FX Pulse: The Safe-Haven Challenge - Morgan Stanley

MORGAN STANLEY RESEARCH

Global Currency Research Team For research analysts, please see contact list at the back of this material.

August 16, 2012

Currencies Global

FX Pulse The Safe-Haven Challenge Markets diverge. While bond, credit and equity markets have made bullish moves, currency markets remain driven by safe-haven themes. As the markets correct, either bond, credit and equity markets turn sour from here – or safehaven currencies lose ground. Positive US data surprises. Bullish US data releases have pushed the USD higher, namely against EUR. A strengthening US economy increases USD safe-haven qualities beyond repatriation flows from overseas investments. Hence, the market’s bullish USD reaction to positive US data makes sense to us, as long as investors remain EUR-sceptical. Warning in Swiss currency reserves. According to weekly SNB data, Swiss currency reserves are no longer growing, suggesting that the capital flight out of the eurozone has come to a halt. The successful stabilisation of peripheral bond markets via ECB President Draghi’s verbal intervention has stopped deposit shifts into Switzerland, in our view. However, other FX market segments have not taken notice. Safe-haven currencies have remained in demand. Challenging safe-haven currencies. Should the “Draghi Put” prove successful in the near term, as we expect, we like buying the EUR and EMFX, funded with safe-haven currencies. We investigate the divergence between high FX market correlation and historically low volatility in our thematic section this week. This divergence is unusual, suggesting either volatility increases or correlation subsides. In January 2011, we discovered a similar regime. In the period shortly after, it was correlation coming down which contributed to the EUR/USD advance from 1.27 to 1.49. Hedging with FX options. High liquidity and relatively inexpensive implied volatility can make FX options an attractive proxy for hedging cross-market risk. We have developed a filtering process to determine which currencies offer the most cost-effective proxies for event risk in other markets.

Trade Recommendations Closed Trades Long USD call/SGD put Active Trades Short SGD/PHP 12m NDF Long CHF/JPY Short GBP/MXN Short AUD/NOK Buy EUR/GBP Sell GBP/RUB Limit Orders Buy EUR/AUD Buy USD/JPY Active Options Trades Long USD put/MYR call Short USD put/MYR call Long GBP put/USD call Long EUR call/USD put Short EUR call/USD put Long USD call/SGD put

Entry Stop 10-May-12 10-Aug-12 Entry Stop 34.15 34.15 79.15 78.20 20.50 22.50 6.260 6.315 0.785 0.775 50.20 51.50 Entry Stop 1.1650 1.1550 78.50 78.10 Entry Date Expiry Date 14-Jun-12 13-Sep-12 14-Jun-12 13-Sep-12 2-Aug-12 2-Nov-12 2-Aug-12 5-Oct-12 2-Aug-12 5-Oct-12 9-Aug-12 9-Nov-12

Target 1.2700 Target 32.00 92.00 18.00 5.95 0.820 44.00 Target 1.3000 82.00 Strike 3.1310 3.0400 1.5112 1.2151 1.2650 1.2650

See page 21 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

3Q12

4Q12

1Q13

2Q13

1.24 77.0 1.53 0.89 1.04 1.00 0.79 95.5 0.81 1.10 9.00 7.60

1.19 78.0 1.51 0.92 1.06 0.95 0.75 92.8 0.79 1.10 9.20 7.65

1.15 80.0 1.46 1.00 1.10 0.91 0.70 92.0 0.79 1.15 9.40 7.70

1.19 83.0 1.47 0.99 1.08 0.93 0.72 98.8 0.81 1.18 9.20 7.65

Note: Forecasts for end-of-period. G10 forecasts updated on July 3, 2012.

Market Overview USD: Telling Tails EMFX: Intervention Strikes Again Volatility, Correlation, and Risky Assets KRW: Off Target Strategic FX Portfolio Trade Recommendations G10 & EM Currency Summary Global Event Risk Calendar FX Volatility/Carry Grids, Tactical Indicators MS FX Positioning Tracker FX and Macro Forecasts

P2 P8 P11 P14 P17 P21 P26 P28 P30 P34 P35

For important disclosures, refer to the Disclosures Section, located at the end of this report.

