are even lower. GBP enjoyed relatively high growth
major economies (Canada’s fiscal deficit versus the OECD
and high yield as balance sheets were expanded during the
average; the Bank of Canada’s policy rate vs. the G7
good years; the converse is likely to be true as balance
average). As is clear, the improvement in Canada’s fiscal
sheets are pared back. GBP’s undervaluation and current
position went hand in hand with deterioration in CAD’s
stabilization in the economy should prevent a fresh GBP
interest rate advantage. In short, the marked relative
crisis; this though is a very different proposition from
tightening in Canadian fiscal policy forced an offsetting
assuming GBP can resume the mantle of investment
marked relative loosening in Canadian monetary policy.
currency and participate in continued asset price reflation.
Throughout the decade CAD was essentially transformed
from a country with high deficits and high yields to low
deficits and low yield; in other words, CAD was
transformed from an investment currency to a funding
currency courtesy of fiscal consolidation. Not surprisingly
this policy shift resulted in CAD depreciating for the best
part of the decade, albeit with a temporary reprieve in
1995/1996 (chart 15).
Chart 14: Canadian fiscal consolidation in the mid-1990s triggered a
marked switch from internationally loose fiscal/tight monetary policy
to tight fiscal/loose money
6 Canadian fiscal deficit v s OECD av erage deficit, % GDP
BoC policy rate v s G7 av g policy rate
4
-2
-4
1985 1988 1991 1994 1997 2000
Source:J.P.Morgam
Chart 15:Fiscal consolidation and a shift in the fiscal/monetary

policy mix resulted in a multi-year depreciation for CAD
CAD REER, lhs
140 6
Canada v s OECD public sector deficit, % GDP
130 4
120
2
110
0
100
90 -2
80 -4
1982 1985 1988 1991 1994 1997 2000
Source:J.P.Morgan
51
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 8769-1906

Research Note The changing structural nature of CHF
CHF: Franc to rally as SNB For most of this year we have been broadly neutral towards
CHF, or at least EUR/CHF. We downplayed fears early in
steps off the brakes the year that Switzerland’s vast banking system would drag
down the economy and in turn the currency. We then played
the range in EUR/CHF as the SNB decided to take matters
• A post-crisis world changes the rules of engagement into its own hands and help recycle Switzerland’s current
for CHF. Devoid of a growth or interest rate account surplus via FX intervention. While this policy has
impediment, CHF is transforming to a pro-cyclical proved remarkably successful – EUR/CHF vol has
currency with a trade surplus (as is JPY) rather collapsed from 11% at the start of the year to less than 5% –
than an anti-cyclical funding currency. it should not detract from the transformation in the
relationship between CHF and risk markets that has
• CHF has been remarkably stable in recent months occurred this year. As a funding currency going into the
as the irresistible force for CHF appreciation (a deleveraging crisis, CHF was perfectly positioned for
record basic balance surplus and non-existent sizeable outperformance as equities crashed. But the
interest rate differentials to recycle this surplus) met converse has not held – despite a near 60% retracement of
an immovable object (the SNB). the S&P’s peak-to-trough decline and the SNB’s helping
hand, CHF’s NEER has retraced only one-quarter of its own
• We see continued balance of payments pressure for
crisis-led appreciation.
CHF appreciation next year. Switzerland’s will soon
have a double digit current account surplus again. The changing relationship between CHF and risk markets
Recycling of this will remain problematic given that can be seen in chart 1, which plots the correlation between
other industrialized countries will offer no growth daily changes in CHF NEER and the S&P500. The rolling
or interest premium over Switzerland. If anything, one-year correlation is still highly negative but the 6-month
long-term capital flows have turned in favor of CHF correlation has risen to almost zero, indicating the extent to
following five years of growth outperformance in which CHF has ceased to behave as an anti-cyclical
Switzerland vs. other developed countries. currency in recent months. It would be a stretch to yet
describe CHF as an investment currency but it appears to be
• Without wider interest rate differentials, expect shedding its funding currency, or anti-cyclical, tag.
CHF to become more positively correlated to risk
markets in the same way as the yen. Global recovery Chart 1: Changing relationship between CHF and risk
boosts Switzerland’s external surplus without Correlation between daily changes in CHF NEER and S&P500
30%
delivering yield differentials capable of generating 1Y 6m
20%
offsetting capital outflows
10%
• The key for CHF lies with the SNB. Having lost 0%
control of interest rate differentials, the SNB had to
-10%
resort to direct intervention to control CHF. Whilst
successful, an indefinite extension of this policy -20%
cannot be justified. Switzerland has a relatively -30%
small output gap, little obvious deflation and a -40%
record trade surplus. -50%
• Currency pegging in the late 1970s was ultimately Aug-00 Aug-03 Aug-06 Aug-09
inflationary, a bitter experience which will make the Source: J.P.Morgan
SNB wary of overstaying its welcome in the FX
market this time around. Its monetarist leanings
mean that the recent sharp acceleration in broad
money growth will not be ignored.
The changing structure of growth and interest rate
• We have revised down our forecasts for EUR/CHF differentials in a post-crisis world
and USD/CHF to a floor of 1.46 and 0.91.
There is nothing structural about a currency’s sensitivity to
• Trade: Position for eventual withdrawal of the risk markets. Whether it behaves as a funding currency with
intervention ceiling via a 6-mo 0.89 USD/CHF one- a negative risk correlation or an investment currency with a
touch. positive risk correlation comes down to carry. This
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Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 8769-1906

comprises not only short-term interest rate differentials, Chart 3: Switzerland has grown faster than the developed country
which influence hot-money flows, but also the long-run average for the past five years
Swiss-developed world GDP growth, % oya. Forecast for 2010.
expected rates of return on capital, which influence equity
3%
and FDI flows and are in some sense related to the long-run
growth prospects of the economy. 2%
The SNB was easily able to position CHF as a funding 1%

currency in the lead-up to the global meltdown in 2008; all
0%
it had to do was to set short-term interest rates at a sufficient
discount to global rates. But once the crisis hit and global -1%
central banks raced to implement ZIRP, the SNB lost its
-2%
ability to control interest rate differentials (nominal rates
being floored at zero). Spreads collapsed and CHF -3%
appreciated (chart 2), forcing the SNB to switch to an -4%
alternative form of exchange rate control – namely direct
FX market intervention. 1981 1985 1989 1993 1997 2001 2005 2009
Source: J.P.Morgan
Chart 2: Negative carry is no longer an impediment to CHF
125 0
Chart 4: Switzerland’s long-term investment flows have improved
CHF NEER, lhs Net investment flows, % GDP
CHF-G7 2Y sw ap spread 5%
120 -0.5
-1
115 0%
-1.5
110 -5%
-2
105
-2.5
-10%
100 -3 Net equity flow Net FDI
Aug-99 Aug-01 Aug-03 Aug-05 Aug-07 Aug-09 -15%

Source: J.P.Morgan 1990 1993 1996 1999 2002 2005 2008
This much is conventional wisdom. But it is also quite Source: SNB; J.P.Morgan
striking how, in recent years, the Swiss economy has This matters because sustained growth outperformance
outperformed its developed world peers. The widespread from Switzerland, or at least the elimination of the previous
perception is of Switzerland as a low growth country, an decades of underperformance, should be expected to
ideal and in some senses necessary condition for CHF to depress outflows of long-term capital from Switzerland on a
function as a funding currency. This categorization may more sustained basis. Allied to the collapse of short-term
have been valid through the 1990s and the early part of this interest rate differentials, such a shift in long-term flows
decade, when the country persistently underperformed the would make it harder for Switzerland to neutralize the
rest of the developed world, but Swiss GDP growth has positive effect on its currency from the outsize current
exceeded the developed world average in each of the past account surplus that Switzerland still runs. Interestingly, the
five years (chart 3). This, moreover, is not merely a capital flow data provide some evidence in support of just
function of export growth encouraged by an undervalued such a hypothesis. In particular, Switzerland boasted a
currency – domestic consumption growth in Switzerland record net inflow of equity capital last year, and is on
has picked up substantially relative to other countries, to the course to do so again this year. Inflows last year can be put
extent that last year and this Swiss consumption has down to repatriation amid depressionary fears; continued
exceeded the OECD average. inflows this year are harder to dismiss out of hand.
Similarly, the net FDI outflow has dwindled to a bare trickle
this year (chart 4).
So the changing sensitivity of CHF to risk markets may not
merely reflect the obvious collapse in short-term interest
rate differentials. It may also reflect the improvement in
Switzerland’s relative growth performance. Skeptics may
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Paul Meggyesi (44-20) 8769-1906

argue that this improvement is only due to deterioration in and during the crisis has actually been rather good. Indeed,
growth prospects in the rest of the world. This is not when measured by the peak-current decline in GDP (chart
entirrely true, but even if it were, it would not negate the 6), Switzerland suffered a less severe recession than any
bullish implications for CHF of a more sustained post-crisis other major economy bar Australia. A 2% drop in GDP
narrowing in growth potential and interest rate differentials scarcely constitutes an economic emergency, certainly not
between Switzerland and other developed countries. when set against the 5-6% declines endured by European
neighbors such as the UK and Sweden.
In summary, Switzerland is a country with a large and rising
current account surplus which is finding it harder to That Switzerland has a much smaller output gap than most
neutralize the resultant upward pressure on the currency other countries should place the SNB towards the front of
because there is no longer any meaningful carry to the queue to normalize unconventional monetary policies,
encourage short-term outflows nor any growth in its case by abandoning FX intervention, rather than
underperformance to encourage longer-term outflows. The towards the back. A comparison of Switzerland’s inflation
combined demand for CHF arising from the current account performance with other developed countries offers no
surplus and long-term investment flows (equity and FDI) is reason to alter this judgment. As chart 7 shows, core CPI
running at a record rate this year, some 12.5% of GDP has fallen far less in Switzerland than in other developed
(chart 5). Set against this, short-term interest rate countries (chart 7), in addition to which core CPI is 0.2%
differentials are at a record low. Something has to give. above its long-term average in Switzerland whereas in other
develop countries it is 0.9% below. A fear of
Chart 5: Demand for CHF from Switzerland’s basic surplus is
running at a record level this year disproportionate deflation hardly justifies an extended
20% Sw iss current account, % GDP period of exchange rate targeting.
Current a/c+equity +FDI, % GDP Chart 6: Switzerland in line for early policy normalization?
15% Peak-current decline in GDP, %
2%
10% 0%
5% -2%
-4%
0%
-6%
-5%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 -8%
Source: SNB; J.P. Morgan
ro
US
UK
NZ
Sw alia
n
da
en
d
ay
pa
lan
Eu
na
ed
rw
tr
Ja
Is SNB paranoia towards CHF justified?
er
s
Ca
Sw
No
Au
itz
What gave over the past year was the SNB’s nerve. When Source: J.P. Morgan
faced with a fundamentally justified appreciation in CHF, Chart 7: Switzerland has seen less core CPI disinflation than other
the SNB adopted its own version of quantitative easing developed countries
which involved it becoming the first G-10 central bank Core CPI, % oya
since the Bank of Japan in the middle of the decade to 3%
intervene in its currency. The move was criticized in some Sw itzerland Dev eloped countries
quarters at the time but it seems that the SNB was able to
appease its critics by refraining from chasing CHF lower. 2%
As detailed above, we disagree with the notion that CHF
appreciation was or indeed is speculative or unjustified. The 1%
question now for the SNB is whether further FX
intervention is either justified or desirable?
0%
Given that the SNB is the only major central bank to have
resorted to FX intervention, it is not unreasonable to ask
whether economic conditions in Switzerland are any worse -1%
than in other countries sufficient to justify the SNB’s Jan-95 Jan-98 Jan-01 Jan-04 Jan-07
singular emphasis on the exchange rate. As shown in chart Source: J.P. Morgan
3, Switzerland’s relative growth performance both before
54
Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 8769-1906

