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					                                                                                                                          6 December 2010
FX Strategy



                                                             FX Top Themes & Trades: 2011
              This material should be regarded as a
              marketing communication and may have           A year ago, in The FX Top Themes & Trades outlook for 2010, published 1
              been produced in conjunction with the RBS
              trading desks that trade as principal in the   December 2009, we focused on the potential for 2010 to be a year that was
              instruments mentioned herein.                  dominated by periods of “risk on” and “risk off”, with the “risk on” being the
                                                             dominant theme. In the review (see below) on directional trades for 2010, the
                                                             balance did tilt towards positive risk exposure and, while the theme was
                                                             generally correct, currency performance did not exactly match up with the
              Top Themes & Trades
                                                             constructive risk appetite environment that was consistent with the combination
               1) Short G3 (USD, EUR, JPY) vs                of consistent solid global growth and accommodative monetary conditions in the
               PLN, ZAR, CLP, ILS, KRW                       developed world.
               2) Short G3 (USD, EUR, JPY) vs
               SGD, MYR, INR                                 Indeed, while 2010 generally rewarded exposure to growth oriented, higher
                                                             yielding currencies (the JPY the notable exception), the gains for those top
               3) Short USD/MXN
                                                             performing major currencies (as ranked by Bloomberg) was very muted
               4) Short EUR/USD at 1.36 and/or
                                                             compared to the gains of 2009. The top 5 currency total returns versus the USD
               Long EUR/USD at 1.24
                                                             in 2009 (BRL, ZAR, AUD, NZD, NOK) averaged 33.8%. The top 5 total return
               5) Long ADXY vs. USD, shift to                performances in 2010 (through 30 November), while including 3 of the same 5
               short EUR through 1.36/USD                    currencies (AUD, JPY, ZAR, BRL, MXN), averaged only 10.4% versus the USD.
                                                             And the lower average return did not reflect significant change in the USD, as
               6) Long NOK/SEK
                                                             the USD gained versus only 4 currencies in 2010 YTD – EUR, DKK, NOK and
               7) Long AUD, NZD, CAD vs                      GBP – with an average gain of only 6.4%. In general, while higher-
               USD, EUR, JPY                                 yielding/commodity currencies again performed well in the last year, their gains
                                                             were muted by higher valuations entering the year and less dramatic flows into
                                                             what had been “under-owned” currencies.

                                                             In our view, 2011 might be an even more difficult year to generate the type of
                                                             divergent currency performance that enables investors to generate sizable gains
                                                             relative to other asset classes. Moreover, although the fundamental environment
                                                             remains constructive, the case for continued out-performance of growth-
                                                             oriented currencies in the year ahead will be challenged by, in general, a)
                                                             high valuations, even compared to improved terms-of-trade, b) strong
                                                             ownership, including new flows from a number of sovereign wealth funds, c) a


                                                             Directional Trades from 2010 Top Themes & Trades
                                                             (3 Dec 2009 to 30 Nov 2010, % total return)
                                                             Recommended Trade                                          % Return       Closed

                                                             Long AUD, NOK, KRW, ILS vs USD, EUR, JPY, GBP                 +5.7%
                                                             Long BRL, IDR, AUD, INR, ARS vs USD, JPY, THB, CZK            +2.4%          2/20
                                                             Long KRW, INR, IDR, CNY vs USD, EUR                          +11.4%
                                                             Long AUD/USD                                                  -5.4%           2/5
                                                             Short GBP/NOK                                                 +0.2%          1/20
                                                             Short EUR/CHF                                                +15.1%           9/8
                                                             Short PEN/MXN                                                 -2.0%          5/25
              Robert Sinche & Strategy Team
                                                             Long PLN/CZK                                                  +3.7%          4/15
              FX Strategy                                    Short JPY/KRW                                                 -0.7%
              +1 203 897 4833                                Long IDR, INR, KRW vs THB                                     +0.4%          2/19
              Robert.Sinche@rbs.com                          Short EUR/ILS                                                +14.2%           7/2

              www.rbsm.com/strategy
              Bloomberg: RBSR<GO>                                                                                                  Source: RBS
The Royal Bank of Scotland


                             maturing growth cycle in a number of faster-growing emerging economies and
                             d) perhaps most important, rising inflation pressures in many emerging
                             economies that will likely lead to broader monetary tightening while the thrust of




                                                                                                                   FX Strategy | 6 December 2010
                             monetary policy in the developed (G4) world turns more neutral, at best. In this
                             context, 2011 is expected to be a year that generates a smaller divergence in
                             relative currency returns and a year that rewards a consistent review of
                             positioning and active trading, rather than holding positions for the entire year.