MORGAN STANLEY RESEARCH August 16, 2012 FX Pulse

Market Overview Morgan Stanley & Co. International plc

Hans Redeker

Morgan Stanley & Co. International plc

James Lord

+44 20 7425-2430

+44 20 7677-3254

 We remain bullish on risky assets and trade related currencies accordingly.  Positive G-10 data surprises and the cutting off EMU tail risks by the ‘Draghi put’ are the main drivers of risk appetite.  EMU bond and equity markets have outperformed, but this outperformance is not yet reflected in FX rates.  The EUR has created an inherit risk premium which will protect the downside for now.  EUR crosses have upside potential. We like EURAUD, EURGBP and EURJPY long positions.  We continue to favor adding risk on dips in EM currencies, particularly with EM funding conditions still benign.  Greater differentiation is required, with the prospect of “strong-side” intervention returning in Latin American markets.  We like currencies with high carry-to-volatility ratios, such as the RUB. We prefer to fund this in GBP. MXN remains our favorite currency in Latin America.

Our Starting Point Most markets have bought into the ‘Draghi put’, but FX markets have remained risk averse. The EUR trades at a substantial discount according to most of our indicators. Meanwhile, the weakening JPY and Switzerland reporting its currency reserve increase has come to standstill argue that risk-averse FX investors are reconsidering positions. Turning safe haven FX flows should push JPY crosses lower and the EUR higher. A short-positioned EUR market and the EUR trading at a discount to short-term ‘fair value’ models have created what we call an ‘asymmetric market’ that is developing an increasing sensitivity to EUR bullish news.

contrary, construction contributes only 2.7% to US GDP, but real estate is important to portfolios and household net worth. When house prices stabilize, concerns about moving into negative equity drop, allowing households to relax their saving efforts. The outlook becomes brighter.

Assessing Risk Sentiment US survey indicators have stabilized only recently, yet the equity market has rallied since June 4. The assessment of risk sentiment is important for currency markets. Trying to predict equity market movements based on business and consumer surveys has failed. But if we add real estate price data, the recent equity market rally makes sense. Exhibit 1 shows the evolution of equities against an indicator using PMI and house prices as input factors. While by no means perfect – there was a two-year misalignment when equities continued to rise in 2006 and 2007 when the indicator provided stark warning signals – the indicator’s prediction capacity has increased since Lehman. However, equity markets have shown significant divergence, with many Asian markets underperforming while EMU markets have compensated investors handsomely over the past couple of months. Since early June, the EUR Stoxx 600 has gained 16%, the S&P 500 increased by 10%, while China’s Shanghai Composite index has lost 9%. Debt markets have developed similar performance divergence. Here again, EMU markets have done best, which we believe is not adequately priced into FX markets yet, suggesting EUR upside potential. Exhibit 1

Stock Prices Important for Risk Assessment

Risk Rallies as US Confidence Indicators Improve We continue to focus on the developments in the US housing market, which has recently shown some signs of life. Prices are rising along with mortgage applications, and the market composite index has reached its highest level since Lehman. It is not that we regard construction activity as super important for improvement in the current business cycle. On the

Source: Reuters EcoWin, Morgan Stanley Research

Asymmetric EUR Markets With Western economic indicators improving, central banks standing ready to provide additional monetary

2


accommodation if required, and the possibility the ECB will take steps to implicitly guarantee the short end of peripheral yield curves, high-yielding assets and the EUR have further upside potential, we think.

Exhibit 2

Non-Homogenous EMU Bond Market Increased the Relative Attractiveness of AUD Debt

The path of least resistance for the EUR seems to be to the upside, illustrated by EUR reaction following Q2 EMU GDP releases. While data were weak, contractions in Greece (-6.2%) and Italy (-2.5%) were not as bad as feared, pushing the EUR initially higher. Currently, EUR markets seem asymmetrical, with bearish data not having as great a market impact as bullish data. Near-record EUR short positioning (see page 34) leaves us with the impression that a rising EUR could impose substantial pain to the market, forcing investors out of non-performing EUR short positions. Source: Reuters EcoWin, Morgan Stanley Research

Trading EUR Crosses Long EURUSD has rebounded from its lows, in line with our call for this currency pair to head towards a tradable rally (see EUR Heading Towards a Tradable Rally, August 2). However, there should be a broad-based EUR rebound if the ECB’s road map, designed to stabilize bond spreads, falls into place, suggesting EURJPY, EURGBP and EURAUD will rally. The JPY, GBP and the AUD have benefited from safe haven related inflows and with EMU’s tail risks coming in, safe haven flows are likely to reverse. In the August 9 FX Pulse article ‘Reversing Safe-Haven Flows: Sterling Leads the Bearish Ranking, we explored the ‘stickiness’ of these safe haven flows, concluding the JPY and GBP saw flows often characterized as ‘hot money’. Hence, turning risk sentiment has the potential to weaken these two currencies disproportionally. The AUD benefitted from investors placing funds into its sovereign and high-rated corporate bond market. AUD investments represented a yield pick-up positioning when EMU yields lost attractiveness due to rising sovereign risks.

