Currency Market Monitor

Transcription

1 CURRENCIES Currency Market Monitor 2 nd Quarter 2014 JULY 3, 2014 John W. Labuszewski Sandra Ro Bluford Putnam Managing Director Executive Director Chief Economist Fin l Research & Product Development jlab@cmegroup.com FX Research & Product Development 011 (44) sandra.ro@cmegroup.com Research & Product Development bluford.putnam@cmegroup.com

2 An ongoing debate has long persisted in the global currency or FX markets is FX an asset class akin to stocks and bonds? While practitioners and academics may debate this point at length, perhaps the most practical answer is does it really matter provided that investors may draw a return from currency investments? The performance of the currency or FX markets is found in the exchange rates and cross-rates associated with the world s myriad currencies. Many fundamental factors, including national economic conditions, monetary and policies, current and capital account flows, impact the returns associated with the world s currencies. This document represents a review of these factors as they played out in the most recently completed calendar quarter. We include consideration of the so-called carry trade as well as a look at the theory of purchasing power parity as it impacts FX markets. While we cover activity in a broad spectrum of currencies, we focus on the currencies underlying some of the most liquid of CME Group FX futures. This includes the U.S. dollar (USD), Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar (AUD) and Mexican peso (MXN). We also have special interest in the currencies of significant emerging market economies including the Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese yuan or renminbi (CNY). Growth and Employment Q2-14 saw a rebounding economy relative to a weather-dampened 1 st quarter performance. The employment situation continues to improve amidst concerns about a historically low employment participation rate. Still, previously upbeat U.S. economic forecasts for 2014 have largely been downwardly revised. Although international tensions in the Crimea and elsewhere have abated somewhat, risks are still present. Equity markets have pushed quietly to new all-time highs on reduced volatility with interest rates on hold. The Fed summarizes the situation in its June 18 th Press Release, suggesting that growth in economic activity has rebounded in recent months. Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated. Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has been running below the Committee s longer-run objective, but longer-term inflation expectations have remained stable. 1 Qtrly Change in GDP GDP during Q1-14 was reported at a very disappointing -2.9%, driven by generally inclement weather conditions and down from Q4 s +2. and Q3 s even more impressive +4.1%. As a result, the Fed downgraded its 2014 GDP forecast from % to % with a longer-run forecast of %. Meanwhile, the unemployment rate wound its way down to 6.3% by May-14 and below the Fed s previously targeted level of 6.5%. While past Fed statements had suggested that this target may be a significant milestone towards reconsidering its 0-25 basis point target range for the Fed Funds rate, it had subsequently revised this guidance to focus on a 2% target inflation rate. In particular, the steady decline in unemployment is negatively colored by the employment force participation rate at a scant 62.8% - the lowest rate seen since March Still, the labor market 1 2% 0% -2% % -10% Q1 05 Q4 05 Growth and Employment Q3 06 Q2 07 Q1 08 Real GDP (SA) Q4 08 Q3 09 Q2 10 Q1 11 Q4 11 Q3 12 Q2 13 Q1 14 Unemployment Rate Source: Bureau of Economic Analysis (BEA) & Bureau of Labor Statistics (BLS) 11% 10% 9% 8% 7% 5% Federal Reserve Press Release dated June 18, Unemployment Rate 2 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

3 situation is encouraging to the extent that the nonfarm payrolls (NFPs) have now risen above the Jan- 08 peak of million recorded at the onset of the subprime mortgage crisis. It has taken a full 76 months for NFPs to recover to million as seen in May 2014 the longest recovery in the last 40 years but we can now say that labor force numbers are at new highs. Unemployment Rate 11% 10% 9% 8% 7% 5% Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 68% 67% 6 65% 6 63% 62% The Fed s recent statement spoke of moderate advances in household spending and business fixed investment along with a slow recovery in the housing sector. NFPs as % of Peak 101% 100% 99% 98% 97% 9 95% 9 93% Employment Statistics This is supported by the May-14 retail sales figure of $ billion, up 1.65% from May-13. Similarly, light vehicle sales were reported for May-14 at million units and up 8.27% from May-13. Jan-09 Jan-11 Unemployment Rate Labor Force Partcipation Source: Bureau of Labor Statistics (BLS) NFP Recovery from Recession Months Since Peak NFP Apr - Dec-80 Aug-81 - Oct-83 Jul-90 - Jan-93 Mar-01 - Jan-05 Labor Force Participation Retail Sales (Bil $) The Index of Industrial Production was reported at in May-14, an improvement of 4.7% on a year-on-year (YOY) basis. Capacity utilization continued to advance to 79.1% in May-14 and moderately higher than the 77.9% seen a year earlier. Note that 80% is often viewed as a significant mark, above which point production bottlenecks and inflationary pressures and are generally thought to emerge. Industrial Production Index $190 $185 $180 $175 $170 $165 $160 $ Aug-07 Consumer Sector Activity Mar-08 Oct-08 May-09 Dec-09 Real Retail Sales SA Jul-10 Corporate profits were reported at $1,879.7 billion for the 1 st quarter, down 1.30% from Q4-13 but an advance of 5.32% from the Q1-13. Of course, most analysts would dismiss the Q1 hiccup as a consequence of poor weather conditions. The Fed alluded to slow housing market conditions, noting that building permits fell to 991 thousand units in May-14, down 1.9% from 1,010 thousand units a year earlier in May-13. But housing starts Feb-11 Sep-11 Apr-12 Nov-12 Jun Light Vehicle Sales Source: U.S. Census Bureau and Dept.of Commerce Industrial Sector Activity Aug-07 Mar-08 Oct-08 May-09 Dec-09 Jul-10 Feb-11 Index of Industrial Production Sep-11 Apr-12 Nov-12 Jun-13 82% 80% 78% % 70% 68% 6 Vehicle Sales Capacity Utilization Capacity Utilization Source: St. Louis Federal Reserve FRED Database 3 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