                             The macro backdrop, at least during the early months of 2011, remains relatively
                             constructive. Global growth is expected to moderate to about 4% in 2011 from
                             the heady expansion of nearly 5% during the current year. While much of that
                             moderation comes from non-Japan Asia (NJA) – from an unsustainable +9% real
                             GDP gain to about 7.5% in 2011 - that moderation appears to be a well digested
                             view. The real issue is the skew of risks; in our view, the risks are skewed to the
                             upside. As our Asia team has argued earlier, NJA balance-sheets are distinctly
                             superior at the household, corporate and government levels, and this superiority
                             provides the basis for faster growth. The last of these is of particular relevance
                             as it implies that the region will not lack the fiscal capacity to stimulate the
                             economy. Indeed, despite rising inflation pressures, we note that most
                             governments are seeking only a modest fiscal consolidation in 2011. Even a
                             modest consolidation masks the real level of underlying stimulus, as several
                             governments have now initiated a number of public-private infrastructure
                             projects.

                             The upside bias to growth at a time when developed countries are mired in sub-
                             potential growth and potentially deflation will continue to define divergent policy
                             exits in non-Japan Asia (NJA) and G3. Overall, NJA will see monetary exits
                             ahead of fiscal tightening, whereas that in G3 will be diametrically opposite. This
                             divergence has and will continue to set the direction of capital flows from G3 to
                             Asia. Indeed, our estimates show that YTD 2010 capital flows into the region
                             already exceeded full year levels since 2004.

                             One of the two FX trades that entered into the RBS multi-asset Global Top
                             Themes & Trades 2011 dated 29 November) was the purchase of a basket of
                             Asian currencies (ADXY) versus the EUR and USD. In fact, we think one of the
                             ways to best boost currency performance in 2011 is to manage the liability
                             (short) side of trades, perhaps even more than the long side of positions. Our
                             forecasts for the year ahead suggest a EUR/USD range of about 10 cents – 1.26
                             to 1.36 – and shifting the short position among majors should contribute
                             significantly to performance during the year ahead. At the same time, however,
                             we face questions about the durability of the “long Asia” recommendation. After
                             all, “long Asian currencies” has been a consistent, consensus theme over recent
                             years and there have been sizable flows into Asian currencies and currency
                             proxies. With such unanimity of thought and positioning, it seems reasonable to
                             question the ability of Asian currencies to continue to provide solid performance.

                             What is interesting, however, is the lack of Asian currency outperformance in
                             recent years despite widespread optimism and steady investment inflows. As is
                             well documented, Asian central banks and reserve managers have, through
                             persistent intervention, deflected those inflows and pushed them back into the
                             markets. The inflows have been substantial – a total of reported FX reserves for
                             the largest eight reserve countries in Asia (China, S. Korea, Hong Kong,
                             Indonesia, Taiwan, Singapore, Malaysia and Philippines) increased by USD1tr
                             (+38.3%) over the 24 months ended September 2010. Therefore, rather than
                             letting these inflows push up the value of currencies, the authorities have
                             deflected these flows into other currencies and asset markets, with bubble-
                             like inflows diverted into domestic real estate markets, global commodity
                             markets, other (free-floating) currencies and, perhaps, even global equities and

                                                                                                                   2
The Royal Bank of Scotland


                                    bonds. In fact, over the period since the end of 2008 the basket of Asian
                                    currencies (ADXY) has increased only 6.2% compared to much larger gains
                                    for the AUD (37.1%), the CRB commodity index (+54.3%) and gold (+54.5%).




                                                                                                                                 FX Strategy | 6 December 2010
                                    In this context, it appears quite reasonable to maintain long exposure in a basket
                                    of Asian currencies as their price movement appears to have lagged far behind
                                    both sentiment and inflows.