Chart 8: The link between CHF and Swiss export performance has from a cyclical CHF appreciation that accompanies
broken down since 2005 economic recovery than it did from the anti-cyclical
160 Dev eloped country ex ports/Sw iss ex ports, 1998=100 125 appreciation in the face of a deep recession, or at least what
CHF REER
was expected to be a deep recession. To this extent the
140 115 context in which CHF is appreciating is likely to matter for
the SNB. It should not be assumed that there is a fixed line
in the sand (around 1.50 EUR/CHF) irrespective of broader
120 105
economic conditions. The SNB will wish to manage the exit
from unconventional policy gracefully, which argues
100 95 against any form of rapid retreat from the market, but we
would expect its forays in the market to become less
80 85 frequent and less aggressive, opening the way for gradual
downside in EURCHF and more pronounced downside in
Jan-88 Jan-93 Jan-98 Jan-03 Jan-08
USD/CHF.
Source: J.P. Morgan
A cautionary tale from the 1970s
What, finally, of the export sector – is the desire to insulate
this not at the heart of the SNB’s FX policy? The Swiss There is one other piece of context to the SNB’s
export sector has certainly underperformed the developed intervention policy which is worth considering and this is
country average in recent years but it would be wrong to the central bank’s experience with exchange rate pegging in
wholly attribute this to the exchange rate. Chart 8 plots the the tail end of the 1970s. In the mid 1970s the SNB
relative developed country/Swiss export performance struggled to define monetary policy in the chaos that
against the franc’s real effective exchange rate. The relative followed the collapse of Bretton Woods. It embraced
performance was very much correlated with the exchange monetarism but found that its hair-shirt policies during this
rate up until 2005 but after that point CHF depreciated yet period of rampant global inflation generated substantial
Swiss exporters continued to lose market share. It would capital inflows and a huge appreciation in the currency. In
hardly seem to be an appropriate goal of monetary policy to the four years to September 1978, the real exchange rate
correct for a structural loss in export competitiveness leapt by 50%. This proved too much for Swiss businesses,
unrelated to the exchange rate. Moreover, it should not be politicians and eventually the SNB, which in September
overlooked that the Swiss trade surplus is currently at a 1978 abandoned money supply targeting in favor of a
record high (chart 9), a fact which sits uneasily with the formal target for DEM/CHF. This was not so much a peg
Chart 9: Record Swiss trade surplus but rather a ceiling for CHF – formally, the SNB committed
Swiss merchandise trade balance, 12m sum, CHF bn to keeping DEM/CHF well over 0.80 (which equates to 1.56
20
in EUR/CHF terms). The policy proved very successful–
the Swiss monetary base exploded and DEM/CHF rallied
15 sharply, from just below 0.80 in September to 0.90 by
10
December of that year. But the success in weakening the
currency eventually backfired as the rapid growth in money
5 supply required to control the exchange rate eventually
0
fuelled a sharp rise in inflation (chart 10), following which
the SNB abandoned its exchange rate experiment in favor of
-5 a return to more orthodox money supply targeting in the
-10 early 1980s.
-15 Few would argue that Switzerland is faced with a repeat

performance. Nonetheless, there has been a conspicuous
acceleration in broad money growth this year, from 2% last
Source: SNB
December to 8% currently, which the SNB is starting to
claim that CHF is either unreasonably strong or severely take note of. As the SNB wrote in its last quarterly
impeding the absolute performance of the export sector. monetary policy assessment, ‘The amount of liquidity is
significant, not just in banking and financial industry, but
In summary, Switzerland has a relatively small output gap, also in the household and corporate sectors. This is
relatively little disinflation and a record trade surplus. The reflected in the increasingly rapid growth of the monetary
argument for continued FX intervention in light of this is aggregates since the beginning of the year. The M3
weak, and likely to become weaker still as next year aggregate, which was still increasing at a moderate rate at
progresses. Moreover, the SNB should have less to fear
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Global FX Strategy
November 24, 2009
Paul Meggyesi (44-20) 8769-1906

our last assessment in June, has begun to advance more

rapidly. The SNB is keeping a close watch on the monetary
aggregates’.
As the economic emergency recedes, and as the central
bank recognizes that this was less serous than feared, it is
reasonable to expect the SNB to reorientate policy away
from the exchange rate towards more traditional, domestic
considerations. The circumstances behind such a
reorientation may be less dramatic than they were in the
early 1980s; nonetheless, such a policy shift should prove
bullish for CHF against a backdrop of strong external
surpluses and a reduced capacity of the private sector to
recycle such surpluses.
Chart 10: The SNB is watching the rise in money supply with caution
14% M3, lagged 2 y ears, lhs 7%
12% Core CPI, % oy a 6%
10% 5%
8% 4%
6% 3%
4% 2%
2% 1%
0% 0%
-2% -1%
-4% -2%
Jun-78 Jun-83 Jun-88 Jun-93 Jun-98 Jun-03 Jun-08
Source: SNB; J.P. Morgan
56
Global FX Strategy
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Kamal Sharma (44-20) 7777-1729

kamal.x.sharma@jpmorgan.com
Research Note external surpluses over the past decade, driving the view
that the krona is failing to deliver the kind of performance
SEK: The myth of krona that one would expect from a currency with such strong
structural underpinnings.
undervaluation Chart 1: Riksbank projections for real SEK TWI
Rising TWI implies SEK depreciation and vice versa.
• Sweden has run strong structural surpluses since 160
1994 with the current account running at 8% of 155
GDP. The established view has been that the krona 150
has been persistently undervalued over that period 145
and will significantly appreciate over the medium- 140
term. 135
130
• The JP Morgan fair value model suggests that the 125
real TWI krona is currently undervalued by 9%. 120
According to the model, the krona has not been as 115
persistently or as significantly undervalued as many
2000 2002 2004 2006 2008 2010 2012
have suggested. This has been due to the trend
deterioration in Sweden’s terms of trade. Source: Riksbank Monetary Policy Report, October 2009
International macro comparisons are favourable

• Based on previous episodes of krona under-
valuation, the bulk of the recovery will occur in The backdrop to the argument that the krona has been
2010 and that by Q4 2010, the krona will be fairly persistently undervalued rests on cyclical and structural
valued. This is supported by the recent factors. Swedish growth has been impressive, matching the
improvement in the terms of trade. pace of global growth since the start of this decade. Indeed
Sweden growth has outpaced Euro area growth for much of
• Longer term projections suggest that Sweden’s this period. Global growth between 2000 and 2008 averaged
terms of trade position will deteriorate again over 2.9% whilst developed world growth averaged 2.1%.
the coming years, thus limiting the upside that many Swedish growth over the same time horizon averaged 2.7%,
expect. which compares favourably to the Euro area (average 2%).
Indeed, in 2006, Swedish growth was the strongest in G-10,
• Trade and forecasts: EUR/SEK to 9.6 by end-2010. rising 4.5% year on year.
Buy a 12-mo EUR/SEK ratio call spread in 1x1.5
notional for 0.88%. Chart 2: Swedish growth has kept pace with the rest of the world
Growth in real GDP, %oya
5.0 Global
Exploding the myth Dev eloped
4.0 Sw eden
For many years, the issue of Swedish krona valuation has
occupied the minds of both the Riksbank and the markets. 3.0 EMU
At the heart of this debate has been the observation that
traditional exchange rate valuation models have concluded 2.0
that the krona is persistently and significantly undervalued.
Indeed the market has been infatuated with the view that a 1.0
fair value for EUR/SEK is estimated to be between 8.50 and
0.0
8.80 without clear recognition that EUR/SEK has rarely
traded much below 9.00 for a sustained period of time. -1.0
Nonetheless, such facts have not prevented many 2000 2001 2002 2003 2004 2005 2006 2007 2008
forecasters from projecting that the krona will appreciate on Source: J.P. Morgan
a trend basis over the medium-term. Indeed, the forecasts
laid out in the Riksbank’s Monetary Policy Report have for From a structural perspective, Sweden has recorded a
many years stated that the krona should be stronger over the succession of fiscal surpluses since the start of the decade,
longer-term. The argument centres around the fact that averaging 1.7% of GDP since 2000 and is behind only
Sweden has been amongst the most structurally sound Norway within Europe as having the most structurally
economies in G10, benefiting from strong fiscal and sound fiscal position. This strength in the fiscal outlook is in
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Kamal Sharma (44-20) 7777-1729

stark contrast to the preceding decade where the average actual real TWI krona exchange rate has broadly followed
fiscal deficit between 1990 and 1999 was 3.5% of GDP. the levels predicted by our model.
Chart 3: Sweden has enjoyed sound fiscal balances Chart 4: SEK REER versus JP Morgan fair value estimate.
Average fiscal balance as %GDP, 2000-2008 130 130
15.0 Actual
FV
10.0 120 120
5.0
110 110
0.0
100 100
-5.0
-10.0
90 90
NOK NZD SEK AUD CAD CHF EUR GBP USD JPY
1980 1985 1990 1995 2000 2005 2010
Source: J.P. Morgan
Source: J.P. Morgan
The krona and the JP Morgan fair value model According to current calculations, we estimate that the
krona TWI is around 9% undervalued, with the degree of
Since 1982, the krona has never been more than 10% undervaluation slightly higher than that observed in 2001.
undervalued or overvalued and immediately challenges the This implies 9.34 for EUR/SEK and 6.28 for USD/SEK
long held view that the currency has persistently deviated
Chart 5: FV Model residuals for krona REER
from its fair value. Chart 4 shows the long-term Deviation of actual krona REER from FV model estimate, %.
development of the krona real effective exchange rate 15%
(REER) versus the JP Morgan Fair Value (FV) Model
estimate. The FV model is based on two elements. The first 10%
is a long-run econometric relationship between the real
5%
exchange rate and economic drivers: the terms of trade,
government debt, current account balance, net international 0%
investment income and inflation. The second is a
decomposition of the data into permanent and transitory -5%
components. Some of the moves in the fundamental drivers -10%
are transitory which reduces their weight in the FV model.
-15%
The treatment of the current account balance is worthy of
1982 1985 1988 1991 1994 1997 2000 2003 2006 2009
mention. The model inverts the sign on the current account
to reflect the mirror opposite which is the capital account Source: J.P. Morgan
balance. So in the case of Sweden, the current account
surplus turns into a capital account deficit as the former Our Fair Value Model does not support more extreme
implies domestic investor interest for overseas assets. Many valuation measures which suggest that the krona could be as
observers have argued that current account deficits do not much as 30% undervalued at present. Since 1982, there
result from over-spending by the deficit country but rather have been five occasions where the krona REER has
should be seen as capital account surpluses reflecting deviated by around 10% from fair value: three periods
international investor demand for the deficit country’s where the krona has been undervalued and two periods
assets. Viewed from this perspective, the autonomous where the krona has been overvalued. Looking at the
capital inflows (capital account surplus) appreciate the periods of approximately 10% undervaluation of the krona
currency, resulting in current account deficits. (Dec 1982 and June 2001), it took between 18-21 months
for the krona to recover back to fair value from the
The real TWI was broadly overvalued between 1985 and maximum degree of undervaluation. The peak in recent
towards the end of the 1990’s, a period which coincided krona undervaluation occurred in Q1 2009. Since then there
with deficits on both the current account and on the fiscal has been some recovery. If previous corrective episodes are
balance in addition to Swedish inflation being persistently any guide then the krona is set to recover through much of
higher than the average for the OECD. Since 2000, the 2010 with the bulk of the undervaluation likely to have been
eliminated by Q4 2010.
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Global FX Strategy
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Kamal Sharma (44-20) 7777-1729

it is amongst the worlds most open economies and given its

size relative to the global economy, it has little influence in
In an attempt to understand the key drivers behind such
affecting the price of its imports or its exports. Chart 7
deviations, we have looked at the fair value model residuals
shows developments in the terms of trade for the non-
in relation to the main cyclical drivers for Sweden: equity
commodity exporting G10 economies. The obvious
prices and interest rate differentials.
omission is Japan due to distortions to the chart given the
Chart 6: FV Model residuals versus the S&P significant deterioration to its terms of trade over the past
Chart show the residuals from the JP Morgan Fair Value Model plotted against the 20-years. With the exception of Japan, the chart clearly
y/y changes in the S&P.
highlights that Sweden has suffered the most significant
15% FV Model Residuals, % (lhs) 50% deterioration in its terms of trade position since 1990.
SPX %y /y (rhs) 40%
10%
Chart 7: Swedish terms of trade have deteriorated by more than
30% other commodity importing G10 economies.
20% Terms of Trade rebased to January 1990 = 100.
5%
10% 130 US UK
Sw iss Sw eden
0% 0% Germany
120
-10%
-5%
-20% 110
-30%
-10%
-40%
100
-15% -50%
90
1994 1996 1998 2000 2002 2004 2006 2008
80
Source: J.P. Morgan
1990 1993 1996 1999 2002 2005 2008
Our analysis shows that deviations in the krona REER from
fair value have been driven by cyclical factors. As chart 6 Source: J.P. Morgan
highlights, the fair model residuals have shown a close Such developments in Sweden’s terms of trade look at odds
correlation to the year on year change in the S&P500. with the rising current account surplus. We can attribute
Regressing the fair value model residual on the year on year these dynamics to two major developments in Sweden in
change in the S&P and Sweden rate differentials versus a recent years. Firstly, the Swedish household savings rate
weighted average of G10 yields strong results, with an R- has risen significantly since 2005, from just under 7% to
squared of over 70%. According to our calculations a 5% nearly 16%. According to OECD projections for 2009, the
year on year appreciation in the S&P would be sufficient for Swedish household savings rate will be the highest in the
the residual to normalise to zero. In level terms, the S&P OECD area at 15.6%. Part of the explanation for this rise
need not move from current levels for the residual to has been due to the increase in pension contributions in
normalise given the strong recovery in the S&P since Q4 recent years. Demographics have certainly played a
2008. significant part in this dynamic. Between 1990 and 2008 the
Trend depreciation of the krona population of the age 45-64 category rose by 25%, the
largest per cent rise for any age category. At the same time,
Notwithstanding the cyclical divergences between the the retirement population (65+) rose by less than 8%.
actual level of the krona and our fair value model, a Consequently, Sweden’s household balance sheet shows a
noticeable feature of chart 4 has been the depreciating trend near 80% increase in social insurance reserves since 2000.
of the krona in real effective terms since 1980. Indeed, the Secondly, the breakdown of the Swedish national accounts
speed of that depreciation both in the actual REER and the data reveals that export volumes have consistently outpaced
fair value model coincided with the point at which the import volumes since 2000, thus driving the improvement
Swedish current account balance was posting healthy and in the current account over the past decade.
rising surpluses. With inflation levels also in line with those
in the OECD, what can explain this trend depreciation of A brief respite following the surge in global
the krona? telecommunications prices in the late 1990s provided some
support to the Swedish terms of trade position (due largely
As highlighted above, a key element of the JP Morgan fair to the status of Sweden as the world leader in the
value model is the development in a country’s terms of telecommunications market), but this boost has proved
trade position. For Sweden, this is particularly important as fleeting as the technology boom burst. In broader terms,
59
Global FX Strategy
November 24, 2009
Kamal Sharma (44-20) 7777-1729