Traditionally, the AUD is known as a high-beta currency, outperforming when markets show high risk appetite. Indeed, over the past couple of years, the AUD has benefited from the best of both worlds. It continued to be supported by its highbeta status when equity markets and other risky assets were rallying. On the other hand, in risk-off periods, international investors shifting funds from sovereign-risk-prone EMU peripheral bonds into AUD-denominated debt also supported the AUD. No wonder EURAUD moved from 1.30 to 1.16 within the past three months. The RBA cutting rates and rising international demand for AUD debt instruments have pushed local yields lower across the board. The spread between 5-year nominal bond yields and nominal GDP has widened, inspiring local credit demand. As a result, Australia’s economic data haven beaten expectations, causing the economic surprise index to rise sharply. Exhibit 3 compares Australia’s surprise indicator with the G-10 indicator for economic surprises, showing a wide gap. Relatively strong Australian economic data allowed interest rate differentials to move in AUD’s favor as markets reduced the probability of the RBA cutting rates further.

Australia’s Yield Pick-up Positioning Exhibit 2 shows the evolution of 10-year yields, comparing Spanish, Italian and Australian sovereign bond yields. While bond yields were positively correlated for a decade, the picture changed with the outbreak of EMU’s sovereign debt crisis in March 2010. The positive correlation between Australian yields and peripheral bond yields, here presented by Spain and Italy, reversed. When EMU peripheral bond yields rose, the AUD-denominated yields for sovereigns and top-rated corporate bonds fell. The AUD was established as a ‘safe haven currency’.

3


Exhibit 3

Exhibit 4

Australia Leading the Cycle?

RMB Forwards Price in Increasing RMB Depreciation Risks

140 120

Upside Surprise

Australia Leading by 13W

100 80

In d e x

60

G10

40 20 0 -20 -40 -60 -80

Downside Surprise

-100 6/09 9/09 12/09 3/10 6/10 9/10 12/10 3/11

6/11 9/11 12/11 3/12 6/12 9/12 12/12

Source: Morgan Stanley Research Source: Reuters EcoWin, Morgan Stanley Research

Relative Risk Shift Interestingly, Australia’s economic surprises tend to lead by three months. While this relationship is not written in stone, it has been remarkably stable over recent years. Should Australia act as a lead once again, the global economy may be a less risky place by the end of this year. Current risk perception in the foreign exchange market is very different. Positioning in currencies viewed as safe havens has remained high, highlighting that the market is not prepared for positive economic surprises. Consequently, we conclude the path of least resistance for EURUSD is to the upside for now. However, it is not only the absolute risk perception that is important. Currency positions are relative positions. Hence relative risk perception requires close scrutiny. Since April, the dominant perceived risk was linked to EMU and the increasing concerns the currency union could fail. On the other hand, Asia-related risks were hardly considered by investors using the AUD as a safe haven instrument. Weak local equity markets and RMB expectations turning to deprecation indicate that capital is leaving China. Exhibit 4 shows the difference between the USDRMB cash and the one-year forward rate, which we use as an indicator for local capital flows. Capital is no longer moving into China; instead July FDI outflows where the highest since December 2011 and local entities have started hording foreign currency cash, notably USD. Combined with the weakening trade balance, capital outflows have pushed China’s currency reserve growth into the red. Bullish AUD investors should take notice as Asia is no longer considered the globe’s favorite investment destination.

