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MORGAN STANLEY RESEARCH Global Currency Research Team For research analysts, please see contact list at the back of this material. October 2, 2014 Currencies Global FX Pulse Revising USD Higher FX Forecast Changes: We have revised our USD forecasts higher. We had forecast a broadening of the USD rally across the currency spectrum, a trend we still expect to continue. But now we expect the pace of USD gains to accelerate. Hence, we have taken our USD forecasts higher through the remainder of this year and next. However, USD/JPY is one place where we expect USD gains to be moderate, especially as challenges to global risk appetite increase. Relative JPY strength is a likely result of increased asset market volatility. To capture this dynamic, we recommend short CAD/JPY positions. Bearish Commodity Currencies: Our most significant forecast changes are for the commodity-related currencies. The negative spillover from a higher USD onto the broader risk picture has developed more rapidly than initially expected. We look for AUD/USD to reach 0.76 and NZD/USD 0.67 by end-2015. We add a short AUD/CLP strategy to our portfolio as a relative-valuation trade. ECB Issues: The ECB disappointed currency markets by providing no guidance regarding the size of its assetpurchase programmes. Draghi also attempted to play down the emphasis placed on the extent of balance-sheet expansion. While this may take some steam out of the EUR’s declines, we still expect a sustained EUR/USD downtrend. We have taken our EUR/USD forecast down to 1.12 for end-2015. Closed Trades Long USD/NOK Active Trades Long USD v EUR CHF and SEK* Short EUR/USD Short NZD/USD Long USD/SGD Short EUR/INR Short SEK/JPY Long GBP/NZD Short EUR/NOK Limit Orders Buy USD/TRY Sell CAD/JPY Sell AUD/CLP Options Trade Long USD Put/JPY Call Closed at 6.4228 on 30-Sep-14 Entry Stop Target 100.00 1.2920 0.8150 1.27 78.50 15.05 2.0440 8.1135 Entry 2.2450 97.80 528.0 Entry 24-Jul-14 100.00 1.2840 0.8140 1.25 78.50 15.50 1.9970 8.2200 Stop 2.2000 98.80 534.6 Expiry 24-Oct-14 106.00 1.2000 0.7650 1.32 75.00 14.50 2.2600 7.7500 Target 2.3300 92.80 500.0 Strike 100 See page 14 for more details. Changes in stops/targets in bold italics. MS Major Currency Forecasts EUR/USD USD/JPY GBP/USD USD/CHF USD/CAD AUD/USD NZD/USD EUR/JPY EUR/GBP EUR/CHF EUR/SEK EUR/NOK 4Q14 1Q15 2Q15 3Q15 1.24 108 1.60 0.99 1.14 0.84 0.76 134 0.78 1.23 9.30 8.05 1.22 109 1.63 1.04 1.16 0.82 0.74 133 0.75 1.27 9.20 8.10 1.18 110 1.60 1.08 1.18 0.80 0.71 130 0.74 1.28 9.10 8.15 1.14 112 1.56 1.14 1.20 0.78 0.69 128 0.73 1.30 9.00 8.20 Note: Forecasts for end-of-period. G10 forecasts updated October 2, 2014 FX Market Overview P2 EUR: A New Bearish Regime P6 AUD: The Facts Are Changing P10 Technical Chart of the Week – EUR/USD P13 In This Week’s Edition Strategic FX Portfolio Trade Recommendations P14 We believe the ECB policy measures will have a direct negative impact on the EUR, and we detail the various channels through which the EUR is likely to be pressured. Portfolio outflows, hedging activity and bank lending are all set to drive the EUR lower, in our view. Hence, we reiterate our bearish EUR/USD view, but also expect EUR to come under pressure on many of the crosses. G10 & EM Currency Summary P18 Global Event Risk Calendar P20 MS FX Positioning Tracker P23 Macro Forecasts P24 FX Forecasts P26 Previously supportive portfolio flows for the AUD have come to a halt, and declining commodity prices imply a further deterioration of Australia’s terms of trade. We explain our AUD forecast downward revision in detail. For important disclosures, refer to the Disclosures Section, located at the end of this report. MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Overview Hans Redeker, James Lord, Jessica Liang We have revised our USD projections higher as nonsymmetrical global growth suggests the USD reaching a new equilibrium. Global overcapacity, falling ROE’s outside the US and record high private debt does not bode well for high yielding FX. We no longer expect the AUD to stay stable against the USD. We have revised our projections radically. Generally, commodity currencies should remain offered as falling terms of trade take its toll on local economies. Rising asset and FX volatility suggests currencies with high foreign liabilities should come under selling pressure. We anticipate more depreciation of EM FX, and have switched our AXJ forecasts to expect weakness. Further USD strength, the emergence of macro weakness from China and continued macro fragility elsewhere in EM weigh. reverse, with the USD rising fast while most other currencies have entered a steep downward trend. The recognition that the USD undergoes a move towards a new equilibrium has led us to take our USD projections higher. Exhibit 1 Our Key FX Projections EUR/USD Before USD/JPY Before AUD/USD Before USD/KRW Before USD/IDR Before USD/MXN Before 4Q14 1Q15 2Q15 3Q15 1.24 1.27 108 107 0.84 0.95 1065 1000 12600 11500 13.30 13.20 1.22 1.25 109 108 0.82 0.93 1070 1000 12800 11800 13.30 13.20 1.18 1.22 110 109 0.80 0.92 1075 980 13000 12000 12.90 12.80 1.14 1.20 112 110 0.78 0.90 1080 960 13100 12100 12.70 12.60 Source: Morgan Stanley Research Revising Our USD Projections We have revised our USD projections higher across the board seeing the USD gaining further momentum as the global economy has entered a non-symmetrical growth pattern. EM, Japan and Europe have slowed down, while US data have remained strong. There is currently a discussion of decoupling economies but in a world of open capital accounts and flexible exchange rates, de-coupling cannot take place. Instead, exchange rates move towards a new equilibrium allowing economies to re-couple again. The USD seems to be in the middle of a move towards its new equilibrium. Currencies in search of a new equilibrium need to be differentiated from currencies following a cyclical pattern. The first case is rarer, but when it occurs then currencies move a long way before correcting. The second case is common and currencies are seen to be fluctuating around interest rate differentials. When recognising a macroshift then it makes sense to keep currency exposure for longer. On the other hand, currencies following a cyclical pattern require a more flexible trading approach. Recall 2007/08 when the US economy weakened relative to the rest of the world. The USD weakened quickly, seeing EURUSD rallying from 1.40 to 1.62 in the space of less than a year. High yielding currencies gained even more. Now it is the . However, the pace of the USD rally has not been uniform and has varied to a significant extent. The first legs of the USD rally developed against low-yielding currencies such as the EUR and the JPY but now it is the high-yielding FX segment that is leading the decline against the USD. Markets speculating on the Fed hiking rates early, volatility breaking higher and private non-US balance sheets running substantial USD short positions have created strong headwinds for high yielding FX. Our bearish EUR projections have been reached early but there seems more weakness in store. Hence we have lowered our EURUSD projections once again. In the year 2015 we expect EURUSD to trade down to 1.12. EMU’s core inflation rate falling back to 0.7% indicated that dis-inflationary trends have remained strong and despite the EUR losing value, medium term inflation expectations have eased further. The ECB’s often-used mantra calling medium-term inflation expectations firmly anchored no longer holds up in the current environment. In August, import prices continued to fall with the effect of falling commodity and other producer prices outweighing the impact of a falling EUR. The ECB wants a lower EUR. This desire is best illustrated by watching its policy approach. Cutting its deposit rates into the negative territory by simultaneously offering TLTRO’s 2 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse weakens the EUR via the rate expectation angle, but this policy mix also increases the ECB’s balance sheet. The negative deposit rate will reduce bank willingness to run excessive reserves with the ECB. Accordingly banks have not bid aggressively for TLTRO’s. Exhibit 2 Inflation Expectations Have Fallen in Europe Source: Macrobond, Bloomberg, Morgan Stanley Research For too many years, USD funding costs were too low for China-growth-inspired EM countries. USD claims accelerated, pushing debt growth towards unsustainable levels. While debt creation initially supported investment spending, allowing EM countries to do surprisingly well within the post-Lehman DM environment, many EM countries now see their debt growing at a faster pace than their nominal GDP. Simultaneously, local returns on investment have fallen, which seems to be the consequence of missing lucrative investment opportunities. For years, EM, especially in Asia, has built up capacity. Investments to GDP ratios have been high. Now there is excessive capacity, too much private sector debt and falling revenues creating a problematic environment when funding costs are rising. New-Zealand it was milk sector investment creating severe overcapacity. In Australia it was mining sector investment now seeing revenues falling well behind expectations. However, both countries run globally the highest foreign liability positions, which is a non-issue for FX valuation when volatility and yields for risk free assets are low. Earlier this year when volatility and US yields were falling, Oceanic currencies rallied, pushed higher by yield-seeking investors. Japanese money especially made its way into Oceania. However, with volatility-adjusted yield differentials turning against the AUD and the NZD, Australia and New-Zealand will find it increasingly difficult to find sufficient, foreign funding needs at current local yield or FX rates. Either local yields will have to rise or values of the AUD and the NZD will have to fall to attract appropriate amounts of funds, in our view. With local revenues falling due to declining terms of trade and declining returns on investment, it will be the FX rate carrying the main burden of the adjustment. Hence, we have changed our previously constructive view on the AUD seeing it now weakening against most G10 currencies with the NZD the notable exception. While the NZD and the AUD were immune against USD strength earlier this year, falling terms of trade, rising FX volatility and Asia slowing down faster than anticipated changed the outlook for these two currencies from August onwards. Oceania has not seen a recession for more than 20 years as its small, open and commodity-export-oriented economies benefited from the China inspired EM boom. Projected EM FX weakness follows a similar rationale. Here too, the inability of the highly-leveraged Chinese economy to generate positive growth surprises has eliminated an important pillar of EM support. It was China’s manufacturingdriven expansion that stood behind the commodity supercycle and now, as the