                                    Figure 1 | Asian FX Intervention Deflects Capital Flow into Other Market


                                     165
                                                 ADXY      AUD/USD        CRB       Gold

                                     155


                                     145


                                     135


                                     125


                                     115


                                     105


                                      95


                                      85
                                       Jan-09   Apr-09    Jul-09     Oct-09     Jan-10     Apr-10   Jul-10   Oct-10


                                                                                                             Source: Bloomberg


                                    Moreover, the NJA region generally continues to struggle with narrow or negative
                                    output gaps, a process that has contributed to rising inflation pressures while the
                                    G4 economies continue to struggle with unusually wide output gaps, monetary
                                    and fiscal policy constraints and fears about deflation risks. In this context, and
                                    given the lacklustre performance of NJA currencies in recent years, it is not
                                    surprising that our first two themes/trades involve short exposure in G3
                                    (USD+EUR+JPY) currencies versus baskets of emerging market currencies. We
                                    emphasize, however, the likely trading nature of the 2011 outlook, with
                                    increasing risks on monetary restraint in the rapidly-growing economies,
                                    combined with a shift to monetary neutrality in developed economies, setting a
                                    less-favourable risk environment as the year progresses.


                                    Themes and Trades
                                    EMFX – Going with the Flow
Trade 1:
                                    The excess liquidity generated from ultra loose global monetary policies will
Short G3 (USD, EUR, JPY) / Long
                                    continue seeking a home in emerging market economies, with their stronger
PLN, ZAR, CLP, ILS, KRW
                                    balance sheets and higher relative growth prospects. Emerging market
basket.
                                    currencies have been battling with the flood of portfolio inflows over the last year,
Enter 100, Target 110, Stop at 95   which will continue apace in 2011, those emerging markets that will have the
                                    most “hands off” approach to their currency regimes and can tolerate Real
                                    Effective Exchange Rate (REER) appreciation are selected based on RBS
Trade 2:
                                    currency flexibility models. Herein, we create a “less-interventionist” favourite
Short G3 (USD, EUR, JPY) /          EM currency basket versus the G3 and a second basket long Asian currency:
Long SGD, MYR, INR basket.          SGD, MYR and INR.
Enter 100, Target 110, Stop at 95
                                    Very strong capital inflows, accelerating domestic demand, elevated commodity
                                    prices and a loose policy framework are in combination an ominous cocktail for
                                    inflation. Asian companies have greater pricing power in the non-tradables

                                                                                                                                 3
 The Royal Bank of Scotland


                                  sector and should be able to pass on higher input costs. Asian central banks will
                                  try to mitigate these flows through the usual mix of soft capital controls, sterilised
                                  intervention and even delayed rate hikes. However, until now, these measures




                                                                                                                                       FX Strategy | 6 December 2010
                                  have at best had only a marginal impact. Against this background, Asian
                                  currency appreciation will remain a durable theme in 2011.

                                  Singapore and Malaysia have done well in fighting domestic inflation pressures
                                  by tightening FX and/ or monetary policies much earlier than the rest of the
                                  region. Facing the most severe inflation pressure earlier, India also bit the bullet
                                  and relentlessly tightened policy. On the growth front, there are also sufficient
                                  domestic drivers to keep them on a steady growth path, with casino-related
                                  spending boosting the Singapore economy and infrastructure spending doing
                                  the job for Malaysia and India.



Trade 3:
                                  US Growth Kicker
Short USD/MXN at 12.39*           The US economy has recently begun to regain its upward momentum and the
Target 11.80, Stop at 13.0        likelihood of a double-dip recession is much less than it was a few months ago.
                                  We expect a further gradual acceleration in real GDP growth next year, from
* originally recommended 29 Nov
                                  roughly 2.5% in 2010 to around 3¼% by the end of 2011. A US growth kicker
at 12.56
                                  trade that we like in emerging markets FX is short USD/MXN. Mexican exports do
                                  well as US demand picks up. ‘FX appreciate or monetary policy accommodate’
                                  will continue to be a key theme for global emerging markets and for Latin
                                  American markets in 2011. We think the authorities in Mexico will maintain a
                                  relatively conservative intervention strategy and hence position themselves over
                                  to the ‘FX appreciate’ side of the spectrum. MXN looks cheaply valued in a
                                  global EMFX context on the valuation models we run.


