J. P Morgan -The beginning of the end by riteshbhansali


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									                                                                                Global FX Strategy
                                                                                24 May 2013

The beginning of the end of easy
Implications for the dollar, FX volatility and correlation

 As the US labour market firms and expectations of Fed tapering build,         Global FX Strategy
  Treasuries are underperforming almost every other bond market while           John Normand

  the dollar outperforms almost ever currency.                                  (44-20) 7134-1816
 At some levels the dollar appears to be benefitting from the most             J.P. Morgan Securities plc
  unusual cyclical and structural environment in 15 years as the US
                                                                                Paul Meggyesi
  economy and stock market outpace most others and the country inches           (44-20) 7134-2714
  towards energy independence.                                                  paul.meggyesi@jpmorgan.com

                                                                                J.P. Morgan Securities plc
 The cyclical arguments for a stronger dollar are more convincing than
  the structural ones, since there is little evidence their either a soaring    Arindam Sandilya
                                                                                (1-212) 834-2304
  S&P or booming energy production have strengthened the US balance of          arindam.x.sandilya@jpmorgan.com
  payments. Hence this note focuses on the basic business cycle issues
                                                                                JPMorgan Chase Bank NA
  which will influence the dollar during the next few phases of Fed policy
                                                                                Niall O'Connor
  (tapering, pause and then tightening).
                                                                                (1-212) 834-5108
 The note addresses several issues around the broad dollar: (1) is the
                                                                                JPMorgan Chase Bank NA
  currency overshooting; (2) how would this Fed transition differ from
  previous ones based on global cyclical conditions, global imbalances,         Matthias Bouquet
                                                                                (44-20) 7134-1819
  investor leverage and position concentrations; (3) how credible is a
  structural improvement in the US balance of payments from energy
                                                                                J.P. Morgan Securities plc
  production, foreign direct investment or portfolio equity; (4) how should
  volatility and correlation behave as rates rise; (5) what is the long-term    Justin Kariya
                                                                                (1-212) 834-9618
  technical outlook for the USD index; (6) has it paid to pre-position for      justin.p.kariya@jpmorgan.com
  Fed tightening; and (7) how best to position now for the next Fed phase.
                                                                                JPMorgan Chase Bank NA

 The answers do not suggest continuation of USD strength as broad as
  has occurred this year: (1) the currency looks about 4% rich to cyclical      Contents
  conditions, second only to the 6% overvaluation post-Lehman; (2) every        I. Preparing to pause, not hike             2
  Fed cycle is different for the dollar, and this one is characterized by       II. The annual overshoot...                 3
  unusually large long USD positions but unusually high foreign
                                                                                III. …or a once-a-decade regime change      7
  ownership of bond markets in Australia, New Zealand and some
                                                                                IV. Volatility & correlation: higher but
  emerging markets; (3) energy independence, FDI and portfolio equity all
                                                                                constrained by USD longs                    10
  look overstated as supports for the US balance of payments; (4) FX
  volatility, and particularly USD-based currency correlations, should tick     V. Long-term FX technicals                  11

  modestly higher (VXY to 10%, correlations up 15-20 points) as Fed             VI. Strategy: selective rather than broad   12
  policy shifts, but large USD longs should constrain the move; (5) the
  dollar’s technical backdrop has improved, with key levels at 85.5 for
  JPMQUSD, 1.2760 for EUR/USD and 1.0450 for USD/CAD.

 The arguments for an extended, broad USD rally are not compelling,
  based either on historical performance, returns to pre-positioning before
  Fed hikes or US balance of payments trends. Better to position for
  cyclical lift on a more selective basis, focusing either on deficit
  currencies which are overvalued and vulnerable to a reversal of bond
  inflows (AUD and NZD), or where policy is most divergent (JPY).
  European currencies with the exception of GBP are unconvincing sells.
See page 14 for analyst certification and important disclosures.
John Normand                              Global FX Strategy
(44-20) 7134-1816                         24 May 2013

As US labour market data firm and discussions of Fed                 Chart 1: Every cycle's different
tapering build, Treasuries are underperforming almost every          Trade-weighted USD (JPMQUSD) versus Fed funds rate
other bond market and the dollar outperforming almost                  120                                                                  20
                                                                                                               JPM nominal effective rate
every currency this year.1 Bond market spasms like the                 115                                     Fed funds, %                 18
current one should look familiar: they have occurred at least          110                                                                  16
annually since 2009 because every prediction of a durable                                                                                   14
US slowdown or EMU implosion has proven alarmist. 2                                                                                         12
The dollar’s response to yields has been changing recently,            100
however. Having weakened during every previous bond                     95
market sell-off between 2009 and mid-2012, the dollar has               90
been strengthening with higher rates since late 2012. Such              85                                                                  4
decorrelation too is common when economies decouple,
                                                                        80                                                                  2
though the current episode has persisted for longer than we
expected due to persistent weakness in the rest of the world            75                                                                  0
(notably China, Australia and Europe).                                         1973 1978 1983 1988 1993 1998 2003 2008 2013
                                                                     Source: J.P. Morgan
At some levels the dollar appears to be benefitting from
the most unusual cyclical and structural environment                 Chart 2: Rate and FX vol remain low for a rate normalisation period
since the late 1990s. The US economy is outpacing all                FX vol measured in % by VXY Global index of 3-mo implieds across 22 G-10 and
                                                                     EM pairs. Rate vol measured in basis points per day on US 3Mx10YR swaptions.
regions but Japan by a wide margin; US stocks are
                                                                       220                                                                   26
outperforming all other others but the Nikkei, Switzerland
                                                                       200               US 3Mx10YR swaption vol, bp                         24
and parts of Southeast Asia; and America is progressing                                  VXY Global, %
slowly but steadily towards energy independence. To us the             180                                                                   22
first factor is more credible than the last two, so is the main                                                                              20
focus of this note. Summer 2013 indeed looks like the                                                                                        18
beginning of the end of easy money in the US but not the                                                                                     16
onset of a structural improvement in the US balance of                                                                                       14
payments. And since this new monetary regime will unfold                                                                                     12
in phases – tapered asset purchases from late 2013 to                   80                                                                  10
early/mid 2014, zero rates until mid 2015 – and against                 60                                                                  8
some eventual improvement in non-US economies (note                     40                                                                  6
this week’s improvement in Europe’s PMIs), the dollar’s                        93    95    97   99   01   03    05    07    09    11   13
almost-comprehensive rally this year looks overdone. This            Source: J.P. Morgan
note examines several aspects of the long-term outlook for
the dollar and FX volatility in the context of Fed policy.           and (7) how best to position now for the next Fed phase.
The note addresses several issues around the broad                   I. Preparing to pause, not hike
dollar: (1) is the currency overshooting; (2) how would
                                                                     As at any turning point in the business or policy cycle,
this Fed transition differ from previous ones based on global
                                                                     market moves this spring have been abrupt, potentially
cyclical conditions, global imbalances, investor leverage
                                                                     discounting a more extreme outcome on Fed policy than
and position concentrations; (3) how credible is a structural        what is likely to unfold over the next few years. For the
improvement in the US balance of payments from energy                record, J.P Morgan sees changes to Fed policy over the next
production, foreign direct investment or portfolio equity; (4)       two years as gradual and incremental, while the underlying
how should volatility and correlation behave as rates rise;
                                                                     setting remains highly accommodative. JPM’s scenario is
(5) what is the long-term technical outlook for the USD
                                                                     the following: the Fed begins reducing its $85bn of monthly
index; (6) has it paid to pre-position for Fed tightening;
                                                                     asset purchases by September at the earliest and by
                                                                     December at the latest; it ends asset purchases around mid-
1                                                                    2014; and it begins lifting the funds rate in mid-2015. The
 Sweden is the only government bond market to have
                                                                     Fed would probably only sell Treasuries and/or MBS in
underperformed Treasuries year-to-date. MXN, CNY, MYR and
THB are the only currencies to have outperformed USD.                coming years if it needed to tighten financial conditions
                                                                     beyond what rate normalisation achieved.
  Since the Lehman crisis, 10-yr Treasuries have sold off at least   If Fed policy evolved so incrementally along this timeline,
40bp on five occasions: March-June 2009 (+140bp), October 2010       the Fed would effectively stop easing around mid-2014 and
- February 2011 (+130bp), October 2011 (+62bp), July – August        remain on hold for a year. This pause would be equivalent
2012 (+40bp) and Dec 2012 – March 2013 (+48bp).

