Pre-reading Risk Currency Mock Session

The Global FX Monthly Analyst
March 2012

SEK
C$
RUB
NOK

£ PLN
US$
€ CHF
CNY ¥

MXN INR
HK$

BRL

ZAR A$

ARS
NZ$

„„ The beginning of the year has seen a strong performance in FX carry strategies.
„„ We look at the drivers and conclude that this mainly reflects an improvement in risk sentiment.
„„ The recent strong rally in $/JPY surprised, given most fundamentals remain Yen-supportive...
„„ ...although the recent BoJ shift may be important if the Yen remains weak in the new fiscal year.

Goldman Sachs Global Economics, Commodities and Strategy Research The Global FX Monthly Analyst

Contents

Overview Asia
Recommended FX Trade Ideas i Australian Dollar 26
Feature ii Chinese Yuan 27
Hong Kong Dollar 28
G3 Indian Rupee 29
US Dollar 1 Indonesian Rupiah 30
Euro 3 Korean Won 31
Japanese Yen 5 Malaysian Ringgit 32
New Zealand Dollar 33
Europe, Middle East & Africa Philippine Peso 34
British Pound 7 Singapore Dollar 35
Czech Koruna 8 Taiwan Dollar 36
Hungarian Forint 9 Thai Baht 37
Israeli Shekel 10
Norwegian Kroner 11 FX Analytics
Polish Zloty 12 Interest Rate Forecasts 38
Russian Ruble 13 GS Sentiment Index 39
South African Rand 14 FX Currents 41
Swedish Krona 15 GS Trade Weighted Indices 43
Swiss Franc 16 GS Anecdotal Flows 45
Turkish Lira 17 GSDEER 47
Key Economic Data 49
Americas Policy Rate Forecasts 54
Argentine Peso 18 Exchange Rate Forecasts 55
Brazilian Real 19
Canadian Dollar 20
Chilean Peso 21
Colombian Peso 22
Mexican Peso 23
Peruvian New Sol 24
Venezuela Bolivar 25

The source for all tables/charts is Goldman Sachs Global ECS Research unless otherwise stated.

March 2012


Recommended FX Trade Ideas

Our Recommended Top Trades for 2012
Trade Opened At Now At Potential Gain

1. Close protection on the iTraxx Europe Xover Index 30-Nov-11 759 n/a -3.4 %
2. Close short 10-yr German Bunds 30-Nov-11 2.28 n/a -3.5 %
3. Long EUR/CHF 30-Nov-11 1.23 1.21 -1.97 %
4. Long S&P TSX vs Nikkei, FX unhedged 30-Nov-11 100 94.7 -5.30 %
5. Long CNY, MYR vs GBP, USD 30-Nov-11 100 102.54 2.54 %
6. Close long July 2012 ICE Brent Crude Oil Futures 30-Nov-11 107.80 n/a 11.6 %

Tactical FX Trade Performance 2012
Number Cum Return Avg Return Avg Duration

All Trades 5 5.1% 1.01% 18 days
Profitable 5 5.1% 1.01% 18 days
Loss-Making 0 0.0%

Recent Tactical FX Recommendations
Description Open Close Open Quote Close Quote Potential
Day Time Day Time Return
Short USD CNY (expiry 10Jun11) 01-Jan-11 "00:00" 10-Jun-11 "02:15" 6.5326 6.4853 0.73%
Short AUD CAD 11-Jan-11 "23:43" 08-Feb-11 "17:00" 0.9703 1.0076 -3.70%
Long EUR USD 13-Jan-11 "13:51" 28-Jan-11 "15:37" 1.3267 1.3636 2.78%
Short USD PHP (expiry 09May11) 07-Feb-11 "11:07" 07-Apr-11 "05:57" 43.5900 43.0900 1.16%
Long EUR TRY 09-Feb-11 "09:06" 12-Sep-11 "17:00" 2.1620 2.4349 9.04%
Short EUR&USD RUB 01-Mar-11 "12:50" 19-Apr-11 "17:09" 33.6800 33.8472 -0.49%
Long EUR USD 18-Mar-11 "10:06" 23-Sep-11 "17:00" 1.4085 1.3517 -4.03%
Short USD MYR (expiry 29Mar12) 31-Mar-11 "01:58" 04-Aug-11 "21:36" 3.0660 3.0270 1.29%
Short USD PHP (expiry 04Apr12) 07-Apr-11 "05:57" 04-Aug-11 "21:36" 43.1300 42.7300 0.94%
Short MXN CLP 06-Jun-11 "12:22" 10-Aug-11 "17:09" 39.9703 38.2700 4.44%
Long AUD JPY 29-Jun-11 "09:03" 18-Jul-11 "17:00" 85.7802 83.5749 -2.57%
Long Basket (NZD, RUUSD 10-Aug-11 "14:20" 14-Sep-11 "17:00" 100.0000 97.7400 -2.26%
Short USD, EUR SGD, MYR 18-Oct-11 "00:11" 01-Jan-12 "00:00" 100.0000 99.0000 1.01%
Short AUD JPY 31-Oct-11 "16:02" 02-Nov-11 "16:34" 82.7092 80.7573 2.42%
Long RUB HUF 09-Nov-11 "11:16" 06-Dec-11 "17:00" 7.4200 7.1550 -3.57%
Short USD, EUR SGD, MYR 01-Jan-12 "00:00" 18-Jan-12 "12:36" 99.0000 97.1702 1.88%
Short USD MXN 25-Jan-12 "20:17" 15-Feb-12 "13:35" 13.0300 12.7387 2.29%
Short USD CAD 25-Jan-12 "20:17" 10-Feb-12 "17:00" 1.0056 1.0016 0.40%
Long EUR USD 25-Jan-12 "19:43" 15-Feb-12 "13:35" 1.3059 1.3086 0.21%
Short GBP NOK 22-Feb-12 "18:15" 08-Mar-12 "16:30" 8.8685 8.8424 0.30%

Please see our Global Markets Daily Comment and Trade Updates for changes in these live trading strategies, as they
change in line with market developments and our views.