                                  Trading the Liability Currency
Trade 4:                          Both the Euro zone and the US will face challenges during 2001, and the
Short EUR/USD at 1.36             opportunities to trade this major currency cross are likely to be present in the
and/or
                                  year ahead. While our forecast of a end-2011 EUR/USD rate appeared a bit
Long EUR/USD at 1.24
                                  extreme in early November as the FOMC voted to implement QE3, better US
                                  economic data and the sudden (although well-flagged by our rates strategy
                                  team) deterioration in the EU periphery funding environment led to a much more
Trade 5:                          rapid fall in EUR/USD than we had expected. The broad EUR/USD range for
Long ADXY vs. USD
                                  2011 could be 1.20 – 1.40 and, given the expectation that trending moves are
Entry at 114.97
With shift to short EUR @
1.36/USD                          Figure 2 | EUR Remains Stronger Than Average vs. Asian Dollar Basket


                                   125

                                   120

                                   115

                                   110

                                   105

                                   100

                                    95                                               Average since 1999

                                    90

                                    85

                                    80

                                    75

                                    70
                                     Jan-99       Jan-01      Jan-03       Jan-05       Jan-07            Jan-09


                                                                                                                   Source: Bloomberg


                                                                                                                                       4
The Royal Bank of Scotland


                             likely to be limited, we highlight in advance our expectation that there will be
                             opportunities to trade this key currency pair. Reflecting that expected range, we
                             would set up a EUR/USD sell at 1.36 and a buy at 1.24, 4 cents from the




                                                                                                                        FX Strategy | 6 December 2010
                             extremes of the range. Obviously, we plan to try to fine tune entry and exit levels
                             as the year ahead unfolds, but trading the broad range in this pair is, like in
                             2010, to be a worthwhile endeavour. This trading range also can be used to shift
                             the short position versus a core long exposure in the ADXY – Asian Dollar
                             Currency basket – a trade in our cross asset Top Themes and Trades 2011
                             Published 29 November.


                             Shifting Nordic Growth Dynamics
                             A vigorous economic recovery underpinned a sharp SEK appreciation in 2010.
                             The speed of recovery was a function of the particularly savage nature of the
                             recession in Sweden. However, spare capacity is still abundant and it’s unlikely
                             that the Riksbank will have to respond aggressively in the near future because of
                             higher inflation. It’s also likely that the market is overplaying the Riksbank’s future
                             possible monetary policy response to a still buoyant residential real estate
                             market given that it considers it to be a financial stability issue rather than a
Trade 6:
Long NOK/SEK                 monetary policy consideration. There is also the possibility that continuing
                             periphery stress starts to weigh on the Euro area recovery in 2011 as fiscal
Spot Reference = 1.1403
                             austerity kicks in, credit is constrained and consumer/business confidence sags.
Target 1.25, Stop 1.090      This would hurt Sweden’s small open economy and leave the SEK vulnerable to
* originally recommended 4   a ratcheting down of rate expectations.
Nov at 1378
                             Norway experienced a far more sedate growth performance in 2010. Despite
                             this, the economy has very little spare capacity as the country’s large public
                             sector helped shelter the economy from the worst of the financial crisis. Wage
                             growth is already high (3.5-5.5% yoy) and domestic pressures are expected to
                             build steadily. With imported disinflationary pressures also set to ease, Norges
                             Bank will find it difficult to stop price inflation heading higher without tightening
                             monetary policy significantly. The NOK continues to have a very tight positive
                             correlation with interest rate spreads, so this will play positively for the currency
                             during 2011. The petroleum sector is also seen supporting the mainland
                             economy, through continued fiscal stimulus and stronger service sector activity,
                             in a lagged response to still strong off-shore investment and a recovery in global
                             activity. The NOK also has the added advantage of not being a high beta trade
                             on Euro area recovery (unlike the SEK) and will be relatively well insulated if
                             periphery concerns linger well into 2011 as we fully expect them to. The currency
                             should also benefit if the US authorities continue to add further stimulus (given
                             Norway’s status as a major oil producer).