When exploring AUD bearish trading opportunities, we take guidance from the relative performance of capital markets. Above we highlighted how the inverse relationship between Australian and EMU peripheral bond markets established the AUD as a safe haven currency. However, there are signs safe haven flows are reversing, now working against the AUD. Peripheral bond markets have rallied while AUD-denominated debt prices have eased. Exhibit 5 shows bond markets leading FX. For instance in winter, bond spreads turned in favor of the EUR, but it took the FX market until February before taking notice, driving EURAUD from 1.22 to 1.30. Once again, bond yield differentials have turned in favor of EURAUD, but this currency pair is still trading near its recent cycle low. Exhibit 5

Bond Yield Differentials Have Built a EURAUD Safety Net


Of course, risk premiums need to be considered when a currency diverges from forward-looking indicators, as we are

4


now seeing in EURAUD. The current divergence between the bond and FX markets suggests one of the two markets has got it wrong. Either bond markets are too optimistic on EMU issues or FX markets are too pessimistic. Of course, bond markets have the better track record; hence their price moves have higher predictive power. But it would be too easy – and incorrect – to say the ‘bond market always gets it right’. For us, the analysis of the ‘Draghi put’ and its impact on financial markets is important.

The ‘Draghi Put’ and Its Impact on FX In his speeches on July 26 and August 2, ECB President Draghi made three important statements. First, the ECB is independent; second, it is committed to price stability; and third, high bond spreads have reduced the efficiency of the monetary transition mechanism. Deflation risks have endangered the goal of price stability, but without a functioning monetary transition mechanism, the ECB will be unable to reach that goal. Draghi underlined the independence of his institution because peripheral bond buying is certainly going to meet criticism from core countries, such as Germany. Citing the institution’s independence and emphasizing it monetary stability mandate will provide the ECB with substantial room to maneuver, including bond purchases to restore the monetary transition mechanism.

If the ECB successfully manages peripheral bond spreads, it could create ‘quasi safe assets’ by effectively becoming the lender of last resort for this part of the curve. Safe assets are essential for banks to create credit. Consequently, banklending standards might loosen, if the ECB can successfully control the short end of sovereign yield curves, which then can provide some cyclical support for the EUR. Without going into further detail, the potential effectiveness of the ‘Draghi put’ should not be compared with the relatively unsuccessful SMP buying programs, which started in May 2010 and were re-launched in July 2011. Then, ECB action aimed to reduce volatility via its open market intervention program, but now the ECB targets restoring the monetary transition mechanism by moving bond yields lower. In sum, the ECB insistence that the monetary transition mechanism is not fully functional provides it with substantial flexibility and this potential flexibility is not currently priced into FX markets. Exhibit 7 shows our risk-adjusted yield differential versus EURUSD. EURUSD trades at a substantial discount relative to the risk-adjusted yield differential. Obviously, bond markets believe the ‘Draghi put’ will work, while the FX market has remained skeptical. Exhibit 7

Sovereign 5-year Risk-Adjusted Yield Differential

When intervening in the short end of sovereign bond markets the ECB could effectively anchor the short end of EMU yield curves, creating conditions for financial institutions to ride the curve via short funded bond purchases. Peripheral bond markets, undergoing an initial bullish steepening, will support related asset classes reaching from equities to the EUR. Exhibit 6

Spanish Yield Curve Has Moved Away From EURUSD

Source: Bloomberg, Morgan Stanley Research

The Risk Calendar Is Long


Of course, uncertainties are high. Exhibit 8 provides a list of potential risk events. Italy and Spain have not yet asked for additional fiscal assistance and their participation is required for the Draghi put to swing into action. Even more important is the German Constitutional Court decision concerning the ESM, due September 12. There is a chance that things could go wrong and if they do they might go terribly wrong. Hence, caution is warranted. However, a EUR-short-positioned

5


market and bond yield differentials provide the EUR with a cushion, justifying EUR long positions. Exhibit 8

Upcoming EMU Risk Events Date 20-Aug 21-Aug 23-Aug 24-Aug 24-Aug 28-Aug 28-Aug 29-Aug 29-Aug 31-Aug 31-Aug 01-Sep 03-Sep 03-Sep 06-Sep 06-Sep 06-Sep 07-Sep 09-Sep 12-Sep 12-Sep 12-Sep 12-Sep 13/14-Sep 13-Sep 14-Sep 14-Sep 14-Sep

Event Greek bond redemption of 4.10% 2012 for €3.13bln Spain T-bill auction European flash PMI data Spain T-bill redemption for €9.815bln French Socialist Party Conference Italy CTZ/linker auction Spain T-bill auction Italy T-bill auction Italy month-end bond auctions Italy T-bill redemption for €8.75bln Fed's Bernanke speaks at Jackson Hole symposium Spain VAT hike to take effect Spain regional Q2 public finance Eurogroup meeting OECD Economic Outlook report ECB meeting, Draghi to give ECB Staff Forecasts Spain bond auctions Eurozone Q2 flash GDP data Central bankers dinner meeting in Basel on Libor Dutch election date German Constitutional Court ruling on ESM, Fiscal Compact Italy T-bill auction ECB start of reserve maintenance period G20 FinMin meeting Italy mid-month BTP auction Eurogroup meeting EcoFin Meeting Spain/Cyprus deadline for Moody's downgrade review