commodity boom has turned around, many commodity-producing EM’s are experiencing falling terms of trade. The other big EM challenge is private sector debt, often used to fund local investment. In as much as this debt is USD denominated, rising USD funding costs combined with the higher FX value of the USD undermines USD debt funded balance sheets. Often EM authorities tried keeping FX within a relatively narrow range against the USD, resulting in a record increase in EM currency reserves. This policy has effectively linked local rates to low US rates, adding fuel to the credit and debt boom. Now as US credit costs rise, feeding into higher volatility, the level of debt becomes an important factor driving currency valuation. The other differentiator is the willingness of countries to undergo necessary structural reforms. Here, progress made in India and Mexico looks promising, while reforms in South-Africa, Turkey and Russia have not gone far enough, in our opinion. Prolonged periods of expansion run the risk of misallocating capital as investors become over confident about the sustainability and the drivers to the current growth cycle. In Like our broader USD forecasts, the EM currency projections have also been revised to reflect even weaker EM profiles. For the most part, this is due to the fact that our end-year or 3 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Q1 2015 forecasts have been hit much sooner than expected. In the case of our AXJ forecasts, we have switched from expecting strength versus the USD to anticipating a continuation of the recent weakening trend. This partly reflects an intensification of the existing drivers for USD strength and EM weakness, but it also reflects the emergence of risks that were previously more closely tied to our bear case for EM currencies, with recent weakness in China data important in this latter regard, and particularly so for the AXJ block. Ongoing JPY weakness has been a factor behind our AXJ revisions too. Given the extent of the USD moves that we have seen so far, we believe it is prudent to show some caution from here into the year end, so our Q4 2014 forecasts are not showing significantly weaker trends from current levels. However, we have taken our USD forecasts higher as we head into 2015. There are several reasons for taking our EM currency forecasts weaker. First, and as explained above, the strengthening trend of the USD is expected to be even more pronounced than we previously envisaged. We anticipate the structural break higher in the USD to be a long term event that reflects the currently unsynchronized global growth outlook that forces the USD higher to a new equilibrium. For the most part, the macroeconomic outlook in Emerging Markets remains poor, in our view. Asia is the only place where growth is still meaningfully above the trends seen in the developed world, but even here the differential is narrowing with the US and there is great uncertainty over the pace of future growth in China – the regional growth anchor. As such, monetary policy and growth divergences between EM and the US are likely to remain high and exchange rates will be an adjustment mechanism to reflect these trends. A stronger USD is not without its problems for EM though, and has the potential to create some negative feedback loops. With a stronger USD, and expected future increases in UST yields, the cost of servicing USD-denominated debt goes up. The private sectors of many EMs, including in Asia, have relied heavily on both foreign currency denominated and local currency credit growth to help boost GDP, leaving overall private sector leverage at historically high levels. As the following exhibit shows, a number of EMs have boosted credit/GDP by a significant amount over the past five years. At a time when growth is slowing, an increase in the cost of funding (generated by a move higher in the USD versus the local currency, as well as move higher in yields) amid a high level of leverage, is not a healthy combination. While we are not necessarily anticipating a rise in credit risk across all of EM, there are clearly some markets where this combination of higher leverage and a weak growth outlook is of more concern. This leads us onto our second factor that has prompted a downward revision in our EM FX forecasts: China. Exhibit 3 Private Sector Leverage Up, Growth Down 8 150 140 6 130 4 120 2 110 100 0 90 -2 -4 Mar 01 80 70 Mar 04 Mar 07 Real GDP Growth (%) Mar 10 Mar 13 PS Credit % (GDP) Source: Haver, BIS, Morgan Stanley Research China’s recent growth performance has been disappointing relative to expectations, particularly in light of the market consensus held earlier in the year that the economy would continue to stabilize following government stimulus. Indeed, the stability that China provided for the rest of the AXJ block was a key reason for the outperformance of AXJ currencies for much of this year, and was a pillar of our prior view that AXJ would strengthen versus the USD over the coming months. However, the weakness of the recent data and the limited (or “targeted”) stimulus measures that the authorities have engaged in have not been enough to give the market confidence that the economy would accelerate from here on. This is being reflected in commodity prices, and increasingly AXJ currencies as well, which we have now reflected in our forecasts. The AXJ region has also received a competitiveness shock from the recent acceleration in JPY weakness. While our new forecasts for USD/JPY suggest stability in the near term, currencies have needed to adjust in the region to reflect trends in JPY over the past couple of months. With that in mind, we have marked some of our AXJ forecasts to market. 4 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse While not necessarily a new risk per se, it’s worth highlighting that EM export growth remains weak too. This has been a key factor behind our long-standing negative view on the asset class, and it remains very much intact. Some economies are showing some tentative signs of strength, but the big picture is that export growth has been stagnant for several years. Without a stronger acceleration in export growth, we believe it will be difficult to mount a serious recovery in EM currencies over the long term. Exhibit 4 EM Export Growth Remains Disappointing In Indonesia, we are past the political enthusiasm that dominated the first half of this year. Apart from the strength observed in the past months, IDR suffers from negative market perception over the reform outlook and the prospect of policy tightening from the Fed. NDF points are moving higher which could trigger further hedging activities by foreign bond holders. We see IDR as one of the more vulnerable currencies in the region, which leads to our forecast of 13000 for USD/IDR for 2Q15. 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% Dec-08 Dec-09 Dec-10 Dec-11 AXJ CEEMEA Source: Haver, BIS, Morgan Stanley Research and MYR, while lower commodity prices resulting from reduced demand from China impacts both MYR and IDR. Previously long KRW was one of our high conviction trades in the AXJ basket; however, a combination of China slowdown, weakness in the Yen and also the subdued domestic economy means we may see KRW trending higher in the medium term. However, we do continue to believe that KRW will be a relative outperformer, thanks to its strong external position and competitive economy. As such, our base case is for USD/KRW to reach 1075 for 2Q15, but the move is more modest than seen elsewhere. Dec-12 Dec-13 LatAm The key variable that will help to drive any recovery in EM currencies over the long term, and thus remains an upside risk to our forecasts for EM weakness, is the prospect for economic reforms: productivity-enhancing reforms that will help to attract capital in the face of higher yields in the US. There are only a few economies where we see real prospect for this, and these include India and Mexico. Within the CEEMEA region, the biggest changes we have made are in the TRY, ZAR and RUB. We now expect USD/TRY to reach 2.40, USD/ZAR to hit 11.75 and USD/RUB to reach above 41 by 2Q next year. From current levels these seem highly attainable, and within the range of current forward prices. However, given how stretched long USD momentum is at present, we would expect to see better entry points to monetize these forecasts before the end of the year. Within Latin America, we have made changes to our USD/COP and USD/PEN forecasts, to reflect further weakness, while we still expect MXN to be a significant outperformer. We see USD/COP up to 2150 by 2Q next year, USD/PEN to 3.02 and USD/MXN to 12.9 In the AXJ region, our largest revisions are in KRW, IDR and MYR. China is the largest export destination for both KRW For MYR, prices of its three largest commodity exports have fallen significantly, compressing its trade balance, while foreign ownership of bonds remains at an all-time high. We see MYR as susceptible to continued low commodity prices and the potential for portfolio investment outflows in the event of carry trade unwinds. We are relatively optimistic on India, where the new government is making encouraging efforts for reforms and the RBI has continued to absorb capital inflows this year to build up reserves. We see USD/INR remaining range bound between 58-62, with INR strengthening versus EUR. Exhibit 5 AXJ vs US: Compression in GDP Spread 10 YoY GDP 9 2010-2013 8 2014E 7 2015E 6 5 4 3 2 1 0 Source: Bloomberg, Morgan Stanley Research 5 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse EUR: A New Bearish Regime Ian Stannard, Calvin Tse We see the ECB action impacting the EUR in several ways: We have lowered our EURUSD forecast to 1.24 for end-2014 and 1.12 for end-2015. The increase in the ECB’s balance sheet and emphasis on divergence in global monetary policy send a clear negative EUR signal. The ECB increasing its balance sheet, purchasing assets and providing further liquidity in an already low-yield environment will likely weaken EUR… The increased liquidity to the banks is likely to help deleveraging and expedite the return to investing/lending overseas. …via discouraging foreign investment inflows and increasing current hedging of EUR-denominated portfolios. The lower cost of lending makes overseas lending more attractive for European banks. Lower yields leave EMU assets relatively less attractive to foreign investors. A slowdown in central bank reserve diversification also removes another pillar of EUR support. Lower returns and increased currency volatility reduce risk-adjusted returns – suggesting increased currency hedging of European asset holdings. The EUR regime has changed – ECB easing measures are set to put EUR under continued pressure. Following the AQR and stress tests, bank lending – even overseas lending – is expected to pick up. EUR is set to take on the role of a funding currency, in our view. Exhibit 1 A New EUR Regime Central Bank Balance Sheet EUR’s trading behavior has changed. This