John Normand                            Global FX Strategy
(44-20) 7134-1816                       24 May 2013

in length to the one which followed the last three easing        Chart 3: The trade-weighted USD has tended to rally about 2.5% for
cycles in 1995, 1998 and 2001-03, but half as long as the        every 25bp move in 10-yr rates between the US and rest of the world
                                                                 Trade-weighted USD vs trade-weighted 10-yr spreads versus the rest of the world
pause following the 1990-92 cuts. Thus markets are
approaching the beginning of the end of easy money                 110                                                                       250
rather than something more ominous like tighter global             105
liquidity.                                                                                                                                   200
Naturally this view presumes that the Fed can afford                                                                                         150
patience because its model of the labour market will be             90                                                                       100
proven correct. As the economy improves, participation will
rise, the unemployment rate stabilise, wage growth remain           85                                                                       50
moderate and inflation below 2%. If the Fed's model is              80
wrong, all bets on fixed income and currencies are off.             75
1994 is a fair template for how disruptive Fed tightening           70                        JPM USD nominal trade-wtd index                -50
can be when central bank actions are aggressive due to                                        avg 10-yr spread, US to Rest of World
                                                                    65                                                                       -100
perceived lack of slack. 2004-06 is an example of how
benign these cycles can be when policy proves predictable.                91 93 95 97           99    01    03 05 07 09           11 13
Since no two cycles are the same, potentially the coming         Source: J.P. Morgan
transition to higher rates will be somewhere between these
extremes.                                                        Chart 4: The trade-weighted USD is overshooting by about 4%
                                                                 second only to the Lehman overshoot of 6%
In terms of what the baseline Fed scenario means for             Actual versus predicted trade-weighted USD (JPMQUSD) from regressing index on
Treasury yields, J.P. Morgan Fixed Income Research               trade-weighted 10-yr rate spreads versus the rest of the world and equity volatility.
estimates that terminating QE lifts 10-yr rates about 25bp to      98
a June 2013 target of about 2%, after controlling for other        96
depressants on yields like the Fed’s 2015 rate guidance and        94
                                                                                                     JPM USD nominal trade-wtd index
inflation expectations (see Will Fed tapering lead to a            92                                Model
repeat of the 1994 sell-off? Wadhwa and Feroli, May 15).           90
Moving towards the first rate hike in 2015 is worth another        88
couple of basis points per month, which combined with              86
moves higher in other variables like growth expectations,          84
should deliver a 2.4% US 10-yr by the end of 2013.                 82
II. The annual overshoot...                                        78
This summer's repricing towards those yield targets may
seem violent, but measured in term of implied volatility in                  2009          2010            2011         2012          2013
rates and FX, the moves are somewhat tame (chart 2). In          Source: J.P. Morgan
rates, 3Mx10YR swaption vol is up from 55bp (near record
low) in April to 73bp now, while FX vol is up from 8.6% to       of which can prompt massive position reversals.
9.6% (still a below-average level). By other measures the        Occasionally the misalignments are based on perceptions of
dollar seems much more excited than bonds about an               structural change, like the capital flows related to the dot-
imminent change in Fed policy. Over most horizons the            com and USD bubble in the late 1990s. This year’s dollar
dollar has been sensitive to rate shifts between the US and      rally has elements of both. Relative to cyclical conditions
the rest of the world (chart 3), such that on average every      (proxied by rate spreads and equity volatility), the trade-
25bp shift in spreads is worth about 2.5% on the trade-          weighted dollar looks about 4% too strong, which as an
weighted dollar. So while this year’s dollar rally is            overshoot is second only to the 6% overvaluation
understandable directionally given how spreads have              experienced post-Lehman (chart 4). This rerating is hard to
moved, the magnitude of this move looks excessive. 10-yr         rationalise with respect to structural improvement in the US
rate spreads have only moved 15bp in the US's favour this        balance of payments, since the US is failing to attract net
year while the dollar has jumped 4%, implying that the           equity inflows as the S&P climbs, nor has the current
usual beta has more than tripled.                                account deficit fallen over the past four years as oil and gas
                                                                 production have surged (see pages 6-7 for more on these
For those who like models as shorthand for reality, these        points). The blue box on page 13 (Is the dollar due a
FX overshoots seem to occur at least annually, either due to     fundamental rerating) examines long-term valuation more
inflection points in the business cycle or market stress, both   formally.