4 were up 9. while completions were up 24.8% over the same YOY period. 000 Units Inflation While the Fed recognizes that inflation is running below the Committee s longer-run objective [and] inflation expectations have remained stable the Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance and it is monitoring developments carefully for evidence that inflation will move back towards its objective over the medium term. 2 Year-on-Year Change 2,500 2,000 1,500 1, Jan-04 Sep-04 May-05 Jan-06 Housing Activity Sep-06 May-07 Sep-08 May-09 Sep-10 May-11 Sep-12 May-13 Building Permits Housing Starts Completions Source: Dept. of Housing & Urban Development (HUD) 5% 3% 2% 1% 0% -1% -2% Jan-04 Personal Consumption Expenditures Jan-05 Jan-06 Jan-09 Jan-11 PCE Core PCE Source: Bureau of Economic Analysis (BEA) Personal Consumption Expenditures (PCE) were recorded at +1.77% in May-14 on a year-on-year basis while Core PCE ex-food & energy checked in at +1.49%. Both of these figures fall short of the Fed s target of 2% although the Fed is projecting PCE and Core PCE to be clocked at % and 1.7%- 2.0%, respectively, by Still, with Capacity Utilization straining up towards the key 80% mark, inflation could perhaps become a cause for some concern on the part of the Fed sooner than anticipated. Monetary Policy The Fed s quantitative easing (QE) programs historically called for the monthly purchase of $85 billion of Treasuries, agency debt and agency mortgage backed securities (MBS), in an attempt to keep intermediate- to long-term rates at modest levels. But the Q4-13 saw the Fed begin to taper the program by $10 billion per month. In what has become a predictable move, and [i]n light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month. 3 The Committee reiterated its intent to closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in the context of price stability. If incoming information broadly supports the Committee s expectation of ongoing improvement in labor market conditions and inflation moving back (up) toward its longer-run 2 Ibid. 3 Ibid. 4 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

5 objective, the Committee will likely reduce the pace of asset purchases in further measured steps. 4 But the Fed remains intent on holding target Fed Funds, historically, its primary monetary policy tool, steady at current levels. Thus, the Fed reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to ¼ percent target range for the federal funds rate, the Committee will assess progress both realized and expected toward its objectives of maximum employment and 2 percent. This assessment will take into account measures of labor market conditions, indications of inflation pressures and inflation expectations, and readings on financial developments [and is likely to] maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends. 5 Thus, we remain in a long-term holding pattern in this regard. 5% 3% 2% 1% 0% Jul-07 Benchmark U.S. Rates Jul-08 Jan-09 Jul-09 Target Fed Funds 5-Yr Treasury 30-Yr Treasury Jul-10 Jan-11 Jul-11 Jul-12 Jul-13 2-Yr Treasury 10-Yr Treasury during Q1-11. But Federal total receipts rose to $3.112 trillion in Q1-14 from $2.516 trillion in Q1-11. Thus, net borrowing contracted to $775.3 billion on a seasonally adjusted and annualized basis in Q1-14 from $1,378.2 billion in Q1-11. $4,000 $3,000 $2,000 $1,000 $0 -$1,000 -$2,000 -$3,000 -$4,000 Q1 04 Q4 04 Q3 05 Q2 06 Q1 07 Q4 07 Current & Capital Account Flows The current account deficit had been improving nicely before falling back to $ billion in Q1-14 from $ billion in Q4-13. Still, the figure is less than the $ billion deficit seen in Q1-12 and much less than the >$200 billion deficits witnessed in the pre-crisis era in $0 -$50 Federal Receipts vs. Expenditures (Annualized in Billions) Q3 08 Q2 09 Q1 10 Q4 10 Q3 11 Q2 12 Q1 13 Q4 13 Fed Total Recepits Fed Total Expenditures Net Lending/Borrowing Source: Bureau of Economic Analysis (BEA) Balance on Current Account (Billions USD) Fiscal Policy The Fed continues to suggest that [f]iscal policy is restraining economic growth although the extent of restraint is diminishing. 6 -$100 -$150 -$200 Total expenditures on the part of the Federal government on a seasonally adjusted and annualized basis were at $3.887 trillion during the Q1-14, down from the peak of $4.004 trillion seen -$250 Q1 04 Q4 04 Q3 05 Q2 06 Q1 07 Q4 07 Q3 08 Q2 09 Q1 10 Q4 10 Q3 11 Q2 12 Q1 13 Source: Bureau of Economic Analysis (BEA) Q Ibid. Ibid. Ibid. Another source of flow of funds data is the U.S. Treasury Department s Treasury International Capital (or TIC ) database. This database tracks flows into and out of the U.S. The data is broken 5 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