has become evident since the EURUSD peak in May, and implies that the ECB’s easing measures announced at the September meeting will exacerbate EUR weakness over the coming year, in our view. As a result, we have lowered our EURUSD forecast further, expecting 1.24 for year-end and 1.12 for end2015. We believe that the EUR regime has changed. From the second half of 2012 to the beginning of this year, no news was good news for EUR as financial inflows and central bank reserve diversification underpinned the currency. However, going forward, we believe that no news will be bad news for EUR and that EUR rallies will be limited unless accompanied by significant domestic upside surprise in Europe. This is consistent with a complete reversal of investor sentiment towards EUR and our view that the provision of further ECB easing measures and extra liquidity is now set to weaken EUR. This contrasts with previous rounds of unorthodox measures by the ECB, which strengthened EUR, and likely makes EUR one of the main transmission channels for current ECB easing measures. Source: Macrobond, Morgan Stanley Research Macro Impact The ECB announced that it is hoping to expand its balance back to the same levels as in 2012, suggesting an increase of €1 trillion, reversing the decline over the past two years, which coincided with the recovery of EUR. This expansion is expected to be achieved via a mixture of measures, including TLTROs and asset purchases (ABS and covered bonds). The ECB also appears to be looking to EUR to act as the transmission mechanism of its latest policy initiatives. Will these measures be enough to weaken EUR? 6 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse The ECB’s announced measures fall into the category of credit easing, rather than full-blown QE. Indeed, the TLTROs are aimed at the banking system and specifically at unblocking the lending channels to the SMEs. In the longer term, this could be positive for the European economy if it were to increase credit availability to SMEs. However, in the meantime we see other dynamics resulting from these measures that are likely to put EUR under pressure. Exhibit 2 European Bank Overseas Lending Picking Up Source: Macrobond, Morgan Stanley Research Our European economists point out that, although the TLTROs are likely to reduce the cost of credit, they will not necessarily increase the demand. The first of the TLTROs showed an allotment of just €83 billion – at the lower end of market expectations (although market expectations are for a much greater take-up at the December TLTRO). While the credit and economic cycles are correlated, credit demand is lagging the economic cycle, suggesting that the feed-through to SME lending that policy-makers want may take some time. While the ECB’s Bank Lending Survey showed some pick-up in demand for credit from enterprises in 2Q, coinciding with a net easing of credit standards on loans to enterprises, demand is still running well below the banks’ own expectations. The Morgan Stanley economics team has revised lower its GDP forecast for this year and next, now expecting growth of only 0.8%Y for EMU in 2014, down from the previous forecast of 1.0%Y, with the 2015 GDP projection lowered to 1.2%Y from 1.5%Y previously (see European Economics: Waiting for the Credit Impulse to Kick in. September 7, 2014). The UK has shown that liquidity aimed at SME lending does not necessarily end up there. While the ECB TLTRO scheme is very different to the UK’s Funding for Lending Scheme, the objectives of the two programmes are similar, in so far as they are both aimed at increasing SME lending. The UK scheme was considered a success, but most of the lending was used for real estate (mortgages). Lending to SMEs remained negative. The take-up by the UK banks for its scheme overall was relatively light. Bank Lending – EUR a Funding Currency We do see some positive impact from the ECB measures on bank deleveraging, but even this is likely to be EUR-negative. The extra liquidity and purchasing of private assets is likely to help European banks repair their balance sheets. This repair process in Europe has lagged that of other global regions, and over the last two years added to EUR support, in our view – initially via repatriation of funds and lately by the lack of overseas lending and investment by banks. Without this outflow, there has been little to offset the current account inflows, keeping EUR supported, especially given the volume of foreign investor portfolio inflows. Now, however, with signs that balance sheets are being cleaned up, banks can increase risk again, and EUR is likely to be exposed to the underlying negative fundamentals. Indeed, there are already indications that European banks are lending overseas again. We expect this process to accelerate once the ECB’s AQR and bank stress testing is complete (anticipated in November), when the ECB takes over as the banking regulator in EMU. If demand for credit locally remains limited, the option of lending overseas is likely to become more attractive for European banks, especially given the low interest rates in EMU. This could result in EUR becoming the favored funding currency globally, we believe, suggesting sustained weakness for the currency. Furthermore, if the ECB’s asset purchases also reduce yields to such a depressed level that the domestic carry trade is also unattractive (even to banks with access to cheap ECB funding), overseas assets will likely become an increasingly attractive alternative, leading to domestic investor outflows. European banks could start lending and investing overseas once again. Investment Flows to Potentially Slow or Reverse The last EUR uptrend began in July 2012 after ECB President Draghi’s famous ‘bumblebee’ speech, in which the central bank head pledged to do “whatever it takes” to preserve the euro. At that time, asset valuations were attractive. Sovereign bond yields offered a large spread to that in other developed countries, and equity valuations traded at a discount to historical averages. This resulted in a very large demand for European financial assets, driving up the value of EUR on the back of foreign inflows (see Exhibit 3). 7 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Exhibit 3 Exhibit 5 Large Inflows into European Asset Markets EU Equity Valuations Have Caught Up EUR, Blns 600 Gross Flows into European Asset Markets (12m sums) Debt 500 Equity 400 300 200 100 0 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Source: Haver Analytics, Morgan Stanley Research Source: Morgan Stanley Equity Research However, at present, asset valuations are not as attractive from a foreign perspective. Exhibit 4 compares bonds across the sovereign rating spectrum on a volatility-adjusted basis. Both EU core and peripheral bonds look unattractive from a valuation perspective when compared to other global assets. There is already evidence to suggest that foreign investor behavior towards European assets is changing, as highlighted by the changing relationship between EUR and yield spreads (see Exhibit 6). Exhibit 4 EUR Returning to a Traditional Relationship with Yield Spreads Eurozone Debt Not Attractive 0.8 10y Yield / 3m FX Implied Vol Exhibit 6 Less Highly Rated 0.7 Highly Rated 0.6 0.5 0.4 0.3 0.2 0.1 0 EU Core US UK Australia NZ EU Periph EM Source: Bloomberg, Morgan Stanley Research In equities, valuations on broad European indices were cheap to their historical averages at the start of the EUR rally in 2012 (see Exhibit 5). However, that valuation discount no longer exists from a historical standpoint, suggesting that foreign inflows will slow or reverse here too. Source: Macrobond, Morgan Stanley Research Until May, EUR continued higher with the decline in yields, developing a strong inverse correlation. This was consistent with foreign investor inflows driving yields lower and simultaneously supporting EUR, given that these flows were unhedged. However, since EUR’s peak against USD in May, this has changed, with EUR returning to a more traditional relationship to yields. EUR is now declining as yields fall. Hence, asset purchases by the ECB, which depress yields further, are likely to reduce the attractiveness of European assets, deterring foreign investor inflows, and even leading to an investor outflow. 8 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Our real-time indicator of portfolio flows suggests that foreign investor outflows from the eurozone have already begun (see Exhibit 7). The Morgan Stanley Global Flow Monitor shows outflows developing in recent weeks following two years of steady inflows (see Life in FloMo, September 2, 2014). While these outflows have been significant by recent standards, compared to the accumulated inflows they are still moderate, suggesting plenty of scope for portfolio adjustment, keeping EUR under sustained pressure. Exhibit 8 Expanding ECB Balance Sheet Should Take Excess Liquidity Significantly Higher Exhibit 7 Real-Time Data Show Strong Selling of EUR Assets 500 400 USDmn EUR ETF Flows EURUSD (RHS) 300 200 100 0 -100 1.41 1.39 1.37 1.35 Source: Bloomberg, Morgan Stanley Research 1.33 Indeed, we think that the dichotomy between US and EU monetary policy – Draghi aims to weaken EUR and keep front-end rates in negative territory for the foreseeable future while the Fed inches towards normalization – will encourage European asset investors to increasingly hedge their FX risk, as it will increasingly pay to do so. Thus, we believe that EUR will stay under pressure as both outright outflows and FX hedging on existing eurozone asset holdings will weigh on the common currency. Hence, we have lowered our forecast for EURUSD to 1.12 for end-2015. 