John Normand                              Global FX Strategy
(44-20) 7134-1816                         24 May 2013

Matthias Bouquet
(44-20) 7134-1819

The move also looks hasty given historic dollar patterns            Chart 5: Over the last four Fed tightening cycles the dollar has
in the years before and during Fed tightening. On                   tended to fall in the lead up as well as the initial year of tightening
                                                                    USD performance and changes in Fed funds rate around the first Fed hikes in April
average over the past four tightening cycles since 19873 the
                                                                    1987, February 1994, June 1999 and June 2004. USD indexed to 100 at first hike,
dollar has tended to decline in the run-up to and during the        where rise indicates USD appreciation. Change in Fed funds shown in basis points,
first year of Fed tightening (chart 5). This pattern is intuitive   so rise indicates tightening. X-axis in business days around date of first rate hike.
since the recession which originally prompted rate cuts               115                                                                                   250
tends to relegate the dollar to a low-yield funding currency.                               USD trade-wtd, indexed to 100 at t=0, lhs
It isn’t until the tightening cycle is more advanced that the         110                   Fed funds, change since t=0, bp, rhs
dollar becomes worth holding as an investment currency.
This pattern is quite inconsistent across cycles (chart 6),           105
however, so prepositioning versus some currencies makes                                                                                                     100
sense under the right conditions. With the 1987 cycle, the            100
dollar fell in the two years before the first hike and during                                                                                               50
the first year of Fed tightening, although the Plaza Accord
to weaken the dollar from record levels skews the trend.                                                                                                    0
With the 1994 cycle, the dollar rallied about 4% in the two
years preceding the first hike but fully unwound that move             90                                                                                   -50
                                                                            -500 -400 -300 -200 -100             0        100   200    300    400     500
during the first year of rates hikes given the market stress
                                                                    Source: J.P. Morgan
created by an aggressive Fed. With the 1999 episode the
dollar rose two years before the first hike – aided by the          Chart 6: Over the last four Fed tightening cycles the dollar has
Asian Crisis – then resumed its uptrend once tightening             tended to fall in the lead up as well as the initial year of tightening
ended and the stock market/global M&A bubble inflated               Performance of trade-weighted USD around the last four Fed tightening cycles. USD indexed
further. The 2004 cycle witnessed a continuous decline in           to 100 at first hike, where rise (fall) indicates USD appreciation (depreciation).

the years prior to the first hike and during the first year of        140

tightening, possibly due to a very large current account              130
                                                                                                                 1987                    1994
deficit at the time (about 5% of GDP) plus heady growth in
the rest of the world.                                                120
                                                                                                                 1999                    2004

The necessity of caveats highlights an essential point:               110
every cycle is different. Much depends on the monetary
stance of other countries at the time; growth gaps between
the US and the rest of the world at the time; and market               90
positioning and leverage. Table 1 and charts 7, 8 and 9
present a few of the stylized facts to describe the conditions         80
                                                                            -506 -406 -306 -206 -106              -6       94    194    294     394     494
around the onset of Fed tightening to help in thinking about
how stable the Treasury market should be over the next
                                                                    Source: J.P. Morgan
couple of years, how likely the US’s economic
outperformance is likely to persist and how the broad dollar        Chart 7: Europe’s uptick is the first indication that US cyclical
should trade during this Fed transition.                            outperformance may not persist as long as it did in the 1990s
                                                                    US PMI manufacturing versus average PMIs in other regions plotted against
In terms of US cyclical conditions, headline inflation has          average rate spreads between the US and the rest of the world
tended to be around 2% (so higher than the current 1.1%),            15                                                                                     250
while long-term inflation expectations have ranged from              10                                                                                     200
2.8% to 4% (versus the current 2.9%). Wage growth at the
time has ranged from 2% to 3.6% compared to the current               5                                                                                     150
1.9%, and real GDP growth had been averaging 2.4% to                  0                                                                                     100
4.9% compared to the current 2.5%. No surprise then why
the Fed can afford to be a patient with the funds rate even if       -5                                                                                     50
it begins tapering asset purchases this year: inflation, wage
                                                                    -10                                                                                     0
                                                                                                US minus rest-of-world avg PMI, lhs
                                                                    -15                                                                                     -50
                                                                                                US minus rest-of-world 10-yr rates, bp, rhs
3                                                                   -20                                                                                     -100
  Fed cycles pre-1997 are excluded since the high-inflation               91    93     95      97    99     01       03    05    07     09    11      13
environment of that era is not comparable to the environment
                                                                    Source: J.P. Morgan
likely to prevail over the next few years.

John Normand                            Global FX Strategy
(44-20) 7134-1816                       24 May 2013

Paul Meggyesi
(44-20) 7134-2714

gains and real GDP growth are all at the low end of the           Table 1: Stylized facts on cyclical conditions and global imbalances
range for starting a hiking cycle.                                around last four Fed tightening cycles versus today
                                                                                                    Apr-87         Feb-94        Jun-99         Jun-04       current
Cyclical conditions in the rest of the world are not               US cyclical conditions
markedly different today than at the onset of previous Fed         headline CPI                          1.8%           2.3%            1.9%         1.9%          1.1%
tightening cycles. Proxied by the spread between the US            core CPI                              3.9%           2.8%            2.0%         1.9%          1.7%

manufacturing PMI and other countries’ PMIs, the US is             Inflation ex pectations1              4.0%           3.5%            2.8%         2.8%          2.9%
                                                                   Av g hourly earnings                  2.0%           2.4%            3.6%         2.0%          1.9%
indeed outperforming but no longer by a huge margin (chart
                                                                   real GDP grow th2                     2.4%           2.7%            4.9%         4.1%          2.5%
7). And importantly, this gap is closing with respect to a
key region like Europe, whose crawling from recession is           Global imbalances
allowing EUR/USD to remain relatively stable in the high           US current account                    -3.7%          -1.5%        -3.5%          -4.8%         -2.9%
1.20s even as the dollar soars versus other currencies like        Japan CA                              4.3%           2.9%            2.9%         3.6%          0.9%
AUD, NZD, CAD and ZAR. If we are correct that other                Euro area CA3                         3.1%           -1.1%        -0.2%           0.4%          2.5%
economies too will experience some lift by year-end, it            6 largest CA deficits globallyNZD (-6.8%) MXN (-6.0%) HUF (-7.9%) HUF (-8.0%) ZAR (-6.5%)
would be hasty to think that US economic outperformance                                          AUD (-4.0%) THB (-5.0%) AUD (-5.7%) CZK (-6.0%) TRY (-6.0%)
                                                                                                  NOK (-3.4%) CAD (-2.8%) PLN (-5.5%) AUD (-5.4%)           INR (-5.5%)
will persist for as long as it did in the mid-to-late 1990s                                       CAD (-2.4%) AUD (-2.7%) BRL (-4.6%) NZD (-4.4%)            NZD (-5%)
(chart 7). Thus the massive USD longs, which are                                                  TRY (-2.1%) TRY (-2.5%) NZD (-3.8%) PLN (-4.0%) CLP (-4.0%)
materially higher than at the onset of any previous Fed                                           SEK (-0.7%) NZD (-2.4%) MXN (-3.5%) ZAR (-3.4%) AUD (-3.9%)
tightening cycle (chart 9), will probably be unwound as and        1 5-10y r   from Michigan survey ; 2 q/q saar, average of previous four quarters; 3 Germany pre-EMU
when growth gap close.
                                                                  Source: J.P. Morgan
Global imbalances have shifted considerably. The US               Chart 8: Current account balances (% of GDP) over past 15 years –
current account deficit ahead of Fed tightening has ranged        max, min and current
from -1.5% (1994) to 4.8% (2004) and has now fallen to
2.9%. But in contrast to previous Fed tightening cycles,                                                          max
Europe's balance of payments is at its strongest (1.5-2.0%          15%
surplus) and Japan's at its weakest (1% surplus). The               10%                                           current
watchlist of countries running the largest current account
deficits in the world, and therefore vulnerable to capital            5%
outflows and weaker currencies in a rising rate environment           0%
unless their central banks are tightening too, contains
familiar suspects from previous Fed cycles: South Africa
(-6.5%), Turkey (-6%), India (-5.5%), New Zealand (-5%),           -10%
Chile (-4%), Australia (-3.9%) and Canada (-3.8%). Chart 8
highlights how vulnerable some currencies are – and aren’t