i March 2012


Feature
Carry and the Yen move – Fade or Follow?
Since the beginning of the year, FX carry strategies have had a very good run. More recently, Thomas Stolper
even the Yen—historically one of the prime funding currencies for FX carry strategies—has thomas.stolper@gs.com
+44 (0)20 7774 5183
started to depreciate notably. These developments raise the question of whether carry is back
and whether the recent moves could be the beginning of a new multi-year uptrend. We look at Robin Brooks
the evidence and find little indication of a change in the underlying fundamentals so far. robin.brooks@gs.com
Instead, continued gains in carry strategies are still likely to depend mainly on broader risk +1 (212) 902 8763
sentiment. More specifically on the Yen, we continue to believe that most of underlying
appreciation forces remain in place and we are particularly suspicious of sudden Yen moves Themistoklis M. Fiotakis
themistoklis.fiotakis@gs.com
around fiscal year-end. However, before shifting too quickly into the ‘fade’ camp, we have to +44 (0)20 7552 2901
acknowledge the potentially important recent policy shift by the BoJ. The price action around
the next BoJ meeting and the beginning of the new fiscal year will be particularly interesting. Fiona Lake
Lastly, we take a more detailed look at the NOK, which in many respects seems to be following fiona.lake@gs.com
a pattern that is more customary in Asia. We see the potential for significantly more NOK +852 2978-6088
strength in the near future, which is reflected in our new forecasts.
Constantin Burgi
constantin.burgi@gs.com
1. How FX Carry Works in Theory +44 (0)20 7051 4009
FX carry strategies are based on the so-called forward rate bias, which is a violation of
George Cole
uncovered interest rate parity (UIP). On average, significant returns could be earned over george.cole@gs.com
long periods of time in the past simply by investing in high-yielding currencies, funded out +44 (0)207552 3779
of low-yielding ones. In a more technical sense, the high-yielding currencies did not
depreciate as much as UIP would have suggested.

Many FX carry strategies are
A Rebound in FX Carry after a Difficult 2011
implemented in more or less
sophisticated baskets, such as our own 1.14
investable FX Carry Index, which has
recently been revamped to reduce 1.12
transaction costs (BBG ticker 1.10
GSIMCAR1).
1.08
Since the beginning of the year, these 1.06
simple FX carry strategies have been
1.04
performing well, recovering fully the
losses accumulated in 2011, as can be 1.02
seen in the chart. For example, our GS 1.00
Carry Index has posted a total return of
about 3.5%, with a high Sharpe ratio 0.98
and virtually no pullback. This has been 0.96
the best performance window since 07 08 09 10 11 12
Source: GS Global ECS Research
early 2009, when FX carry strategies
rebounded from the 2008 slump.

Summary and Key Points
The beginning of the year has seen strong performance in FX carry strategies.
We look at the drivers and conclude that this mainly reflects an improvement in risk sentiment, rather than a
fundamental shift back towards a more carry-supportive environment.
The recent strong rally in $/JPY surprised given that most fundamentals remain firmly Yen-supportive.
Also, the Yen tends to display sudden trend reversals around fiscal year-end in Japan, which would support our
bias to ‘fade’ the recent move.
But the recent BoJ shift may be important and warrant a change in view.
Much will depend on the BoJ’s determination and the response to additional policy easing in fixed income markets.
We look at Norway (and the NOK), which increasingly seems to follow the pattern of Asian ‘surplus’ countries.
Given rising appreciation and inflation pressures and low interest rates, this creates scope for further NOK appreciation.

ii March 2012


Such a period of strong carry returns always raises the Cross Sectional Standard Deviation Remains
question of whether FX carry could again become a at Levels Close to Post-GFC Lows
8
major investment theme. Back in the years leading up to
the Global Financial Crisis (GFC), diversified carry
7
strategies delivered some of the highest Sharpe ratios of
any investment strategy. A revival of FX carry would
therefore be an important development for FX investors. 6

There is a considerable body of academic research about 5
carry strategies and the violation of UIP, but relatively
little has been said so far about the reasons why carry has
4
performed so badly in recent years. Depending on
implementations, total returns have been close to zero
since 2007 in most cases. As a starting point, we describe 3 Std Devn of 2Y Swap Rates
some key characteristics that drive carry returns and why. Average of 2Y Swap Rates
2
Most simple FX carry implementations start with a 01 02 03 04 05 06 07 08 09 10 11 12
Source: Bloomberg, GS Global ECS Research
basket of currencies on the long side and another bunch
of currencies on the funding side. These strategies currencies from appreciating in response to easing by
typically perform well in the following broadly defined other countries, in particular the mature but debt-ridden
situations: developed economies. In recent months, the Fed, BoE,
ECB and BoJ have all engaged in additional non-
When the average interest rate differential between conventional easing. Many central banks in smaller
the high-yielding and the low-yielding currencies is developed countries and emerging markets (EM) were
relatively high, as this represents the primary source of obliged to follow, unless they were willing to engage in
returns. In the most basic description of carry returns, some form of ‘macro-prudential’ capital controls or
one can assume that spot exchange rates follow a intervention to prevent their currencies from excessive
random walk, which means that on average the return appreciation. The latest measures by Brazil are an
will be close to the interest rate differential between excellent example of how the carry potential is being
these two currencies. eroded by central bank rate cuts in combination with
tighter capital controls.
When the high-yielding currencies appreciate relative
to the low-yielding ones (a strong violation of UIP). In Even from a slightly forward-looking perspective, when
this case, a second source of return, spot looking at 2-yr swap rates, the overall level of rates
appreciation, will be added to the gains from the remains low in most countries, with few expectations of
interest rate differential. future tightening. Moreover, the cross-sectional standard
deviation of interest rates also remains at levels close to
When the correlation among the basket constituents
the post-GFC lows (see chart). Simply put, interest rate
is relatively low. This helps the diversification of
differentials are small across the world, which means that
idiosyncratic risks and hence increases risk-adjusted
the primary driver of carry returns in the long run
returns of carry strategies.
remains very subdued.
When the correlation between currency moves and
broader risky asset returns are low, as this reduces Hypothetical return of shorting $/TRY
%
the likelihood of market-wide risk aversion swings via 1-year forwards
affecting the risk-adjusted returns of the strategy. 120