strong productivity gains in Sweden have also been a Under the assumption that the year on year growth in the
significant driver for the deterioration in the terms of trade terms of trade remains steady, the analysis suggests that the
as export price growth has slowed. Although there has been krona REER will peak in Q4 2010 before reversing course.
some recent improvement in the terms of trade position this Should the terms of trade remain deteriorate more quickly
has also proved temporary and the rebound in energy prices then the REER will peak earlier, in Q3. The key take away
has seen a resumption of the downtrend. from the above analysis is that the krona is set to appreciate
in 2010 as favourable terms of trade developments in recent
Chart 8: krona REER versus Sweden terms of trade.
quarters combine with some cyclical undervaluation.
20 SEK REER, %y /y (lhs) 7 However, the future terms of trade trends will determine at
6
15
Terms of Trade, % y /y adv 12mths (rhs) 5 what point the REER will peak in 2010. Thereafter,
10 4 forecasts for a renewed deterioration in the terms of trade as
3
5 2 forecasted by the NIER will weigh on the REER.
0 1
0 A cyclical upturn but trend depreciation likely
-5 -1
-10 -2 Our analysis of the long-term performance of the krona
-3
-15 -4 exchange rate has challenged the prevailing market view
-20 -5 that the krona has been persistently undervalued despite the
-6
-25 -7 many structural positives for the currency. The current
undervaluation of the krona has been driven by cyclical
1993 1995 1997 1999 2001 2003 2005 2007 2009
factors such as equity market moves. The long-term
Source: J.P. Morgan deterioration in the terms of trade has been the major driver
for the trend depreciation of the krona and though our
In the absence of another technology led boost to the terms analysis suggests that the recent improvement in Sweden’s
of trade, the Swedish National Institute of Economic terms of trade should provide a lift to the krona over the
Research (NIER) forecasts that the terms of trade will coming year, the longer depreciating trend is likely to
improve over the coming year, but will then deteriorate continue as the terms of trade begins to deteriorate again.
again thereafter. Chart 8 shows the relationship between the
krona REER and the terms of trade, in year on year terms. We project a higher krona over the course of 2010 as the
The chart would suggest the krona will recover over the economic recovery in Sweden gathers momentum and the
year ahead, in line with our own forecasts for SEK. Using currency benefits from the recent improvement in the terms
the 12-month rolling beta of a regression of the year on year of trade position. However, we do not believe that this will
change in the krona REER on the year on year change in the be the start of a multi-year era of krona appreciation for the
terms of trade (advanced by 24-months), we can project the reasons stated above. Though our directional bias is for a
path of appreciation of the krona REER through to Q3 lower EUR/SEK, we disagree with the view that a
2009. Chart 9 shows this path of the krona REER under two fundamentally fair level for EUR/SEK is between 8.50 and
different assumptions on the path of the terms of trade. The 8.80. Our 2010 view on the krona is bullish, with a year-end
first assumes that the year on year growth in the terms of target for EUR/SEK of 9.60. Given modest krona upside,
trade remains steady around current levels. The second the preferred trade is a 12-mo EUR/SEK ratio call
assumes that the terms of trade deteriorate at a sharper pace. spread in 1x1.5 notional for 0.88%. See Five global
macro themes and top trades on page 11.
Chart 9: Path of the krona REER under various assumptions on the
y/y change in the terms of trade
105
Steady Rev ersal
100
95
90
85
80
2008 2009 2010 2011
Source: J.P. Morgan
60
Global FX Strategy
November 24, 2009
Kamal Sharma (44-20) 7777-1729

61
Global FX Strategy
November 24, 2009
Gabriel de Kock (1-212) 834-4254

We use a two-pronged approach to answer these questions:

Commodity currencies: First, we assess how much valuations are stretched both
Where’s the gold? relative to cyclical commodity price drivers and the long-
term structural fundamentals captured by J.P. Morgan’s
G10 fair-value model. Second, we analyze forces that could
• The commodity currencies were the strongest G10 drive over- or under-performance relative to commodity-
performers during the 2009 scramble for risk, price and long-term macroeconomic fundamentals. Among
regaining much of the ground lost in the crisis- these forces, we include the global growth cycle and
driven deleveraging of 2008 and early 2009. attitudes toward risk as reflected by equity markets, regional
growth and trade patterns, the monetary-fiscal policy mix,
• Commodity FX as a group should do well while the and post-crisis headwinds from deleveraging.
USD overshoots to the downside, even though the
global recovery largely is discounted. However, Our analysis suggests that the commodity currencies will
performance gaps should widen over 2010. rally, but not outperform uniformly, in an environment
where the USD overshoots to the downside but the recovery
• We use a long-term macroeconomic fundamentals is discounted and commodity prices are roughly flat. NOK
model and cyclical commodity price-driven models, should be the best-performing G10 currency in 2010, and
along with an analysis of forces that could drive AUD should outperform CAD and NZD. NOK is
over- or underperformance vs. these valuation undervalued relative to long-term structural fundamentals
metrics, to pick commodity FX winners and losers. and fairly valued against oil. It also will get a boost from
• The NOK should be the strongest G-10 currency in Norges Bank rate hikes after a shallow recession.
2010. It is fairly valued relative to oil and under- The valuation picture for AUD, NZD and CAD is mixed:
priced compared to long-term macroeconomic they appear overvalued relative to cyclical commodity price
fundamentals given Norway’s sound fiscal policy drivers, and AUD and NZD against long-term macro drivers
and outsized international assets. Rate hikes after a as well. However AUD benefits disproportionately from
shallow recession also will lift NOK. falling risk aversion and should get a further boost from
• AUD is rich to commodity prices and long-term Australia’s close trade links with rapidly-growing EM
drivers, but should outperform on falling risk Asian economies and from RBA policy tightening. CAD
aversion, rate hikes and robust exports. will be held back by its relatively slow-growing trade
partners and, like NZD, by a relatively dovish central bank.
• CAD and NZD should lag both on valuations and Also, Canada’s close trade ties with the US should cap
dovish central banks. CAD performance when the USD overshoots to the
downside.
The commodity currencies have performed spectacularly in
Structural foundations: Sand or rock?
the headlong rush into risk assets since March, outpacing
other G10 currencies by a wide margin. AUD and NZD Valuations relative to long-term macroeconomic
surged more than 33% and 25%, respectively, on a trade- fundamentals do not appear to be a serious constraint on
weighted basis. CAD and NOK gained about 17%, but had commodity-currency performance within the G10 near
fallen less during last year’s deleveraging frenzy – about term. Table 1 compares the real trade-weighted exchange
25% compared to AUD and NZD’s 38% falls. Indeed, of rates for the AUD CAD, NZD and NOK to fair value
the four G-10 commodity curren cies only NZD still stands estimates that reflect long-term structural fundamentals: the
more than 10% below its 2008 peak. And as a group, the terms of trade, government debt ratios, current account
G10 commodity currencies have been more tightly related balances, international investment income, and inflation.9
in 2008-09 than in earlier global recessions, reflecting both Despite the commodity currency rally since March and the
the impact of the global financial crisis and the unusual steep terms of trade-driven decline in fair values from their
synchronicity of the economic cycles around the world. 2008 highs, AUD and NZD appear only somewhat
overvalued (6.4% and 3.2%) on a real trade-weighted basis,
Against this backdrop, investors face two key questions: while CAD and especially NOK remain undervalued.
First, will commodity currency outperformance persist in an
environment where the global economic recovery largely is
discounted, but the USD overshoots to the downside?
Second, can we identify global and local economic trends
9
that will drive divergence within the G10 commodity For a detailed discussion of the J.P. Morgan fair-value model, see A new
currency group and pick winners and losers? fair-value model for G10 currencies, Gabriel de Kock, September 6, 2008
and updated quarterly in World Financial Markets.
62
Global FX Strategy
November 24, 2009

The degree of AUD and NZD overvaluation is small relative size of the commodity sector.10 Canada’s and
relative to historical misalignments. In fact, as Table 1 Norway’s international trade exceeds 60% of GDP, New
shows, last winter the G10 commodity currencies were Zealand’s over 45% and Australia’s more than 30%.
undervalued by margins ranging from 12% to 22%. Current
The importance of commodity export composition is
AUD and NZD overvaluation also is close to the EUR’s and
illustrated in Charts 1 and 2. AUD, NZD and NOK already
smaller than that of the JPY, suggesting that they would
stand above their early-2007 levels in real trade-weighted
fully reflect the roughly 7% downside USD overshoot that
terms, in line with their inflation-adjusted commodity
we expect over the coming six months.
export prices, while CAD remains below its early-2007
The NOK and CAD are undervalued by about 8.5% and level largely because the prices of Canadian wood and base
than 4% respectively. The bullish assessment if NOK’s metals exports have not recovered to their early-2007 levels.
longer term prospects, which largely reflects Norway’s
The currency impact of commodity price swings also
strong fiscal fundamentals, suggests that NOK could
reflects government policies. The oil price more than
outperform the dollar bloc over the medium term. In
doubled, inflation-adjusted, from March 2007 to July 2008,
contrast, CAD undervaluation is less constructive than
but the NOK appreciated only about 10% in real trade-
might appear in an environment where the USD
weighted terms despite the fact that oil makes up roughly
undershoots to the downside. The US role as Canada’s
70% of Norway’s merchandise exports. The response
dominant trade partner implies that a USD drop against the
CAD is a much bigger competitiveness shock and more Chart 1: Inflation-adjusted commodity price indices in the 2008-09
damaging for economic growth and profits than a similar global cycle (recession trough -24 months =100)
move against AUD, NZD or NOK. 225 CRB 225
Table 1: Commodity currencies actual and fair-value real trade- 200 CAD 200
weighted exchange rates (1Q09 =100), 2Q08-4Q09 AUD
175 175
AUD CAD NZD NOK
OIL
Actual 134.4 121.1 125.8 117.6 150 150
2Q 08 NZD
Fair Value 128.5 127.0 132.2 144.7 125 125
Actual 100.0 100.0 100.0 100.0
1Q 09 100 100
Fair Value 117.2 112.0 118.1 122.5
75 75
Actual 125.9 112.5 125.5 112.7
4Q 09*
Fair Value 118.4 117.3 121.6 123.3 50 50
* denotes preliminary estimates. Source: J.P. Morgan -24 -20 -16 -12 -8 -4 0 4 8 12
Months from recession trough
Not all commodity currencies are created equal
Source: J.P. Morgan
The commodity currencies, as a group, are the most
procyclical of the G10 currencies. Outperformance during Chart 2: Real trade-weighted exchange rates (recession trough-24
months =100), current cycle
business cycle upswings and underperformance during
downturns largely reflect cyclical swings in commodity 120 120
prices, which in return reflect the commodity-intensive 115 115
manufacturing sector’s predominant role in cyclical 110 110
fluctuations of global economic activity. 105 105
100 100
However, not all commodity currencies are created equal: 95 CAD 95
while conforming to a common cyclical pattern, their 90 90
AUD
performance over the global business cycle often diverges 85 85
significantly. The divergence reflects both the make-up of NZD
80 80
their commodity export baskets and the size of their 75
NOK
75
commodity export sectors relative to the overall economy.
-24 -20 -16 -12 -8 -4 0 4 8 12
Global commodity price increases drive up profits in the
Months from recession trough
commodity sector attracting foreign capital and stimulating
demand. The magnitude of capital inflows and hence Source: J.P. Morgan
pressures on the currency will be greater the larger the
10
For a discussion of export composition and the economic and FX impact
of commodity price swings for the dollar bloc, see Drilling for commodity
currency value in the dollar bloc, Gabriel de Kock, June 4, 2008.
63
Global FX Strategy
November 24, 2009