6 into foreign stocks, foreign bonds, U.S. stocks, U.S. corporate bonds, U.S. government agencies and U.S. Treasuries. U.S. vs. overseas capital flows have generally been characterized over the past decade by substantial influx of funds into U.S. Treasuries. This trend peaked in 2010, as overseas investors net purchases totaled $704 billion in U.S. Treasuries, but tailed off to $433, $417 and $43 billion in 2011, 2012 and 2013, respectively. $1,200 $800 $400 $0 -$400 -$ Net US/Foreign Capital Flows (Billions USD) US Treasuries US Gov't Agencies US Corporates US Stocks Foreign Bonds Foreign Stocks Source: U.S. Treasury TIC Database Thru Apr-14 $40 $30 $20 $10 $0 -$10 -$20 -$30 -$40 Mar-12 May-12 Equity Fund Cash Flows (Billions USD) Jul-12 Sep-12 Nov-12 Some $159.8 billion was invested into equity funds during However, only $17.7 billion of this total was focused on U.S. equity funds despite the strong performance. During the first 4 months of 2014 through April, some $58.6 billion flowed into equity funds of which $17.5 came into domestic equity funds. $40 $20 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Domestic Equities Foreign Equities Source: Investment Company Institute (ICI) Equity & Bond Fund Cash Flows (Billions USD) Mar-14 Foreign investors turned their attentions to the U.S. equity marketplace in 2013 as a net $522 billion flowed into stocks on the strength of a sustained bull market continuing through Q2-14. But despite the gains realized in equities in the first half of 2014, foreign investors withdrew some $11 billion from equities in factor of pushing $104 billion into U.S. Treasuries. This was likely driven by concerns over a possible correction given that the S&P 500 and other key indicators have risen to new all-time highs. $0 -$20 -$40 -$60 -$80 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Equity Funds Bond Funds Source: Investment Company Institute (ICI) Mar-14 Mutual Fund Flows The flow of equity and fixed income investments may be examined per data published by the Investment Company Institute (ICI) which tracks activity in the mutual fund industry. 7 Bond funds experienced net withdrawals in 2013 totaling some $80.5 billion, in anticipation of rising rates and declining values. But interest rates have generally not advanced in 2014 and bond prices have not fallen. Thus, some $28.9 billion has come back into bond mutual funds in 2014 through the month of April. 7 These indicators are often highly correlated with price action as retail investors may chase the market by buying in response to a bull trend. Or, they may exhibit a herd mentality by liquidating investments in response to significant market breaks. 6 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