100
There is some overlap between these loosely defined
conditions but each of them can be tracked relatively 80
easily.
60

40
2. Many Headwinds for FX Carry Strategies Remain
Taking the criteria introduced in the section above one by 20
one, we can only conclude that the broader situation
0
remains very unfriendly for FX carry.
-20
Interest rate differentials remain low across the globe.
-40
If anything, central banks seem to be engaging in a kind
of competitive easing, as discussed by Kamakshya -60
Trivedi and Stacy Carlson in a recent Global Economics 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Weekly. This is also partly an attempt to prevent

iii March 2012


The second issue above, additional spot returns, is easy
Correlation Between FX Carry Strategies
to benchmark given that, on average, total returns on and SPX Remains High Index
carry strategies have been almost perfectly flat since 0.6
2007. Although there have been periods of Correlation* between FX 230
Carry Basket and SP500
outperformance, there have also been comparable 0.5
(lhs)
stretches of underperformance. On average, the 210
0.4 FX Carry Basket (rhs)
negligible total returns suggest that higher-yielding
currencies have depreciated sufficiently, while lower- 190
0.3
yielding ones have appreciated, erasing all positive
returns from interest rate differentials. One could even go 170
0.2
as far as to assert that UIP actually did hold in recent
years. Even at the country level, this is true for some of 0.1 150
the higher-yielding currencies. In the chart on the
previous page, we plot the potential percentage return 0 130
from buying the Turkish Lira against the USD via a 1-
year forward and holding it to expiry. Starting right after -0.1 110
00 01 02 03 04 05 06 07 08 09 10 11 12
the last Turkish financial crisis in 2001, total returns
would have been exceptionally high, at times reaching Source: GS Global ECS Research; *255 day correlation
more than 100%. However, since 2008, potential losses
have been about as frequent as gains in the +/-20% range. Finally, with individual currencies highly correlated with
On average, the spot moves in the Lira have fully offset each other and given broader risk sentiment, it is not
any gains from higher interest rates. unexpected that diversified FX carry strategies also
have a high correlation to risky assets. Indeed, the
The correlation between currencies has also remained daily return correlation between FX carry and the SPX
very high on our measures. It is not particularly easy to remains at high levels at around +40%, which is close to
measure the cross currency correlation among the 30-odd where it has been since the GFC. As a benchmark, before
liquid currency pairs, as there are around 200 possible the crisis started in 2007/08, the same correlation
cross rates that one could compare. Depending on the typically oscillated around the +10% mark.
specific choices, very different correlation patterns may
emerge. To tackle this issue in the past, we have simply After analysing all these related indicators, we conclude
looked at the correlations of trade-weighted exchange that the recent rally in FX carry was probably no more
rates to some third factor, typically some measure of than a correlated reaction to the improvement in broader
market risk. If all currencies respond similarly to the risk risk sentiment. The forward-looking implication is that
factor, they are likely also highly correlated among each the recent FX carry rally can only continue if the broader
other. The chart shows the average correlation in daily risk rally continues with little pullback.
returns of the G10 and the most liquid EM currencies
with US stock markets. Given that we are not interested Alternatively, a broader shift back into a carry-favourable
in the direction of this correlation but rather its strength, regime, similar to the pre-crisis period, would also help.
we remove the sign and use the average ‘absolute’ However, this would imply that a number of central
correlations. As can be seen, these have been persistently banks would have to tighten monetary policy to raise
high since the GFC; hence, we think it is unlikely that the interest rate differentials, which will take time. Cross
construction of a broad carry basket offers any major asset correlations would have to become smaller, too. So
diversification benefits. Most currency moves seem to be far, there is little evidence of this happening, as our charts
the result of systemic risks. suggest. But that doesn’t mean the situation couldn’t
change soon. We will watch our indicators closely.
FX-Risky Asset Correlation Remains
Exceptionally High
0.45
3. Carry, the BoJ and the Yen
Average of abolute return
0.4
correlation* between G10
After months of debating the latest twist in the ongoing
currencies and the S&P500 Euro area crisis, a sudden BoJ-induced move in the Yen
0.35
was a welcome distraction for many in FX markets. And,
Average of abolute return
0.3
correlation* between EM
as we have already seen several times in recent years, a
currencies and the S&P500 sharp move higher in $/JPY triggers market speculation
0.25
about the fundamentals finally changing.
0.2
Memories of high carry returns funded out of the Yen
0.15
may be a factor as well, in particular if—as we discussed
0.1 above—FX carry seems to be experiencing a superficial
revival. As in the previous section, ‘fade or follow’
0.05
would seem to be the key question.
0
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Source: GS Global ECS Research; *255 day correlation

iv March 2012


$/JPY A Sharp Move Higher in $/JPY since February JPY Bn Trade Balance Deteriorates but Income
Balance Improves Notably
82 1200
Current Account Balance
JPY spot (lhs) 1000 Net Portfolio Investment Income
81
Net Direct Investment Income
800
80
600
79
400

78 200

0
77
-200
76
-400
96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11
75
01Jan12 15Jan12 29Jan12 12Feb12 26Feb12 11Mar12 Source: Bank of Japan/ Ministry of Finance/ Haver Analytics/
Source: GS Global ECS Research GS Global ECS Research