is muted because the Norwegian government (after a severe commodity FX gains over a six-month horizon in an
bout of Dutch disease in the wake of the discovery of North environment where the USD overshoots to the downside.
Sea oil in the 1970s) purposefully keeps much of its oil Most likely such a USD overshoot will be accompanied by
revenues abroad to mitigate the FX impact of oil price rising USD prices for commodities, partly ratifying
swings. commodity currency valuations. By the same token,
however, with the possible exception of NOK, the
Australian commodity export prices rose more than 50%
commodity currencies most likely will not escape a 2H10
from March 2007 to mid-2008, largely driven by the prices
USD rally.
of its coal and iron exports to Asia, and strong demand from
China has kept them at or above their March 2007 level It may appear surprising that our cyclical model indicates
since. Finally, the prices of New Zealand’s agricultural that NOK is a touch rich to the oil price while our long-term
exports, while cyclical, are a lot less variable than the macro-fundamental fair-value model suggests that it is one
export prices of the other G10 commodity exporters. of the most undervalued G10 currencies. This contrast
captures the currency tensions associated with Norway’s
Table 2 captures the impact of business-cycle frequency
foreign investment of oil revenues. Keeping oil revenues
changes in dollar commodity prices on commodity currency
offshore dampens NOK’s response to oil price swings, but
valuations against the USD, where we measure Canadian,
builds up a large stock of government-owned foreign assets
Australian and New Zealand commodity prices by the BoC,
that yields substantial investment income. Over time, the
RBA and ANZ commodity prices indices. A 10%
government will spend part of these earnings or return some
commodity price increase appreciates AUD and CAD by
of it to taxpayers. The net effect will be a lower national
about 5% and NZD by 12½%. Norwegian foreign
savings rate and the currency appreciation needed to widen
investment of oil revenues caps the currency impact of a
the non-oil trade deficit.
10% oil price increase on NOK at 3.3%.
The cycle beyond commodity prices I: Risk and
Table 2 also shows the cyclical fair values for AUD/USD,
growth expectations
USD/CAD, NZD/USD, and USD/NOK implied by October
commodity price levels. The four crosses are overvalued Commodity prices, while capturing the trend in commodity
relative to their cyclical commodity-price fundamentals. FX, fall well short of the fully explaining price action over
But the NOK overvaluation is slight at 1.4%. NZD is about the business cycle. The disconnect implies that global
4.5% rich relative to the prices of New Zealand’s export economic activity affects the attractiveness of commodity
commodities. CAD and AUD appear more significantly producers’ local asset markets in ways that are not captured
overpriced with 7% and 8½% deviations from their fully or in a timely manner by commodity price moves.
commodity-based equilibrium values. One channel appears to be shifts in investor risk aversion
and capital flows from core G10 countries. When global
Given the JP Morgan commodities team’s broadly flat
equity prices rally on rising growth expectations, the
outlook for commodities, the price gains needed to sustain
currencies of core G10 countries (EUR, USD, JPY and the
current CAD and AUD valuations (16% for Australian
CHF) depreciate as local investors diversify into peripheral
commodity prices and 13% for Canada) appear large. By
markets that offer more attractive risk-reward trade-offs.
contrast the 4% oil price increase discounted by NOK
appears well within reach. Table 3: Short-run elasticity of exchange rates vs USD with respect
to equity prices and interest-rate spreads
Nevertheless, as is the case for our long-term G10 fair value AUD CAD NZD NOK
model, we do not see currency misalignment relative to FV deviation -0.08 -0.04 -0.02 -0.03
commodity prices as an insurmountable hurdle to (3.81) (1.70) (0.98) (2.34)
Table 2: Commodity-based fair values vs USD and long-run elasticity MSCI World 0.30 -0.12
with respect to commodity price indexes (6.12) (3.24)
AUD CAD NZD NOK
Local-MSCI gap 0.21
Commodity Index 0.54 -0.54 1.25 (4.02)
(8.75) (10.98) (6.07)
Interest Spread 0.67
Oil Price 0.33 (2.15)
(3.81) R2 0.92 0.98 0.99 0.99
Commodity-based FV 0.84 1.15 0.69 5.72
Note: Estimates based on an error-correction equation. FV denotes the equilibrium error form
Note: The coefficient estimates are derived from a cointegrating equation linking real bilateral the cointegrating equations show in Table e. Variables are measured in inflation-adjusted
exchange rates to inflation-adjusted USD commodity prices. Source: J.P. Morgan terms and as monthly percent changes. Interest rates are 3-month treasury bill rates. Source:
J.P. Morgan
64
Global FX Strategy
November 24, 2009

Table 3 quantifies the commodity-currency impact of The cycle beyond commodity prices II: Living in
capital flows spurred by cyclical shifts in attitudes towards the right neighborhood
risk as well as the impact of shifts in short-term real interest
In contrast to commodity export price trends, which were
rate differentials. The measured impact on AUD is striking:
broadly similar for the G10 commodity producers, export
A 10% rally in global equities, according to our estimates,
performance diverged dramatically in the global downturn
would lift AUD/USD by 3% over and above commodity
price-driven gains. AUD’s gains would be even bigger if Chart 4: USD/CAD and commodity price-based estimate
Australian equities outperform global indices. incorporating equity prices and momentum, 1994-Oct 09
1.6
Since the end of December, the MSCI global index has
1.5
rallied about 19% in local currency terms and the All
Ordinaries has outperformed global equities by about 8%. 1.4
Together these equity prices moves are worth 7% on AUD’s 1.3
short-term fair value, enough to put on par with NOK. Of
1.2
course, the lift from increased risk appetite fades over time
but the small estimated coefficient on the FV deviation 1.1
indicates that it fades very slowly. 1.0
USD/CAD
Model Estimate
Our estimates suggest that CAD benefits much less from 0.9
more robust risk-taking. This year’s rally in global equities
94 96 98 00 02 04 06 08
would justify CAD trading 2% rich to commodities.
Source: J.P. Morgan
Surprisingly, kiwi and NOK appear not to benefit at all
from shifts in global risk aversion, at least to the extent that Chart 5: NZD/USD and commodity price-based estimate
such shifts are uncorrelated with broad equity indices and incorporating equity prices and momentum, 1990-Oct 09
0.9
commodity prices.
0.8 NZD/USD Model Estimate
On balance, as is the case for our long-term G10 fair value 0.8
model, we do not see currency overvaluation relative to 0.7
commodities as an insurmountable hurdle to commodity FX
0.7
gains in an environment where the USD overshoots to the
0.6
downside. Most likely such a USD overshoot will be
0.6
accompanied by rising USD commodities prices, partly
ratifying commodity currency valuations. By the same 0.5
token, however, CAD and NZD most likely will lag. 0.5
0.4
Finally, current commodity FX valuations do appear
90 92 94 96 98 00 02 04 06 08
broadly consistent with commodity price fundamentals if
Note: Estimate based on error-correction model. Source: J.P. Morgan
we expand our valuation model to allow for the impact of
equity prices, interest rate spreads, and market momentum, Chart 6: USD/NOK and commodity price-based estimate
as illustrated in Charts 3, 4, 5 and 6. incorporating equity prices and momentum, 1994-Oct 09
10
Chart 3: AUD/USD and commodity price-based estimate 9.5
USD/NOK
incorporating equity prices and momentum, 1990-Oct 09 9 Model Estimate
1.0
AUD/USD 8.5
1.0
8
0.9 Model Estimate
7.5
0.9
7
0.8
6.5
0.8
6
0.7
5.5
0.7
5
0.6
0.6 89 91 93 95 97 99 01 03 05 07 09
0.5 Note: Estimate based on error-correction model. Source: J.P. Morgan
90 92 94 96 98 00 02 04 06 08
Note: Estimate based on error-correction model. Source: J.P. Morgan
65
Global FX Strategy
November 24, 2009

and the early stages of recovery. Indeed, export Chart 8 underlines that export growth gaps, while less
performance held the key to differences in overall economic dramatic, will persist in 2010 as EM Asia leads the global
performance since early 2007 and most likely will remain a recovery. Indeed, in contrast to the US and Europe, EM
major driver of growth divergence as recovery unfolds, Asian economic data continue surprising to the upside,
lifting the Australian economy and the AUD. suggesting that risks to Australia and New Zealand’s
exports are skewed to the high side. Strong export
Australian export volumes declined only modestly in the
performance will lift overall economic activity, easing
throes of the world recession, as rapidly growing Chinese
excess capacity and feeding though to monetary policy.
demand offset the fall-off in purchases from Japan,
But, perhaps more important, export performance also will
cushioning Australia’s downturn. Exports slipped 3% from
drive profits and equity market performance, attracting
2Q08 to 4Q08, and by mid-2009 already stood 7% above
capital to Australia and, to a lesser extent, New Zealand.
their level a year before the onset of the global recession
(see Chart 7). As a result, Australia has embarked on the Watch the monetary-fiscal policy mix
recovery path with limited excess capacity, consistent with
The sentiment shift from deep pessimism to discounting a
our call for significant RBA rate hikes.
solid, if sub-par, global economic recovery, naturally has
Canadian export volumes, in contrast, were a major drag on turned FX market attention to central banks and the
economic activity, plunging more than 20% as US auto prospect that divergent rate paths will be a key driver of
demand and residential construction imploded. Norway currency trends in 2010. Indeed, while the interest rate
also suffered, reflecting its close trade ties with Germany spread vs the US is a statistically significant currency driver
and the UK, while domestic forces dominated New only for NZD in Table 4, few would deny that a surprise
Zealand’s recession. rate hike or a jump in rate expectations will lift the
currency, if only temporarily. If so, monetary policy should
Chart 7: Export volumes in the 2008-09 global cycle (cumulative %
change from eight quarters before the recession trough) be a significant source of support for AUD and NOK in
10 10 2010.
5 5 Australia and Norway experienced the shallowest
0 0 recessions in the G10. As a result, their margins of excess
-5 -5
capacity at the start of the recovery were much smaller than
AUD
elsewhere in the G10 (2Q09 GDP gaps below 2% and 1%
-10 -10
of GDP, respectively). Unsurprisingly, the RBA and the
NZD
-15 -15 Norges Bank were first out of the starting gate in the race to
CAD normalize policy. And the markets price further rate hikes,
-20 -20
NOK if more than our economists forecast, which should support
-25 -25
AUD and NOK against other G10 currencies that suffered
-8 -7 -6 -5 -4 -3 -2 -1 0 1 2
deeper downturns (USD, EUR and SEK, see Chart 9).
Quarters from recession
Source: J.P. Morgan Markets also price significant BoC and RBNZ tightening
even though the BoC has committed to hold rates steady
Chart 8: Export-weighted economic growth in commodity exporter
through June and the RBNZ through year-end. We suspect
trading partners (Q4/Q4 %), 2007-2010F
6 markets will be disappointed, given that Canada and New
2007 2008 2009 2010 Zealand had greater-than-5% GDP gaps in 2Q 09 and still
5
have below-target inflation. When all is said and done,
4 translating excess capacity into policy actions may be more
3 art than science. But we should expect more policy
2 tightening where GDP gaps are the narrowest and are
1
disappearing rapidly (see Chart 10). On this basis, rate
hikes and rate expectations should lift NOK and AUD
0
against CAD and NZD next year.
-1
The pace of policy tightening also will depend on fiscal
-2
policy. The Norwegian government has spent aggressively
AUD NZD CAD NOK to support economic activity. But with substantial budget
F = forecast. Source: J.P. Morgan surpluses and a large (125% of GDP) net asset position,
they are under less pressure than Australia, Canada and
New Zealand to consolidate their finances, which could
66
Global FX Strategy
November 24, 2009

have put a damper on growth in 2011 and slowed the pace Will balance-sheet headwinds make a difference?
of Norges Bank rate hikes (see Chart 11).
The global financial crisis wreaked havoc with household
Chart 9: JPM forecast and market pricing for G10 policy rate hikes balance sheets and has reduced banks’ willingness to lend,
through Dec 2010 (%) even though banks in Australia, Canada, New Zealand, and
2.5 Norway suffered minimal crisis-related losses. In this
JPM Forecast environment, highly indebted consumers and companies
2.0 may opt for an extended period of balance sheet repair, with
Market Pricing
lacklustre spending, slow economic growth, and delayed
1.5 policy tightening as the result. Or, central banks may pull
their punches, fearing that rate hikes would elicit a
1.0
disproportionate response from still-fragile consumers.
0.5 It is not obvious, however, that differences in consumer and
corporate debt levels across the commodity producers are
0.0 wide enough to be relevant for FX markets. We suspect
USD EUR JPY GBP CHF CAD AUD NZD NOK SEK not. Norway’s consumers are significantly more indebted
than their counterparts in the dollar bloc, whose debt-to-
Source: J.P. Morgan income ratios range from 142% to 157%. But Norwegian
Chart 10: Estimated G10 GDP gaps (% of potential GDP), 2Q09 & corporates carry surprisingly low debt, which should be an
4Q10F offset (Charts 12 and 13).
2.0 Chart 12: Household debt (% of disposable income), 2007-08
1.0 200
0.0 180 2007 2008
-1.0 160
-2.0 140
-3.0 120
-4.0 100
-5.0 80
2Q09 4Q10 60
-6.0
40
-7.0
20
JPY USD CAD NZD SEK EUR GBP AUD NOK CHF
0
Estimates based on 2Q08 OECD figures and J.P. Morgan forecasts for actual and potential AU D C AD NZD N OK
GDP growth. Sources: OECD and J.P. Morgan
Chart 11: Central government budget balances (% of GDP) 2008- Source: J.P. Morgan
2010F Chart 13: Nonfinancial corporate debt (multiple of gross operating
5 surplus), 2007-08
16
0 2007 2008
14
12
-5
10
-10 8
6
-15 2008 2009F 2010F
4
-20 2
AUD CAD NZD NOK
0
AU D C AD N OK NZD
F = forecast. Source: J.P. Morgan
Source: J.P. Morgan
67
Global FX Strategy
November 24, 2009
Kenneth Landon (1-212) 834-2391

Chart 1. OECD CPI, 1971-2009

Risk scenario 1: Global 18%
inflation starts major uptrend 16%

14%
12%
• OECD CPI has turned negative for first time in 10%
post-Bretton Woods era 8%
• Massive deficit spending and debt monetization 6%

increases chance of inflation turning higher 4%
2%
• EUR, CHF and gold options stand out as cost- 0%
effective instruments to hedge inflation risk -2%
Jan-71 Jan-77 Jan-83 Jan-89 Jan-95 Jan-01 Jan-07
Massive deficit spending with concurrent aggressive debt
monetization in many countries around the world has Source: J.P. Morgan, OECD
caused concerns among investors that inflation could move
Chart 2: DXY dollar index in 12-months before & after bottom of
much higher over the coming three to five years. Recent OECD CPI cycle (rebased to 100 at bottom of cycle)
manifestations of those concerns have been a rebound in
125 Jan-73 Apr-79
commodities prices and moderately rising inflation
breakeven rates. Apr-86 Mar-94
Mitigating inflationary expectations is the widespread belief Oct-06 Av erage

that a trend increase in the general price level is unlikely
during a period of low rates of resource utilization. 100
However, the level of resource utilization does not occur in
a vacuum. If demand for cash liquidity declines along with
a reduction of risk aversion accompanying a pick-up in
global growth, then central banks will be challenged to
withdraw the appropriate amount of money from the 75
system. Central banks’ withdrawal of liquidity in an amount -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
insufficient to balance a possible decline in demand for x -ax is: months from bottom of inflation cy cle
money could result in higher rates of inflation. Even if
Source: J.P. Morgan
inflation does not immediately show up in indices such as
CPI, hard assets would perform well if that were to occur. Chart 3: Gold in 12-months before & after bottom of OECD CPI cycle
(rebased to 100 at bottom of cycle)
In any case, the purpose of this section is not to debate the Jan-73 Apr-79
theoretical arguments for either higher or lower inflation. 250
Apr-86 Mar-94
Rather, the focus is on a risk scenario in which inflation
starts to move higher and exceeds current expectations. As 200 Oct-06 Av erage
Chart 1 shows, global inflation, as proxied by OECD CPI,
has fallen to the lowest levels in the post-Bretton Woods 150
era. In fact, since June 2009, OECD nations have witnessed,
on average, mild deflation as measured by CPI. With gold 100
and commodities prices once again trending higher, the
move into mild deflation is not likely to be a long-lasting 50
phenomenon. If so, then an inflection higher in the major
-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
inflation cycle could occur over the course of 2010.
x -ax is: months from bottom of inflation cy cle
As shown in Chart 2, the dollar DXY index tends to decline Source: J.P. Morgan
in the 12 months before and after major bottoms in OECD
CPI. The mirror image of the dollar’s decline in FX markets As for currency pairs that most consistently perform at
is also evident in Chart 3, which shows the price of gold cycle turns in inflation, EUR/USD and USD/CHF stand out
over the same time periods. Gold performs well in the year from the crowd, which is shown in Charts 4 and 5.
before and after major inflection points in global inflation. GBP/USD also performs well, but not as consistently as the
former two currency pairs. USD/JPY on average moves
68
Global FX Strategy
November 24, 2009