7 Global Economic Performance Emerging market (EM) economies grew quickly even in the wake of the subprime crisis. But growth in the EM countries seems to be decelerating while many analysts look for relatively modest economic upticks in the developed (DM) economies. Actual and Forecast GDP Growth GDP growth has slowed in many of the emerging economies but such growth has nonetheless generally surpassed that of the DMs. This will continue to be the case per Conference Board forecasts, albeit the gaps may narrow. 12% Annual GDP Growth (BRIC Economies) (f) (f) (f) Developed Markets (DMs) Australia % % 2.2% Canada 2.5% 1.7% 2.0% 2.1% 2.0% 1.8% France 2.0% 0.0% 0.2% 0.9% % Germany 3.3% 0.7% % Japan % 1.5% 5.0% 1.0% 0. UK 1.1% 0.1% 1.7% 1.9% 1.9% 1.1% US 1.8% 2.8% 1.9% 2.3% % Emerging Markets (EMs) Brazil 2.7% 0.9% 2.3% 1.8% 2.9% 2.8% Mexico 3.9% 3.8% 1.1% 3.1% 2.9% 3.1% Russia 4.3% % 1.7% 1.8% 1.2% India 6.2% 5.0% % 4.8% 3. China 9.3% 7.7% 7.7% 7.0% 5.9% 3.5% 10% 8% 2% 0% Brazil Russia India China Source: The Conference Board Source: The Conference Board Global Economic Outlook 2014 (May 2014) NOTE: (f) = forecast data Per the Conference Board s Global Economic Outlook, growth in Europe is expected to improve with German and French GDP rising to 1. and 1. on an annual basis between the years Similarly modest yet nonetheless solid growth is expected in other parts of the developed world including Japan (+1.0%), the United Kingdom (+1.9%) and the United States (+2.). 5% 3% 2% Annual GDP Growth (Mature Economies) Trade surpluses that have supported many EM economies have generally contracted along with trade deficits in the U.S. and Europe. Despite the Q1-14 setback, the U.S. current account deficit shrank to 2.29% of GDP in 2013 from a peak deficit of 5.7 in Conversely, Chinese trade surpluses shrank from a peak of 11.00% of GDP in 2007 to 2.30% in Arguably, these trade imbalances have been a fundamental driving engine behind much emerging market growth over the past several decades. 2% 0% -2% Current Acct Balance (% GDP) (Mature Economies) 1% - 0% -1% Germany Japan UK US Source: The Conference Board US Euro Area UK Japan 7 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

8 12% 10% 8% 2% 0% -2% - - Price Performance The factors discussed above exert an obvious impact upon the price performance of the U.S. dollar vis-àvis other world currencies. In order to monitor this price impact, CME Group has developed the CME USD Index as one in a family of similarly constructed FX Indexes. 8 1,250 1,200 1,150 1,100 1,050 1, Current Acct Balance (% GDP) (BRIC Economies) The CME USD Index ended Q2-14 at a value of 1, and down 1. from Q1-14 mark of 1, Over the same period, EUR has turned in Brazil Russia India China Jul-07 Jul-08 CME USD Index Jan-09 Jul-09 Jul-10 Jan-11 Long Short 14.3% EUR 100% USD 14.3% JPY 14.3% GBP 14.3% CHF 14.3% CAD 14.3% AUD 14.3% CNY Jul-11 Jul-12 Jul a spot return of -0.5 vs. USD; British pound (GPB) is at +2.6; Japanese yen (JPY) is at +1.88%. Among EM currencies are Brazilian real (BRL) at +2.60%; Russian ruble (RUB) at +3.51%; Indian rupee (INR) at -0.49%; and, Chinese yuan (CNY) at -0.23%. 9 Total Return The carry trade has been one of the most popular long-term FX trading strategies over the past decade. A carry trade is deployed by borrowing in countries with low nominal interest rates to invest in countries with high nominal interest rates. Thus, one sells the low-rate currency and buys the high-rate currency. Carry trade Sell low-rate currency & buy high-rate currency By so doing, one hopes to capitalize on discrepant interest rates, and by implication, divergent investment opportunities, in the two countries. This strategy further recognizes that total currency return consists of 2 components including exchange rate fluctuation plus interest accrual. As such, carry traders implicitly discount classical exchange rate theories by assuming that the interest rate relationships may endure over extended periods of time. I.e., low-yielding currencies that are sold will not advance; or, high-yielding currencies that are purchased will not decline. Total Currency Return = Price Movement + Interest As a practical matter, such relationships have been known to endure for extended periods of time. E.g., vast sums were invested in the carry trade prior to the outbreak of the subprime crisis, often by shorting the low-yielding Japanese yen (JPY) and investing in other high-yielding currencies. Appendix 2 depicts the total return associated with various currencies relative to USD in Q2-14. Among the DMs, the EUR generated a total return of -0.50% 8 The CME USD Index represents a basket of equally weighted positions (as of December 31, 2010) of the USD vs. the Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar (AUD) and Chinese yuan (CNY). It is (arbitrarily) established at a value of 1, as of December 31, The spot return of a currency, or the outright price movements, is distinguished from the total return which includes price movements plus interest accrual. 8 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