Perhaps the easiest way to approach the issue is simply to purchases have been concentrated at the very front end
summarise what has changed and what has not. We start of the yield curve so far has reduced the effectiveness
with the JPY factors that have changed recently: of QE. Moreover, the BoJ has remained substantially
behind the asset purchase targets, which also suggests
The most important factor is that the BoJ has recently a lack of conviction. Without a more convincing
become more dovish. A redefinition of the inflation implementation of asset purchases and front-loaded
target and a stronger commitment to reach this target purchases of longer maturity bonds, the JPY impact
faster via increased asset purchases marks a significant may remain quite limited.
departure from past policy—at least by Japanese
standards. However, even if the BoJ became fully committed to
more aggressive QE, the BoJ would still be at risk of
Japan also experienced a substantial deterioration in being ‘out-eased’ by the Fed. Although growth has
the trade balance, which moved into deficit in 2011 been surprising on the positive side in the US recently,
for the first time since the early 1980s at least on a we still expect the Fed to ease more via a new program
calendar year basis. of non-conventional policies to kick in after the
ongoing ‘Operation Twist’. Further strong activity data
The combination of a trade deficit and easier monetary in the US could change this, but for now there are no
policy appear, on the surface, to reflect a substantial reasons to change our Fed forecast.
deterioration in the factors that have supported the JPY in
the past. However, the situation remains much more In that respect it is interesting to note that $/JPY has
complex, and so far it is far from clear if the JPY moved far ahead of essentially unchanged rate
fundamentals have really changed that much. We would differentials. For example, if we look at 5-yr rate
highlight the following points, largely based on earlier differentials, BoJ QE would need to push 5-yr swap
analysis by Fiona Lake and our Japanese Economics rates down from currently slightly less than 50bp to
team: almost zero in order to bring the rate differential in line
with the current spot rate above $/JPY 80.
A large part of the deterioration in the trade balance
appears to be of temporary nature, linked to global Foreign official investors continue to like the put more
demand weakness and the disruptions from the Yen into their FX reserves. The regular IMF COFER
earthquake as well as the floods in Thailand. data shows that over the last couple of quarters the
Relocation of production to other countries with share of JPY-allocated FX reserves has been growing
cheaper and more abundant labour has also played a steadily. Historically, the low interest rates in Japan
role. However, the income balance remains strong and have probably been a hurdle to a larger allocation, but
has improved notably recently, along with the with European and US interest rates now at
deterioration in the trade balance. Overall, the current comparable levels the opportunity cost of holding
account position of Japan is likely to remain in JPY-denominated bonds has gone down. From a pure
solid surplus, as our Japanese colleagues have also diversification point of view, a larger Yen allocation
argued. appears to be a rational choice, and without any
monetary policy tightening expected in the rest of G3 a
The degree of conviction conveyed by the BoJ continued increase in JPY reserve allocations should
leadership through its actions and communications not be ruled out.
has so far been slightly unclear. With regards to the
change in the BoJ’s stance, the fact that bond

v March 2012


$/JPY $/JPY has Moved Far Ahead of Rate Index US$/YEN vs GS Sentiment Index US$/YEN
%
Differentials 10 140
125 4.5 Sentiment
8 Index (lhs)
120 130
4.0
US$/YEN (rhs)
115 6
3.5 120
110 4
3.0 2
105 110
100 2.5 0
100
95 -2
2.0
90 -4 90
JPY spot (lhs) 1.5
85 -6
5Y Swap Rate Differential US 1.0 80
80 less Japan (rhs) -8

75 0.5 -10 70
1Jan04 1Jan06 1Jan08 1Jan10 1Jan12 08 09 10 11 12
Source: GS Global ECS Research Source: GS Global ECS Research

With rate differentials failing to correlate with the Overall, most factors point to a likely reversal of the
recent spot move, the search for alternative recent JPY move, and in that respect the ‘follow or fade’
explanations points to speculative long positioning in question would be relatively easy to answer.
$/Yen. Our latest GS Sentiment Index (see page 39)
suggests that $/JPY positioning is now longer than at However, we also have to recognise that the BoJ policy
most times over the last two years, and probably shift is potentially a very important event, as also
stretched. This would also imply that unwinding of highlighted by our Japanese colleagues. With the
these positions could lead to a notable Yen rally. situation remaining fluid and with fiscal year-end still a
few weeks away, we want to remain open-minded to the
Returning to a point made above, risky asset possibility that a more substantial change has taken place
correlations remain quite strong, and hence it is quite with regard to the JPY. In that respect, March 13 will be a
likely that the continued rally in cyclical assets has key date as both the BoJ and the FOMC announce their
helped $/JPY higher. monetary policy decisions. Any signs of continued
reluctance by the BoJ to engage in more aggressive QE
Lastly, it is important to signal that Japan is approaching would strengthen our preference for the ‘fade’ camp. The
fiscal year-end, a period that has historically seen same applies for a dovish FOMC.
strong seasonal trends. When we have analysed this
phenomenon in the past, $/Yen displayed the strongest The ultimate litmus test will likely be interest rate
trends, regardless of direction, in March. And in the last differentials on longer maturities. If they catch up with
three years these trends have seen JPY weakness of the recent move, $/JPY may have more upside.
comparable magnitude into fiscal year-end, only to
reverse into JPY strength straight after the beginning of
the new fiscal year in April.

% of Rising Share of Yen Holdings Rally in Cyclical Assets may Have Helped
total $/JPY Index
in Global FX Reserves* $/JPY higher
3.5 1375
85 JPY spot (lhs)
3.0 Yen denominated S&P 500 (rhs) 1325
reserves
2.5 83
1275
2.0
81
1225
1.5

1.0 79
1175

0.5
77 1125
0.0
05 06 07 08 09 10 11
75 1075
1-Mar-11 1-Jun-11 1-Sep-11 1-Dec-11 1-Mar-12
* Developing Nations, Source: IMF, GS Global ECS Research

vi March 2012


$/JPY Another Temporary Fiscal Year End Rally for
€/NOK EUR/NOK Moved Lower Recently
$/JPY?
102.5 10.50
100.0 JPY spot (lhs) EUR/NOK
10.00
97.5
95.0 9.50
92.5
9.00
90.0
87.5
8.50
85.0
82.5 8.00

80.0
7.50
77.5
75.0 7.00
Jan09 Jul09 Jan10 Jul10 Jan11 Jul11 Jan12 07 08 09 10 11 12