JPMorgan Chase
JPMorgan Chase Bank
Bank NA
NA
lower after inflections in the inflation cycle, but the Chart 5: USD/CHF in 12-months before & after bottom of OECD CPI
performance also is not as consistent as with EUR and CHF. Cycle (rebased to 100 at bottom of cycle)
150
As expected, the commodities-linked AUD/USD performs
well during major cycle turns in global inflation, but Jan-73 Apr-79
slightly less consistently than either EUR/USD or Apr-86 Mar-94
USD/CHF (see chart 6) 125 Oct-06 Av erage
Investing on the assumption of higher future rates of

inflation requires timing well in advance of the final
100
evidence of such. The question boils down to one’s
framework for anticipating inflation before the fact.
Although we are cognizant of the empirical data indicating
more subdued rates of measured inflation during times of 75
low rates of resource utilization, commodities-based FX can -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
still be an attractive investment during those times. x -ax is: months from bottom of inflation cy cle
Historically, there is little correlation between the level of
resource utilization and future changes in commodities. The Source: J.P. Morgan
key is marginal changes in utilization, which implies that it Chart 6: AUD/USD in 12-months before & after bottom of OECD CPI
is growth that drives commodities and not the absolute level cycle (rebased to 100 at bottom of cycle)
of capacity usage. Given the current low level of resource 130
Jan-73 Apr-79
utilization and on-going global economic recovery, the
120 Apr-86 Mar-94
likely trend in capacity utilization is higher over the coming
Oct-06 Av erage
12 months, which in turn implies higher commodity-FX
levels. 110
A short position in the USD makes sense if one wishes to 100

hedge against a possible inflection higher in global
inflation. We prefer to express this view through a basket of 90
long EUR, CHF, and Gold, the historic performance of
which is illustrated in Chart 7. In the following section, we 80
discuss cost-effective ways of implementing this strategy. -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
Chart 4: EUR/USD in 12-months before & after bottom of OECD CPI x -ax is: months from bottom of inflation cy cle
cycle (rebased to 100 at bottom of cycle) Source: J.P. Morgan
Jan-73 Apr-79
Apr-86 Mar-94 Chart 7: Basket of EUR, CHF & Gold vs. USD in 12-months before &
130 Oct-06 Av erage after bottom of OECD CPI cycle (rebased to 100 at bottom of cycle)
175
Jan-73 Apr-79
Apr-86 Mar-94
150
100 Oct-06 Av erage
125
70
100
-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
75
Source: J.P. Morgan -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12

Source: J.P. Morgan
69
Global FX Strategy
November 24, 2009

Cost-effective hedges: EUR, CHF & Gold Chart 8: Gold, EUR and CHF calls are the most efficient option-based
inflation hedges for next year
Aside from the responsiveness of potential hedges to an Return on investment from various inflation hedges, calculated as the P/L from
upturn in the inflation cycle, the cost of entering into them buying and holding to maturity a 1Y ATMF option (call or put depending on whether
is a key strategic consideration for portfolio managers. Tail the underlying rallies or sells-off in response to inflation), divided by its current
premium. At-expiry P/L calculations assume that we are at the bottom of inflation
risk hedges are generally executed through low-delta option cycle at present, and that each underlying will evolve over the course of the year
structures that provide lottery ticket style payoffs in the exactly along the average trajectories in Charts 2 through 7. No transaction costs.
event of the unlikely turning imminent. In such a setting, 500%
the cost of hedging is the option premium paid upfront; a
simple gauge of hedge efficiency is the P/L that it stands to 400%
generate in a shock scenario. 300%
Chart 8 ranks the inflation hedges discussed earlier along
200%
such bang-for-buck lines. The starting point of the analysis
is to price up 1Y ATMF options for all assets considered in 100%
the chart, in the correct direction (i.e. call or put) as dictated
by the signs of their betas with respect to inflation. Though 0%
unlikely to be the actual hedge instrument deployed, ATMF -100%
option premia are an acceptable proxy for comparing the
nominal cost of option-based hedging across underlyings. Gold [Gold EUR CHF DXY AUD NZD JPY GBP CAD
EUR,CHF]
Under the drastic assumption that we currently stand at or
close to the bottom of the inflation cycle, and that all assets Source: J.P. Morgan
will exactly track the average post-inflation trough
trajectories over the course of the next year as described in
charts 2 through 7, it is then simple enough to compute at-
expiry P/Ls from these options. The cost-effectiveness
tradeoff is captured by a return on investment (RoI) metric,
measured as the ratio of option P/L in an inflation shock to
its upfront premium, and is the variable along which chart 8
ranks our hedge universe.
The message from the chart is unambiguous – gold calls,
followed by those in EUR and CHF, are an inflation
hedger’s best friends, being among a handful of
underlyings where the expected at-maturity RoIs are in
excess of 1. They also have the advantage of not being
traditional risk assets, meaning that hedge gains are likely to
be well preserved even in the unlikely scenario of an
inflation scare morphing into a funding crisis (see Risk
Scenario 2 below), where the resulting volatility might
place more pro-cyclical assets like commodity FX at risk.
70
Global FX Strategy
November 24, 2009

If investors perceptions about inflation shift radically over

Risk scenario 2: Funding the coming year, then there could be simultaneous concerns
crisis in the US about the sustainability of fiscal policies in both the United
States and other countries that are running large budget
deficits. Commodity currencies generally do well during
• Higher inflation is generally good for commodity periods of rising inflation. However, should a funding crisis
currencies, but not if it leads to a growth-sapping accompany the higher inflation, then currencies that are tied
funding crisis to global growth could be harmed. Currencies such as AUD
would come under selling pressure if investors revert to risk
• The U.S. government is funding over 50% of its aversion. In that case, a long position in less cyclically
spending with debt, which is a post-War high exposed currencies such as EUR and CHF would make
sense.
Predicting a funding crisis is subject to considerable error
for the obvious reason that trajectories of deficit spending Profiling a funding crisis
are subject to a number of countervailing forces. For As noted, there is considerable difficulty in predicting a
example, the pace of economic growth affects both the level funding crisis. Additionally, there are few, if any, episodes
of spending and tax collections. Furthermore, policymakers of such a crisis in a G3 country upon which to base a
are not passive observers of the budget. They have the definitive trading strategy. However, the US has
power to make changes that could significantly change the experienced several months of crisis-like conditions in FX,
level of deficit spending. For the purposes of this section, it bonds and equities since the 1970s that provides a template
makes sense to focus on shifts in the market’s perceptions of possible outcomes. FX Markets Weekly (September 16,
that could lead to the pricing of significant funding stress. 2009) provided a useful guide to financial markets when
Federal spending relative to GDP has reached 28% in 2009, crisis-like conditions hit. Since 1971, there were 21 months
which is a post-war high. Investors around the world are in which the trade-weighted dollar, US Treasuries and the
watching with particular interest whether or not the S&P 500 declined simultaneously. By currency crisis
government of the United States will implement healthcare standards, those episodes were mild – average monthly
and energy reforms that could push the deficit significantly moves of -3% for the trade-weighted dollar, +30bp for the
higher. Although legislation has yet to be signed into law, US 10-yr and -2% for the S&P500. However, it is revealing
there is a high enough probability of passage for investors that almost all of the crisis-like months occurred during
to be concerned about the sustainability of the U.S. budget. periods of rising inflation such as 1972-74, 1976-80, 1986-
As it stands today and as shown in Chart 1, the U.S. federal 90 and 1994. Similarly, an inflation surprise in 2010 would
government is financing over 50% of its overall spending be the most likely trigger for similar conditions, as that
with debt. The longer this continues, the greater will be the shock would coincide with an obvious source of leverage –
risk of a financing crisis. Additionally, any significant shift government debt.
higher in the rate of inflation would bring with it concerns The historical record suggests a handful of possible hedges.
that the interest burden of existing and new debt will further Charts 2 and 3 rank G-10 currencies and benchmark
boost the deficit. commodities by two criteria: their profitability, or average
Chart 1: U.S. fiscal deficit as percentage of total federal spending returns in months when the trade-weighted dollar,
60% Treasuries and stocks sold-off simultaneously; and their
50% consistency, or the percentage of crisis-like months in
which these assets delivered positive returns. The most
40% consistent hedges are EUR, CHF and gold, which rallied in
30% at least 75% of those months. The most profitable hedges
20% have been the same three: Gold, EUR and CHF, which
returned between 3.5% and 5% in those crisis-like months.
10%
Unsurprisingly, commodity currencies are poor hedges
0% since the rise in volatility could undermine cyclical assets
-10% and the carry trade. The strategy to hedge against a funding
crisis in the U.S. coincides with the strategy to hedge
1962 1966 1970 1974 1977 1981 1985 1989 1993 1997 2001 2005 2009
against inflation.
est
Source: J.P. Morgan
71
Global FX Strategy
November 24, 2009

Chart 2: Most-profitable hedges: Currency and commodity returns in

months when trade-weighted USD, bonds and equities decline, 1971-
2009
%, based on 21 occurrences since 1971
Gold
EUR
CHF
JPY
Oil
GBP
NZD
AUD
CAD
Copper
-4% -2% 0% 2% 4% 6%
Source: J.P. Morgan
Chart 3: Most-consistent hedges: percentage of months in which

each currency pair or commodity delivered positive returns as trade-
weighted USD, bonds and equities declined
Consistency defined as percentage of events in which currency has appreciated vs
USD or commodities have risen.
EUR
CHF
Gold
JPY
NZD
GBP
Oil
AUD
CAD 50% win/loss mark
Copper
0% 20% 40% 60% 80% 100%
Source: J.P. Morgan
72
Global FX Strategy
November 24, 2009

House veered sharply toward the middle of the political

Risk scenario 3: Divided US spectrum from its previous stance. Policies of the executive
government after November’s branch moderated and the markets responded in a very
positive way. The four-year cumulative change in the S&P
mid-term elections 500 was 41% before divided government was instituted in
1994 and an outsized 156% in the four years after. The
• Political risk will increase with the approach of the political environment was not the only factor driving
U.S. mid-term elections in November 2010. investment returns, but investors were comforted by the fact
that divided government lessened the chances of radical
• A possible shift to divided government would have shifts in important policies such as taxes and regulations.
important implications for financial markets.
An examination of the entire post-war period indicates that
• Global investors may welcome a divided the above pattern is not consistent. As shown in chart 1, the
government, thus helping the USD. average annual increase in the S&P 500 was 30% in the
four years prior to the switchover to divided government
The House of Representatives recently passed a healthcare and 24% in the following four years. Leaving out the
reform bill that polls indicate is opposed by approximately experience of 1994, the average annual increase was 32% in
50% of the U.S. population. Over the course of the past six the four years prior and just 8% in the four years post the
months, surveys suggest that most Americans support shift to divided government. Obviously, the equity market is
reform of some sort, but not the kind currently making its not necessarily comforted by divided government, but there
way through Congress. Although 79% of registered are times when it can be a strongly positive factor (e.g.,
Democrats support such reform, the plan is opposed by 78% 1994).
of Republicans and, most ominously for Congress, by 61% Chart 1 also indicates that the USD tends to be weaker and
of unaffiliated voters (source: rasmussenreports.com). gold stronger during one-party rule as compared to the
The purpose of this section about risk scenarios is not to following years of divided government. When examining
debate the merits or demerits of the current healthcare the USD and gold, we have to be cognizant of the fact that
reform plan that is making its way through Congress. The there are few observable points. Since floating FX rates
purpose is to shed some light on possible market reactions were established in the early-1970s, there have been only
should Congress push through healthcare legislation that is three instances of the overthrow of one-party rule (i.e.,
opposed by the overwhelming majority of “swing voters” 1980, 1994, and 2006). During those three instances, gold
(unaffiliated, independents). One possible result of the was stronger and the USD was weaker during one-party
passage of an unpopular healthcare Bill would be a shift in rule.
political power at the mid-term elections in November Chart 1: Average yearly change in S&P 500, Gold & USD in the years
2010. The entire House of Representatives and one-third of prior and post a switch to divided government (1946 – present)
the Senate is up for re-election.
35% S&P 500 Gold USD
Currently, one party – the Democrats – controls both houses 30%
of Congress and the White House. In the post-war period, 25%
there were six occasions in which an election resulted in the 20%
overthrow of one party rule and in favor of divided 15%
government. In 1946, 1952, 1968, 1980, and 1994, the one- 10%
party rule of Democrats was overturn when Republicans 5%
took control of either the White House or of at least one 0%
house of Congress. In 2006, the one-party rule of -5%
Republicans was overcome when Democrats took control of -10%
both the House and the Senate.
4y r 3y r 2y r 1y r 1y r 2y r 3y r 4y r
Would return to divided government be bullish, bearish or prior prior prior prior post post post post
neutral for markets? Many people recall a similar situation
as today. In November 1994, the one-party rule of Source: J.P. Morgan
Democrats was demolished when Republicans took control Another important aspect of one-party versus divided
of both houses of Congress. Potential healthcare reform as government is the impact on the budget. As shown in Chart
put forth by Democrats played a part in that upset victory. 2, one pattern that has consistently repeated is that the
When Republicans took control of Congress, the White growth of Federal spending slows after the start of divided
73
Global FX Strategy
November 24, 2009

government. Divided government results in restraint that

otherwise would be lacking when one party controls
Washington. In this respect, the dollar could conceivably
benefit from a shift in political power in November if it
allays global investors’ concerns about runaway deficits in
the US.
Chart 2: 4-year percentage change in Federal spending before &
after switch to divided government (1946 – present)
120%
100% Before After
80%
60%
40% est.
20%
0%
-20%
-40%
1946 1952 1968 1980 1994 2006
Source: J.P. Morgan
74
Global FX Strategy
November 24, 2009