9 for the quarter; GBP at +2.80%; and, JPY at +1.89%. To the extent that interest rates remain at near zero levels in these mature economies, the total returns are not much different than spot returns as reported above. USD-ARS USD-COP USD-RUB USD-KRW USD-BRL USD-CAD USD-TRY GBP-USD AUD-USD USD-TWD NZD-USD USD-JPY USD-INR USD-MXN USD-ISK USD-CNY USD-ZAR USD-CLP USD USD-CHF EUR-USD But interest accruals may exert a much greater influence in less mature economies. The BRL posted a total return of +5.41% for the quarter; RUB was seen at +5.90%; INR at +1.72%; and, CNY at +0.87%. 1,050 1,000-1% 0% Carry Return (Q2 2014) 1% 2% 3% CME FX Carry Index 5% 7% returns. 10 The CME FX Carry Index closed Q2-14 at and up 1.38% from Q1-14 s Purchasing Power Parity The purchasing power parity (PPP) theory dates to the 16 th century and the School of Salamanca but was further developed in the early 20 th century by economist Gustav Cassel. 11 It is based upon the assumption that exchange rates are in equilibrium when purchasing power is equivalent amongst various countries. On a granular level, PPP is based Adam Smith s law of one price or the notion that identical products should be priced at the same level in different national markets adjusted for exchange rates. Typically, this law is qualified by the absence of significant trade barriers or other artificial constraints on commerce. But the theory of PPP expands the application of the law of one price from any single good or product to generalized prices in any particular economy as measured by inflation indexes, e.g., Consumer Price Index (CPI) or Producer Price Index (PPI). The implication of this theory is that inflation rates and exchange rates should exhibit negative correlation. If inflation increases Currency value should decline Long Short 16.7% BRL 50% USD 16.7% AUD 50% EUR 16.7% ZAR 16.7% NZD 16.7% TRY 16.7% MXN If inflation decreases Currency value should advance Thus, if inflation as measured by an inflation index increases, the value of the currency should decline to maintain price equilibrium. Similarly, if inflation declines, the value of the currency should advance. 700 Jul-07 Jul-08 Jan-09 Jul-09 Jul-10 The CME FX Carry Index follows the performance of a basket of currencies offering relatively high rates and have historically generated favorable total Jan-11 Jul-11 Jul-12 Jul The CME FX Carry Index represents a basket of equally weighted positions (as of December 31, 2010) which is long a basket including the Australian dollar (AUD), Brazilian real (BRL), Mexican peso (MXN), New Zealand dollar (NZD), South African rand (ZAR) and Turkish lira (TRY) vs. short positions in the USD and EUR. It is (arbitrarily) established at a value of 1, as of December 31, The long components of the CME FX Carry Index were selected in light of high local interest rates during the post-financial crisis era through The short components of the index were identified because of the low interest rates offered. 11 See Cassel, Gustav, Abnormal Deviations in International Exchanges (December 1918). 9 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

10 The theory of PPP is closely related to the International Fisher Effect (IFE). This theory suggests that the disparity between nominal interest rates in two countries drive the future path of exchange rates. Thus, one expects that the value of a currency with a low nominal interest rate will increase into the future. Or that the value of a currency with high nominal rate will decline. IFE further assumes that real interest rates (i.e., the risk-free interest rate less inflation) should generally be equal across countries. This implies that nominal interest rates and inflation are positively correlated. If inflation increases If inflation decreases Rates increase Rates decrease Currency value should decline Currency value should advance The IFE suggests interest rates and exchange are negatively correlated. Similarly, PPP suggests inflation and exchange rates are negatively correlated. As such, the IFE theory is generally consistent with the PPP theory. Putting the classic PPP theory into practice requires a measurement of inflation in order to calculate the proportion by which any particular currency is (theoretically) over- or under-valued relative to the norm. There are three popular methodologies that have been used in this regard. OECD - The Organization for Economic Cooperation and Development (OECD) provides data that is useful in this regard by comparing price changes in a representative basket of goods in various countries. Bloomberg - Bloomberg offers an analytical tool that is grounded in a very long-term assessment of inflation, as measured by either CPI or PPI in various countries extending from January 1982 through June Big Mac - Finally, the Economist s Big Mac PPP methodology compares the price of a (almost) universally available product with verifiable pricing in the form of the McDonald s Big Mac hamburger in various countries. provides data from all three methods. Further, we have taken the average of the three assessments (where available) for a variety of national currencies and rank-ordered the set from most over-valued to most under-valued. Norwegian krone (NOK) stands out as the most over-valued currency per this analysis at %. NOK is followed by Swiss franc (CHF) at %; New Zealand dollar (NZD) at %; Danish krone (DKK) at %; and, Icelandic krona (ISK) at %. Under-valued currencies include Turkish lira (TRY) at %; Polish zloty (PLN) at %; South African rand (ZAR) at %; Polish zloty (PLN) at %; and, Malaysian ringgit (MYR) at %. One may wish to create baskets of several currencies to buy and sell on the basis of this analysis in order to diversify risks. However, it is important to recognize that currencies might remain over- or under-valued for extended periods of time. In fact, the carry trade, as discussed above, takes a completely opposite approach to the classic PPP theory by buying high-rate currencies and shorting low-rate currencies. Commodity Countries Top performing currencies are often found in nations whose national income is tied heavily to commodity production. Crude Oil ($ per Bbl $160 $140 $120 $100 $80 $60 $40 $20 Crude Oil & Gold Jan-09 Jan-11 Crude Oil Source: Bloomberg Gold $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 Gold ($ per troy oz) All three methodologies may readily be referenced on Bloomberg quotation devices. Appendix 3 below 10 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