– relative to history.
FX positioning entering this Fed transition is unusually          Source: J.P. Morgan
long USD. Typically Fed easing promotes the build-up of           Chart 9: USD longs are at record large ahead of a Fed turn
USD shorts which are unwound in anticipation of Fed               Two position proxies: aggregate USD positions on the IMM in US$ billion and
tightening or after US rates have risen to worthwhile levels.     currency manager beta with trade-weighted USD
This cycle looks quite different in that the EMU crisis has          4                                                                                            50
                                                                                          Currency manager beta to JPMQUSD, lhs
kept investors short euros for most of the past three years,                                                                                                      40
                                                                                          IMM aggregate USD longs ($bn), rhs
while economic weakness outside the US (China, Australia,            3
Canada) over the past six months has motivated a shift into
                                                                     2                                                                                            20
additional USD longs. Thus CTAs and currency managers
appear to be longer of USD than they have been during any            1                                                                                            10
previous Fed pause (chart 9).                                                                                                                                     0
                                                                     0                                                                                            -10
Other vulnerabilities stem from massive inflows into
                                                                   -1                                                                                             -20
non-US bond markets during the QE era, as well as a
significant increase in USD cross-border lending. When                                                                                                            -30
considering how the dollar’s response to the looming turn in                                                                                                      -40
the US monetary policy/interest rate cycle might differ from       -3                                                                                             -50
previous ones it is important to consider the unique aspects             92        94      96      98      00      02       04     06      08      10       12
of the easing cycle over the past five years, in particular the   Source: J.P. Morgan

Paul Meggyesi                              Global FX Strategy
(44-20) 7134-2714                          24 May 2013

extreme and widespread financial repression that has                  Chart 10: There is no evidence of a 2008-style dollar-shortage from
occurred in much of the industrialized world as central banks         the FX basis
                                                                      3-mo FX basis
pushed risk-free rates to zero and expanded their balance
sheets in a hitherto unprecedented manner. It is not
unreasonable to question whether these extreme and                        0
protracted policy measures have led to the accumulation of
unusually large or concentrated position imbalances in
foreign exchange, which have the potential to unravel as the          -100
era of easy and unlimited money begins to wind down.
There are two aspects of this which are relevant for the         -200
dollar’s outlook, both of which are linked to the notion of the                                     EUR/USD
dollar as a funding currency. First, will there be a shortage of -250
dollars, as higher US rates triggers a squeeze on USD-           -300
funding and some form of short-covering scramble in the
dollar (analogous to the post-Lehman’s rally)? Second, has       -350
                                                                     Jan-08        Jan-09   Jan-10       Jan-11   Jan-12                        Jan-13
the financial repression in structurally-impaired economies
                                                                 Source: Bloomberg
such as the US sponsored excessive and unsustainable
capital inflows to the less-troubled economies, which            Table 2: Foreign ownership of G10 sovereign debt
threatens a deeper-than-normal retrenchment of investment                                                       Change since
from the healthier economies in G10 (commodity producers)                           USD bn % total stock % GDP 2007, % GDP
and EM as the US rate cycle slowly turns?                         NZD                  33       69         79         50
The focus on a possible dollar-shortage is understandable              AUD                   202              73         55           42
given that this was probably the most unanticipated and                USD                  5546              50         35           18
disruptive phenomenon in the immediate post-Lehman                     GBP                   632              31         27           16
period. Before the crisis struck, few had any idea of the
                                                                       EUR                  3200              26         26           13
extent to which non-US banks had expanded their USD-
balance sheets, and the problems this would cause as USD-              JPY                   820              9          18            6
funding markets shut down and banks were unable to                     SEK (non-FX)           59              49         11            7
liquidate what suddenly became very illiquid assets quickly            CAD                   129              21             7         5
enough to offset their reduced USD-funding. The result: a              NOK                    33              60             7        n/a
massive scramble for USD liquidity through the FX swap
                                                                       CHF                    34              16             6         1
market, an unprecedented and almost uncontrollable rise in            Source: National sources, J.P .Morgan
the FX basis (i.e. a de facto surge in the effective cost of
USD-funding) and an attendant surge in the value of USD4.             Table 3: Foreign ownership of selected EM public sector debt
                                                                      Asia includes sovereign and central bank debt
The dynamics at work in 2008 were very specific to the                                                                           Change since
Lehman’s period however; in particular the complete                                        USD bn % total stock         % GDP    2007, % GDP
breakdown in confidence towards and between financial                  MYR                    68              36         23           16
institutions which led to the cessation of interbank lending
                                                                       HUF                    21              39         17            5
and the inability of banks to borrow USD at virtually any
price. A repeat of these extreme, unique circumstances                 PLN                    64              37         13            8
seems improbable. A whole raft of government and central               ZAR                    41              38         12           10
bank initiatives were of course required to stem the rot, but          MXN                   141              37         11           10
from an FX perspective the one which made most                         ILS                    7               5              9         6
difference – the provision of USD-swap lines by G7 central             TRY                    71              30             9         6
banks – remain in place and continue to function as a                  THB                    29              14             8         8
backstop for foreign banks that require USD-funding. USD-
                                                                       KRW                    85              17             8         4
funding strains can of course be monitored through the FX
basis and the message which the basis is so far sending                BRL                   116              13             5         5
                                                                       CZK                    9               13             5         2
                                                                       IDR                    29              30             3         2
  See: Central bank co-operation and international liquidity in the    RUB                    24              23             1         1
financial crisis of 2008-9, Moessner and Allen, BIS Working           Source: National sources, J.P. Morgan
Paper Number 310, May 2010