75
Global FX Strategy
November 24, 2009
Matthew Franklin-Lyons (212) 834-4565

matthew.d.franklin-lyons@jpmorgan.com
Event risk calendar for 2010

Month Date Country Event Notes
November 2009 30 Norway Norges Bank foreign exchange purchases
December 2009 1 New Zealand Fronterra dairy auction
10 New Zealand RBNZ Monetary Policy Statement
22 Angola 155th (extraordinary) meeting of the OPEC Conference in Luanda
31 Norway Norges Bank foreign exchange purchases
January 2010 29 Norway Norges Bank foreign exchange purchases
February 2010 5 Australia RBA's Quarterly Statement of Monetary Policy
10 United Kingdom Bank of England Inflation Report
March 2010 11 New Zealand RBNZ Monetary Policy Statement
17 Austria 156th (ordinary) meeting of the OPEC Conference in Vienna
April 2010 24-25 United States Spring Meeting of the International Monetary Fund and the World Bank Group
27 Japan Bank of Japan publishes outlook report
May 2010 United Kingdom Parliamentary elections (must be called by May)
7 Australia RBA's Quarterly Statement of Monetary Policy
June 2010 25-27 Canada G8 and G20 summit to be held in Muskoka
July 2010 Japan Upper-house legislative elections
August 2010 6 Australia RBA's Quarterly Statement of Monetary Policy
September 2010 16 New Zealand RBNZ Monetary Policy Statement
19 Sweden General election
October 2010 3 Brazil Legislative election
9-11 United States 2010 Annual Meeting of the International Monetary Fund and the World Bank Group
November 2010 Korea G20 summit to be held in Seoul
2 United States Midterm elections
13-14 Japan APEC summit in Yokohama
December 2010 9 New Zealand RBNZ Monetary Policy Statement
76
Global FX Strategy
November 24, 2009
Matthew Franklin-Lyons (212) 834-4565

matthew.d.franklin-lyons@jpmorgan.com
Central bank announcement dates in 2010

2009 2010
DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC
United States 16 27 16 28 23 10 21 3 14
ECB 3 14 4 4 8 6 10 8 5 2 7 4 2
Japan 18 26 18 17 27 21 15
United Kingdom 10 7 4 4 8 6 10 8 5 9 7 4 9
Switzerland 10 11 17 16 16
Canada 8 19 2 20 1 20 8 19 7
Australia 1 2 2 6 4 1 6 3 7 5 2 7
New Zealand 10 28 11 29 10 29 16 28 9
Norway 16 3 24 5 23 11 22 27 15
Sweden 16 11 20 2
77
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

Kamal Sharma (44-20) 7777-1729
J.P. Morgan FX Forecasts vs. Forwards & Consensus

Exchange rates vs. U.S dollar
Current JPM forecast gain/loss vs Dec-10* Actual change in local FX vs USD
Majors Nov 24 Mar 10 Jun 10 Sep 10 Dec 10 forward rate Consensus** Past 1mo YTD Past 12mos
EUR 1.49 1.55 ↑ 1.62 ↑ 1.55 ↑ 1.50 ↑ 0.7% 4.0% -0.5% 6.8% 14.3%
JPY 88.7 85 ↑ 82 ↑ 85 ↑ 89 ↑ -0.5% 9.6% 3.8% 2.2% 7.4%
GBP 1.65 1.65 ↑ 1.74 ↑ 1.68 ↑ 1.67 ↑ 0.8% 1.7% 1.4% 13.3% 6.9%
AUD 0.92 0.95 ↑ 1.02 ↑ 1.01 ↑ 1.00 ↑ 13.5% 14.3% -0.5% 30.7% 41.4%
CAD 1.06 1.02 ↑ 0.99 ↑ 1.00 ↑ 1.01 4.7% 5.2% -0.8% 14.7% 15.3%
NZD 0.73 0.73 ↑ 0.76 ↑ 0.76 ↑ 0.74 4.7% 7.2% -3.8% 25.3% 32.5%
JPM USD index 82.5 80.4 ↓ 78.6 ↓ 79.6 ↓ 80.8 ↓ -0.7% -6.0% -9.3%
DXY 75.1 72.4 ↓ 69.3 ↓ 72.0 ↓ 74.1 ↓ -0.5% -7.7% -11.7%
Europe, Middle East & Africa

CHF 1.01 0.96 ↑ 0.91 ↑ 0.95 ↑ 0.97 ↑ 3.4% 8.9% -0.3% 5.6% 16.9%
ILS 3.78 3.65 ↑ 3.60 ↑ 3.60 ↑ 3.55 ↑ 6.3% 3.5% -2.1% 0.1% 4.1%
SEK 6.92 6.45 ↑ 6.05 ↑ 6.26 ↑ 6.40 ↑ 7.7% 5.0% -2.0% 13.2% 14.0%
NOK 5.61 5.16 ↑ 4.88 ↑ 5.03 ↑ 5.00 ↑ 14.1% 10.1% -0.9% 24.0% 23.5%
CZK 17.33 16.26 ↑ 15.43 ↑ 16.00 ↑ 16.33 ↑ 6.9% 5.5% -0.4% 10.9% 11.4%
PLN 2.76 2.65 ↑ 2.47 ↑ 2.55 ↑ 2.53 ↑ 11.8% 3.9% 0.8% 7.6% 5.0%
HUF 180 168 ↑ 157 ↑ 165 ↑ 170 ↑ 10.3% 7.3% -1.0% 5.9% 10.8%
RUB 28.85 26.85 ↑ 25.41 ↑ 26.45 ↑ 26.94 ↑ 14.5% 13.7% 0.3% 1.9% -5.6%
TRY 1.50 1.45 1.40 ↑ 1.40 1.35 ↑ 19.9% 12.3% -1.8% 2.8% 4.2%
ZAR 7.51 7.40 ↑ 7.20 ↑ 7.40 ↑ 7.40 ↑ 9.3% 8.2% -0.6% 26.9% 31.0%
Americas ARS 3.80 4.00 ↑ 3.95 ↑ 4.10 ↑ 4.25 ↑ 0.4% 4.3% 0.7% -9.0% -12.1%
BRL 1.73 1.65 ↑ 1.60 ↑ 1.65 ↑ 1.75 ↑ 7.5% 0.2% -0.5% 34.1% 34.1%
CLP 493 475 ↑ 490 ↑ 500 ↑ 500 ↑ -2.1% 9.5% 8.1% 29.6% 37.6%
COP 1965 1925 ↑ 1850 ↑ 1950 ↑ 2000 ↑ 3.1% 4.4% -2.4% 14.4% 18.0%
MXN 13.09 12.80 ↓ 12.50 12.80 ↑ 13.00 5.5% 1.5% 0.8% 5.4% 2.0%
PEN 2.88 2.80 ↑ 2.75 ↑ 2.78 ↑ 2.80 ↑ 3.3% 3.4% -0.3% 9.0% 7.5%
VEF 2.14 2.15 2.15 2.15 3.00 ↓ -28.4% -13.7% 0.1% 0.1% 0.1%
Asia CNY 6.83 6.75 ↓ 6.70 ↓ 6.65 ↓ 6.58 ↓ 0.2% 0.2% 0.0% 0.0% 0.0%
HKD 7.75 7.77 ↑ 7.78 ↑ 7.80 7.80 -1.0% -0.4% 0.0% 0.0% 0.1%
IDR 9475 9000 9000 ↑ 9200 ↑ 9500 5.9% -2.3% -0.4% 17.4% 33.5%
INR 46.6 45.0 ↓ 43.5 ↓ 42.8 ↓ 42.0 ↓ 12.2% 4.8% -0.1% 4.8% 7.3%
KRW 1156 1130 1130 ↓ 1100 ↑ 1120 ↑ 4.1% -4.8% 2.2% 9.0% 30.0%
MYR 3.39 3.35 ↓ 3.30 ↓ 3.25 3.25 ↑ 4.1% 2.0% -0.1% 2.4% 6.9%
PHP 47.04 46.00 ↓ 45.50 45.50 ↓ 45.00 ↑ 6.0% 2.8% -0.1% 1.0% 5.2%
SGD 1.39 1.36 ↓ 1.35 ↓ 1.34 ↓ 1.33 4.3% 2.8% 0.6% 3.1% 8.7%
TWD 32.25 31.00 ↓ 30.50 30.50 ↓ 30.00 3.4% 3.3% 0.4% 1.7% 3.4%
THB 33.23 33.00 ↓ 32.50 ↓ 32.00 32.00 ↑ 4.7% 2.0% 0.7% 4.5% 5.6%
Exchange rates vs Euro Actual change in local FX vs EUR

JPY 132 132 ↑ 133 ↑ 132 ↑ 134 ↑ -1.2% 5.4% 4.4% -4.3% -6.0%
GBP 0.90 0.94 0.93 0.92 0.90 ↑ 0.0% -2.2% 2.0% 5.8% -6.4%
CHF 1.51 1.49 ↑ 1.48 ↑ 1.47 ↑ 1.46 ↑ 2.7% 4.7% 0.2% -1.2% 2.3%
SEK 10.33 10.00 ↓ 9.80 ↑ 9.70 9.60 7.0% 0.9% -1.4% 6.0% -0.2%
NOK 8.37 8.00 7.90 7.80 7.50 13.3% 5.9% -0.4% 16.1% 8.0%
CZK 25.9 25.20 ↑ 25.00 ↑ 24.80 ↑ 24.50 ↑ 6.1% 1.4% 0.1% 3.8% -2.5%
PLN 4.12 4.10 ↑ 4.00 ↑ 3.95 ↑ 3.80 ↑ 11.0% -0.2% 1.4% 0.7% -8.1%
HUF 268 260 ↑ 255 ↑ 255 ↑ 255 ↑ 9.5% 3.1% -0.5% -0.9% -3.0%
RON 4.27 4.20 ↑ 4.10 ↑ 4.10 ↑ 4.00 16.8% 2.7% 0.5% -5.6% -10.9%
↑ indicates revision resulting in stronger local FX , ↓ indicates revision resulting in weaker local FX
* Negative indicates JPM more bullish on USD than consensus,** Consensus Economics Publication: Foreign Exchange Consensus Forecasts November 2009
Source: J.P.Morgan
78
Global FX Strategy
November 24, 2009
Grace Koo (44-20) 7325-1362

grace.x.koo@jpmorgan.com
J.P. Morgan Forecasts: Rates, Credit, Equities & Commodities

Interest rates Current Dec-09 Mar-10 Jun-10 Sep-10 YTD Return*
United States Fed funds rate 0.125 0.125 0.125 0.125 0.125
10-year yields 3.38 3.36 3.75 4.00 4.25 -2.0%
Euro area Refi rate 1.00 1.00 1.00 1.00 1.00
10-year yields 3.28 3.28 3.30 3.40 3.45 2.3%
United Kingdom Repo rate 0.50 0.50 0.50 0.50 0.75
10-year yields 3.65 3.65 4.05 4.30 4.45 1.2%
Japan Overnight call rate 0.10 0.10 0.10 0.10 0.10
10-year yields 1.31 1.31 1.30 1.40 1.50 0.6%
Credit Markets Current Index YTD Return*

US high grade (bp over UST) 191 JPMorgan US Index (JULI) 16.9%
US high grade (bp over swaps) 173
Euro high grade all (bp over swaps) 92 JPMorgan Euro Credit Index (MAGGIE) 14.8%
USD high yield (bp vs. UST) 745 JPMorgan Global High Yield Index 53.9%
Euro high yield (bp over Euro gov) 771 JPMorgan Euro Credit Index (MAGGIE) 69.1%
EMBIG (bp vs. UST) 318 EMBI Global 28.2%
Quarterly Averages
Commodities Current 09Q4 10Q1 10Q2 10Q3 JPMCCI Index YTD Return*
WTI ($/bbl) 78.4 70.0 70.0 65.0 70.0 Energy 8.4%
Gold ($/oz) 1165 1000 1050 1000 1000 Precious Metals 28.7%
Copper ($/metric ton) 6820 5950 6250 6000 5750 Industrial Metals 66.9%
Corn ($/Bu) 4.13 3.65 4.00 4.15 4.05 Agriculture 7.8%
3m cash YTD Return*

