Market Update JUN A Conversation about Currencies

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1 Market Update JUN 216 A Conversation about Currencies David Cleary, CFA, Managing Director, Portfolio Manager/Analyst Yvette Klevan, Managing Director, Portfolio Manager/Analyst Aristotel Kondili, Director, Research Analyst The last two years have been characterized by significant moves in foreign exchange (FX) markets. A key trend during this period has been a consistent strengthening of the US dollar since mid-214, which seems to be easing recently. On the other hand, emerging markets currencies have suffered against the backdrop of a challenging environment in many of those economies and capital markets. Investors have been especially surprised by the depreciation of the yuan. In terms of developed markets, the euro and yen have been subject to fluctuations on the back of global monetary policy decisions. We believe it is instructive for investors whether stock pickers or asset allocators to address some of the most relevant questions in today s FX markets, which we discuss in the pages that follow. David Cleary, from Lazard s US fixed income team and asset allocation platform, leads the discussion through questions posed to Yvette Klevan (Global Fixed Income) and Aristotel Kondili (Emerging Income). For additional context see the Key Indicators on FX Trends on page 2. David Cleary: For several years now, the US dollar has been king. Are we now entering a new currency regime where the dollar strength is no longer the predominant trend? Aristotel Kondili: US dollar strength, based on the US economy s macro-fundamentals, has been highly disruptive for much of the rest of the world; exacerbating weakness in commodities, tightening liquidity in many emerging markets, and amplifying the strains on China s de facto US dollar peg. In our view, the change in the US dollar trajectory has been driven by three factors. First, the Fed has become more sensitive to US dollar strength, highlighting its contribution to the tightening of financial conditions. While further rate hikes are possible, US interest rate support is likely to be diminished especially if the rate-hiking trajectory proves to be short. The second factor is the risk premium associated with China s FX outlook. Fears of a one-off yuan depreciation caused most emerging markets currencies to weaken early in 216. The yuan has stabilized, though, and its risk premium has been priced out of the options and forward markets. This has allowed emerging markets currencies to recover against the US dollar. The final factor causing a change in the US dollar trajectory has been commodity prices. After over two years of weakness, commodities and commodity-related currencies have seen a significant recovery so far in 216. Brent oil prices have rallied 5% from their January lows and iron ore prices have rebounded by over 6% to the April high and about 3% through 6 June. Consequently, most of the top-performing currencies year to date in G1 countries and emerging markets are commodity currencies, which have all rallied against the US dollar. In addition, the recent revealed preference of the European Central Bank (ECB) for limited further policy rate cuts and of the Bank of Japan (BoJ) for significant further yen depreciation no longer entails a strong trend in the US dollar. Yvette Klevan: We expect more volatility and choppy trading within current ranges given the long list of global macro risks so no the US dollar will not necessarily be king. Technical factors such as flows and liquidity will be as important as fundamentals, but we believe commodity prices will continue to dominate currency movements, and oil prices are now trading higher thus leading to a weaker US dollar. Furthermore, investors have tilted back towards a dovish Fed (softer US dollar) and given strong US economic data plus inflation pressures building, we believe the recent US dollar weakness could reverse to some degree in the second half of 216 potentially a period of risk aversion. LR26793

2 2 Key Indicators on FX Trends Broad US Strength, Return versus USD (%) Japanese Yen Swiss Franc Chinese Yuan Indian Rupee British Pound Korean Won Singapore Swedish Krona Euro Australian New Zealand Mexican Peso Norwegian Krone Canadian African Rand Brazilian Real The US Has Generally Weakened in 216 Return versus USD (%) Mexican Peso British Pound Chinese Yuan Indian Rupee Korean Won New Zealand Australian African Rand Swiss Franc Swedish Krona Euro Singapore Canadian Norwegian Krone Japanese Yen Brazilian Real Historically, US Appreciation Has Subsided after Rate Hikes Trade Weighted Index, 1=Rate Hike Date Days, =Rate Hike Date Commodity Prices Dropped as the US Climbed Index, 2 January 214= USD Trade Weighted Index CRB Commodities Index Brent Oil Jan 214 May 214 Sep 214 Jan 215 May 215 Sep 215 Jan 216 May 216 Dates: Broad USD Strength, 31 December 215; USD Has Weakened in 216, 31 December 215 to 7 June 216; USD and Rate Hikes, 3 June 216; Commodities Prices Dropped as USD Climbed, 2 May 216. The information is not representative of any product or strategy managed by Lazard. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. Source: Bloomberg