Paul Meggyesi                             Global FX Strategy
(44-20) 7134-2714                         24 May 2013

about a possible repeat of a 2008-style dollar-scarcity is         Chart 11: AUD and NZD stand-out in terms of foreign positioning in
entirely benign (chart 10).                                        their government bond markets, both the current size and change
                                                                   over the past five years
While fears about a broad-based dollar-shortage might                                                                 60
be misplaced, there is some evidence to suggest that

                                                                       Change in foreign ownership of domestic govt
financial repression has fostered sizeable, and                                                                       50                                                        NZD
potentially excessive, capital inflows to some of those
countries which came through the financial crisis largely                                                             40

                                                                       debtt from end-2007, % of GDP
unscathed and were therefore attractive to investors as a
result of their relatively high yield and low credit risk. It is
these pockets of excess positioning which would appear to                                                             20                 GBP
                                                                                                                                 MYR              USD
offer the better prospect for sizeable, albeit selective,
appreciation in the dollar as the slow end to easy money                                                              10                    EUR
triggers a reversal of these capital flows, or at least the fear
of such a reversal.                                                                                                   0
                                                                                                                           0        20          40           60          80           100
A complete dissection of global capital flows is of course                                                                     Foreign ownership of domestic govt debt, % GDP
beyond the scope of this research note. But as an indicative       Source: National sources, J.P. Morgan
illustration, tables 2 and 3 together with charts 11 and 12,
                                                                   Chart 12: It’s fairly clear which bond markets benefitted most from
detail the scale of foreign inflows to certain G10 and EM
                                                                   financial repression, and which currencies are therefore most
sovereign bond markets since the start of 2008. It will            vulnerable to a reversal of this tide
surprise nobody surely to learn that Australia and New             Foreign purchases of sovereign debt, latest vs Q4 2007. Percent of local GDP
Zealand enjoyed the greatest bond inflows over this period          50
(scaled as percent of local GDP). But what is nonetheless
striking is the sheer scale of the foreign buying of these             40
markets - at 50% and 42% of GDP respectively, foreign
inflows into NZ and Australian government debt were more               30
than double the next greatest, the US. The UK also punched
above its weight, with foreign purchases of Gilts amounting            20
to 16% of GDP.
The inflows into public sector debt in EM are less extreme
(16% of GDP to Malaysia is one exception, followed by                    0
10% to Mexico), although this of course does not capture
inflows into other EM asset classes, particularly corporate
debt, so may understate the level of foreign leverage in EM
as a whole. By contrast, inflows into Sweden and Norway            Source: National sources, J.P. Morgan
were only relatively light, which tends to contradict a
widely held view that both currencies benefited from               audacious asset bubble at the time (in retrospect the bubble
substantial safe haven or diversification inflows. Foreign         critique proved correct). At present there are two possible
investors hold a high proportion of the bond market, it is         structural trends which could strengthen the US balance of
                                                                   payments and support the dollar, even as cyclical supports
true, but since Sweden has a relatively low debt/GDP ratio,
these inflows were relatively less significant for the             to use are overstated if the Fed is patient and the rest of the
currency (so too, therefore, any potential reversal of these       world likely to turn higher. Once is the prospect of
inflows).                                                          American energy independence as oil and gas production
                                                                   booms. The other is the prospect of capital repatriation – or
III. Or the once-a-decade regime change                            at least reduced capital outflows from the US – given the
                                                                   incomplete restructuring of other big economies (China,
An admitted blind spot in this cyclical and flows analysis         Euro area ex Germany, Australia, Brazil). Admittedly, this
is failure to appreciate a regime shift in currency
                                                                   capital flow dynamic could be as cyclical as structural.
markets driven by a structural transformation in the US
balance of payments. Indeed, the regime shift of the late          Previous J.P. Morgan Research has examined the energy
1990s, when the dollar maintained a positive correlation           independence phenomenon from several perspectives5 and
with equities for about four years due to the confluence of
unprecedented equity and M&A inflows was labeled both a            5
revolution (Greenspan’s “productivity miracle”) and an               See American energy independence and the dollar: the
                                                                   arithmetic is too challenging without Fed help, Normand, March

Paul Meggyesi                            Global FX Strategy
(44-20) 7134-2714                        24 May 2013

concluded that the production increase required to eliminate      Chart 13. US's energy trade deficit has stabilised but its total trade
the US current account – a doubling of oil production or          deficit remains large
                                                                  Annual US total trade balance, energy balance and non-energy balance. Figures
tripling of gas production – is too impractical to be relevant
                                                                  expressed as 4-quarter moving sum in US$ billion
to FX over the next few years. Perhaps unsurprising then
that the US's energy trade deficit has fallen only trivially
and the non-energy deficit actually widened despite four
years of record output (chart 13).                                     -200

Other balance of payments trends in portfolio equity                   -400                                                                  -448
and FDI are no more encouraging. The dollar has been
positively correlated over the past two decades with the               -600             non-energy trade balance
growth gap between the US and other major economies.
However, the correlation is only relatively loose (30% since                            energy balance
1990) and was much more pronounced in the 1990s than
over the past decade, when for long periods the dollar                                  total trade balance
weakened during periods of increasing US economic                             99        01         03         05       07       09      11
outperformance (most notably 2002-2004 - chart 14). One
explanation for this relatively uneven link between               Source: J.P. Morgan
economic growth and the dollar is the unstable relationship       Chart 14: USD is 30% correlated with US vs rest-of-world growth
between economic growth and long-term capital flows               gap, but relationship was stronger in 1990s than 2000s
(equity and FDI). The dollar tracks the broad trend in these
                                                                   4           US - G7 ex US GDP,, % oya             USD NEER, % oya, rhs    20
long-term capital flows relatively closely (chart 15).
However, long-term capital flows themselves are almost             3                                                                         15
wholly uncorrelated with the performance of the US                 2
economy, either the absolute rate of US growth or the                                                                                        10
growth gap between the US and the ROW (chart 15 and                1
table 4). So while long-term capital flows are a significant       0
determinant of the dollar's long-term trend, the flows                                                                                       0
themselves tend to be much less cyclical than the                 -1
conventional wisdom asserts.                                                                                                                 -5
This is relevant to the current episode because one popular       -3                                                                         -10
explanation for the way in which the dollar is overshooting
interest rate-based models of fair value relies on the US         -4                                                                         -15
                                                                   Feb-90 Feb-93 Feb-96 Feb-99 Feb-02 Feb-05 Feb-08 Feb-11
being able to attract sizeable inflows of equity and M&A          Source: J.P. Morgan
capital as a consequence of its economic outperformance.
The switch from a bond- to an equity-centric investment           Chart 15: USD still tends to track long-term capital flows (equity,
environment will, so the argument runs, usher in a re-run of      FDI)
the late-90s, when the US economy boomed (growing                  4                         Net US equity and FDI inflows, % GDP            20
nearly 4% faster than the G7 average), which sucked in             3                         USD NEER, % oya, rhs
record amounts of equity and M&A capital (4% of GDP),
and in turn fostered a late cycle overshooting in the dollar.      2
The main problem with this hypothesis is that the capital          1
inflows in the late 1990s were the product of the unique           0
circumstances of the dot-com bubble in equities, which had                                                                                   0
as its epicenter of innovation the US. There is little in the     -1
current cycle to suggest that the US growth gap will widen                                                                                   -5
to anywhere near the late-1990 level, nor that the US will be
                                                                  -3                                                                         -10