Foreign Exchange Current Mar-10 Jun-10 Sep-10 Dec-10 index in USD
EUR/USD 1.50 1.55 1.62 1.55 1.50 EUR 9.1%
USD/JPY 88.9 85 82 85 89 JPY 2.7%
GBP/USD 1.66 1.65 1.74 1.68 1.67 GBP 17.3%
AUD/USD 0.92 0.95 1.02 1.01 1.00 AUD 36.0%
USD/CAD 1.06 1.02 0.99 1.00 1.01 CAD 17.1%
NZD/USD 0.73 0.73 0.76 0.76 0.74 NZD 27.9%
YTD Return
Sector Allocation * US YTD ($) Europe YTD ($) Japan YTD (¥) EM YTD ($) Equities Current (local ccy)
Energy OW 14.1% OW 45.2% -0.8% OW 88.6% S&P 1091 20.8%
Materials OW 45.8% N 85.4% N 10.7% UW 102.6% Topix 839 -2.4%
Industrials OW 18.8% OW 44.8% N 6.4% 56.0% FTSE 100 5337 20.4%
Discretionary OW 35.2% N 34.2% N 26.4% OW 102.8% MSCI Eurozone* 154 23.5%
Staples UW 15.6% UW 37.6% UW -12.9% UW 4.5% MSCI Europe* 1087 24.1%
Healthcare UW 16.0% UW 18.3% UW -12.2% UW 32.4% DAX 5754 19.6%
Financials OW 18.5% N 53.2% OW -16.1% OW 79.8% CAC 3792 17.8%
Information Tech. OW 53.2% N 36.5% N 5.0% OW 92.6% MSCI EM* 41999 58.2%
Telecommunications N 1.2% OW 21.2% N -12.7% UW 27.1% MSCI EM $* 965 74.3%
Utilities UW 4.0% OW 10.0% UW -22.7% UW 51.5% *Levels/returns as of Nov 19, 2009
n
Source: Bloomberg, Datastream, IBES, Standard & Poor's Services, J.P. Morgan estimates
79
Global FX Strategy
November 24, 2009
David Hensley (1-212) 834-5516

Carlton Strong (1-212) 834-5612
Global Growth and Inflation Forecasts

Real GDP Real GDP Consumer prices
% over a year ago % over previous period, saar % over a year ago
2008 2009 2010 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 3Q09 4Q09 2Q10 4Q10
The Americas
United States 0.4 -2.4 3.3 -0.7 3.5 3.5 3.0 4.0 4.0 3.5 -1.6 1.2 2.2 ↑ 1.1 ↑
Canada 0.4 -2.6 2.4 -3.4 0.5 3.0 3.0 3.0 3.5 4.0 -0.9 0.8 1.4 2.3
Latin America 3.8 -3.2 ↓ 3.8 ↓ 0.7 ↓ 5.3 ↓ 5.8 ↑ 4.7 3.1 ↓ 4.0 ↑ 1.9 ↓ 5.9 5.6 6.8 ↓ 7.2 ↑
Argentina 6.8 -4.5 2.5 1.1 -10.0 -4.0 12.0 10.0 6.0 4.0 5.9 ↓ 6.0 10.0 10.2
Brazil 5.1 0.3 5.0 7.8 7.2 6.7 4.3 5.0 4.0 4.0 4.4 ↑ 4.2 4.5 4.7
Chile 3.2 -1.5 5.0 -1.2 ↑ 4.6 ↓ 6.0 6.0 5.0 3.0 3.0 -0.6 ↓ -1.5 2.0 3.0
Colombia 2.4 -0.5 3.0 2.7 1.9 3.2 3.5 4.3 5.5 4.5 3.2 3.3 3.9 4.3
Ecuador 6.5 -1.0 1.5 -1.0 -2.0 0.0 2.0 2.5 4.0 4.0 3.5 ↑ 3.5 2.4 4.0
Mexico 1.3 -7.0 3.5 -4.4 10.1 7.5 3.7 -0.6 3.3 -0.9 5.1 4.6 5.3 5.2
Peru 9.8 1.0 5.4 -1.6 8.0 13.0 3.0 3.5 3.5 4.0 1.9 1.1 1.5 2.0
Venezuela 4.8 -2.5 ↓ 1.5 ↓ -4.1 ↓ -7.8 ↓ 5.0 ↑ 3.0 3.0 ↓ 5.0 ↑ 0.0 ↓ 28.7 29.0 ↓ 34.2 ↓ 37.9 ↑
Asia/Pacific
Japan -0.7 -5.2 ↑ 2.4 ↑ 2.7 ↑ 4.8 ↑ 2.5 2.5 1.5 1.5 2.0 -2.2 -1.8 -1.8 -1.3
Australia 2.4 1.0 2.9 2.5 1.2 3.8 2.1 2.4 4.4 6.2 1.3 ↑ 2.1 ↑ 2.5 ↑ 2.6
New Zealand 0.1 -1.3 2.8 0.3 2.5 2.1 2.6 4.3 3.4 2.8 1.7 ↑ 2.6 ↑ 2.4 ↑ 1.7
Asia ex Japan 5.8 4.2 ↑ 7.3 12.6 ↓ 9.6 ↑ 5.3 6.9 ↑ 7.0 7.3 6.9 ↓ 1.4 ↑ 2.7 ↑ 4.3 ↑ 3.4 ↑
China 9.0 8.6 9.5 14.8 10.0 9.1 9.0 9.5 9.3 8.7 -1.3 0.9 3.2 2.7
Hong Kong 2.4 -3.3 4.5 14.8 1.6 5.0 4.2 4.0 3.8 3.5 -0.9 -0.4 0.6 2.1
India 6.1 6.0 7.5 6.7 9.0 -1.0 10.0 7.0 9.6 9.0 11.8 ↑ 12.2 ↑ 11.9 ↑ 6.2 ↑
Indonesia 6.1 4.3 5.3 4.3 5.3 3.5 5.5 6.0 6.0 6.0 2.8 2.8 4.9 6.0
Korea 2.2 0.2 4.7 11.0 12.3 4.0 2.0 3.5 3.5 3.5 2.0 2.5 3.0 3.3
Malaysia 4.6 -2.4 ↑ 5.0 10.1 ↓ 9.4 ↑ 4.5 1.6 4.9 4.9 4.9 -2.4 ↑ -1.2 0.5 1.5
Philippines 3.8 1.5 5.0 10.0 4.0 4.0 5.0 5.0 5.0 5.0 0.3 ↓ 3.0 3.6 3.7
Singapore 1.1 -2.1 ↓ 6.5 21.7 ↑ 14.2 ↓ -3.6 ↓ 8.2 ↑ 7.0 ↓ 4.9 ↓ 4.9 ↓ -0.4 ↑ -0.8 1.9 1.8
Taiwan 0.1 -3.8 5.8 20.7 11.5 4.2 3.8 4.0 3.8 3.8 -1.3 -1.0 1.8 2.1
Thailand 2.6 -3.1 6.1 9.6 7.0 5.3 4.9 5.7 7.0 7.0 -2.2 ↓ 1.4 4.6 4.0
Africa/Middle East
Israel 4.0 0.0 3.0 1.0 2.2 ↑ 2.5 3.0 3.0 3.0 3.0 3.2 3.3 3.4 3.3
South Africa 3.1 -2.0 3.0 -3.0 0.5 3.4 4.4 3.8 3.6 4.1 6.4 6.2 4.3 4.8
Europe
Euro area 0.6 -3.9 2.5 -0.7 1.5 2.5 3.0 3.0 3.0 2.5 -0.4 0.3 0.9 1.2
Germany 1.0 -4.7 3.4 1.8 2.9 4.0 3.5 3.5 3.5 2.5 -0.4 0.3 0.5 0.3
France 0.3 -2.3 2.5 1.1 1.1 2.5 3.0 3.0 3.0 2.5 -0.5 0.6 1.0 0.7
Italy -1.0 -4.8 1.7 -1.9 2.4 1.0 2.0 2.0 2.0 2.5 0.1 1.0 1.4 1.0
Norway 2.5 -1.1 2.9 1.3 3.0 3.0 3.0 3.0 3.0 3.0 1.8 1.3 1.0 0.4
Sweden -0.4 -4.2 3.4 0.6 3.0 4.0 4.0 3.5 3.5 3.0 -1.1 -0.3 0.8 0.5
Switzerland 1.8 -1.3 2.2 -1.0 1.8 2.3 2.5 2.5 3.0 3.0 -1.0 ↓ -0.4 ↓ 0.6 ↓ 0.7
United Kingdom 0.6 -4.7 1.6 -2.3 -1.6 2.0 2.0 2.5 2.8 3.5 1.5 2.2 2.3 1.4
Emerging Europe 4.1 -5.3 4.0 2.1 4.7 4.9 3.4 3.2 3.3 3.6 7.0 6.2 5.2 5.3
Bulgaria 6.0 ↓ -5.8 -2.0 … … … … … … … … … … …
Czech Republic 2.7 -4.0 2.5 1.2 3.2 5.0 2.8 2.5 2.2 2.0 0.1 0.6 1.9 3.6
Hungary 0.6 -6.5 1.0 -7.9 -7.0 3.5 3.0 2.5 2.5 3.5 5.0 5.1 3.7 2.8
Poland 5.0 1.7 3.2 2.8 5.5 3.0 2.5 3.0 3.5 3.5 3.5 3.4 2.1 2.3
Romania 7.1 -6.0 2.0 … … … … … … … 5.0 4.7 5.5 6.5
Russia 5.6 -8.5 5.0 4.5 7.9 6.5 4.5 4.0 4.0 4.5 11.4 9.5 7.0 7.4
Turkey 0.9 -5.3 5.0 … … … … … … … 5.3 ↓ 5.0 6.3 5.2
Global 1.3 -2.5 ↑ 3.4 ↑ 1.3 3.6 ↑ 3.4 3.4 3.6 3.7 3.4 ↓ -0.1 1.2 ↑ 1.9 ↑ 1.6
Developed markets 0.4 -3.4 2.7 -0.3 ↑ 2.6 ↑ 2.9 2.8 3.1 3.2 3.0 -1.0 0.5 1.1 0.8
Emerging markets 4.9 0.6 5.8 7.5 7.4 ↓ 5.3 5.6 5.3 5.7 5.0 ↓ 3.5 ↑ 4.0 ↑ 5.0 ↑ 4.6 ↑
Source: J.P. Morgan
80
Global FX Strategy
November 24, 2009
David Hensley (1-212) 834-5516