Source: Morgan Stanley Research

EM Currencies Continue Grinding Higher In EM, we continue to believe we are in a risk-positive environment. The ‘Draghi put’ should have just as strong an impact on EM currencies as on DM FX. We have been recommending a ‘buy on dips’ strategy toward EM currencies since early July, and with EM currencies continuing to grind stronger, we stick to this view. Some currencies are of course strengthening faster than others. In Latin America, for example, the strength of some currencies is prompting concern among policy makers. In particular, central banks in Colombia and Chile seem to be taking the lead in acting on that concern. As we explain in more detail on page 11, the COP has been strengthening to such a degree that the central bank is likely to double its daily minimum amount of USD purchases, to USD40mn from USD20mn.

CEEMEA region, there are few countries that are considering intervention to weaken currencies. The Central Bank of Turkey may start to lean against currency strength if the TRY were to strengthen to beyond the 1.72-1.73 levels seen in February, though even this is not guaranteed. The Central Bank of Russia’s old intervention guidelines would have suggested the CBR start buying USD close to current levels. However, the recently widened corridor (including a doubling in the size of the ‘no intervention zone’) has left the threshold for USD purchases some way off. For this reason, and others, we continue to focus on the RUB to express our bullish recommendations in CEEMEA currencies. Exhibit 9

RUB Basket and CBR Intervention Bands 39 38

CBR Action Previous no intervention zone

Sells $200m daily Sells $135m daily

37

Sells $70m daily

36 35

No intervention zone

34 Buys $70m daily 33 32

Buys $135m daily Buys $200m daily

31 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 RUB Basket


Our Russia economists have recently revised their macro forecasts for 2012 and 2013, lowering the GDP growth forecasts to 4.2% from 5.0% previously for the current year and to 3.7% from 4.0% for 2013. This tempers the case for long RUB to some extent. More significant though in our view is the 75bps of interest rate hikes our economists expect between now and “early 2013”. The Central Bank of Russia is the only EM central bank that will hike rates this year, according to Morgan Stanley forecasts, which suggests that the carry available on the RUB could become even more attractive Indeed, in a period of rebounding risk appetite, investors will focus on carry. In particular, volatility-adjusted carry is a key metric to examine when considering currencies to invest in. The RUB comes out strong on this basis too, with high carry and medium levels of volatility, suggesting that RUB is an attractive currency to own in these more stable times.

These sorts of policy initiatives may prompt some interesting relative value opportunities within the EM world. In the

6


currencies, we think, is that our Funding Stress Index continues to come lower, as ample market liquidity continues to alleviate any funding concerns.

Exhibit 10

EMFX: Carry vs Vol 20

12m Implied Volatility, %, 15th August 2012

HUF 18

PLN

ZAR

16

RON

CZK

14

MXN

12

CLP

KRW

10

COP

IDR

BRL RUB TRY INR

ILS

8

THB PEN

PHP SGD

6

TWD 4

In fact, the following chart suggests that the level of funding stress is more consistent with a much stronger level of EM currencies. Of course, the relationship is not linear over long periods of time. But over short periods, there is typically a very high and consistent degree of co-movement between Funding Stress, the VIX and our USD/EM index. Over the past couple of months, EM currencies have been lagging behind considerably.

CNY

2

HKD

Exhibit 11

0 -1

0

1

2

3

4

5

6

7

EMFX Keeping Pace vs Risk Metrics

12m Implied Carry Return, %, 15th August 2012


In Latin American, we favour being long MXN versus JPY. We doubt the current difficult political environment will hinder flows, since Mexico continues to exhibit very strong fundamentals. Though progress on long-awaited reforms may be delayed, positive momentum on the political side would also provide a better backdrop for MXN, especially amid declining global growth prospects.