4. Norges Bank in the ‘Asian’ Corner prices now well above pre-crisis levels, as can be seen in
The following scenario is very much the standard case for the chart. Unsurprisingly, this credit-driven rise in house
most Asian surplus countries: prices also led to rather high levels of household
indebtedness. Key measures of inflation also point to the
Currency appreciation is continuously resisted by a upside. And, in response to the Euro area crisis, Norges
combination of rather accommodative monetary policy Bank has already cut rates aggressively—by 50bp in
and ongoing FX interventions. Every now and then, December.
however, inflation starts to materialise, including in asset
prices, which then triggers concerns for the monetary The situation now looks very much like the typical Asian
authorities. In practice, we often see Asian ‘surplus’ appreciation case. Without much scope to ease further
countries tolerate more nominal appreciation during these and concerns about asset and goods prices, the logical
periods of higher inflation and strong growth. But history conclusion would be to allow the currency to appreciate.
has shown that many Asian currencies ONLY appreciate This is already happening to some extent but we think
in these circumstances. there is more scope for appreciation and hence we have
strengthened our already bullish NOK forecasts. We now
The same dynamics seem to be at play in Norway see EUR/NOK at 7.30, 7.20 and 7.20 in 3, 6 and 12
currently. Intervention is being conducted on behalf of months. Indeed, the trading range for our forecasts could
the ‘Petroleum Fund’ (Government Pension Fund— easily reach 7.00, so there is potential for an even larger
Global) to neutralise the revenues from oil exports. As ‘Asia-type’ move in the Nokkie.
Lasse Nielsen has highlighted, growth is accelerating, as
evident in strong positive surprises from business surveys We are also adjusting our EUR/SEK forecasts to reflect
and industrial production. Moreover, years of low real recent strength but see much less upside for the Swedish
rates have led to continued property price increases, with Krona than for its Norwegian cousin.

Index Low Real Rates Have Led to Continued
Property Price Increases
160
Norway House Price Index
140 New FX Forecasts
New Forecasts Old Forecasts
120
3m 6m 12m 3m 6m 12m

100 EUR/NOK 7.30 7.20 7.20 7.70 7.70 7.60
EUR/SEK 8.80 8.70 8.60 9.00 8.90 8.80
80 EUR/CZK* 25.00 25.50 24.25 27.50 27.00 25.50
EUR/HUF* 315 315 325 340 350 320
60
EUR/PLN* 4.25 4.10 4.10 4.80 4.70 4.30
40 $/RUB 28.9 28.2 27.4 28.8 28.0 27.4
$/CNY 6.27 6.22 6.10 6.28 6.24 6.12
20 $/ARS 4.50 4.80 5.20 4.45 4.70 5.20
$/BRL 1.70 1.70 1.75 1.80 1.85 1.90
0
92 94 96 98 00 02 04 06 08 10 *Forecast changes released since our last FX Monthly was published

vii March 2012


G3
US Dollar
FX Forecasts: We maintain our EUR/$ forecast at 1.33, 1.38 and 1.45 in 3, 6 and 12 months respectively. Our $/¥
forecast is unchanged at 77.0, 76.0 and 74.0. Current GSDEER for EUR/$: 1.20; $/¥: 105.7.

Motivation for Our FX View: Since early February, the USD trade-weighted index has remained broadly flat. And in
the near term, until more of the Euro area risks are resolved, we could see renewed bouts of USD strength. But in the
medium and longer term, broad Dollar weakness remains our core view. Underpinning our Dollar-bearish views are the
structural, large twin deficits that will likely persist. The overall monetary stance of the US is also one of the easiest in
the world following 'Operation Twist' last September and given the likelihood of QE3 this year. In addition, the
accommodative policy in the majors should eventually prove supportive for risky assets and bearish for the Dollar.

Monetary Policy and FX Framework: The Fed has a dual growth and inflation target. As a result, monetary policy
has generally been more volatile and reactive than in pure inflation-targeting countries. The exchange rate floats freely.
The US Treasury is in charge of FX policy, although the Fed occasionally comments on currency issues too.

Growth/Inflation Outlook: We expect real GDP growth to be around 1.9%qoq ann in Q1, as the strong contribution
of inventories to the 3.0%qoq ann growth in Q4 is likely to fade. Also, consumer spending has decelerated and the data
flow was more mixed recently. We see considerable spare capacity in the economy, which underpins our view of a
deceleration in core inflation.

Monetary Policy Forecast: At the January meeting, the FOMC remained dovish despite the stronger data recently and
published its forecast for the Fed Funds rate. The projections show that the Fed intends to keep rates close to zero
through the end of 2014. The FOMC continued to highlight the slack in the economy and slowing inflation, and we
expect further easing through outright asset purchases in 1H2012.

Fiscal Policy Outlook: Over the next few years, the US will need to undertake fiscal tightening of at least 6% of GDP.
We expect only a modest fiscal tightening in the near term and most is likely to take effect after the presidential
elections.

Balance of Payments Situation: The US BBoP deficit has narrowed sharply to -0.9% of GDP in Q3, reflecting to a
large extent the record level of foreign buying of US treasuries in August. The current account deficit narrowed
marginally to 2.9% of GDP in Q3, but we expect it to widen again in coming months.

Things to Watch: The pace of the US cyclical recovery remains key to monitor given the implications for the relative
monetary stance and also for overall risk sentiment. In addition, we continue to monitor capital flow trends in the
monthly TIC data for signs of any persistent improvement in the BBoP, and the fiscal and monetary policy
announcements.

Fiona Lake and Constantin Burgi

% of GDP
EUR/$ 4qtr avg US: BBoP vs. Current Account
1.70 2

1.50 0

1.30
-2

1.10
-4
0.90

-6 Current Account
0.70 Spot
BBoP
GSDEER
0.50 -8
81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

Source: Haver Analytics, National Source, Global ECS Research.

1 March 2012


US Dollar
%yoy US Industrial Production and real GDP %yoy US Inflation
15 6

F'cast 5 F'cast
10
4

5 3

2
0
1

-5 0

-1
-10 G10 Inflation
Industrial Production
-2 US CPI
Real GDP
-15 -3
90 92 94 96 98 00 02 04 06 08 10 12 14 92 94 96 98 00 02 04 06 08 10 12 14

% yoy US Trade Volumes Index
1990=100 US Terms of Trade
3-mth ma
24 112
20 110
16 108
12 106
8 104
102
4
100
0
98
-4
96
-8
94
-12 92 TOT
-16 Exports Improvement
90
-20 Imports 88
-24 86
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 90 92 94 96 98 00 02 04 06 08 10 12

Index GS Commodity Indices Index % FED rate vs. 10y yield and S&P500 Index

600 1000 7 1600
S&P GSCI® Energy Index UST 10y yield
S&P GSCI® Industrial Metal Index 900 FED funds rate 1500
S&P GSCI® Agriculture Index 6
500 S&P GSCI® Index (rhs) SPX (rhs)
800 1400
700 5
400 1300
600
4 1200
300 500
3 1100
400
200 1000
300 2
200 900
100 1
100 800

0 0 0 700
00 01 02 03 04 05 06 07 08 09 10 11 12 99 00 01 02 03 04 05 06 07 08 09 10 11 12

2 March 2012


Euro
FX Forecasts: We maintain our EUR/$ forecast at 1.33, 1.38 and 1.45 in 3, 6 and 12 months respectively. EUR/¥ is at
102.4, 104.9 and 107.3. Current GSDEER for EUR/$: 1.20.