Carlton Strong (1-212) 834-5612
Global Central Bank Forecasts

Change from Forecast
Official interest rate Current Aug '07 (bp) Last change Next meeting next change Dec 09 Mar 10 Jun 10 Sep 10 Dec 10
Global GDP-weighted average 1.31 -341 1.30 1.32 1.36 1.43 1.48
excluding US GDP-weighted average 1.86 -257 1.85 1.88 1.94 2.04 2.12
Developed GDP-weighted average 0.49 -365 0.50 0.51 0.52 0.54 0.57
Emerging GDP-weighted average 4.54 -246 4.47 4.56 4.71 4.94 5.13
Latin America GDP-weighted average 5.75 -306 5.75 6.13 6.66 6.94 7.03
CEEMEA GDP-weighted average 4.78 -222 4.44 4.29 4.23 4.58 4.87
EM Asia GDP-weighted average 4.00 -232 4.00 4.07 4.17 4.34 4.53
The Americas GDP-weighted average 0.75 -484 0.75 0.79 0.85 0.88 0.89
United States Federal funds rate 0.125 -512.5 16 Dec 08 (-87.5bp) 16 Dec 09 on hold 0.125 0.125 0.125 0.125 0.125
Canada Overnight funding rate 0.25 -425 21 Apr 09 (-25bp) 8 Dec 09 on hold 0.25 0.25 0.25 0.25 0.25
Brazil SELIC overnight rate 8.75 -275 22 Jul 09 (-50bp) 9 Dec 09 Jan 10 (+50bp) 8.75 9.75 10.75 10.75 10.75
Mexico Repo rate 4.50 -275 17 Jul 09 (-25bp) 27 Nov 09 Jun 10 (+25bp) 4.50 4.50 4.75 5.25 5.25
Chile Discount rate 0.50 -500 9 Jul 09 (-25bp) 10 Dec 09 2Q 10 (+50bp) 0.50 0.50 1.00 2.00 3.50
Colombia Repo rate 3.50 -575 23 Nov 09 (-50bp) on hold 3.50 3.50 3.50 3.50 3.50
Peru Reference rate 1.25 -350 6 Aug 09 (-75bp) 10 Dec 09 on hold 1.25 1.25 1.25 1.25 1.25
Europe/Africa GDP-weighted average 1.36 -323 1.32 1.31 1.30 1.39 1.46
Euro area Refi rate 1.00 -300 7 May 09 (-25bp) 3 Dec 09 on hold 1.00 1.00 1.00 1.00 1.00
United Kingdom Repo rate 0.50 -525 5 Mar 09 (-50bp) 10 Dec 09 3Q 10 (+25bp) 0.50 0.50 0.50 0.75 1.00
Sweden Repo rate 0.25 -325 2 Jul 09 (-25bp) 16 Dec 09 on hold 0.25 0.25 0.25 0.25 0.25
Norway Deposit rate 1.50 -325 28 Oct 09 (+25bp) 16 Dec 09 3 Feb 10 (+25bp) 1.50 1.75 2.00 2.25 2.25
Czech Republic 2-week repo rate 1.25 -200 6 Aug 09 (-25bp) 16 Dec 09 2Q 10 (+25bp) 1.25 1.25 1.75 2.50 3.00
Hungary 2-week deposit rate 6.50 -125 23 Nov 09 (-50bp) 21 Dec 09 21 Dec 09 (-50bp) 6.00 5.50 5.50 5.50 5.50
Israel Base rate 1.00 -300 23 Nov 09 (+25bp) 28 Dec 09 25 Jan 10 (+25bp) 1.00 1.75 2.50 3.25 4.00
Poland 7-day intervention rate 3.50 -125 24 Jun 09 (-25bp) 25 Nov 09 3Q 10 (+25bp) 3.50 3.50 3.50 4.00 4.50
Romania Base rate 8.00 100 29 Sep 09 (-50bp) 5 Jan 09 1Q 10 (-25bp) 8.00 7.75 7.50 7.25 7.00
Russia 1-week deposit rate 4.75 150 29 Oct 09 (-50bp) 24 Nov 09 24 Nov 09 (-50bp) 4.00 3.50 3.00 3.00 3.00
South Africa Repo rate 7.00 -300 13 Aug 09 (-50bp) 17 Dec 09 4Q 10 (+50bp) 7.00 7.00 7.00 7.00 7.50
Switzerland 3-month Swiss Libor 0.25 -225 12 Mar 09 (-25bp) 10 Dec 09 on hold 0.25 0.25 0.25 0.25 0.25
Turkey Overnight borrowing rate 6.50 -1100 19 Nov 09 (-25bp) 17 Dec 09 3Q 10 (+50bp) 6.50 6.50 6.50 7.50 8.00
Asia/Pacific GDP-weighted average 2.08 -147 2.09 2.14 2.21 2.31 2.42
Australia Cash rate 3.50 -300 3 Nov 09 (+25bp) 1 Dec 09 1 Dec 09 (+25bp) 3.75 4.00 4.50 4.75 5.00
New Zealand Cash rate 2.50 -575 30 Apr 09 (-50bp) 9 Dec 09 8 Jul 10 (+50bp) 2.50 2.50 2.50 3.50 4.00
Japan Overnight call rate 0.10 -40 19 Dec 08 (-20bp) 18 Dec 09 on hold 0.10 0.10 0.10 0.10 0.10
Hong Kong Discount window base 0.50 -625 17 Dec 08 (-100bp) 17 Dec 09 on hold 0.50 0.50 0.50 0.50 0.50
China 1-year working capital 5.31 -171 22 Dec 08 (-27bp) 2Q 09 3Q 10 (+27bp) 5.31 5.31 5.31 5.58 5.85
Korea Base rate 2.00 -300 12 Feb 09 (-50bp) 9 Dec 09 1Q 10 (+25bp) 2.00 2.25 2.50 2.75 3.00
Indonesia BI rate 6.50 -175 5 Aug 09 (-25bp) 3 Dec 09 on hold 6.50 6.50 6.50 6.50 6.50
India Repo rate 4.75 -300 21 Apr 09 (-25bp) 1Q 10 1Q 10 (+25bp) 4.75 5.00 5.25 5.25 5.25
Malaysia Overnight policy rate 2.00 -150 24 Feb 09 (-50bp) 24 Nov 09 2Q 10 (+25bp) 2.00 2.00 2.25 2.50 3.00
Philippines Reverse repo rate 4.00 -200 9 Jul 09 (-25bp) 17 Dec 09 4Q 10 (+25bp) 4.00 4.00 4.00 4.00 4.25
Thailand 1-day repo rate 1.25 -200 8 Apr 09 (-25bp) 2 Dec 09 2Q 10 (+25bp) 1.25 1.25 1.50 1.75 2.00
Taiwan Official discount rate 1.25 -188 18 Feb 09 (-25bp) 4Q 09 4Q 10 (+12.5bp) 1.25 1.25 1.25 1.25 1.375
Bold denotes move since last GDW and forecast changes.Underline denotes policy meeting during upcoming week.
Source: J.P. Morgan
81
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

Prior Research Notes available on www.morganmarkets.com

Currency unlikely to prevent strong Euro area export growth, Mackie, Under-hedged IT exporters: Dry tinder to INR spark,
Oct 30, 2009 Ho, Piron, May 21, 2009
The month-end effect in FX: small but predictable, Keeping up with the Watanabes: Who drives the carry trade post-
Normand, Oct 23, 2009 crisis? Normand, May 15, 2009
Gauging the FX impact of M&A announcements, Asia FX Forecasts: Stay defensive Q2, offensive Q3
De Kock, Franklin-Lyons & Sharma, Oct 23, 2009 Piron, Ping Ho, May 14, 2009
Norges Bank will not derail NOK strength, Has HIA-related repatriation started already? Sasaki, Tanase, Kim,
Sharma, Oct 16, 2009 May 13, 2009
JPY: Three reasons why Japan would not intervene Japanese lifers hesitate to take FX risks, Tanase, May 1, 09
Sasaki, Oct 9, 2009
Fiscal stimulus may lift Japanese economy but drag down JPY, Sasaki,
Gold: New upleg highs – should we expect more? Apr 24, 09
Jansen, Oct 9, 2009
Hedging & trading long-term FX with J.P.Morgan’s Fair Value
Central bank support for GBP evaporates, Model, De Kock, Apr 24, 09
Meggyesi, Oct 2, 2009
The inflation trade in FX: cheap and early,
Corporate hedging survey: 2010 USD bounce, cautious hedging of Normand, Apr 3, 2009
2010 exposure,
Sharma, De Kock & Tanase, Oct 2, 2009 Does the turn in housing mark the turn in FX?,
Sharma, Apr 3, 2009
G-10 fair value update: Smaller misalignment, still big opportunities,
De Kock, Sep 18, 2009 Japan passes HIA: What impact on JPY?
Sasaki, Mar 27, 2009
Will Japan’s new finance minister adopt strong-yen policy? Sasaki and
Tanase, Sep 18, 2009 Corporate Hedging Survey: US corporates boost ’09 hedge ratios,
Huffman, Mar 13, 2009
Base metals in H2: Feast or famine? Jansen, Sep 4, 2009
How far can SEK fall? Sharma, Mar 9, 2009
Preview of Japanese lower house elections,
Tanase, Aug 28, 2009 Sterling: Queasy sailing on the QEII,
Meggyesi, Mar 9, 2009
Firm foundations: AUD and NOK to capitalize on revival in house
prices, Sharma, Aug 21, 2009 JPY: Safe Haven no more?
Sasaki and Tanase, Feb 27, 2009
Risk factors for JPY: HIA, seasonals and more,
Sasaki, Aug 14, 2009 Nikkei – USD/JPY correlation to break down,
Sasaki, Feb 20, 2009
Cross-border M&A: USD and GBP are the biggest losers, Sharma,
Aug 7, 2009 Earning the liquidity premium in FX,
Normand, Feb 20, 2009
Precious Metals Outlook H2, Jansen, Jul 31, 2009
Scope for divergence in the dollar bloc,
How will the upcoming Lower House election affect the yen? Tanase, De Kock, Jan 30, 2009
Jul 24, 2009
Japanese retail may again drive yen higher,
Will Mrs. Watanabe undermine AUD/JPY & NZD/JPY again?, Tanase, Tanase, Jan 30, 2009
Jul 10, 2009
Positioning for the growing risk of Swiss QE,
KRW: Under the microscope, Piron, Jul 10, 2009 Meggyesi, Jan 23, 2009
Government deficits & debt will sink the dollar and other fairy tales, Japan flow backdrop yen bullish beyond fiscal year-end, Sasaki and
De Kock, Jul 2, 2009 Tanase, Jan 16, 2009
Implication of FSA’s cap on FX margin leverage, EMU to bend, not break, Sharma, Jan 16, 2009
Tanase, Jun 12, 2009
Central banks still leaning against the wind, Meggyesi, Jan 9, 2009
Baltics give SEK noise but not trend, Meggyesi, Jun 5, 2009
FX in a world with less leverage and more regulation, Normand and
Sell USD when central banks buy, Meggyesi, Jun 4, 2009 Sandilya, Jan 9, 2009
Corporate Hedging Survey: Japanese corporates increase ’09 hedging
ratios,
Huffman, Sharma, Tanase May 29, 2009
82
Global FX Strategy
November 24, 2009
John Normand (44-20) 7325-5222

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Global FX Strategy
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John Normand (44-20) 7325-5222

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Copyright 2009 JPMorgan Chase & Co. All rights reserved. This report or any portion hereof may not be reprinted, sold or
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John Normand (44-20) 7325-5222

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Global FX Strategy
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J.P. Morgan Global FX Strategy

London
John Normand MD Head, Global FX Strategy (44-20) 7325-5222 john.normand@jpmorgan.com
Paul Meggyesi ED G-10 FX Strategy (44-20) 7859-6714 paul.meggyesi@jpmorgan.com
Thomas Anthonj ED Technical Strategy (44-20) 7742-7850 thomas.e.anthonj@jpmorgan.com
Kamal Sharma VP G-10 FX Strategy (44-20) 7777-1729 kamal.x.sharma@jpmorgan.com
Talis Bauer VP FX Derivatives Strategy (44-20) 7777-5276 talis.s.bauer@jpmorgan.com
Robert Beange ED (Emerging Markets Research) CEEMEA FX Strategy (44-20) 7777-3246 robert.m.beange@jpmorgan.com
New York
Ken Landon MD G-10 FX Strategy (1-212) 834-2391 kenneth.landon@jpmorgan.com
Gabriel de Kock ED G-10 FX Strategy (1-212) 834-4254 gabriel.s.de.kock@jpmorgan.com
Niall O’Connor ED Technical Strategy (1-212) 834-5108 niall.oconnor@jpmorgan.com
Arindam Sandilya VP FX Derivatives Strategy (1-212) 834-2304 arindam.x.sandilya@jpmorgan.com
Matthew Franklin-Lyons Analyst G-10 FX Strategy (1-212) 834-4565 matthew.d.franklin-lyons@jpmorgan.com
Asia
Tohru Sasaki ED G-10 FX Strategy (81-3) 6736-7717 tohru.sasaki@jpmorgan.com
Junya Tanase ED G-10 FX Strategy (81-3) 6736-7718 junya.tanase@jpmorgan.com
Claudio Piron ED (Emerging Markets Research) Asia FX Strategy (65) 6882-2218 claudio.piron@jpmorgan.com
Yen Ping Ho VP (Emerging Markets Research) Asia FX Strategy (65) 6882-2216 yenping.ho@jpmorgan.com
Yoonyi Kim Analyst G-10 FX Strategy (81-3) 67367729 yoonyi.x.kim@jpmorgan.com
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Global FX Strategy

November 24, 2009

Global FX Strategy 2010

www.morganmarkets.com/GlobalFXStrategy J.P. Morgan Securities Ltd.

John Normand (44-20) 7325-5222

• Global FX Outlook 2010: New year, new lows (John Normand)

John Normand (44-20) 7325-5222

• The dollar is not yet in bubble trouble. Currency 25%

John Normand (44-20) 7325-5222

John Normand (44-20) 7325-5222

John Normand (44-20) 7325-5222

monthly change in S&P500

disagreement centres on whether this process is natural and -5%

John Normand (44-20) 7325-5222

John Normand (44-20) 7325-5222

Given the historical experience, 2010 looks like a year of 150

John Normand (44-20) 7325-5222

Chart 14: …and a liquidation of yen-funded carry

dollar. Intervention is standard practice for many emerging

John Normand (44-20) 7325-5222

The most significant risks to the bearish view are the 4%

3. A significant upturn in inflation. The consensus expect 0%

Paul Meggyesi (44-20) 7859-6714

 Buy a 6-mo 1.60-1.50 GBP put/CHF call spread

Yoonyi Kim (81-3) 6736-7729

Global FX Carry Trade Monitor

Source: J.P. Morgan, Bloomberg Source: J.P. Morgan, TFE

Source: J.P. Morgan, TFE Source: J.P. Morgan

Yoonyi Kim (81-3) 6736-7729

Source: J.P. Morgan, CME Source: J.P. Morgan, Bloomberg

Source: J.P. Morgan Source: J.P. Morgan

John Normand (44-20) 7325-5222

If historical betas hold, then carry returns could reach

John Normand (44-20) 7325-5222

Alpha strategies Manager performance

Forward Momentum Overlay HFR global

2004 - 2008 (5 years)

1999 - 2008 (10 years)

John Normand (44-20) 7325-5222

Table 1: J.P.Morgan and consensus forecasts in January 2009

and trade recommendations 1, 2009 Q1 09 Q2 09 Q3 09 Q4 09

John Normand (44-20) 7325-5222

III. Technical Strategy portfolio

Arindam Sandilya (1-212) 834-2304

Chart 1. The decline in volatility across asset classes in 2009 was

• We envision growth surprises to be fairly muted in

Arindam Sandilya (1-212) 834-2304

Arindam Sandilya (1-212) 834-2304

Leverage within the investor community in FX carry trades -10 -2

Arindam Sandilya (1-212) 834-2304

Arindam Sandilya (1-212) 834-2304

Arindam Sandilya (1-212) 834-2304

As liquidity returned to the options market in the second

Niall O’Connor (212) 834-5108

retracement, it does not guarantee a sustained shift in trend.

Niall O’Connor (212) 834-5108

Niall O’Connor (212) 834-5108

In terms of monetizing these described scenarios we suggest

Niall O’Connor (212) 834-5108

EUR/SEK. Remaining below these resistance levels the

Niall O’Connor (212) 834-5108

we’d have to be prepared for a new down-trend (C-wave)

Assuming that the long-term up-trends for NOK and SEK