3 3 DC: Fundamentally, do all roads lead to Fed policy or are there other factors at play which determine relative currency strength? YK: The G4 central banks (Fed, BoE, ECB, and BoJ) 1 are all important, but as the central bank to the world, it seems apparent that many roads do lead to the Fed. Fed policy affects investor behavior related to many segments of the market, and perhaps most importantly, can influence the direction of the US dollar. Over longer periods of time, there can be many factors which impact specific currency pairs; however, we believe the recent weakening of the US dollar has largely been a function of a reversal of prior expectations for future Fed rate hikes and a significant rally in oil and commodity prices. AK: The FX markets are trading on the back of the idea that the Fed will avoid driving the US dollar significantly higher through aggressive rate increases. Not only does US dollar strength tighten domestic financial conditions, but it has also exacerbated many of the problems afflicting emerging markets currencies. US dollar strength increased the urgency for emerging markets corporates to hedge their US dollar liabilities especially in China, where capital outflows had already complicated efforts to manage yuan depreciation. Emerging markets FX volatility aggravated global risk aversion, and the Federal Open Market Committee (FOMC) has become more sensitive to the feedback loop of global market volatility back to the US economy. Even if the FOMC were to deliver a second rate hike in the second quarter of 216, there is not a strong case to be made that the US dollar would rally meaningfully, as it did in the fourth quarter of 215 leading up to the first rate hike. DC: The US dollar s ascent relative to both the yen and euro appears to have stalled, in spite of increasingly divergent monetary policies and rate regimes. Why do you think that is so? YK: The euro and yen have shared the safe haven spotlight with the US dollar since the middle of 215, and we expect this trend to continue unless US interest rates move significantly higher diverging from Europe, Japan, and the rest of the world. Some potential reasons for this trend include: unwind of the carry trade, 2 as European and Japanese investors stop positions on riskier investments abroad and bring the proceeds home; strong current account surpluses; and the end of the line for monetary policy expansion in both regions. AK: Sizable output gaps in the euro zone and Japan should keep inflation and inflation expectations subdued and add to the pressure on the ECB and BoJ to ease further, undercutting the demand for euro and yen. However, recently the yen has been helped by both risk aversion and investors' belief that the BoJ has limited room to change the yen s trajectory. That said, with risks to growth and inflation in Japan still on the downside, the BoJ will probably announce more quantitative and qualitative easing (QQE) and a further rate cut into negative territory ahead of the upper house elections in July 216. As the ECB shifts away from the FX devaluation channel towards direct easing of credit and liquidity conditions in the euro zone via credit purchases and bank targeted longer-term refinancing operations (TLTROs), the net effect should still be negative for the euro. Also, the long-term outlook should remain negative. Foreign demand for euro-denominated funding should intensify after the ECB starts corporate bond purchases. The euro looks undervalued given the euro zone s current account surplus but we are not seeing the flows that typically support current account surplus currencies. Instead, foreign borrowers in euro are helping recycle euro zone excess savings abroad while euro zone exporters seem to delay long-euro hedges. DC: The yen and euro often strengthen during market sell-offs and periods of risk-off. This is counterintuitive. Why is it so? YK: Given the low and even negative yields in parts of Europe and Japan, investors are incentivized to borrow (short) euro and yen and invest abroad the carry trade. This strategy is very sensitive to volatility as daily movements in some currencies can eliminate the excess yield advantage and therefore, as volatility picks up (very often related to risk-off periods), investors sell the higher yielding, higher beta investments and cover their shorts (euro and yen). By extension, Japanese and European investors are investing their excess savings overseas in an effort to find higher yielding alternatives. They typically repatriate (i.e., buy euros and yen) during periods of increased volatility. We also respect the strong correlation between the yen and the Nikkei 225 Index, and downward pressure on the Japanese equity market has also contributed to a stronger yen. AK: Safe-haven currencies tend to have low interest rates, a strong net foreign asset position, and deep and liquid financial markets. Japan and the euro zone meet these criteria. The yen reaction is the most evident of the two. The yen is widely considered a safe-haven currency and one that appreciates when global investors behavior becomes more risk-averse or economic fundamentals are more uncertain. Risk-off appreciations of the yen are driven by massive increases in financial inflows recorded in the balance of payments following spikes in the VIX, as Japanese residents reduce their rate of accumulation of foreign assets and foreign investors increase their rate of accumulation of Japanese assets (capital flight).