11 Commodity prices have sometimes seen steep advances during the past decade as seen in the rise in the value of energy, grain, livestock, precious metals and industrial metals. Price advances have frequently been fueled by demand from EM economies, although some of these trends have corrected in the past couple of years with EM deceleration. $ per Bushel $18 $16 $14 $12 $10 $8 $6 $4 $2 Jul-07 Jul-08 Jan-09 Jul-09 Grains The CME FX Commodity Country Index tracks a basket of currencies from nations that rely heavily upon the exportation of commodities and other raw 12 materials. The CME FX Commodity Country Index closed Q2-14 at and up 0.9 from Q1-14 s , largely on strength in the energy sector. Jul-10 Jan-11 Jul-11 Jul-12 Jul-13 Corn Soybeans Wheat Source: Bloomberg 1,100 1,050 1, Conclusion CME FX Commodity Country Index Jul-07 Jul-08 Jan-09 Jul-09 CME offers a broad array of currency futures and option contracts covering a wide range of currency pairings (where one side is the U.S. dollar) and cross-rate pairings (which do not involve the U.S. dollar). These products provide facile and liquid vehicles with which one may express a view on prospective market movements. Or, to manage the risks associated with currency holdings or international investments during turbulent times. For more information please visit our website at Jul-10 Long Short 16.7% AUD 100% USD 16.7% BRL 16.7% CAD 16.7% NOK 16.7% NZD 16.7% ZAR Jan-11 Jul-11 Jul-12 Jul The CME Commodity Country Index is constructed to be effectively long Australian dollar (AUD), Brazilian real (BRL), Canadian dollar (CAD), Norwegian krone (NOK), New Zealand dollar (NZD) and South African rand (ZAR) vs. a short position in the U.S. dollar (USD). It is (arbitrarily) established at a value of 1, as of December 31, Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

12 Appendix 1: Summary of World Economic Conditions Growth, Inflation & Fiscal Policy Monetary Policy Special Factors Growth, Inflation & Fiscal Policy Monetary Policy Special Factors Australia Brazil Canada Economic growth has been slow in Brazil. Modestly improved real GDP growth is expected in the second half of Inflation may have peaked and may finish 2014 close to. Australia s economy is now growing at a good pace and the inflation is close to 3%, all this despite the uncertainties related to China and global commodity markets. Monetary policy has been on hold in Australia, but with better growth, a short-term interest rate rise could occur if new data shows more inflation pressure. The Australian dollar has gained on most major currencies in 2014 with economic activity resuming a healthy pace and signs of a possible rate rise in the second half of Chinese real GDP may decelerate further to around 6.5% to 7% real GDP growth in The economy is likely to avoid a hard landing but continues to face significant challenges. Short-term interest rates above 10% have provided solid support for the currency, which has appreciated nicely in Rate cuts are possible in the second half of A successful World Cup has the potential to give the markets a boost of confidence in the Brazilian economy and currency ahead of fall elections. Canada is benefiting from the continued jobs expansion in the US. A positive decision on the Keystone pipeline could help the Canadian dollar, but political uncertainties abound. Canada s short-term interest rates are low. Some inflation pressures appear to be developing. The Bank of Canada may consider a rate rise, especially if US job growth remains robust. A rate rise in Canada could add support to the Canadian dollar, if it comes. A negative US decision on the Keystone pipeline, if it goes that way, would hurt the Canadian dollar. China European Union India Europe is likely to post only small gains in economic growth in The banking system remains under-capitalized and not able to expand lending at a pace to support stronger growth. With the RMB weakening in the first half of 2014, China did not accumulate US Treasury securities. In the past, China has bought US Treasuries to prevent RMB volatility during periods of upward pressure on the currency. China has widened the bands for currency volatility, and the RMB weakened by 2.5% from end-2013 through 2Q/2014. The weakness may have run its course for now. The ECB announced negative deposit rates in an attempt to encourage banks to use that money to lend to private enterprises. Our view is that negative deposit rates are a tax and will hurt bank profitability and not encourage new lending. The EU Parliamentary elections in May 2014 gave fringe parties much more voice. Most of the fringe parties are not supportive of Brussels, and this could encourage a further split with the UK. India s elections in May brought in new leadership and enthusiasm for change. So far, the currency has reacted positively. Short-term interest rates have been cut 0.5% in 2014, and more cuts are possible if the currency continues to gain ground and inflation pressures diminish, even incrementally. The Indian rupee is on the mend. The elections in May brought the possibility of meaningful economic reforms. 12 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