                             Oil, Silver and Metals vs. Crisis, Deflation and QE
Trade 7:                     It might be a story that has been in play for nearly two years, but it is likely to
Long AUD, NZD, CAD /         maintain further upside into H1 2011. We still favour commodity currencies and
Short USD, EUR, JPY          we want to fund these from the heavily impaired major economies that remain
Enter 100                    firmly in need of non-standard monetary policy measures.
Target 110, Stop at 95
                             Commodity prices across the board remain in up-trends. Precious metals have
                             led the rise over the last several years, but agricultural prices have really lifted off
                             since mid-2010, now approaching the peaks in 2008. Industrial metals are at
                             their highs since 2008, and energy prices have also recently risen to new highs
                             since 2008. These are multi-year trends; they reflect solid growth in emerging
                             markets and the increasing intensity of energy and metals use as incomes grow.
                             Commodities are also being sought as an inflation hedge as the major
                             economies pursue quantitative policy easing.


                                                                                                                        5
The Royal Bank of Scotland




                             Figure 3 | Commodity Price Indices and DXY dollar index




                                                                                                                       FX Strategy | 6 December 2010
                              360
                                               Industrial metals
                                               Energy
                              310              Precious
                                               Agriculture
                                               DXY (inverted)
                              260



                              210



                              160



                              110



                               60
                                Jan-05       Jan-06                Jan-07   Jan-08    Jan-09        Jan-10


                                                                                                   Source: Bloomberg


                             Unsurprisingly most major exporters of commodities have relatively strong
                             economies, solid banking systems, largely closed their output gaps, avoided
                             using non-standard monetary policies, and begun to raise interest rates. This is
                             true for the AUD, NZD and CAD.

                             Commodities are by no means cheap, and this is imposing some restraints on
                             their economic activity. However, the conditions that have driven them to
                             historically expensive levels likely have further to run. The market will fear that
                             commodities and commodity currencies are not well anchored by historical
                             norms in an era of prolonged quantitative policy easing. Furthermore, this trade
                             offers significant carry.

                             At the same time, quantitative policy easing if anything has stepped up a few
                             gears in recent months. The ECB has recently moved to a more quantitative
                             stance, not as direct as the Fed’s, but it extended term liquidity facilities and
                             retains an unlimited capacity to buy government bonds. They have proven this
                             year that when its sovereign debt crisis worsens, the ECB is prepared to expand
                             monetary policy to stabilise financial conditions. There are potentially years of
                             fiscal austerity in Europe and a long road back to stability for many of its banks.
                             The BoJ used unsterilized intervention in September. The BoJ expanded its
                             asset purchase and term liquidity facilities in several steps in Sep/Oct. They are
                             not as proactive as the Fed, but the Japanese government and BoJ have been
                             particularly responsive to JPY strength in 2010. If the JPY rises, Japan will likely
                             expand its QE. Like the US, fiscal consolidation will increasingly become an
                             imperative, and Japan is as far as it ever was from credibly raising interest rates.

                             Overall the incentive and pressure for further expanding QE in 2011 are
                             significant and, thus, it does not feel like 2011 will be a turning point for our
                             funding trio. And while the AUD has rates above normal and is closer to the end
                             of its tightening cycle, CAD and NZD are still early in their policy tightening
                             cycles.




                                                                                                                       6
The Royal Bank of Scotland




                                                                                                                                                                                                                                        FX Strategy | 6 December 2010
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Recommendation history.
This material has been prepared by The Royal Bank of Scotland plc and affiliated companies (“RBS”) for information purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or
instrument or to participate in any particular trading strategy. This material should be regarded as a marketing communication and may have been produced in conjunction with the RBS trading desks that trade as principal in
the instruments mentioned herein. This commentary is therefore not independent from the proprietary interests of RBS, which may conflict with your interests. Opinions expressed may differ from the opinions expressed by
other divisions of RBS including our investment research department. This material includes analyses of securities and related derivatives that the firm's trading desk may make a market in, and in which it is likely as principal
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                                                                                                                                                                                                                                        7

				
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