Motivation for Our FX View: Since late January, the Euro has been broadly flat against the USD, with the second
LTRO and stronger data supporting the EUR, and the uncertainties regarding the Greek PSI (which are yet to be fully
resolved) pulling in opposite directions. The Euro may thus remain volatile in the short term, before strengthening as
per our medium- and long-term views. The key driver of our view is that FX markets will remain dominated by broad
Dollar weakness, particularly on the back of the weakness of the US external balance. The Euro area BBoP remains
strong on a trend basis, whereas the US has recorded large deficits for some time. A gradual further decline in the Euro
area fiscal risk premium should boost the Euro. These factors should enable the Euro to trade strongly relative to 'fair
value' for a protracted period.

Monetary Policy and FX Framework: The ECB is a strict inflation targeter. As a central bank serving 17 countries,
the ECB is arguably the most independent central bank in the world. The Euro is a freely-floating currency. FX policy
responsibility is not clearly defined, but in practice the ECB is unlikely to act in FX markets without Eurogroup
approval.

Growth/Inflation Outlook: The Euro area manufacturing PMI increased marginally in February to 48.9; this
compares with the February US ISM decrease to around 52.4. Euro area business surveys suggest upside risks to our
current GDP forecasts and we expect Q1 GDP to come in at -0.3%qoq. For the entire year, we forecast -0.4% real GDP
growth in 2012 followed by 0.7% in 2013. We see inflation falling to 1.8% in 2012 from 2.7% in 2011 and to 1.5% for
2013 as the food and energy contribution declines.

Monetary Policy Forecast: The ECB left rates unchanged at 1.00% in March and specified that while there are
tentative signs of stabilisation, downside risks to activity prevail. The inflation risks remained broadly balanced. We
think the ECB will keep rates at 1.00% through 2013.

Fiscal Policy Outlook: Many governments in Europe are heading into substantial fiscal consolidation, which is likely
to prove a drag on growth. However, the relative fiscal positions between the Euro area and the US are what matters
for the EUR/$, and the US also faces large adjustment needs of its own, which have not yet been addressed.

Balance of Payments Situation: The Euro area runs a small current account deficit, which is fully financed by net
FDI and net portfolio flows on a trend basis, leading to a quite positive BBoP.

Things to Watch: Developments in the European Sovereign Situation, in particular the outcome of the Greek PSI deal.

Fiona Lake and Constantin Burgi

% GDP Euro area: BBoP vs Current Account
EUR/$ 12-mma
1.70 5%
CA
4%
BBoP
1.50
3%

2%
1.30
1%
1.10 0%

-1%
0.90
-2%
0.70 Spot -3%
GSDEER -4%
0.50
81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 -5%
98 00 02 04 06 08 10 12

3 March 2012


Euro
%yoy Euro area Industrial Production and real GDP %yoy Euro area Inflation
10 5
F'cast
F'cast
4
5
3
0
2

-5 1

0
-10
Industrial Production
-1
Real GDP
-15
-2 G10 Inflation Euro area CPI

-20 -3
90 92 94 96 98 00 02 04 06 08 10 12 14 92 94 96 98 00 02 04 06 08 10 12 14

% yoy Euro area Trade Volumes Index Euro area Terms of Trade
3-mth ma 2000=100
20 130
16 125
12 120
8
115
4
110
0
105
-4
100
-8
95
-12 TOT
-16 Exports 90 Improvement

-20 Imports 85
-24 80
01 02 03 04 05 06 07 08 09 10 11 12 90 92 94 96 98 00 02 04 06 08 10 12

% EUR/$ Vol EUR/USD: 3-mth Risk Reversals
EUR/$ vs 2-yr Rate Differential
3 1.8 2.0
2-yr Germany Swap Minus 2-yr US Swap
EUR/$ (rhs) 1.7 1.0
2
1.6
0.0
1
1.5
-1.0
0 1.4

-2.0
1.3
-1
1.2 -3.0
-2
1.1
-4.0
-3 1.0
06 07 08 09 10 11 12 -5.0
08 09 10 11 12

4 March 2012


Japanese Yen
FX Forecasts: Our views have not changed. We continue to expect $/JPY to trade at 77, 76 and 74 in 3, 6 and 12
months. EUR/¥ is 102.4, 104.9 and 107.3. The current $/¥ GSDEER is 105.7 and EUR/¥ is 126.6.

Motivation for Our FX View: JPY has depreciated by about 6% against the USD since early February, with the bulk
of the move generated by a surprise easing move from the BoJ at the February meeting, which included a firming of
the commitment to 1% inflation in the medium term. At this point we would be inclined to fade this weakness unless
there is further, more aggressive easing from the BoJ. Our view is based on our expectation of further QE from the
Fed, the fact that Japan continues to run a more positive external balance than the US and that positioning in USD/JPY
appears to be rather long. Further reserve diversification into the Yen would also be supportive.

Monetary Policy and FX Framework: The BoJ has effectively shifted back to a zero interest rate policy. The Yen is
formally a freely floating currency, but the MoF is in charge of FX policy and has often intervened in the past. Since
September 2010, there have been several examples of bilateral intervention, as well as the post-earthquake co-
ordinated intervention.