13 Appendix 1: Summary of World Economic Conditions, cont. Growth, Inflation & Fiscal Policy Monetary Policy Special Factors Growth, Inflation & Fiscal Policy Monetary Policy Special Factors Japan Mexico Russia As consumers sought to beat Japan s hike in its national sales tax, January-March real GDP was exceptionally strong. Some setback is expected when the April-June quarterly data is released. The Bank of Japan may consider expanding its already massive quantitative easing (asset purchase) program if real GDP fails to meet expectations in the second half of The Japanese yen has remained quite stable since mid-2013, trading between 100 and 103 yen per US dollar. The Bank of Japan can be expected to resist any yen appreciation outside this range, yet may welcome yen weakness should it develop. Mexico is benefiting from improved growth in the United States. Mexico has also increased its imports of relatively inexpensive natural gas through its pipeline link with Texas. The Bank of Mexico has made small cuts in shortterm interest rates, in part, to make sure the currency does not appreciate too rapidly to jeopardize trade prospects. Mexican inflation is well contained. If it were not for the Bank of Mexico short-term rate cuts, the peso might have been much stronger. Russia s annexation of the Crimea and further political turmoil in the Ukraine have led to costs and economic sanctions that possibly could cause a recession. Russia has had to raise short-term interest rates to protect the currency during the Ukraine turmoil. Over the long-term, the big issue for Russia is global oil and natural gas prices. Russia has agreed a deal to ship natural gas to China. The Iraq turmoil has raised oil prices to Russia s benefit. Switzerland United Kingdom United States Switzerland is seeing some benefits from Europe s stabilization. Moreover, stronger growth in the US may also help exports. As the EU debt crisis has morphed into a longterm banking capital adequacy problem, the Swiss have little flexibility, and they are likely continue to keep a lid on the Swiss franc relative to the euro. The post-2008 financial crisis has led to increased regulation of financial institutions all over the world. On net, this increased regulation poses additional challenges for the traditional model of Swiss secrecy and the overall role of Switzerland in the world s financial system. The UK s growth prospects are steadily improving. The London housing market is booming, due to foreign buyers. The budget deficit as a percent of GDP is also declining. The Bank of England may well revisit plans to keep rates low. It is possible that the UK could be the first major country to raise rates during the post-crisis economic expansion. The pound is already rising on rate hike anticipation. The vote in Scotland on independence in September is a major uncertainty. The outcome will depend on the tug of war between the pocket book and the heart strings. Economics says independence would hurt Scotland and the UK. But Scots can achieve at the ballot box what eluded Robert Bruce and William Wallace. The US economy suffered through a tough winter in midwest and northeast, but appears to have bounced back. The Federal budget deficit is likely to be balanced by FY State and local finances have improved enough to end the job losses from this sector. The Yellen-led Federal Reserve is on track to end the Bernanke-Fed s quantitative easing by year-end The next decision, in 2015, will be when or if to abandon the near-zero federal funds rate target. Some small signs of incremental inflation in the US may emerge in the second half of Even a whiff of inflation pressure, along with steady progress on the jobs front, could bring forward the market s expectations of when the Fed might make a decision to raise its federal funds rate. 13 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

14 Appendix 2: Select Currency Performance (2 nd Quarter 2014) Currency Ticker 2 nd Quarter Year-to-Date Spot Quote Quote 3-Mth Rates Total Spot Interest Total Spot Interest (6/30/14) Convention (6/30/14) Return 1 Return 2 Return 3 Return 1 Return 2 Return 3 Argentine Peso USD-ARS USD per 1 ARS 39.19% 6.07% -1.59% 7.79% -1.95% % 22.30% Australian Dollar AUD-USD AUD per 1 USD 2.89% 2.53% 1.82% 0.69% 7.23% 5.79% 1.37% Brazilian Real USD-BRL USD per 1 BRL 5.41% 2.60% % 6.67% 5.3 British Pound GBP-USD GBP per 1 USD 0.55% 2.80% % 3.58% 3.32% 0.25% Canadian Dollar USD-CAD USD per 1 CAD 1.15% 3.87% 3.55% 0.30% 0.13% -0.45% 0.59% Chilean Peso USD-CLP USD per 1 CLP 0.38% -0.63% 1.02% -3.03% -4.97% 2.05% China Renminbi USD-CNY USD per 1 CNY 4.70% 0.87% 0.23% 0.65% -1.48% -2.40% 0.9 Colombian Peso USD-COP 1, USD per 1 COP 5.92% 4.99% 0.88% 4.41% 2.77% 1.59% Euro EUR-USD EUR per 1 USD 0.15% -0.50% % -0.37% 0.12% Icelandic Krona USD-ISK USD per 1 ISK 5.85% 1.40% % 5.08% Indian Rupee USD-INR USD per 1 INR 8.25% 1.72% -0.49% 2.22% 7.39% 2.68% 4.59% Japanese Yen USD-JPY USD per 100 JPY 0.02% 1.89% 1.88% 0.01% % 0.03% Mexico Peso USD-MXN USD per 1 MXN 3.31% % % 0.53% 1.49% New Zealand Dollar NZD-USD NZD per 1 USD 3.72% 1.97% 1.10% % 6.62% 1.62% Russian Ruble USD-RUB USD per 1 RUB % 3.51% 2.32% % 4.17% South Africa Rand USD-ZAR USD per 1 ZAR 6.50% % 1.55% South Korean Won USD-KRW 1, USD per 1 KRW % 0.50% 4.89% 3.75% 1.10% Swiss Franc USD-CHF USD per 1 CHF -0.01% -0.25% -0.25% -0.01% 0.67% 0.69% -0.01% Taiwanese Dollar USD-TWD USD per 1 TWN 0.87% 2.22% 2.00% 0.21% 0.15% -0.27% 0.42% Turkish Lira USD-TRY USD per 1 TRY 8.90% 3.63% 1.05% 2.55% 6.80% 1.40% 5.32% United States Dollar USD USD 0.27% % 0.11% Notes (1) Return from price movement and interest (2) Return from currency price movement vs. USD as base currency (3) Return from interest at prevailing 3-month rates or implied NDF rate Source: Bloomberg 14 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