50

102

45

101 100

40

99 35 98 30 97 25 96 20

Funding Market Conditions Still Benign Much has been made recently of the VIX index now being back down at pre-crisis levels, suggesting benign trading conditions from a “risk” perspective. More important for EM

95

15

10 Jul-10

94 93 Oct-10

Jan-11

Apr-11

Jul-11

MS Funding Stress Index

Oct-11 VIX

Jan-12

Apr-12

Jul-12

EUR,USD Basket Vs EM


7


USD: Telling Tails Morgan Stanley & Co. LLC

Robert Habib

Morgan Stanley & Co. LLC

Ron Leven

Exhibit 2

+1 212 761-1875

Directional 1Y Correlation with Brent Crude 50%

+1 212 761-3413

Up Days 45%

 High liquidity and relatively low vols have periodically generated interest in using FX as a proxy for ‘tail risk’ in other markets – especially SPX.

40%

 But factors other than correlation can affect the attractiveness of a proxy – in particular, leveraging, vol costs and carry can all affect the relative cost.

30%

 We develop a filter that scans these factors to determine the most effective currencies to use as a proxy.

20%

Dow n Day

35%

25%

CAD AUD RUB

NZD SGD NOK

CLP

HUF

PLN

COP ZAR MXN


A Well-Oiled Story

Separating Up from Down…

In the wake of the financial crisis, we have seen interest in using FX to hedge against another major equity downturn as well as potential moves in other markets – especially oil, gold and bonds. Vast liquidity and the availability of easily traded derivatives may be partial reasons for focus on FX as a proxy hedge. We believe that another factor is relatively low FX implied vol. Exhibit 1 shows average FX vol for G10 versus USD, and we note that it’s the lowest implied vol when compared to the other markets shown, except US Treasuries. And FX vol is particularly low compared with where vols are realizing – including versus Treasuries.

Exhibit 2 illustrates the correlation between oil and currencies that are highly correlated to oil ranked by overall correlation. But this time, we choose to calculate correlation while distinguishing between days when oil rallies and days when it sells off. We do this because if the intent is to create a hedge against oil surging to US$150/bbl, then we would like to find the key currencies that are sensitive to oil price gains. Similarly, a collapse to US$70/bbl will best be proxied by currencies that are particularly sensitive to oil price declines. Although some currencies – e.g., AUD and CAD – have relatively high correlations in either direction, SGD and MXN are only highly linked on rally days and so would not be good candidates for downside tail proxies.

But cheap vol is meaningless if there is not a reliably high correlation between the proxy and the intended market. For the purpose of this article, we focus on the oil market (specifically the front Brent oil futures contract) because this is a market where there is ongoing tail-risk interest in both scenarios where oil goes to US$150/bbl as well as a sharp drop towards US$70. By contrast, there is little interest in ‘protection’ for an SPX move to 1,600. Lastly, the oil market has a high persistent correlation with several currencies. Exhibit 1

3M Implied Volatility for Various Financial Markets

MS USD Index(1) SPX 10Y Treasury Gold Copper WTI

Implied Volatility 8% 15% 5% 17% 20% 29%

5-Year Implied vs Percentile Realized 2% 1.3 0% 1.0 2% 1.0 13% 1.0 3% 0.9 20% 0.9

(1) Weighted average of underlying vols Source: Bloomberg, Morgan Stanley Research

5-Year Percentile 9% 98% 48% 33% 78% 17%

The first step in finding a proxy tail-risk hedge will be identifying currencies with high correlation in the appropriate direction. In addition, we look at an average of 3M and 1Y correlation to help ensure that correlation is persistently high.

…and Then Adding in Leverage There is a reason why FX-implied vols are lower than vols in other markets, and this is because realized vols also tend to be lower. But a market with lower volatility is typically also a market that offers lower return. Indeed, Exhibit 3 shows the return performance for CAD (the currency with the highest overall correlation) with the gains for Brent since the start of the year. But while correlation may be high, the portfolio return movements for CAD are dwarfed by Brent. The implication is that a much larger notional position is required for CAD in order to generate the same total return as a Brent position.

8


Exhibit 3

CAD Leveraged Return versus Brent 120 115 CAD 3 times leveraged

110 105 100 CAD unleveraged

95

Calculating the Score

90 85

Brent

80 Jan

Mar

Since tail-risk hedges will typically be low-delta options, it is important to filter for currencies where the appropriate lowdelta vol is relatively cheap. As a final factor, it is also preferable to focus on currencies where carry works in favor of the position (but given that carry is relatively low for most currencies, this is not likely to be an important determinant). Nevertheless, it is still worth considering as a filtering factor, in our view.