1.31 -200 1.29 -300 1.27 -400 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 1.25 Source: Morgan Stanley Research Balance Sheet and Front-End Rates Repayments of previous LTRO programs have resulted in a steady decline in eurozone excess liquidity over the past couple of years (see Exhibit 8). Ceteris paribus, periods of low excess liquidity have typically resulted in Eonia trading close to the refinancing rate, whereas periods of high excess liquidity (usually over €200 billion) push overnight rates closer to the ECB’s rate on the deposit facility. With the ECB aiming to boost the balance sheet by significant amounts, excess liquidity should also increase in Europe as well. Exhibit 9 Higher Excess Liquidity Suggests Eonia Will Start to Trade Negative This matters for FX investors as higher excess liquidity will likely drive spot Eonia sustainably into negative territory (see Exhibit 9), which should affect hedging decisions, in our view. Source: Bloomberg, Morgan Stanley Research 9 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse AUD: The Facts Are Changing Geoffrey Kendrick, Vandit D. Shah The arguments put forth for constructive view are as follows (see AUD: Parity Predicted, June 9, 2014): We have consistently forecast AUD to be the strongest G10 currency after USD through 2014. This worked well until the last payrolls release, following which two of our key assumptions have been called into question. Specifically, non-resident buyers of ACGBs look to have taken a step back as higher US rates and asset market volatility make ACGBs less attractive… In addition, Chinese policy-makers remain firm on pushing economic reform and only providing targeted stimulus measures in the current environment – a scenario that has led to continued tightening of domestic financial conditions and could potentially lead to a protracted slowdown in Chinese import demand, affecting commodity exporters. As a result, we have downgraded our AUD/USD forecasts, now expecting 0.84 by end-2014 and 0.76 by end-2015. We’ve been constructive on AUD throughout 2014, consistently forecasting it to be the relative G10 outperformer after USD. As Exhibit 1 shows, this strategy worked very well until the September 5 payrolls release. Exhibit 1 Relative G10 Performance index 105 Reasonable terms of trade stabilisation. The point of this approach was that we argued that ‘predictable’ basic balance flows were becoming positive. The math is that non-resident buying of ACGBs and Japanese buying of broader AUD assets is enough to offset a quarterly net income deficit of AUD 9 billion. And as long as the terms of trade stopped collapsing, the export volume increase would move the trade balance to structurally positive territory. Hence, a net positive ‘predictable’ basic balance. However, underpinning this analysis were two assumptions, both of which have now been called into question: Non-resident buyers of ACGBs and Japanese buyers of AUD assets would continue to buy. The terms of trade would stabilise. On the former, the renewed rise in US yields and rise in rates vol have made ACGBs less attractive, in a relative sense. Indeed, we think the vol point is particularly important (see Trans-Tasman Trader, September 22, 2014), resulting in a re-widening of the AU-US rates spread (see Exhibit 2). AUD Exhibit 2 EUR AUD Swaption versus AU-US 10y Spread JPY 100 Japanese buying of AUD assets – having sold AUD 34 billion in the 11 months to September 2013, they’ve now rebought AUD 18 billion in the 10 months to July 2014. Export volume increases ‘baked in the cake’. …and iron ore producers in China have not stopped production despite making significant cash losses, leaving iron ore prices nearly 42% lower YTD. 110 Non-resident buying of ACGBs – ACGB net issuance is AUD 9 billion a quarter this fiscal year and non-residents have bought 95% of total net issuance since 2005. 135 2.8 GBP 2.6 125 CHF 95 90 2.4 CAD 115 NZD 105 NOK 2.2 2.0 1.8 95 1.6 SEK 85 Jan-14 1.4 85 Mar-14 May-14 Source: Bloomberg, Morgan Stanley Research Jul-14 Sep-14 1.2 75 65 Sep-10 1.0 0.8 Apr-11 Nov-11 Jun-12 AUD Swaption 1y10y Jan-13 Aug-13 Mar-14 ACGB - US 10y (rhs) Source: Bloomberg, Morgan Stanley Research 10 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Indeed, we expect carry-induced inflows that had supported AUD throughout this low-volatility environment to dry up further as a move higher in US yields makes volatility-adjusted yields relatively unattractive. Unsurprisingly, the impact on AUD/USD from this recent rise in volatility in the past month has been immediate and meaningful (see Exhibit 3). Exhibit 3 NZ and AU Seeing Sharp Decline in Vol-Adj Yields Deteriorating Terms of Trade Support Rather than stabilise, Australia’s main commodity prices have continued to fall, with iron ore now below US$80/t, having started the year at US$135/t. On iron ore, we’ve been surprised that Chinese producers making significant cash losses have not stopped production (see Exhibit 5). Exhibit 5 China’s Iron Ore Cost Curve -0.15 160 140 US$/dmt 62% Fe equivalent -0.12 -0.09 -0.06 -0.03 SOE 120 Private 100 80 60 40 0.00 20 NZD AUD CAD GBP EUR CHF NOK JPY SEK 0 1m Change in Vol-adjusted 10y Yield 0 Note: Vol-adjusted yield calculated as 10y sovereign yield divided by 3m implied FX volatility. Source: Bloomberg, Morgan Stanley Research Looking ahead, our US interest rates strategists expect the US 2s5s curve to steepen as financial markets continue to price in Fed rate expectations (see US Interest Rate Strategist: Bend Don’t Break, September 26, 2014). In light of this view, we expect high-beta AUD to depreciate further against USD, especially with G10 FX becoming increasingly sensitive to moves in the belly of the US curve (see Exhibit 4 and FX Pulse: Still Watching that Belly, September 25, 2014). Exhibit 4 Steeper US 2s5s Curve Does Not Bode Well for AUD (May 2013-Sep 2014) 1.5 % 1.3 1.1 0.9 0.7 0.5 0.3 0.1 -0.1 100 200 300 Source: Bloomberg, Morgan Stanley Research Indeed, the further (unexpected) decline in Australia’s terms of trade in 3Q is enough to offset growth in export volumes in the 2014/15 fiscal year (for which the Treasury forecasts 5.5% growth in 2014/15 and 7% in 2015/16). Assuming that this new lower level for the terms of trade is now maintained, it will take until 2016 for the trade balance to go into structural surplus territory, on the back of the thenrapid increase in LNG exports (see Exhibit 6 and AUD: LNG Complexities, January 6, 2014). Exhibit 6 AUD LNG Exports about to Rise Sharply 90 Mt, annual AUDbn, annual 60 80 50 60 40 Source: Bloomberg, Morgan Stanley Research; Note: 2s5s selloff is defined as those weeks where the slope change is at least one standard deviation higher than average. Wheatstone APLNG Gladstone-GLNG 40 30 30 20 Gladstone-QCLNG 10 Pluto Gorgon 20 10 Darwin LNG 2020 2019 2018 2017 2016 2015 2014 2013 2012 0 2011 USD/EUR USD/CAD USD/GBP USD/SEK USD/CHF USD/NZD USD/AUD USD/NOK USD/JPY 50 Avg. Overall Weekly Performance Ichthys Prelude 70 Avg. Weekly Performance During 2s5s Selloffs 400 Cummulative Production, million tonnes NWS Source: Bloomberg, Morgan Stanley Research 11 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Until then, this decline in commodity prices is critical for our AUD outlook, and we expect the AUD REER to come off now that the terms of trade have deteriorated significantly (see Exhibits 7 and 8). Exhibit 7 Falling Commodity Prices Will Likely Weigh on AUD/USD 180 1.1 170 1.0 160 150 0.9 140 0.8 130 Exhibit 9 120 0.7 110 100 Jan-09 Finally, we are closely monitoring the recent weakening in China’s economic data and the reluctance of policy-makers to enact broad-based stimulus measures. Until now, only targeted easing measures have been adopted, with Premier Li Keqiang recently making it clear that monetary policy would continue to remain prudent with an eye on reform and economic rebalancing (see Back-to-School China Outlook: More Targeted Easing, For Now, September 8, 2014). In light of this, our domestic financial conditions index for China has continued to indicate tightening, pointing to a slowdown in domestic economic activity (see Exhibit 9). We remain concerned that this could lead to a protracted slowdown in Chinese import demand, adversely affecting exporters into China like Australia. 0.6 Jan-10 Jan-11 Jan-12 Bloomberg Commodity Index Jan-13 Jan-14 AUD/USD (rhs) Tightening Financial Conditions in China Could Continue to Weigh on AUD 100 Index 90 Level % YoY -31 -21 80 Source: Bloomberg, Morgan Stanley Research 70 -11 Exhibit 8 60 -1 AUD REER Still Needs to Adjust to Terms of Trade 50 60 166 50 151 40 19 30 20 29 10 30 136 20 0 Nov-07 Easier Dec-08 Jan-10 Feb-11 MS EMDFC - China 121 10 0 106 -10 -20 Mar-96 9 Tighter 40 91 Mar-99 Mar-02 Mar-05 Citi AUD Terms of Trade Source: Bloomberg, Morgan Stanley Research Mar-08 Mar-11 Mar-14 AUD REER (rhs) Mar-12 Apr-13 39 May-14 AUD/USD (Inverted, rhs) Source: Bloomberg, Morgan Stanley Research Downgrading AUD Forecasts Given this amalgam described above of higher US yields, rising asset market volatility, falling commodity prices, deteriorating terms of trade and potentially slowing Chinese demand, we turn bearish on AUD. We downgrade our forecasts, now expecting AUD/USD at 0.84 by end-2014 and 0.76 by end-2015. 12 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Technical Chart of the Week – EUR/USD Sheena Shah Long-Term EUR/USD Chart 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.8565 0.80 0.8231 RSI 01 02 03 04 100 00 1.6038 B X B A C 1.2043 A 05 06 07 08 09 10 11 12 13 14 05 06 07 08 09 10 11 12 13 14 Our long-term analysis of the DXY last week triggered us to look at EURUSD on a longer timeframe too. A trend line has formed from the low of 0.8352 in 2001 and touched the low in 2012 (A). In the past week EURUSD crossed 1.28. This marked a break of this trend line, and suggests further bearish momentum, in our view. Note that the RSI has been in the oversold region since mid-August. 0 00 01 02 03 04 10-year EUR/USD Chart 1.70 1.6038 1.60 B 1.50 X B 1.3993 1.40 1.30 A 1.20 A C 1.2043 1.10 04RSI 05 06 07 08 09 10 11 12 13 04 05 06 07 08 09 10 11 12 13 EURUSD has formed a sideways correction since the peak of 1.6039 in 2007. It is currently within a downward C wave that began from a peak of 1.3993 earlier this year. This implies that, to complete this C-wave, EURUSD should go below the A-wave bottom at 1.2043. Breaking the 1.2220 area also marks a break out of the lower end of the recent trend channel. 20 2-year EUR/USD Chart 1.42 1.40 1.38 (b) 1.36 1.34 1.32 1.30 1.28 1.26 (a) 1.24 RSI Oct-12 Jan-13 5 Oct-12 Jan-13 (e)= c =B (c) (2) (a) 1.3698 (1) (d) (b) (c)= b Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 EURUSD has come under selling pressure after breaking out of the triangle in May and has since fallen from a peak of 1.3993. An impulsive downwards sequence has formed and is currently in the (3)rd wave, which is incomplete. This suggests that EURUSD has further downside potential. We target 1.24 at year-end and 1.12 by the end of 2015. For a description of the Elliott Wave Theory see: Trading Technicals – The Elliott Wave Method, January 10, 2014. Source: Bloomberg, Morgan Stanley Research 13 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Strategic FX Portfolio Trade Recommendations Evan Brown, Vandit D. Shah Enter: 528, Target: 500, Stop: 534.6 Limit Order: Sell AUD/CLP AUD Vulnerable to Rising Vol Both AUD and CLP are exposed to a China slowdown and decline in base metal prices. However, CLP has already made a significant adjustment, falling 30% against USD since May 2013. AUD, on the other hand, has been well supported on investor flows which we think will subside as volatility picks up. The key risk to this trade is better domestic data in Australia, which would help to offset the decline in the terms of trade. Canada’s Labor Markets Lagging Enter: 97.80, Target: 92.80, Stop: 98.80 105 Limit Order: Sell CAD/JPY We like CAD shorts as we expect the currency to ‘catch up’ to the fall in its terms of trade. Lower energy prices should reduce Canada’s export income at a time when employment and consumption remain headwinds. Meanwhile, we think JPY can strengthen tactically as the global risk environment turns less supportive. Suggestions that the BoJ will signal a more flexible timeframe in