15, 2013; Will US natural gas help save the world? in Commodity   -4                                                                         -15
Markets Outlook and Strategy, Colin Fenton et al, November 15,     Feb-90 Feb-93 Feb-96 Feb-99 Feb-02 Feb-05 Feb-08 Feb-11
                                                                  Source: J.P. Morgan
2011; US: a fracking research note, Michael Feroli, January 20,
2012; and Accounting for the US current account improvement,
Robert Mellman, December 14, 2012.

Paul Meggyesi                                                Global FX Strategy
(44-20) 7134-2714                                            24 May 2013

capable of attracting similar-sized structural capital inflows.
Indeed, the US has failed to post a single quarter of positive
equity and FDI inflows since Q4 2010 - US equities may be
up by one-third since then but the cumulative outflow of
long-term investment capital from the US over this period is
11% of GDP. Averaging over the past two decades, a 1%
increase in US GDP growth versus the ROW is associated
with net equity and FDI inflows of only 0.1% of GDP,
which pales by comparison with the US’s current account
deficit (3% of GDP). The bottom-line is that the dollar
cannot necessarily count on a late 1990s-style inflow of
long-term capital. The fate of the dollar would still appear
to lie more with interest-rate sensitive capital flows, in
which case the dollar’s current overshooting versus interest-
rate metrics remains a cause for concern, or at least some
Chart 16: However, these capital flows are uncorrelated with the
relative performance of the US economy. Faster US growth does not
automatically entail dot-com-style investment inflows
  4                                                          Net US equity and FDI inflows,
                                                             % GDP
                                                             US - G7 ex US GDP growth






  Feb-90    Feb-93       Feb-96      Feb-99    Feb-02    Feb-05       Feb-08      Feb-11
Source: J.P. Morgan

Table 4: A 1% increase in US GDP versus G7 tends to boost net
equity and FDI inflows to the US by a trivial 0.1% of GDP
Correlation statics and betas from regressions of US capital flows on the absolute
rate of US GDP growth and the gap between US and G7 ex-US growth. The betas
show the change in capital flows as a % of GDP for a 1% change in GDP growth
                           Equity                FDI               Equity and FDI
                    Inflow Outflow Net Inflow Outflow Net Inflow Outflow Net
 Correlation with:
 US GDP growth -0.02 0.56 -0.43 0.17 -0.26 0.39 0.10 0.09 0.05
 US - G7 GDP        -0.24 0.19 -0.37 0.03 -0.13 0.16 -0.08 -0.06 -0.02

 Beta with:
 US GDP growth        -0.07   2.33   -1.34    0.39   -0.69     0.88    0.15    0.23    0.10
 US - G7 GDP          -0.11   0.07   -0.18    0.03   -0.13     0.16   -0.08    -0.06   -0.02
Source: J.P. Morgan

Arindam Sandilya                         Global FX Strategy
(1-212) 834-2304                         24 May 2013

IV. Volatility and correlation: higher, but                         Chart 17. FX vols have corrected more than half their
                                                                    undervaluation relative to the cyclical backdrop since Q4’12, but are
constrained by large USD longs                                      still ~1.5 vols too low for the current tepid pace of global growth
Currency volatility is already trading well above our                 26                                            VXY                        35
year-end forecasts, and likely to remain around these                 24                                            JPMorgan Global Composite PMI
elevated levels for the rest of the year. Coming into 2013,
                                                                      22                                                                          40
we viewed FX vols (basis VXY) as abnormally subdued for
the mediocre global growth environment anticipated
                                                                      18                                                                          45
through the year, and due at least a 1.5 vol catch-up from
low 7s to around 9.0. Q1 brought forth a correction and
more – VXY spiked to as high as 9.8 in late February,                 14                                                                          50
driven mostly by frenzied foreign investor demand for USD             12
calls/JPY puts to express bearish yen views at the height of          10                                                                          55
Abe-mania. Current levels around 9.5 still peg VXY Global                 8
USD. In this regard, the extension through important                      6                                                                       60
resistance levels has led to a renewed trending bias while ~          May-05             May-07          May-09            May-11           May-13
1.5 vols too cheap vis-à-vis the global business cycle (chart
                                                                    Source: J.P.Morgan
17), although this amounts to less than half of the deep (> 4
vol) under-valuation that drove our turn-of-year view.              Chart 18. The base case for the VXY is to trade flat-to-modestly
                                                                    firmer over the next few quarters, with risks biased to the upside
Our base case from here is for vols to trade modestly firmer,       YoY change in VXYT = 11.0 – 1.06*VXYT - 1Y – 0.60*Global growth T + 1.7*rolling 4-
with a risk bias to the upside due to the still existing – albeit   quarter std. deviation of global growth T. Quarterly data since 2001. Forward
                                                                    looking global growth forecasts sourced from Bloomberg (ECFC <Go>)
smaller – valuation gap. The baseline view is neatly
captured in chart 18: it updates the vol forecasting exercise        vol pts.
                                                                                   Actual YoY change in VXY
we introduced in our Global FX Strategy 2013 publication,           10             Model fitted YoY change in VXY
linking year-ahead changes in the VXY to three factors –                           Forecast
the initial level of vol (a mean-reversion variable),
consensus expectations of global growth (business cycle                                                                                        ±1-σ bands
proxy) and the trailing 4-quarter std. deviation global               4
growth (growth surprise indicator). Together, the three               2
factors have done a reasonable job of explaining FX vol               0
moves over the past 10 years, and point to a mild VXY                -2
uptick towards 9.8 over the next 12-months.                          -4
Upside risks to the central expectation of modestly                  -6
higher vols over the next few quarters stem from a                   -8
tapering of Fed asset purchases. The obvious channel                  Mar-01        Nov-03          Jun-06        Jan-09       Aug-11        Mar-14
through which a reduction of monetary accommodation in              Source: J.P.Morgan, Bloomberg
the US lifts currency vol is through a trend dollar rally that      Chart 19. History indicates a loose tendency for FX vols to tick ~1-2
dislodges structural EM FX longs, particularly those                pts. higher in the run-up to Fed policy tightening
established via unhedged buying of local market fixed               VXY Global indexed to zero and averaged around onset of Fed hiking cycles
income since the inception of QE. Capital flight fears from            vol pts.                                                          Feb-94
                                                                     10                                                                  Jun-99
EM bond markets may not be altogether unfounded (see                                                                                     Jun-04
section on foreign holdings of fixed income earlier in this           8                                                                  Average
History too indicates a loose tendency for FX vols to tick
~1-2 points higher in the run-up to an eventual                       4
tightening of Fed policy, peak around 6-months prior to
the first hike, and surrender most of those gains as the event        2
draws near (chart 19). Any inference from the graphic is
admittedly skewed by the 1998 Russian/ LTCM crisis, but
the broad message of vol firmness in anticipation of                 -2
liquidity withdrawal by the Fed probably holds. However                   -500      -375        -250        -125          0           125        250
the critical link in the chain of events leading to an EM                            Business days around the onset of Fed hiking cycles
fixed income rout – a radical re-rating of the USD – is             Source: J.P.Morgan