May

Jul


By regressing the returns of CAD against Brent, we can derive the level of leverage that will allow a CAD portfolio to best match Brent returns. The leveraged series in Exhibit 3 shows the performance for a CAD portfolio that starts with three times the notional of Brent. But this significantly compromises the efficacy of using CAD as an option proxy for Brent, since holding triple notional also triples the premium cost of holding an option. So, it will be important in finding the best tail-risk hedge candidates to focus on currencies that require relatively little leverage.

Rounding Out with Skew and Carry One of the primary reason for considering FX as a vehicle for creating proxy positions is the relatively low cost of volatility. Hence, it makes sense to also filter for currencies with relatively low costs of volatility. But, as shown in Exhibit 4, vols can vary considerably for low delta puts and calls versus ATMF vol.

We have identified four ranking factors which should be helpful in identifying currencies that are candidates for creating tail-risk proxies for other markets – in this case, Brent crude. With the exception of correlation, the filter factors are all related to lowering the option price, but a cheap price is not helpful if the proxy does not move in response to the underlying. Consequently, correlation is the dominant factor in picking a proxy hedge, so we give this ranking a 50% weight. Leverage is the next most important factor, as the need to multiply up the position size can have a significant impact on the effective cost of the option; we give this ranking a 25% weighting. The relevant implied volatility is important, but not likely to be as big a factor in relative cost as leverage, so we give this rank a weighting of 15%, and finally the carry ranking is given the smallest weight of 10%. Exhibit 5 shows the five highest-ranking currencies (we only looked at USD crosses) to proxy a decline in oil prices and for a rise in oil prices. In both cases, we calculated the 3M crosscovariance matrix because it is more attractive to create a portfolio of uncorrelated currency pairs as this both makes the tracking more robust and also creates potential to cut costs via basket options. Exhibit 5

Exhibit 4

Covariance Matrix for Highest Ranking Currencies

25-Delta versus ATMF Implied Volatility 19

%

17

Covariance Matrix for Bull Oil Currencies

Put Vol ATMF Vol Call Vol

15 13 11

Covariance Matrix for Bear Oil Currencies

9 7


M X N

C O P ZA R

PL N

C LP H U F

R U B N ZD SG D N O K

C AD AU D

5


9


By focusing on currency pairs with lower cross-correlation, we decided on the following currency portfolios: Portfolio for oil rally: calls on SGD, NOK & PLN vs USD Portfolio for oil decline: puts on COP, CLP & GBP vs USD

Exhibit 7

Short Brent Crude and the Bear Currency Portfolio 120 110

The leverage factor for both portfolios is 3-to-1. Exhibit 6 shows that the leveraged bull oil portfolio has reasonably strong tracking of the oil market and, as expected, it tracks better when oil prices are rallying. In particular, the portfolio significantly underperformed in 2H11 when the oil markets were moving sideways to down. However, as we are proposing low-delta options rather than a tracking portfolio, the periods of divergence are not as important. How does it compare from a relative cost perspective? With spot Brent at US$116.25, the 3M 25-delta put has a strike of US$124.74 (7.3% away from spot) and costs 1.86%. The currency portfolio, by contrast, would have a leveraged cost of 2.67% but, on average, the strikes are only 2.4% away from current spot rates. Moreover, the cost of the option can be reduced to 2.40% by pricing it as a basket option. So, in this case the currency portfolio has no clear cost advantages over the Brent option, but it is still a viable alternative if liquidity and/or regulatory issues make the oil options market unattractive. The cost of the leveraged position can be more significantly reduced to about 93bps by adopting a worst of structure but at this would greatly increase the risk of nonperformance of the proxy in the event of a large move in the underlying market Unfortunately, the bear currency portfolio does not appear to provide very consistent protection for a down market in oil. In particular, the portfolio failed to rally in 2012 when the short oil Exhibit 6

Long Brent Crude and the Bull Currency Portfolio 160 150 140 130 120 110 100 90 80 70 2010

100 90 80 70 2011

2012 FX Portfolio

Oil


portfolio surged in value. The poor performance reflects that currencies generally track oil better when it is in rally mode and the oil futures curve is upward-sloping and provides significant positive carry return for a short position. Conclusion We have identified four ranking factors which should be helpful in identifying currencies – correlation, leverage, implied volatility level and carry. We believe that ranking by these factors can be useful for identifying the most useful currencies to use to build a proxy hedge. Since markets are fairly efficient, we suspect that it would be unusual to find a currency proxy hedge that is substantially cheaper than directly hedging in the target market. Nevertheless, the exercise with the long oil basket shows that it is possible to build a portfolio that has some advantages over the local hedge – in this case, having strikes that are much closer to the current spot rates. And a currency portfolio can have significant cost savings if investors are willing to accept the higher tracking error of a worst-of option. This methodology may also be particularly useful for building a currency-based proxy option hedge for markets where low-delta options are not readily available.