reaching its inflation target will also likely reduce expectations for near-term BoJ easing, contributing to JPY strength. The key risk to this trade is strengthening Canadian data. 26-Sep-14 Enter: 15.05, Target: 14.50, Stop: 15.50 Enter: Sell SEK/JPY We like selling SEK/JPY in this environment, where we expect JPY crosses to weaken on the back of stuttering risk appetite. Importantly, we see the Abe government becoming increasingly concerned about JPY weakness reducing real disposable income via rising import prices. While we don’t think this will matter significantly for USD/JPY’s longterm trajectory, we expect JPY crosses to decline in the near term. On the SEK leg, the risks of an even more dovish Riksbank are increasing. The key risk to this trade is better Swedish data. 02-Oct-14 Enter: 2.0440, Target: 2.2600, Stop: 1.9970 104 US Employment Canada Employment 103 102 101 100 99 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14 Weaker Swedish Economy Affects SEK GBP Is Least Sensitive to US 2s5s 14 12 Enter: 2.2450, Target: 2.330, Stop: 2.20 TRY Is Most Sensitive to Higher Yields 10 8 6 4 2 0 -2 US 2s5s Limit Order: Buy USD/TRY USD/GBP USD/CAD USD/EUR USD/CHF USD/NZD USD/AUD USD/SEK USD/NOK -4 USD/JPY Enter: Long GBP/NZD We recommend long GBP/NZD in the current environment, where monetary policy divergence comes to the fore. While the BoE looks set to hike rates in spring 2015, the RBNZ continues to tilt dovishly as falling milk prices begin a spiral of weakening terms of trade and falling dairy farmers’ incomes. Uncertainties about the Scottish referendum have passed and we expect the focus in the case of GBP to return to rate differentials. In this context, yield spreads are moving in favor of higher GBP/NZD. Negative growth surprises in the UK are the key risk to this trade, in our view. Relative 2s5s The CBT has kept the main policy rate on hold for the last two MPC meetings, allaying some market concerns about continued dovish actions from the CBT. This is a welcome development, though we think that fundamentals remain broadly unsupportive while rising UST yields still point to a further rise in USD/TRY. The main risk to this trade is sustained gains in US fixed income. 14 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse 19-Sep-14 Enter: 0.8150, Target: 0.7650, Stop: 0.8140 Hold: Short NZD/USD With Prime Minister Key and RBNZ Governor Wheeler talking down the currency further, we maintain our long-standing bearish stance on NZD/USD. A dovishly tilting central bank in light of weakening domestic fundamentals was one of our three factors for staying cautious on NZD. We expect declining milk prices to weigh on the terms of trade and expect New Zealand’s REER to weaken further. Rising US yields should lead to further NZD weakening. For more on this topic, see FX Pulse: Staying Cautious on NZD (05 Sep 2014). 19-Sep-14 Enter: 1.27, Target: 1.32, Stop: 1.25 Hold: Long USD/SGD We remain long USD/SGD as the market is yet to fully price in China’s slower growth trajectory. The SGD NEER is in the middle of the band, suggesting that there’s considerable room for USD/SGD to move higher. Large-scale easing by the PBOC is the key risk to this trade. 19-Sep-14 Enter: 1.2920, Target: 1.2000, Stop: 1.2840 Hold: Short EUR/USD We remain negative on EUR as we see it gradually transitioning into a global funding currency. This structural change should accelerate after the AQR, which should encourage European banks to lend more abroad. Meanwhile, foreign investors continue to be incentivized to hedge foreign asset holdings. For more, see EUR: A New Bearish Regime on page 6. 18-Sep-14 Enter: 78.50, Target: 75.00, Stop: 78.50 NZD Weakens with Vol Spikes Exports to China and HK (% of Total) EUR/USD Catching Up to 1y1y Spread Change in C/A Balance Favors India 8% 6% 4Q Rolling Current Account (%GDP) 4% 2% 0% -2% -4% -6% -8% TRY ZAR BRL COP IDR CLP MXN INR PLN CZK CNY RUB ILS PHP HUF MYR KRW Hold: Short EUR/INR Relative performance between EM currencies is becoming increasingly correlated to underlying external funding sensitivities. Once US yields rise, we expect INR to be less vulnerable, given that India’s current account deficit has narrowed convincingly over recent quarters. Combining this with our long-standing bearish EUR view, we remain bearish EUR/INR. This position also provides significantly positive carry, although a prolonged drop in investor risk appetite could be a risk for this trade. 2Q13 12-Sep-14 Hold: Long USD against Short EUR, CHF, and SEK Enter: 100, Target: 106, Stop: 100 Latest Inflation Diverging in the G10 Space We remain long USD against a disinflationary basket of EUR, CHF and SEK as we see a clear divergence in inflationary pressures within the G10. As such, we short disinflationary currencies in a basket against USD as disinflation-fighting central banks keep policy easy for longer, buttressed by the ECB’s ongoing dovishness, and the SNB emphasizing the likelihood of inflation printing lower. Weak US data is a risk for this trade. 15 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse 30-Sep-14 Long USD/NOK Enter: 6.1500, Closed: 6.4228 Short EUR/NOK Enter: 8.1135, Target: 7.7500, Stop: 8.2200 Close: Long USD/NOK Enter: Short EUR/NOK We closed our long USD/NOK position this week, booking profit of 4.5%. Norges Bank’s decision to sell NOK 250 million per day of foreign currency is bullish for NOK in the near term. We see better risk/reward of being bullish NOK against EUR in the near term and entered a short EUR/NOK position this week. For more, see Closing Our Long USD/NOK Position (September 30, 2014). 24-July-14 Norway’s FX Purchases Spot: 101.84, Strike: 100.00, Cost: 55bp G10 Beta to S&P 500 30% 20% Hold 3m USD/JPY Put Option This option was established as a hedge on our broader portfolio, as too swift a rise in US rates could undermine risk appetite, leading to Japanese repatriation and JPY strength. Several potential geopolitical risk catalysts remain outstanding as well. Of course, we remain bullish USD generally in our portfolio, so we will not be concerned if this option expires out of the money. 10% 0% -10% -20% -30% 12m -40% 3M -50% AUD NOK SEK NZD GBP CAD EUR CHF JPY Source for all charts: Bloomberg, Haver Analytics, Macrobond, Reuters EcoWin, Morgan Stanley Research 16 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Strategic FX Portfolio Trade Recommendation Notional Nominal Weight Entry Date Entry Level Current Stop Target Spot P&L Carry P&L Portfolio Contribution Closed Trades Long USD/NOK $10.0mn 9.8% 22-Aug-14 6.1500 Active Trades Long USD v EUR CHF and SEK* Closed at 6.4228 on 30-Sep-14 $424.7k -$14.2k $410.5k $10.0mn 9.8% 12-Sep-14 100.00 100.98 100.00 Short EUR/USD $10.0mn 9.8% 19-Sep-14 1.2920 1.2686 1.2840 106.00 $158.8k $0.3k $159.1k 1.2000 $193.5k $0.5k Short NZD/USD $10.0mn 9.8% 19-Sep-14 0.8150 0.7892 $194.0k 0.8140 0.7650 $309.2k -$14.2k Long USD/SGD $10.0mn 9.8% 19-Sep-14 1.27 $295.0k 1.27 1.25 1.32 $42.9k $0.3k Short EUR/INR $10.0mn 9.8% 18-Sep-14 $43.1k 78.50 77.64 78.50 75.00 $55.2k $29.7k Short SEK/JPY $10.0mn 9.8% $84.9k 26-Sep-14 15.05 15.07 15.50 14.50 $11.6k -$0.4k Long GBP/NZD $10.0mn $11.2k 9.8% 2-Oct-14 2.0440 2.0460 1.9970 2.2600 $15.1k $0.0k Short EUR/NOK $10.0mn $15.1k 9.8% 30-Sep-14 8.1135 8.1679 8.2200 7.7500 -$72.6k $0.4k -$72.2k 2.3300 Lim it Trades Buy USD/TRY $10.0mn 2.2450 2.2680 2.2000 Sell CAD/JPY $10.0mn 97.80 97.07 98.80 92.80 Sell AUD/CLP $10.0mn 528.00 524.48 534.60 500.00 Cash $31.2mn Portfolio Mark to Market 30.5% $102.2mn Source: Morgan Stanley Research Notes: (1) Stops are based on the WMR fixing. (2) The portfolio represents hypothetical, not actual, investments. For more details regarding calculations, please see “Reading FX Tactical Trade Performance” at the back of FX Pulse. Our FX Trade Data Performance Package (24 Sep 2014) contains complete performance statistics. (3) Reported returns are unleveraged. Reported returns do not take into account transaction fees and other costs; past performance is no guarantee of future results. (4) In the case that trade allocations are increased, entry levels are a weighted average. * Global Risk Demand Index – US Pat. No. 7,617,143. We updated our methodology for our portfolio in 2011 (FX Pulse: Watching Europe, October 13, 2011). Performance on Recommended Discretionary Currency Portfolio and Market Benchmark Simple return, index 135 GBP 130 JPY 125 INR 120 Basket 115 EUR 110 NOK 105 100 SGD 95 90 2005 MS FX Strategic Portfolio 2006 2007 2008 2009 Barclay Currency Fund Index 2010 2011 2012 2013 NZD USD mn -20 2014 -15 -10 -5 Last week 0 5 10 This week Sim ulated Managed Account Monthly Gross Perform ance - % Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Year return 2006 -1.11 1.70 4.36 -0.37 1.24 -0.44 0.52 -1.47 -0.85 -0.84 -0.58 -0.01 2.03% 2007 -0.75 -0.77 -1.08 0.94 0.36 -2.02 1.07 2.75 1.26 0.45 1.16 0.18 3.52% 2008 1.07 2.25 2.72 -1.41 -0.53 1.28 -0.17 -0.24 -0.86 3.12 0.62 0.87 8.96% 2009 0.74 -0.97 -0.15 -1.09 0.50 -0.87 0.30 0.22 2.00 0.77 1.27 0.55 3.27% 2010 -0.01 -0.27 1.71 1.13 1.39 -0.86 -2.36 0.95 0.67 -0.30 0.13 0.66 2.80% 2011 -1.20 0.29 -1.71 0.51 -1.11 -0.33 0.84 -1.02 0.50 -1.03 -0.18 0.44 -3.97% 2012 0.34 0.46 -0.42 0.52 1.78 -0.43 0.39 0.56 0.43 0.53 0.96 0.47 5.72% 2013 -0.23 -0.66 0.08 0.10 0.26 0.05 -0.71 -0.13 -0.62 0.23 1.17 -0.27 -0.75% 2014 1.09 -0.67 -0.54 -0.02 -0.20 -0.26 1.20 0.30 1.23 0.13 Trade Recommendation Notional Entry Date Expiry Date Strike Entry Spot Entry Vol Entry Cost Current Spot Active Option Trades Long USD put/JPY Call $10.0mn 24-Jul-14 24-Oct-14 100.00 101.7800 6.08% 0.55% 108.47 2.24% Current Vol Current Cost P&L Total 2014 P&L -$54.5k 11.51% -$54.5k 0.00% Source: Morgan Stanley Research; see notes above. 