4 4 Since 28, the yen has appreciated against the US dollar, in effective terms, in the aftermath of various shocks. A few examples of such yen reaction function were evident recently. First, the global financial crisis was associated with a large real exchange rate appreciation of over 2%. Second, in May 21, higher market distress about peripheral European sovereigns led to a large jump in the VIX, followed by a 1% yen appreciation against the euro within a matter of weeks. Third, following the Great East Japan Earthquake, the yen appreciated further on account of expectations about sizable repatriation of foreign assets by insurance companies, which in fact subsequently did not occur. These examples illustrate that appreciation of the yen during episodes of increased global risk aversion is recurrent. They also illustrate why we believe that persistent yen strengthening due to safe-haven demand is troubling to the BoJ, as a weak currency is a key part of Abenomics. This means that there is a much stronger reaction function out of the BoJ relating to their yen policy. The BoJ will continue to cut rates and expand QQE to loosen policy and weaken the yen our forecast is that the yen will reach 12 (yen per US dollar) by the end of 216. DC: For some time now, emerging markets currencies have been under significant pressure. Chicken or egg is it a function of weak local economies and commodity weakness or are emerging markets economies and commodities weak because of the strong dollar? YK: We believe emerging markets currency weakness has been a function of deteriorating fundamentals (especially in the case of commodity producers/exporters) and lack of structural reforms in certain countries. The strong US dollar puts pressure on countries that have increased offshore debt issuance and are forced to manage the currency mismatch. De-risking by certain sovereign wealth funds has increased flows and liquidation, exacerbating the price movements. The overall slow global trade environment is weighing on all countries, but especially on emerging markets. AK: If we examine correlations, in the midst of the US dollar rally between June 214 and the first quarter of 215, the US dollar rallied against almost all currencies at the same time that global risk assets (equities) were rallying. This was true for the US dollar against both G1 and emerging markets currencies. Recently, though, these correlations have changed. Rallies in risk assets are now being associated with US dollar weakness against emerging markets FX especially Asia ex-japan. This change in US dollar correlations is an important sign of stability in risk sentiment. Investors are more likely to embrace emerging markets FX and commodity-related FX during times of positive sentiment. The implication for the US dollar is that the days of broad-based gains against all currencies are behind us. DC: Is the recent reversal in EM currencies sustainable? YK: We believe that more volatility is to be expected. The recent risk rally benefiting emerging markets currencies was likely based more on capitulation of overstretched valuations rather than fundamental improvements. Looking forward, the emerging markets currency landscape is mixed, presenting tactical opportunities for positioning on a selective basis. AK: Emerging markets currencies are, on average, undervalued on a trade-weighted basis. They are not as undervalued as during the early 2s but neither are they as expensive as they were during Moreover, outside of Japan and Europe, we have a dovish Fed (US dollar negative), good US data, a rising US equity market (risk positive), and stability/rally in commodities (good for commodity currencies and local markets). That does not leave much for the US dollar to rally against. Financial markets focus on the second derivative (the change in the rate of change) emerging markets GDP growth has been weakening in tandem with commodities and emerging markets currencies and equities. The current account surplus and GDP growth advantage of emerging markets over developed markets has been shrinking year after year, but both should potentially stabilize or even slightly improve this year. DC: What about China? Is a managed depreciation of the yuan inevitable? AK: The new emphasis on a trade-weighted basket approach for the yuan s soft peg, combined with China s existing capital controls, should reduce one-way expectations (in either direction) for the yuan. This should help to limit outflows, which were a headache for policymakers in 215 net outflows reduced domestic money supply, forcing policymakers to cut the reserve requirement ratio (RRR) to counter this effect. Policymakers have now adopted a clear pro-growth stance, which was underscored at the recent National People s Congress (NPC) meetings. Going forward, we believe China s authorities should be able to continue to maintain a soft peg for the yuan s trade-weighted value, at an index level of around 1 for the new China Foreign Exchange Trade System (CFETS) effective exchange rate (EER) index. This is the level of the yuan s trade-weighted value that prevailed at end-214 and is likely not too far from what the IMF judges as fair value for China s currency. While the index has fallen almost 2% below this level in April May, it could likely be a tactical move by the authorities to allow some of the broader US dollar weakness to spill over into the CFETS EER. This creates space for the yuan to rebound modestly in tradeweighted terms (in a mean-reverting move back to 1 on the index) as expectations of Fed policy tightening rebuild.

5 Market Update YK: China has been carefully managing the valuation of their currency. Chinese authorities are very focused on creating more two-way flows because they are most concerned with the outflows in recent years, which have been overwhelming any inflows. Reserves spent to defend the currency may have peaked, and policymakers will look for other ways to manage or stabilize the yuan such as through the (contentious) inclusion of local bond markets in widely used bond indices, which would not only bring in passive flows but also diversify their investor base. Conclusion Over the past several years, the US dollar s strength has been so predominant that many investors have completely discounted it. Yet today, it appears as if fundamental data and trends appear to be more mixed and continued dollar strength is not assured. Negative interest rates in Europe and Japan as well as a dramatically changed picture in commodity markets complicate foreign exchange markets and will likely lead to less visible, more volatile trends. In our view, active fundamentally driven viewpoints will be required in order to navigate this new currency paradigm. This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 BoE = Bank of England, ECB = European Central Bank, BoJ = Bank of Japan. 2 Carry trade definition (Bloomberg): A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. Important Information Published on 7 September 217. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 16 June 216. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit for the specific Lazard entities that have issued this document and the scope of their authorized activities.

FX BRIEFLY. 12 December Helaba Research. Performance on a month-over-month basis

FX BRIEFLY. 12 December Helaba Research. Performance on a month-over-month basis Helaba Research FX BRIEFLY 12 December 2018 AUTHOR Christian Apelt, CFA phone: +49 69/91 32-47 26 research@helaba.de EDITOR Claudia Windt PUBLISHER: Dr. Gertrud R. Traud Chief Economist/ Head of Research