Growth/Inflation Outlook: While the Japanese economy has recovered more strongly than expected from the March
earthquake, it faces the challenge of a slower global environment over the next 6 months and beyond. This will weigh
on export performance, as will the strength of the Yen. We now expect growth to be 2.0% in FY2012, with public-
sector demand offsetting the global slowdown. We expect growth to be 1.8% in FY2013, a fairly strong print, which is
likely to be helped by the frontloading of demand ahead of a potential consumption tax hike in 2014. We expect
inflation to turn positive in 4Q2012, but price pressures are likely to remain mild.

Monetary Policy Forecast: The BoJ increased, and extended to end 2012, its Asset Purchase Program by JPY10trn to
JPY65trn on February 14, probably due to an ongoing dovish Fed and domestic political pressure. For the Yen to
remain weak, the BoJ is likely to need to extend its recent easing further. As yet, progress on the asset purchase
program remains slow.

Fiscal Policy Outlook: Japan has introduced several rounds of supplementary budgets after the earthquake, totalling a
touch above 4% of GDP. A consumption tax hike is being debated for 2014 to stabilise the worrying debt trajectory.

Balance of Payments Situation: Japan continues to run a BBoP surplus on the back of a current account surplus,
which is dominated by a positive income balance. Unlike in other countries, bond outflows in recent years have
typically coincided with Yen strength.

Things to Watch: Any further aggressive policy action from the BoJ/Japanese government. Any increased focus on
the Japanese fiscal and debt levels, particularly if question-marks over unsustainability start to emerge more forcefully.

Fiona Lake

% GDP Japan: BBoP vs Current Account
$/¥ 12-mma
300 8%

Spot 6%
250 GSDEER 4%

2%
200
0%

-2%
150
-4%

100 -6%
CA
-8% BBoP

50 -10%
81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

5 March 2012


Japanese Yen
%yoy Japan Industrial Production and real GDP %yoy %yoy Japan Inflation
15 40 5
F'cast G10 Inflation F'cast
30 4 Japan CPI
10
20 3
5
10 2

0 0 1

-10 0
-5
-20 -1
-10 Real GDP
-30 -2
Industrial Production (rhs)
-15 -40 -3
90 92 94 96 98 00 02 04 06 08 10 12 14 92 94 96 98 00 02 04 06 08 10 12 14

% yoy Japan Trade Volumes Index Japan Terms of Trade
3-mth ma 2000=100
50 150

40 140

30 130

20 120

10 110

0 100

-10 90

-20 80 TOT
Exports 70 Improvement
-30
-40 Imports 60

-50 50
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

% $/JPY Vol USD/JPY: 3-mth Risk Reversals
$/JPY vs 2-yr Rate Differential
8 125 2
2-yr US Swap Minus 2-yr Japan Swap
7 $/JPY (rhs) 120
0
6 115

5 110 -2

4 105
-4
3 100

2 95 -6

1 90
-8
0 85

-1 80 -10

-2 75
06 07 08 09 10 11 12 -12
08 09 10 11 12

6 March 2012


Europe, Middle East & Africa
British Pound
FX Forecasts: We maintain our EUR/GBP forecasts at 0.87 in 3, 6 and 12 months. Given our EUR/$ forecasts, this
translates into GBP/$ at 1.53, 1.59 and 1.67 in 3, 6 and 12 months. Current GSDEER for EUR/GBP is 0.79 and for
GBP/$ is 1.51.

Motivation for Our FX View: Sterling is trading at a discount to 'fair value' vs the EUR. However, persistently high
inflation prints have started to erode GBP valuation. GBP has recently benefited from 'safe haven' flows linked to the
Euro area crisis and a broader weakening of the EUR. Therefore, it has overshot our forecast. Cyclically, the
consolidation in fiscal policy combined with an accommodative monetary policy stance is typically negative for FX
(the BoE eased monetary conditions by increasing asset purchases by GBP50bn over three months). These forces
should keep GBP within our flattish forecast path, with the recent strength reversing in the near term. Broader USD
weakness should lead to considerable strength in Cable.

Monetary Policy and FX Framework: The Bank of England is tasked with price stability, defined as CPI at 2% over
time. If inflation falls below 1% or rises above 3%, the BoE must write a letter of explanation to the Chancellor of the
Exchequer. Sterling operates under an entirely free float, although the BoE occasionally comments on exchange rate
developments.

Growth/Inflation Outlook: We expect the economy to grow by 1.2% in 2012 (above consensus of 0.5%) and by 2.3%
for 2013. The composite PMI fell to 53.6 in February, with both manufacturing and services falling. In January,
headline CPI fell sharply to 3.6% as the effect of the 2011 VAT hike faded. We expect inflation to continue to fall in
the coming months and average 2.6%yoy in 2012 and 2.0%yoy in 2013.

Monetary Policy Forecast: The BoE extended asset purchases at its February meeting (GBP50bn over three months),
due to weak growth and thus considerable easing in inflation pressures. We expect a further easing by GBP50bn in
May.

Fiscal Policy Outlook: The government has set out a plan for an 8% of GDP reduction in the structural deficit and 9%
of GDP in the primary structural deficit. Three-quarters of the adjustment will occur via spending cuts, while the
change in taxes is minor in comparison.

Balance of Payments Situation: We expect further improvements in the current account balance. Our forecast is for
an improvement to -1.8% of GDP for 2012 before moving back to -2.3% for 2013, after -2.4% in 2011. Meanwhile,
portfolio flows remain notoriously difficult to assess given the large gross cross-border flows linked to London as a
financial centre.

Things to Watch: The impact of fiscal policy on final demand and the trajectory of the PMI remain the key factors to
watch. A sudden change in the Bank of England's stance would be relevant as well.

Constantin Burgi

% GDP UK: BBoP vs Current Account
EUR/£ 4-qtr ma
1.00 20%
CA
0.90 15% BBoP

0.80 10%

0.70 5%

0.60 0%

0.50 -5%
Spot
0.40 -10%
GSDEER
0.30 -15%
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 91 93 95 97 99 01 03 05 07 09 11

7 March 2012


Czech Koruna
FX Forecasts: We recently revised our EUR/CZK forecasts to 25.00, 25.50 and 24.25 in 3, 6 and 12 months,
respectively, from 27.5, 27.0 and 25.5. This implies a USD/CZK forecast of 18.80, 18.48 and 16.72. Current GSDEER
for EUR/CZK is 23.09, equivalent to a 7.0% 'undervaluation' against the EUR. USD/CZK GSDEER is 19.28.