17 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Click here for interactive currency pages: G10 Currency Summary Dara Blume, Sheena Shah USD Broad USD Strength 6.7% We have revised our USD projections higher as non-symmetrical global growth suggests that the USD could reach a new equilibrium. EM, Japan and Europe have slowed down, while US data have remained strong. A few months ago we saw the USD gain against the low yielders (CHF, EUR, SEK). USD strength then broadened out to the high yielders too (AUD and NZD). The USD has gained from expectations from the Fed, therefore we will be watching the minutes release this week. Bullish Watch: Non-farm payrolls, JOLTS, Consumer Credit, FOMC Minutes EUR Revising EUR Lower -6.7% Our bearish EUR projections have been reached early but there seems more weakness in store. Hence we have lowered our EURUSD projections once again. We expect EURUSD to head towards 1.14 by the middle of next year. EMU’s core inflation rate falling back to 0.7% indicated that dis-inflationary trends have remained strong. The ECB remains determined to get the balance sheet to 2012 levels, indicating further EUR downside from here. JPY JPY strength on the crosses 7.1% We are still cautious on long USDJPY strategies since we see some JPY appreciation pressure coming from the crosses. A sell off in both the high yielders (AUD and NZD) and the low yielders (EUR and CHF) against the JPY, could limit USDJPY upside. Indeed, USDJPY hit 110 and has since come lower. Over the medium term, there are risks to our JPY view. Our economists still expect the BoJ to ease this month. Should that be correct, then the JPY would weaken. Bearish Neutral Watch: Services PMI, Retail Sales, German Industrial Production Watch: Leading Index, Machine Orders, Trade Balance GBP GBP Weakness Deepening - 5.3% GBP should remain supported on the crosses as economic data is still strong and the BoE is likely to be among the first central banks to hike. However, we would expect GBPUSD to remain sold, for a few reasons. First, recent economic data has weakened more than recent US data, which makes sense given the UK’s closer ties to EMU. Second, central bank commentary from the BoE recently has sounded mildly dovish, also supporting our GBPUSD downwards view. CHF Maintaining Bearish CHF outlook 6.4% We expect EURCHF to slowly head higher, making long USDCHF attractive as a high beta short EURUSD. We expect the SNB will remain committed to its 1.20 EURCHF floor and intervene if necessary. Thus far, we do not believe intervention has been used, which should be confirmed by the upcoming release of the SNB FX reserves. However, this does not mean the central bank is not open to further action, including, but not limited to, intervention. CAD 4.7% AUD Time to Sell Neutral Bearish Bearish Watch: PMI Services, Industrial Production, BoE decision Watch: SNB FX Reserves, CPI, Retail Sales, Unemployment Watch: Trade, Ivey PMI, Housing Starts, Unemployment Rate We believe CAD is beginning to look vulnerable once more. Declining oil prices have weighed on terms of trade. Falling terms of trade in Australia and New Zealand have led to a large sell off, but this has not yet occurred in Canada. We now think that CAD is due for a catch up. What’s more, as we approach key resistance levels, we see room to break them, creating the potential for new highs in USDCAD. Further Weakness to Come Bearish Watch: Consumer Confidence, RBA, Employment Change - 6.4% We have revised our AUD forecasts lower, seeing the USD broaden out against the high yield currencies. Iron ore prices have been falling on risks developing from a slowing China, this is likely to have an effect on the Australian economy which relies on exporting metals to China. Also, the rising US rate environment would have the largest impact on the AUD. Overall, a rise in asset volatility and FX volatility would contribute to a bearish AUD view. NZD NZD Falling Sharply - 10.0% High yielding currencies should come under pressure over coming weeks, and we believe NZD will continue to weaken. As US rates rise, it will render currencies reliant upon USD funding vulnerable. Falling commodity prices will also pressure NZD, as its terms of trade have fallen significantly and this requires a currency adjustment. What’s more, news that the RBNZ sold NZD highlights the central bank’s desire for currency depreciation. SEK Bearish Risks Remain 6.2% We believe SEK will continue to weaken. Consumption is unlikely to pick up in an environment of high unemployment and high household debt. Though further Riksbank easing is not our base case, we believe that the central bank will retain a dovish bias, keeping pressure on the currency. That said, we prefer to play SEK weakness against USD, as the Riksbank is unlikely to keep pace with the ECB’s aggressive balance sheet expansion. Near Term Upside Neutral Watch: Unemployment, Industrial Production, CPI NOK Bearish Bearish Watch: Global risk appetite Watch: PMI Services, Industrial Production In October, Norwegian oil revenues did not cover the government’s deficit, pushing the government to sell FX from its sovereign wealth fund revenues. In the near term, this creates an additional bid for NOK. This marginal support, on top of monetary policy differentials, should pressure EURNOK. However, we note that this announcement is also in line with our longer run view that oil production has peaked, and a weaker NOK will help improve the competitiveness of the non-oil sector. Charts show 1M performance against USD, as normally quoted and DXY for USD. Click on any currency for a reference webpage on Matrix. 4.3% 18 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse EM Currency Summary Jessica Liang (AXJ), Meena Bassily (CEEMEA), Felipe Hernandez (LatAm) -0.5% CNY Neutral INR Neutral IDR Bearish -0.3% 1.2% 0.9% KRW Bearish 0.0% MYR Bearish 0.1% PHP Neutral THB Neutral CZK Neutral HUF Bullish ILS Bearish PLN Neutral RUB Bearish TRY Bearish ZAR Bearish BRL Bearish CLP Neutral COP Neutral 0.3% 2.3% 3.4% 4.0% 2.9% 3.8% 1.4% 2.9% 0.0% 2.5% 5.7% 0.4% MXN Bullish 2.4% PEN Neutral Over the last two weeks, both CNY and CNH have lost the positive momentum from previous months, in line with weaker than expected activity indicators and market expectations. We expect to remain range bound into year end. In the near term, we expect INR to be range-bound between 58 and 62. However, if the current USD strengthening trend continues, INR could be vulnerable. Longer-term prospects for INR will hinge more on the success of reform efforts. We see IDR as one of the more vulnerable currencies within AXJ to USD strength, given its large CAD and high foreign ownership in local currency bonds. Furthermore, talks of fuel subsidy cuts are weighing on the currency. In recent weeks, USD/KRW has been climbing higher along with USD/JPY. In the medium term, we expect China slowdown, weakness in USD/JPY and subdued domestic growth to continue to weigh on the currency. Prices of Malaysia’s three largest commodity exports have fallen significantly, compressing its trade balance, while foreign ownership of bonds remains at all-time high. We see MYR susceptible to continued low commodity prices and the potential for portfolio investment outflows in the event of carry trade unwinds. The Philippines’ strong fundamentals and a more hawkish central bank bias support the peso. Looking ahead, as we get closer to the strong seasonal period of overseas worker inflows (November/December) the chances of PHP outperformance within AxJ are increasing. As the military junta is making progress in revitalizing the economy after disruptions in Q1, we’ve seen a return of portfolio inflows, helping THB recover some of the earlier losses. However, we remain cautious on the THB given its weak current account cushion and uncertain political outlook. We expect the EUR/CZK floor at 27 to remain in place through 2015. The spread to the floor has narrowed on the back of EUR weakness, though we expect resistance to moves lower to increase at 27.50. With EUR/CZK volatility remaining subdued CZK/USD will act as a proxy to EUR/USD. The NBH has made clear that FX demanded by banks for the conversion of FX mortgages (spring 2015) will be supplied using the NBH’s FX reserves. This means there should be no direct flow implications from conversion, though indirect flows related to equity performance are possible. USD/ILS has seen a sizeable move over the last two months, and the BoI has reduced rhetoric against FX overvaluation. We continue to forecast moves higher in the cross; however, momentum may slow in coming weeks, and we prefer to wait for dips before re-entering long USD positions. With EM FX weakness being predominantly seen against the USD, EUR/PLN has stayed relatively stable and within ranges. We think NBP cuts are more or less priced-in, though we see some downside risks if the NBP increases the pace of cuts to 50bp per meeting. We like PLN/HUF shorts. We keep to a medium-term bearish outlook on RUB, though would advise against adding to fresh long USD positions at current levels as momentum is stretched and the CBR will start selling USD on further weakness. As such, we prefer to wait for more attractive entry levels to long USD/RUB positions. The CBT has started to show some concern with recent currency weakness, increasing their USD selling auctions and marginally tightening liquidity conditions. We do not think recent measures will be enough to contain TRY weakness, though are mindful of the risk of further policy actions. The continued fall in commodity prices and increased downside risks to Chinese growth should keep USD/ZAR within its multi-year upward trend. More uncertainty on who will be the next SARB governor also adds risks to the currency, while yields remain low relative to peers. Uncertainty ahead of the election in October and broad USD strength have pushed USD/BRL higher. Macro imbalances imply further adjustment is necessary, but in the short term official intervention and high interest rates could provide support particularly now that momentum looks stretched. Fiscal stimulus in the budget next year implies potential inflows and lower expectations for further monetary easing and reduces weakening pressure on the currency. China and copper prices are still risks, but improved valuations and the current account deficit already closed reflect a sharp adjustment and more limited downside. Lower capital inflows now that the rebalancing of the GBI-EM and the tightening cycle are over contrast with ongoing official intervention and help push USD/COP higher. Potential dollar demand from changes to private pension fund regulation, lower oil prices and weak seasonality also add pressure. Implementation of structural reforms is moving forward and, together with evidence of recovering economic growth, supports our constructive view on the currency. However, in the short term, we prefer avoiding exposure to broader USD strength and global risks and favour positioning long MXN in relative-value trades. Active central bank intervention should continue to moderate volatility and currency adjustments in the short term, but weak growth and monetary easing are still likely to push USD/PEN higher. Unattractive valuations and deteriorating external accounts are also consistent with the need for a weaker currency. Charts show 1M performance against USD, as normally quoted 19 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Click here for a full, searchable calendar Global Event Risk Calendar Charles Rubenfeld Date Day 3-Oct Fri 5-Oct Mon 7-Oct Tue 7-8 Oct Tue 8-Oct Wed N/A 10-Oct Ccy Event 13:30 10:00 9:30 9:00 9:05 7:00 7:30 8:30 13:30 13:30 13:30 15:00 CAD EUR GBP NOK NOK SEK SEK SEK USD USD USD USD Trade Balance Retail Sales (MoM) PMI Services Unemployment Rate Norges Bank's Nicolaisen spks (Kristiansand) Riksbank's Ingves speaks (Stockholm) PMI Services Industrial Production (MoM) Trade Balance Change in Nonfarm Payrolls Unemployment Rate ISM Non-Manufacturing Composite N/A 9:00 BRL EUR Brazil General Elections PMI Services 15:00 CAD Ivey PMI 0:30 4:30 13:30 8:15 9:30 9:30 6:00 N/A N/A 9:00 8:30 15:00 15:00 AUD AUD CAD CHF GBP GBP JPY JPY IDR NOK SEK USD USD Consumer Confidence RBA Rates Decision Building Permits (MoM) CPI (YoY) Industrial Production (MoM) Manufacturing Production (MoM) Leading Index CI BoJ Rates Decision BI Rates Decision Industrial Production (MoM) Household Consumption JOLTs Job Openings IBD/TIPP Economic Optimism N/A JPY 13:15 6:45 2:45 0:01 0:50 N/A 19:00 Ref. Period MS forecast Market Aug Aug Sep Sep 0.2% 58.3 1.6B 0.1% 59 2.7% 2.58B -0.4% 60.5 2.9% -41.5B 230k 6.1% 1% -40.8B 216.5k 6.1% 58.5 54.2 -1.07% -40.5B 142k 6.1% 59.6 52.8 52.8 52.8 Sep Aug Aug Sep Sep Sep Previous Sun 6-Oct 9-Oct Time (Ldn) Sep F Sep 50.9 Aug Aug Aug Oct 113.7 2.5% 11.8% 0.1% 0.5% 0.3% 105.4 0.1% 7.5% -0.6% -1.2 4.67m 45.2 Eco Watchers Survey Outlook Sep 50.4 CAD CHF CNY GBP JPY PLN USD Housing Starts Unemployment Rate PMI Composite BRC Shop Price Index (YoY) Trade Balance BoP Basis NBP Rates Decision FOMC Minutes Sep Sep Sep Sep Aug 1:30 12:00 0:50 0:00 13:30 15:00 16:00 AUD GBP JPY PEN USD USD USD Employment Change BoE Rates Decision Machine Orders (MoM) BCRP Rates Decision Initial Jobless Claims Wholesale Inventories (MoM) ECB's Draghi spks (Washington, D.C.) Sep N/A N/A CNY NOK New Yuan Loans CPI Underlying (YoY) Sep Sep 13:30 13:30 9:30 0:50 0:50 N/A CAD CAD GBP JPY JPY NOK Unemployment Rate Employment Change Visible Trade Balance GBP/Mn Tertiary Industry Index (MoM) BOJ minutes Norges Bank's Olsen spks (Washington D.C.) Aug Sep Aug Aug Aug P 2.50% 2.5% 0.0% 0.1% 0.0% 0.1% 0.1% 104.1 0.1% 7.50% 7.5% ¥-770.6B 2.25% 192k 3% 52.8 -1.6% ¥-828.1B 2.5% 0.5% 1.2% 3.5% 297k 0.3% 121k 0.5% 3.5% 3.5% 293k 0.1% 3% 2.25% 16/17 Sep Thu 0.50% Aug Oct Aug 3.50% Thu 750B 703B 2.2% Fri Sep Sep Aug Aug 3-4 Sep Oct £-9500 0.1% 7% -11k £-10186 0% 20 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Date 14-Oct 15-Oct 16-Oct 17-Oct 22-Oct 23-Oct 28-Oct 29-Oct 06-Nov 11-Dec 11-Dec Day Time (Ldn) N/A N/A N/A N/A Ccy Event NOK CNY CNY CNY Existing Homes (QoQ) Trade Balance Exports (YoY) FDI (YoY) 0:30 1:30 10:00 10:00 10:00 9:30 9:30 0:50 8:30 AUD AUD EUR EUR EUR GBP GBP JPY SEK Consumer Confidence NAB Business Confidence German ZEW Survey Expectations Eurozone ZEW Survey Expectations Industrial Production (MoM) CPI (YoY) ONS House Price (YoY) M3 (YoY) CPI (YoY) 14:00 10:00 2:30 7:00 9:30 9:30 5:30 2:00 9:00 22:30 N/A 13:30 13:30 15:00 CAD CHF CNY EUR GBP GBP JPY KRW NOK NZD NZD USD USD USD Existing Home Sales (MoM) ZEW Survey Expectations CPI (YoY) German CPI (YoY) Average Weekly Earnings (3M/Y) (excl. bonuses) ILO Unemployment Rate 3Mths Industrial Production (MoM) BoK Rates Decision Trade Balance Manufacturing PMI Global Dairy Trade Milk Auction Results Retail Sales Advance (MoM) Empire Manufacturing Business Inventories 13:30 13:30 22:00 10:00 1:00 8:30 13:30 14:15 14:15 15:00 15:00 21:00 CAD CAD CLP EUR NZD SEK USD USD USD USD USD USD Int'l Securities Transactions Manufacturing Sales (MoM) CBCH Rates Decision CPI (YoY) ANZ Consumer Confidence Index Unemployment Rate Initial Jobless Claims Industrial Production (MoM) Capacity Utilization Philadelphia Fed Business Outlook NAHB Housing Market Index Total Net TIC Flows CAD EUR USD CAD NOK SEK NZD EUR CHF USD Ref. Period 3Q Sep Sep Sep MS forecast Market 41.4B 13% Previous 3.76% 49.84B 9.4% -14% Tue 113.7 7.8 6.9 14.2 1% 1.5% 11.7% 2.4% -0.16% Sep Oct Oct Aug Sep Aug Sep Sep Wed Sep Oct Sep Sep F Aug Aug Aug F Sep Sep 1.8% -7.7 2% 0.8% 0.6% 6.2% -1.5% 2.25% 22.36B 56.5 Sep Oct Aug 0.6% 27.54 0.4% Aug Aug Sep Sep Oct Oct Aug 5.3B 2.48% 3.25% 0.4% 127.7 7.4% 293k -0.1% 78.8% 22.5 59 57.7B CPI (YoY) Construction Output (MoM) Fed's Yellen spks (Boston, MA) Sep Aug 2.1% 0% BoC Rates Decision Norges Bank Rates Decision Riksbank Rates Decision RBNZ Rates Decision ECB Rates Decision SNB Rates Decision FOMC Rates Decision Oct Oct Oct Oct Nov Dec Dec 2.25% Thu 3.00% Sep F Oct Sep 297k Fri 13:30 10:00 13:30 Upcoming Risk Events 15:00 09:00 08:30 20:00 12:45 08:30 19:00 1.00% 0.25% 3.50% 0.05% 0.0% 0.125% 1.00% 1.50% 0.25% 3.50% 0.05% 0.0% 0.125% N/A Denotes timing approximate or not confirmed / All times and dates are GMT and correct as of the date of publication / For a full list of economic events see the calendar on the Morgan Stanley Matrix Platform / Source: Morgan Stanley Research, Bloomberg 21 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Click here for interactive charts G10 FX Tactical Indicators Charles Rubenfeld Exhibit 1 Exhibit 2 Historical Currency Performance FXVIX (FX Volatility Index) 3% 2% 1% 0% -1% -2% -3% -4% -5% -6% -7% 11.2 10.2 9.2 8.2 7.2 6.2 DXY GBP SEK EUR CHF CAD NOK JPY NZD AUD Monthly 5.2 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Weekly Source: Bloomberg, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research Exhibit 3 Exhibit 4 Relative Momentum Indicator MS GRDI – Standardized 10 3 2 5 1 0 0 -1 -5 -2 -3 -10 JPY USD SEK NOK CAD Curre nt GBP CHF AUD EUR La st we ek NZD -4 Oct-13 Dec-13 Feb-14 Apr-14 Source: Bloomberg, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research Global Risk Demand Index – US Pat. No. 7,617,143 Exhibit 5 Exhibit 6 G10 Surprise Index IMM Positions Summary ($bn) 0.20 AUD 0.15 MXN 0.10 Jun-14 Aug-14 CAD 0.05 NZD 0.00 GBP -0.05 CHF -0.10 JPY -0.15 -0.20 Oct-13 EUR Dec-13 Feb-14 G10 Average Source: Morgan Stanley Research Apr-14 Jun-14 Aug-14 -24 -22 -20 -18 -16 -14 -12 -10 -8 -6 -4 -2 2 G10 GDP Weighted Average Note: Aggregate USD positioning in nominal terms, see appendix for details. Source: Bloomberg, Morgan Stanley Research 22 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Click here for a full positioning history Morgan Stanley FX Positioning Tracker Calvin Tse, Evan Brown Overall Score Component Scores This Week Last Week Short Neutral Long -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 USD 3 2 EUR -5 -6 JPY -2 -2 GBP -2 -1 CHF -6 -6 CAD 2 2 AUD 1 1 NZD -2 -2 NOK -2 -1 SEK -7 -7 9 10 MS Flow IMM TFX Beta ETF Sentiment -9 10 -4 10 1 8 USD 10 -9 -4 -10 -10 -9 EUR 10 -8 -8 -1 -2 -8 JPY 6 -3 -2 4 -9 -6 GBP -1 -8 -8 -9 CHF 1 4 6 -5 CAD 0 0 9 3 -8 AUD -1 -8 10 -4 -8 Toshin 2 NZD 2 -5 NOK -3 -10 SEK Since Monday, September 29, positioning in currencies has shifted slightly. In the majors, the biggest long is in USD; the largest shorts are in EUR and CHF. USD positioning moved into long territory intraweek, driven by Japanese retail and relative equity flows. EUR short positioning moderated, largely as Japanese leveraged margin traders reduced positions. We will provide a full updated report and refresh positioning scores for all of our underlying subindicators on Monday. For Methodology see Appendix Morgan Stanley High-Frequency Misalignment Monitor 1-Oct-14 1Yr USD EUR JPY GBP CHF AUD CAD NZD NOK SEK -3.2% -3.9% -0.7% -2.9% 0.3% 1.0% -5.1% -1.9% -1.2% -2.2% -0.3% 2.9% 3.6% 2.6% 4.8% -0.8% 2.4% 3.1% 2.1% 4.3% -0.5% -7.3% -4.1% -3.4% -4.4% -2.2% -7.0% -6.5% -0.9% 2.3% 3.0% 2.0% 4.2% -0.6% -0.1% 6.4% -2.9% 0.3% 1.0% 0.0% 2.2% -2.6% -2.1% 4.4% -2.0% EUR JPY GBP CHF AUD CAD NZD NOK > +/- 1 sd > +/- 2 sd > +/- 3 sd The one-year model, which generates the most reliable trading signals, suggests the USD is due for a downward correction against most G10. NZD, CHF and EUR have the most upside against USD. AUD and CAD are the only currencies that don’t appear significantly undervalued against USD. Misalignments over a two-year look-back window again show broad USD overvaluation, again emphasizing NZD, EUR and CHF, except against CAD and AUD. The model estimated over a three-year lookback window again shows USD overvaluation. NZD, GBP, EUR and SEK are most undervalued here. Our suite of high-frequency misalignment models implies that USD can tactically correct lower against most currencies. This contrasts with our fundamentally bullish USD view. Tactical NZD longs look attractive on the crosses. 2Yr USD EUR JPY GBP CHF AUD CAD NZD NOK SEK -3.6% -3.1% 0.5% -2.6% 0.9% 0.4% -4.4% -0.8% -1.3% -1.7% 0.0% 3.6% 3.1% 2.6% 4.4% -0.9% 2.7% 2.2% 1.8% 3.5% -0.9% -6.2% -2.6% -3.1% -3.5% -1.8% -6.2% -5.3% -2.6% 0.9% 0.4% 0.0% 1.8% -2.6% -1.8% 3.6% -3.9% -0.3% -0.8% -1.2% 0.5% -3.9% -3.0% 2.3% -1.2% EUR JPY GBP CHF AUD CAD NZD NOK > +/- 1 sd > +/- 2 sd > +/- 3 sd 3Yr USD EUR JPY GBP CHF AUD CAD NZD NOK SEK -3.3% -1.9% 1.5% -4.2% -0.9% -2.3% -2.8% 0.5% -0.9% 1.4% -0.4% 2.9% 1.5% 3.8% 2.4% -1.1% 2.2% 0.8% 3.1% 1.7% -0.7% -5.9% -2.5% -4.0% -1.7% -3.1% -5.5% -4.8% -4.2% -0.9% -2.3% 0.0% -1.4% -3.8% -3.1% 1.7% -4.0% -0.7% -2.1% 0.2% -1.2% -3.6% -2.9% 1.9% 0.2% EUR JPY GBP CHF AUD CAD NZD NOK > +/- 1 sd > +/- 2 sd > +/- 3 sd For Methodology, see Appendix Note: Misalignment measured as the overvaluation of the column currency versus the row currency 23 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Central Bank Watch Next rate Market MS decision expects (bp) expects (bp) US 29 Oct 0 0 Euro Area 06 Nov 1 Japan 06 Oct 0 UK 09 Oct 1 Canada 22 Oct Switzerland 0 11 Dec -4 Current Morgan Stanley Forecasts 3Q14 4Q14 1Q15 2Q15 0.125 0.125 0.125 0.125 0.125 - 0.05 0.05 0.05 0.05 0.05 0 0.10 0.10 0.10 0.10 0.10 0 0.50 0.50 0.50 0.75 0.75 0 1.00 1.00 1.00 1.00 1.00 0 0.00 0.00 0.00 0.00 0.00 0.25 0.25 0.25 0.25 Sweden 28 Oct -3 0 0.25 Australia 06 Oct 0 0 2.50 2.50 2.50 2.50 2.50 New Zealand 29 Oct 1 0 3.50 3.50 3.50 3.50 3.75 Russia 31 Oct - - 8.00 8.00 8.50 8.50 8.50 Poland 08 Oct -39 -25 2.50 2.50 1.75 1.75 1.75 Czech Rep 06 Nov -2 0 0.05 0.05 0.05 0.05 0.05 0 2.10 2.10 2.10 2.10 2.10 - - 3.25 3.00 3.00 3.00 3.00 Hungary 28 Oct Romania 1 04 Nov Turkey 23 Oct - 0 8.25 8.25 8.25 8.25 8.50 Israel 24 Nov -2 0 0.25 0.25 0.25 0.25 0.75 South Africa 20 Nov - 0 5.75 5.75 5.75 6.00 6.00 Nigeria 25 Nov - - 12.00 12.00 12.00 12.00 11.50 Ghana 3 Nov - - 19.00 19.00 19.00 19.00 19.00 China - - - 6.00 6.00 6.00 6.00 6.00 8.00 8.00 8.00 7.75 India 02 Dec - - 8.00 Hong Kong 16 Oct - - 0.50 0.50 0.50 0.50 0.50 S. Korea 15 Oct -2 0 2.25 2.25 2.25 2.25 2.25 Taiwan 31 Dec 29 13 1.875 2.00 2.13 2.25 2.38 Indonesia 06 Oct - - 7.50 7.50 7.50 7.50 7.50 Malaysia 06 Nov 13 25 3.25 3.25 3.50 3.50 3.50 Thailand 05 Nov 0 0 2.00 2.00 2.00 2.00 2.00 Brazil 29 Oct 10 0 11.00 11.00 11.00 11.50 11.75 Mexico 31 Oct 4 0 3.00 3.00 3.00 3.00 3.00 -25 3.25 3.25 2.75 2.75 2.75 3.50 3.50 3.50 3.50 4.50 4.75 4.75 4.75 Chile 16 Oct -3 Peru 09 Oct - - 3.50 Colombia 31 Oct -1 0 4.25 Source: National Central Banks, Morgan Stanley Research forecasts as of Sep 7; Note: Japan policy rate takes a mid-range value. Market expects for G10 as of Oct 2. EM | What’s In the Price. G4 Policy Rates BRICs Policy Rates US 7 Japan UK Euro Area China 30 Brazil 6 5 4 25 Russia 20 India 15 3 10 2 5 1 0 2002 2004 2006 2008 2010 2012 2014 0 2002 2004 2006 2008 2010 2012 2014 Source: Morgan Stanley Research, Haver Analytics Source: Morgan Stanley Research, Haver Analytics 24 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse FX Bull/Bear Projections EURUSD USDJPY EUR/USD 1.40 Old MS Forecast USD/JPY 130 MS Forecast 120 GBPUSD Jun-15 GBP/USD 1.80 1.75 1.70 1.65 1.60 1.55 1.50 1.45 1.40 Jun-12 Jun-15 AUD/USD 1.05 1.00 0.95 0.90 0.85 0.80 0.75 0.70 Jun-12 Old MS Forecast MS Forecast 110 1.30 100 90 1.20 80 1.10 Jun-12 Jun-13 Jun-14 Jun-15 70 Jun-12 Jun-13 EURCHF Old MS Forecast USD/CAD 1.25 MS Forecast 1.20 Old MS Forecast 1.15 1.10 1.20 1.05 1.15 1.00 Jun-13 Jun-14 Jun-15 0.95 Jun-12 Jun-13 USDSGD Jun-14 1200 32 1000 Old MS Forecast 30 MS Forecast Jun-13 Jun-14 Jun-15 950 Jun-12 Jun-13 EURPLN Jun-14 Jun-15 28 Jun-12 4.25 28 4.15 27 10.5 26 9.5 25 8.5 4.05 Old MS Forecast MS Forecast Jun-14 Jun-15 24 Jun-12 USD/ZAR 12.5 Old MS Forecast MS Forecast 11.5 Jun-13 USDBRL Jun-14 USD/MXN 14.00 Old MS Forecast 13.50 MS Forecast 2.50 Jun-15 MS Forecast 7.5 Jun-12 Jun-13 Jun-14 Jun-15 USDCLP 660 USD/CLP Old MS Forecast Old MS Forecast MS Forecast 610 13.00 MS Forecast 560 2.30 12.50 2.10 510 12.00 1.90 1.70 Jun-12 Jun-15 Old MS Forecast USDMXN USD/BRL 2.90 Jun-14 USDZAR EUR/PLN 4.35 Jun-13 Jun-13 EURCZK EUR/CZK 29 2.70 Jun-15 34 1050 1.21 3.75 Jun-12 Jun-14 MS Forecast 36 1100 3.85 Jun-13 1150 1.26 3.95 MS Forecast USDTHB MS Forecast 1.31 1.16 Jun-12 Jun-15 USD/THB 38 Old MS Forecast USD/KRW Old MS Forecast Jun-14 Old MS Forecast USDKRW USD/SGD 1.41 1.36 Jun-13 AUDUSD MS Forecast 1.25 1.10 Jun-12 MS Forecast USDCAD EUR/CHF 1.35 1.30 Jun-14 Old MS Forecast Jun-13 Jun-14 Jun-15 11.50 Jun-12 Jun-13 Jun-14 Jun-15 460 Jun-12 Jun-13 Jun-14 Jun-15 Source for all charts: Morgan Stanley Research, Bloomberg; shaded area is the range of market forecasts. 