15 Appendix 3: Purchasing Power Parity ( PPP ) Analysis (as of 6/30/14) % Over/Under Valued Currency ISO Bloomberg Bloomberg Average OECD Code (CPI) (PPI) Big Mac Norwegian Krone NOK 31.63% 31.98% 10.10% 52.80% Swiss Franc CHF 31.08% 35.45% 24.41% 10.51% 53.95% New Zealand Dollar NZD 23.02% 21.19% 33.23% 39.92% -2.25% Danish Krone DKK 19.25% % Icelandic Krona ISK 18.23% 18.23% Australian Dollar AUD 16.00% 26.71% % Swedish Krona SEK 12.88% 25.05% -5.95% Euro EUR % 18.11% Canadian Dollar CAD 7.25% 10.48% 7.33% 7.58% 3.62% British Pound GBP 5.79% % 0.92% -7.95% Brazilian Real BRL 3.59% 3.59% Colombian Peso COP Japanese Yen JPY % -0.60% % % % Singapore Dollar SGD % % South Korean Won KRW % % Chilean Peso CLP % % Czech Koruna CZK % % Thai Baht THB % % Chinese Renminbi CNY % % Hungarian Forint HUF % % % Phillipines Peso PHP % % Argentina Peso ARS Indonesian Rupiah IDR % % Russian Ruble RUB % % Hong Kong Dollar HKD % % Mexican Peso MXN % % % Malaysian Ringgit MYR % % Polish Zloty PLN % South African Rand ZAR % % Turkish Lira TRY % % % Notes Please note that data regarding all countries is not generally available. Source: Bloomberg 15 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP

16 CME Group is a trademark of CME Group Inc. The Globe logo, CME, CME Direct and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago INc. NYMEX and ClearPort are trademarks of New York Mercantile Exchange, Inc. All other trademarks are the property of their respective owners. Standard & Poor s and S&P 500 are trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use by Chicago Mercantile Exchange Inc. Futures and options trading is not suitable for all investors, and involves the risk of loss. Futures are leveraged investments, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money initially deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME rules. Current rules should be consulted in all cases concerning contract specifications. The information within this presentation has been compiled by CME Group for general purposes only. Although every attempt has been made to ensure the accuracy of the information within this presentation, CME Group assumes no responsibility for any errors or omissions. All data is sourced by CME Group unless otherwise stated. This communication does not constitute a Prospectus, nor is it a recommendation to buy, sell or retain any specific investment or to utilise or refrain from utilising any particular service. This communication is for the exclusive use of Eligible Counterparties and Professional Clients only and must not be relied upon by Private Clients who should take independent financial advice. Circulation should be restricted accordingly. Chicago Mercantile Exchange Inc. is a Recognised Overseas Clearing House (ROCH) recognised by the Bank of England. Chicago Mercantile Exchange Inc., Board of Trade of the City of Chicago and the New York Mercantile Exchange are Recognised Overseas Investment Exchanges (ROIE s) recognised by the Financial Conduct Authority. Issued by CME Marketing Europe Limited. CME Marketing Europe Limited (FRN: ) is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Copyright 2014 CME Group. All rights reserved. 16 Currency Market Monitor 2 nd Quarter 2014 July 3, 2014 CME GROUP