Arindam Sandilya                        Global FX Strategy
(1-212) 834-2304                        24 May 2013

Niall O'Connor
(1-212) 834-5108

questionable, given the dollar’s already pronounced               Chart 20: Currency investors are heading into a Fed taper flat on
overshoot vis-à-vis Treasuries. Additional complications in       carry and long of a sizeable stock of dollars
gauging the degree of EM contagion arise from a rather                                                                                        $bn
                                                                     0.5                                                                         50
unique positioning set-up in cash FX: spec investors head            0.4                                                                          40
into a potential Fed taper flat on carry and long of a sizeable      0.3                                                                          30
stock of dollars (chart 20). Absent the risk of a USD-regime         0.2                                                                          20
shift, the existing length in dollars would almost certainly
                                                                     0.1                                                                          10
constitute a bulwark against disorderly deleveraging, as
                                                                     0.0                                                                          0
they did in late 2011/early 2012 after EMU disintegration
                                                                    -0.1                                                                          -10
fears had prompted a massive flight-to-safety dollar rally.
                                                                    -0.2                                                                          -20
Hence a vol spike remains a risk scenario to us rather than
the base case.                                                      -0.3                                       Currency manager beta to FX carry-30
                                                                    -0.4                                       Macro HF beta to FX carry        -40
A Fed-driven systemic sell-off in US bonds should push              -0.5                                       IMM USD positions                -50
currency correlations meaningfully higher. Although FX
                                                                      May-10                    May-11               May-12                May-13
correlations have not consistently responded to large
Treasury declines in the past, they do exhibit a tendency to      Source: J.P.Morgan
trend higher by 15-20 percentage points around the onset of       Chart 21: USD-based currency correlations tend to rally 15-20
Fed hiking cycles (chart 21). This is even more likely to         percentage points around the onset of Fed hiking cycles
hold in this cycle since the starting point is an abnormally        80                                   Avg. pairwise USD/G10 3M implied correlations
low level of USD-correlations after a quarter of unusual                                                 Avg. pairwise USD/G10 3M realized correlations
idiosyncratic currency dynamics in Q1. Investors looking to         70
hedge dollar rallies should therefore find good value in
buying basket USD calls/call spreads that are positively
geared to rising correlations within the USD-complex.               50
V. FX technicals: key levels JPMQUSD                                40
85.5, EUR/USD 1.2760 & USD/CAD 1.0450
From a technical perspective, the medium term rally                                                                   Fed hike T-2Y to
phase for the USD has accelerated over the past few                                                                   Fed hike T + 1Y
weeks in line with the backup in US rates. While the
short term setup can allow for some pause, the broad-based          10
strength implies an improved technical backdrop and                  Jan-97            Apr-00       Jul-03        Oct-06       Feb-10        May-13
increased risk that a deeper rally phase is underway. The         Source: J.P.Morgan

key development for the improved setup is the push through
the 2012 highs for the JPM USD Index (84.44) and the              Chart 22: JPM USD Index: Monthly – The recent price action
DXY (84.10). Moreover, the May close will likely confirm          suggests an improved backdrop for additional upside. Still, the
bullish reversal months consistent with the potential for         momentum setup is a developing concern.
additional upside follow-through. In turn, the focus has
shifted to the next line of key levels which should confirm
whether the developing bullish backdrop can persist.
Consistent with the trending bias and potential for
further upside, the 85.50/55 zone for the JPM USD
Index and 84.95 area for the DXY will be the next
important tests for the USD view. These levels represent
the 76.4% retracements of the declines from the 2010 highs.
Upside breaks should confirm the continuation of the
current rally phase and potential for a more sustained
medium term shift. Still, the critical test rests with the
85.90/86.45 zone for JPMQUSD (internal trendline from
the 2011 high and 50% retracement from the 2009 peak), as
well as the 86.15/20 zone for the DXY. This area represents
the trendline resistance from the 2005 high, as upside
                                                                  Source: J.P. Morgan