25 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Click here for custom cross forecasts Morgan Stanley Global Currency Forecasts We updated our G10 and EM forecasts this week. EUR/USD USD/JPY GBP/USD USD/CHF USD/SEK USD/NOK USD/CAD AUD/USD NZD/USD EUR/JPY EUR/GBP EUR/CHF EUR/SEK EUR/NOK USD/CNY USD/HKD USD/IDR USD/INR USD/KRW USD/MYR USD/PHP USD/SGD USD/TWD USD/THB USD/BRL USD/MXN USD/ARS USD/VEF USD/CLP USD/COP USD/PEN USD/ZAR USD/TRY USD/ILS USD/RUB RUB basket EUR/PLN EUR/CZK EUR/HUF EUR/RON MS Dollar Index MS AXJ Index Current 2014 4Q 1Q 2Q 3Q 4Q 1Q 2Q Consensus Forward 1.27 108 1.61 0.95 7.20 6.45 1.11 0.88 0.79 137 0.79 1.21 9.11 8.17 6.14 7.76 12150 61.6 1061 3.25 44.7 1.27 30.4 32.4 2.49 13.40 8.45 6.29 597 2022 2.90 11.20 2.27 3.67 39.6 44.41 4.18 27.49 310 4.42 85.38 106.01 1.24 108 1.60 0.99 7.50 6.49 1.14 0.84 0.76 134 0.78 1.23 9.30 8.05 6.14 7.80 12600 62.0 1065 3.33 45.0 1.29 30.6 33.0 2.30 13.30 10.00 12.00 605 2070 2.96 11.30 2.30 3.70 40.0 44.3 4.23 27.60 318 4.42 86.73 105.03 1.22 109 1.63 1.04 7.54 6.64 1.16 0.82 0.74 133 0.75 1.27 9.20 8.10 6.12 7.80 12800 62.5 1070 3.37 45.5 1.30 30.8 33.3 2.45 13.30 10.63 12.00 615 2130 3.00 11.50 2.35 3.75 40.5 44.5 4.20 27.60 314 4.35 87.52 104.46 1.18 110 1.60 1.08 7.71 6.91 1.18 0.80 0.71 130 0.74 1.28 9.10 8.15 6.13 7.80 13000 62.5 1075 3.40 46.0 1.31 31.0 33.6 2.47 12.90 11.25 14.00 610 2150 3.00 11.75 2.40 3.80 41.1 44.4 4.15 27.50 308 4.33 89.40 103.93 1.14 112 1.56 1.14 7.89 7.19 1.20 0.78 0.69 128 0.73 1.30 9.00 8.20 6.14 7.80 13100 62.3 1080 3.43 46.3 1.31 31.1 34.0 2.50 12.70 11.88 14.00 600 2170 3.02 11.65 2.40 3.85 41.6 44.22 4.12 27.50 304 4.33 91.68 103.66 1.12 114 1.51 1.17 7.99 7.37 1.22 0.76 0.67 128 0.74 1.31 8.95 8.25 6.09 7.80 13000 62.2 1085 3.45 46.5 1.32 31.2 34.0 2.52 12.50 12.50 14.00 595 2180 3.03 11.50 2.37 3.85 41.8 44.06 4.08 27.25 300 4.30 93.59 103.67 1.15 116 1.50 1.16 7.83 7.22 1.23 0.77 0.66 133 0.77 1.33 9.00 8.30 6.10 7.80 12800 62.0 1083 3.43 46.3 1.32 31.0 33.8 2.57 12.50 12.50 14.00 590 2170 3.02 11.40 2.35 3.80 42.0 44.84 4.05 27.25 298 4.30 93.43 103.97 1.17 117 1.49 1.15 7.74 7.18 1.24 0.78 0.65 137 0.79 1.34 9.05 8.40 6.09 7.80 12700 62.0 1080 3.40 46.3 1.31 30.8 33.8 2.62 12.40 12.50 14.00 585 2160 3.01 11.35 2.33 3.80 42.0 45.21 4.02 27.15 295 4.30 93.35 104.33 -3.1 0.0 -2.4 4.4 4.7 2.6 2.7 -6.7 -7.3 -3.0 -0.6 1.7 1.6 -1.2 0.3 0.5 5.9 2.5 3.9 3.4 1.8 1.6 2.0 1.5 -2.1 1.5 5.0 11.8 3.4 5.1 3.1 2.9 4.5 1.4 5.3 3.6 1.2 0.4 1.0 0.0 -2.1 0.0 -0.7 4.1 4.2 0.3 2.1 -3.9 -2.8 -2.2 -1.4 1.9 1.9 -1.9 -0.4 0.5 1.7 -1.1 0.1 1.9 0.2 1.4 0.7 1.2 -9.6 -1.3 3.5 90.7 0.5 1.5 0.8 -0.6 -0.9 1.0 -1.0 -2.1 0.8 0.4 2.2 -0.5 2015 2016 4Q14 % change to: Source: Morgan Stanley Research 26 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Appendix The Strategic FX Portfolio Trade Recommendations page presents the portfolio of tactical trade ideas of the FX Strategy team and the performance of this portfolio over time. Strategic FX Portfolio Trade Recommendations (Note: The portfolios represent hypothetical not actual investments.) On 10 June, 2010, we implemented changes to our portfolio to make it more robust and to better reflect our confidence levels and relative risk. A detailed explanation of this change can be found in “Portfolio Methodology Update” (10 June 2010). In summary, the trades and the weightings are primarily reviewed weekly on Thursdays and published in the Pulse. However, if we think there has been a material change to the risk-reward, we will make intraweek changes. We monitor trades daily. We will continue to publish the portfolio as a list of trades where our strongest conviction ideas will be given the largest weightings. We will, however, also adjust the weights of trades in order to manage our risk exposure. A table showing the trade, trade weight, trade entry date, risk allocation and levels for (average) entry, current, stop and target will be shown in the Strategic FX Portfolio Trade Recommendations section of the FX Pulse. If we increase the weighting allocated to a trade, the entry level published in the table will be changed to reflect a proportionally weighted rate of the initial entry level and the entry level on the date the weight was increased. Performance Statistics We rebalance our portfolio daily at the NY close to keep the weight of each trade consistent with the published weight. We will primarily enter and exit trades using the bid or offer rate of the WMR fixing. If we make an intraday change to our portfolio, we will cite the closest Bloomberg half hourly fix in our published note and enter/exit at this rate. Stops or targets will be triggered if the stated level is met at the WMR fix. Returns shown include the cost of carry using the 1W interbank deposit rate if this is quoted liquidly but do not include any other expenses, slippage or fees and no interest on cash holdings are included. Reported returns are not levered. We have re-estimated our returns from 22 June 2006 to 10 June 2010, when we re-launched the portfolio, to take into account our more robust calculation technique. We provide a monthly breakdown of our historical portfolio performance back to Jan 2005 in the Strategic FX Portfolio section of the Pulse. The FX Tactical Indicators table highlights the most recently updated indicators we, as a research team, use as inputs to generate both longer and more tactical forecasts. Matrix charting codes are given in brackets. Change the G10 currency in italics as required. •Historical Currency Performance: Price changes in currency over the past week and past month. (EURUSD) •FXVIX (Volatility Index): An index of 3 month implied volatility calculated using 30 G10 and EM crosses (MSFXVIX) •Relative Momentum Indicator: Measures the momentum of a currency relative to all other currencies; not indicative of historical performance. (MSRMUS) •MS GRDI*: An index to assess risk sentiment. It looks at ten different asset classes to gauge risk demand. The GRDI index seen in the graph is a standardized reading of the index based on the 365-day rolling average. (GRDIIDX) •G10 Surprise Index: Measures the performance of actual economic data in G10 countries relative to expectations. G10 Average Index is a simple index; G10 GDP weighted average is based on GDP weights. (MSSIUSD) •IMM Commitment of Traders Report: The “Aggregate USD Index” is the cumulative aggregate positioning of currencies we track on the IMM against the USD. We combine IMM positioning on the AUD, CAD, CHF, EUR, GBP, JPY, and MXN to calculate an aggregate USD index to measure overall net positioning. (MSPIUS) FX Positioning Tracker Methodology (MSPIUS) See the primer •MS Flow - Our internal flow data track all spot and forward trades transacted by Morgan Stanley FX globally. •IMM - We use the US Commodity Futures Trading Commission’s IMM report to track positioning of non-commercial traders. •Toshin - The Toshin accounts are Japanese foreign currency investment trusts that seek yield abroad. They typically cater to retail investors and offer a higher return by investing in foreign assets on a currency un-hedged basis. •TFX - The Tokyo Financial Exchange (TFX) measures Japanese currency trading on margin accounts, and comprises an estimated 10% of the retail margin market. •Beta - As an alternative proxy for positioning, our Beta-Tracker measures one-month rolling betas of currency managers’ and global macro hedge funds’ daily returns on major currency indices. •Sentiment - The Daily Sentiment Index gathers opinions on all active US futures, eurozone interest rates, and eurozone equities futures markets. Morgan Stanley FX High Frequency Misalignment Monitor Methodology: See the full report (MSSTMEUR) Historic data for all these models can be found on the Morgan Stanley Matrix Platform. See New FX Strategy Interactive Features (January 17, 2014). Click on the Matrix logo throughout this document or here for a G10 currency reference page: * US Pat. No. 7,617,143. 27 MORGAN STANLEY RESEARCH October 2, 2014 FX Pulse Global FX Strategy Team Head of Global FX Strategy (London) Head of EM Macro Strategy (New York) Hans Redeker, Managing Director Rashique Rahman, Managing Director [email protected] [email protected] (44 20) 7425 2430 (1 212) 761 6533 Co-Head of US FX Strategy (New York) Co-Head of US FX Strategy (New York) Currency Strategist (New York) Currency Strategist (New York) Evan Brown, CFA, Vice President Calvin Tse, Vice President Dara Blume, Associate Charles Rubenfeld, Analyst [email protected] [email protected] [email protected] [email protected] (212) 761 2786 (212) 296 5423 (212) 296 5786 (212) 296 5911 Head of European FX Strategy Currency Strategist (London) Currency Strategist (London) Ian Stannard, Executive Director Sheena Shah, Analyst Vandit D. Shah, Analyst [email protected] [email protected] [email protected] (44 20) 7677 2985 (44 20) 7677 6457 (44 20) 7425 3978 AXJ FX & Rates Strategy AXJ FX Strategy Rates/FX Strategist (Hong Kong) AXJ Strategy (Hong Kong) Geoffrey Kendrick, Executive Director Jessica Liang, Vice President Kewei Yang, Executive Director Kritika Kashyap, Associate [email protected] [email protected] [email protected] [email protected] (852) 2239 7399 (852) 3963 3021 (852) 3963 0562 (852) 2239 7179 LATAM Macro Strategy (New York) LATAM Macro Strategy (New York) Felipe Hernandez, Vice President Robert Habib, Associate [email protected] [email protected] (212) 296 4996 (212) 761 1875 Global EM Macro Strategy (London) CEEMEA Macro Strategy (London) James Lord, Executive Director Meena Bassily, Associate [email protected] [email protected] (44 20) 7677 3254 (44 20) 7677 0031 Morgan Stanley entities: London – Morgan Stanley & Co. International plc; New York – Morgan Stanley & Co. 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