Motivation for Our FX View: We expect the Koruna to be supported in the near term by a more positive outlook for
the Euro area and its banks, and global liquidity in general. We see a risk that the CZK weakens towards the middle of
2012, on profit-taking and repatriation of FDI income, but a generally strong balance sheet, low stock of external debt
and limited reliance on foreign funding should help the Koruna appreciate in 2H2012. Euro area news will continue to
affect the Koruna; however, it should remain the least sensitive currency in the CE-3.

Monetary Policy and FX Framework: The CZK is a freely-floating currency. However, since the economy is very
open, the CNB monitors FX movements when setting interest rates. The inflation target is 2%.

Growth/Inflation Outlook: Growth is likely to stay below potential in 2012 as the external environment weakens,
especially in the Euro area; domestic demand should remain weak because of low consumer sentiment and continued
fiscal restraint. We expect inflation to stay above the target for the rest of 2012 following a VAT hike in January, but it
should start to decline from 2H2012 onwards; weak domestic demand should reduce other inflationary pressures.

Monetary Policy Forecast: The CNB has kept the policy rate at a record low 0.75% since April 2010, after a total of
300bp in cuts. In the absence of domestically generated inflationary pressures and a weakening growth outlook, the
CNB will not respond to the recent inflation jump. However, cuts are unlikely as well, suggesting an even longer 'wait
and see' period.

Fiscal Policy Outlook: The three-party government's determination to keep public finances in check and balance the
budget in the medium term has been appreciated by investors and rating agencies, and has kept long-term rates well-
anchored, leading to a two-notch upgrade by Standard and Poor's in 2012. The ongoing consolidation resulted in a
large deficit reduction in 2010 and 2011, but it is affecting consumer sentiment, which was already low following the
crisis, and will continue to weigh heavily on domestic demand.

Balance of Payments Situation: The Czech Republic maintains a trade surplus although the income account remains
in deficit due to the high repatriation of FDI profits. The current account should therefore stay in deficit in 2012-13,
although it should be easily financed with steady FDI and other inflows.

Things to Watch: The economy is highly integrated with the Euro area through trade and financial links, and hence
also with the global economy. The growth outlook abroad therefore has direct implications for Czech exports and
domestic growth, while the financial standing of Euro area banks has a strong impact on the Koruna outlook. Still, a
withdrawal from the country or deleveraging is unlikely, given the strong balance sheets of local banks and ample
domestic funding.

Magdalena Polan

% GDP Czech Rep: BBoP vs Current Account
EUR/CZK 4-qtr ma

45 10%

Spot 8%
40
GSDEER 6%
35 4%
2%
30
0%
25
-2%
20 -4%
-6%
15
CA
-8%
BBoP
10
95 97 99 01 03 05 07 09 11 13 -10%
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

8 March 2012


Hungarian Forint
FX Forecasts: We recently revised our EUR/HUF forecasts to 315 in 3 and 6 months and 325 in 12 months, from 340,
350 and 320, respectively. This implies USD/HUF at 236.8, 228.3 and 224.1 in 3, 6 and 12 months. Current GSDEER
for EUR/HUF is 288.9, which implies a 2.2% 'undervaluation' against the Euro. USD/HUF GSDEER is 241.2.

Motivation for Our FX View: The HUF will likely remain under pressure in 2012 as the government proceeds with
the difficult negotiations with the IMF/EU, and as uncertainties over the eventual outcome persist. Setbacks in
negotiations, an escalation of disagreements with the EU, or increased risk that Hungary again loses access to debt
markets, could lead to a rapid weakening of the Forint, although the recent improvement in the Euro area outlook and
global liquidity could limit the downside risks. An eventual agreement would stabilise the HUF; nevertheless, the
Forint will likely remain under sustained depreciation pressure as domestic deleveraging continues and risks to
program implementation persist. The Forint will remain vulnerable to domestic political news and changes in global
risk appetite. Positive news, such as a lasting solution to the FX debt problem or visible progress in negotiations, would
be HUF-positive.

Monetary Policy and FX Framework: The NBH targets inflation at 3% in the medium term (18 months-2 years). The
MPC normally holds rate-setting meetings every fourth Tuesday of the month.

Growth/Inflation Outlook: Growth reached 1.4% in 2011, thanks to a recovery in external demand; domestic demand
remained depressed. The combination of an external slowdown and further fiscal austerity will likely result in a small
0.5% contraction in 2012. Inflation will stay above the NBH's target until end-2013 as indirect tax hikes, higher energy
and fuel prices, and the effects of a weaker Forint drive up inflation.

Monetary Policy Forecast: The NBH hiked rates by 100bp in late 2011 to support the Forint and reduce the risk of
capital outflows. We think it may have to hike by 100bp more if negotiations with the EU/IMF stall and the HUF
weakens sharply; an eventual agreement should lead to gradual cuts.

Fiscal Policy Outlook: The Fidesz government is implementing structural reforms to stabilise public finances in the
long term and plans to follow a restrictive budget in 2012 to counteract weakening growth as it aims to meet an
ambitious deficit goal. Long-term fiscal sustainability will be at the core of the eventual IMF/EU agreement but weak
growth would likely necessitate a lengthy adjustment.

Balance of Payments Situation: The current account should remain in surplus in 2012-13, but capital outflows are
likely to put pressure on the financial account and the HUF. Without additional financing or a new IMF/EU program,
Hungary could face a 7%-of-GDP funding gap in 2012.

Things to Watch: Risks of a BoP crisis have increased and Hungary needs another sizeable IMF/EU deal to secure
substantial external financing. But the negotiations will be difficult as the government tries to minimise the
conditionality associated with another program, and the recent improvement in risk sentiment reduces the urgency to
secure a credible program.

Magdalena Polan

EUR/HUF % GDP Hungary: BBoP vs Current Account
4-qtr ma
320 20%

CA BBoP
290 15%

260
10%
230
5%
200
0%
170
-5%
140 Spot
GSDEER -10%
110

80 -15%
95 97 99 01 03 05 07 09 11 13 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

9 March 2012

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