John Normand                           Global FX Strategy
(john.normand@jpmorgan.com)            24 May 2013
Paul Meggyesi
Matthias Bouquet

breaks would imply the price action since that timeframe is      the US rates market turned; and of avoiding shorts in
a large basing pattern.                                          European currencies like EUR/USD if their balance of
                                                                 payments was stronger than the US and its growth gap
There are several key markers for USD pairs that
                                                                 about to narrow. This approach has missed some big trading
should help define whether the bullish shift is extending.
                                                                 opportunities and resulted in some major forecast errors but
For EUR/USD, the 1.2770/1.2650 zone is the first key test
                                                                 still yielded a decent success rate (better than two-thirds) on
as it represents the neckline of a broad head and shoulders
                                                                 most trade recommendations (see Performance Statistics
topping pattern. Violations should allow for a closer test of
                                                                 section of FX Markets Weekly each Friday). So as broad as
the 1.24 zone while raising the risk of a deeper extension
                                                                 this USD move has been this year, we are sticking with
into the 1.20 area and July low. Given the persistent
                                                                 year-end targets of EUR/USD 1.30 and USD/JPY 105,
weakness against the USD, commodity currencies remain a
                                                                 while trades outside of USD/JPY will remain tactical.
key focus. For AUD/USD, the focus is on the .9580/.9390
zone which includes the lows from 2012 and 2011, as              Table 5: Pre-positioning long USD ahead of the first Fed tightening
violations would confirm a deeper retracement and likely         has generated inconsistent returns
                                                                 Percentage of months with positive returns on long USD baskets when positioning
sustained bearish shift. Also, USD/CAD faces an important
                                                                 in the two years before the first Fed hike or positioning once Fed hikes have begun
test at the 1.0450/1.0650 medium term range highs, as                                                   1994           1999           2004
upside breaks would confirm a broad basing pattern above
                                                                  Long USD vs rest of G-10
the 2012 low.
                                                                   pre-hike                                 58%            70%            42%
While the price action and trending indicators maintain            post-hike                                49%            72%            56%
the bullish backdrop for the USD, the setup for the
medium term (weekly) momentum studies is a potential
bearish factor. The current overbought and bearishly              Long USD vs EM
diverging backdrop suggests that sustained upside from here        pre-hike                                    NA          76%            38%
could be a difficult task. This setup is similar to the            post-hike                                   NA          95%            49%
reversals seen in 2005, 2009, 2010 and 2012. Moreover,
long term momentum studies for JPMQUSD are close to
                                                                  Long USD vs G-10 and EM
overbought extremes similar to the 2009 and 2012 highs.
Still, this setup has yet to register with the price action.       pre-hike                                    NA          72%            43%
However, it does highlight several important support levels        post-hike                                   NA          82%            49%
that should be monitored for signs of a bearish shift. In this   Source: J.P. Morgan
regard, the early-May breakout levels and monthly lows
should hold to maintain the bullish potential. A violation of
the 83.40/82.75 for JPMQ USD and the 82.50/81.30 levels
for the DXY should confirm another shift for the USD is
VI. Strategy: selective rather than broad
The arguments for an extended, broad-based USD rally
are not compelling. The dollar’s performance in previous
Fed cycles has not been inconsistent, as discussed on page
4. Unsurprisingly, the returns from owning dollars
preemptively well ahead of Fed tightening have been patchy
as well (table 5). The US balance of payments is not
improving as presumed (pages 7-8), and the rest of the
world isn't guaranteed to lag the US as much as it has
during the first half of 2013.
Better instead to position for cyclical lift in USD on a
more selective basis, focusing on those currencies which
are either overvalued and vulnerable to a reversal of major
bond inflows (AUD and NZD), or where monetary policy is
most divergent (JPY). Hence our approach of concentrating
strategic USD longs to one pair (USD/JPY); of holding
tactical USD longs versus currencies like CAD and CHF as

Justin Kariya                           Global FX Strategy
(1-212) 834-9618                        24 May 2013

Is the dollar due a fundamental rerating?                         Chart A1: USD real broad effective exchange versus fair value model
As discussed on pages 7-8, the notion of a structural rerating    Model estimate for the USD REER is based on the J.P. Morgan long-term fair value
in the dollar has gained popularity over the past year given      model.
booming US energy production and downside surprises on             130
                                                                                                                                                         Fair Value
the US fiscal deficit. The J.P. Morgan long-term fair value
model, which estimates currency misalignments based on                                                                                                   REER

four fundamental drivers (terms of trade, productivity             120
growth, debt levels and net investment income, provides a
framework for tracking these multi-year influences and
linking to the direction of a country's real effective exchange    110
rate (for model specifications see Enhancements to J.P.
Morgan’s Long-term Fair Value Model, Kariya and Hebner,
September, 29, 2011). As shown in chart A1, the dollar             100
index was undervalued relative to the model estimate since          95
Q2 2009, but is now 1% expensive following this year’s
rally. But while there is no broad cheapness of the dollar          90
which might justify this year's across-the-board rally,                   00    01      02      03         04    05    06    07    08    09    10         11        12
several other currencies like commodity FX (chart A2) are         Source: J.P. Morgan

expensive enough on long-term models to justify USD               Chart A2: Deviations from real trade-weighted fair value (%)
strength this year as the US rate cycle turned.                   A positive value indicates over valuation

A small 1% overvaluation could suggest further upside in           40
the dollar is limited assuming fair value remains unchanged        35
                                                                   30                                                      27
in the coming quarters. This would be similar to early 2009
when the dollar rallied between Q2 2008 and Q1 2009 and                                                                 18
was 2% expensive at the peak before starting a two year            15
downtrend. However, this is only one example and the               10                                          5 6
dollar has a tendency to deviate significantly from its long-       5                                        0
term estimate (absolute deviation has been 7-8% since               0
2000). So the current misalignment does not provide a clear        -5                          -1 -1 -1 -1 0
                                                                  -10                    -4 -3
signal on the dollars 2-3 year trend at current levels.                               -7
                                                                  -15     -10 -10 -10
If the model drivers change materially in favour of the USD,      -20
                                                                  -25 -19
then this could be source of further USD strength. However














there is no clear trend to suggest a significant change to the
dollar’s fair value. The model estimate has been roughly          Source: JP Morgan
unchanged since mid-2011 and on a long-term downtrend             Chart A3: USD fair value decomposition
since Q3 2007 (8.5% lower from peak). Since 2007 rising           Chart shows the cumulative contribution of each variable to model estimate since
debt levels and declining terms of trade have been the main       2000.
drivers of the lower fair value estimate. US terms of trade         15%
bottomed end of 2011, and has rebounded 2% since then
(equal to 0.5-1% increase to model estimate). In an                 10%
optimistic scenario, where US terms of trade rises to its peak
from the last 10-years (2002), terms of trade would be about
10% higher than current levels. This would be worth a 3-4%           0%
increase to the dollar’s fair value. The other main driver of
the dollar estimate has been government debt levels. The            -5%
IMF projects that it will peak in 2014. But IMF projections                     Debt            NII

into 2018 suggest only a 2-3% percentage point drop in             -10%
                                                                                Productivity    ToT
government debt to GDP, which is only a 0.5%
improvement to the USD fair value estimate over the next 5         -15%
                                                                               01 02       03         04    05    06    07    08    09    10        11         12
                                                                  Source: J.P. Morgan

John Normand                                    Global FX Strategy
(44-20) 7134-1816                               24 May 2013


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John Normand                                       Global FX Strategy
(44-20) 7134-1816                                  24 May 2013

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