We would like to thank Vandit Shah for significant contributions to this article. 2011 FX Portfolio

2012 Oil


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EMFX: Intervention Strikes Again…and Again Morgan Stanley & Co. LLC

Vitali Meschoulam [email protected] +1 212 761-1889

Robert Habib [email protected] +1 212 761-1875

 Strong-side currency intervention is again becoming a relevant theme, as some policy-makers in EM react to the most recent bout of currency appreciation.  But this time around, relative performance, CNY weakness and prospects for rising inflation will likely play a role in determining which countries will act and when.  Thus far, Colombia and Chile seem to be taking the lead – creating opportunities to fund currencies such as MXN, RUB, PLN, and KRW.  We reiterate our call for long MXN against intervention candidates, given this last bout of appreciation in EM and select developed economies such as Japan.

The Pendulum Swings Once More Less than three months ago, we wrote about intervention in EM, as central banks sold dollars to defend their currencies from the European-led downturn that afflicted markets at the time (see EM Strategy Comment: EMFX – The Intervention Seesaw, Now Back to the Weak Side, May 24, 2012). Indeed, the ‘seesaw’ continues to shift. Now, policy-makers – especially in Latin America – have again beaten the drums of potential currency conflict, verbally intervening in attempts to stem further appreciation.

Interestingly, though several Asian currencies managed to perform as well, by and large the region has lagged the rebound meaningfully – likely due to ongoing uncertainty over Chinese growth. This relative performance is important, as it will likely color the way in which different countries react to ensuing currency strength in this latest episode of relative currency appreciation. Exhibit 1

Inflation Breakevens versus USD/EM 105

4.6

103

4.4

100

4.2

98

4.0

95

3.8

93

3.6

90

3.4

88

3.2

Jan-10

May-10

Sep-10

Jan-11

May-11

USDEM

Sep-11

Jan-12

May-12

2y EM BE (RHS)

Source: Morgan Stanley Research, Bloomberg

Exhibit 2

EMFX Performance YTD (%) 10 8 6

Though completely unsurprising, given past episodes, the current juncture is somewhat different this time around. Most importantly, relative currency performance since early June 2012 (when EMFX stabilized after selling off in May) has been quite disparate across EM. Unlike previous bouts of appreciation, we have seen meaningful differentiation between and within different regions this time around.

4 2 0 -2 -4 -6

Latin American currencies (MXN, CLP, PEN, and COP) were buoyed by the strong rebound in commodities, while currencies in CEEMEA (HUF, PLN, RUB, and ZAR) were helped along by increasing signs of a policy backstop in Europe.

-8 -10 CLP HUF COPMXN TRY SGD PLN PENKRWTWDRUB THB HKD CNY ZAR CZK INR IDR BRL


11


Exhibit 3

EMFX Performance from Jan to Apr 2012 (%) 14 12 10 8 6 4

But perhaps offsetting CNY depreciation to some extent are prospects for higher inflation in some countries in EM (see Exhibit 1). The recent pick-up in inflation due primarily to the v-shaped rebound in commodities may make some policymakers more inclined to allow for some additional appreciation at the margin. Though this may become an important driver if sustained, we believe that policy-makers will likely continue to focus on the deteriorating global backdrop instead – making them more likely to take action against further appreciation from here.

2

Exhibit 5 0

Trade-Weighted CNY

-2 -4

8.5

3.7

8

3.5

7.5

3.4

7

3.2

6.5

3.1

HUF PLN COP RUB TRY MXN CLP SGD CZK PHP TWD ZAR THB KRW INR CNY HKD IDR BRL


Exhibit 4

EMFX Performance Since June 1, 2012 versus USD and EUR (%) 12 10

USD

EUR

8

6 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

6

USD/CNY

4

2.9

CNY (TWI)


2

Latin America the Focus Again

0 -2 MXN HUF CLP PLN RUB ZAR KRW SGD TRY PHP MYR CZK BRL THB COP CNY HKD INR TWD IDR


Besides relative FX performance, we also see two additional important factors in the current environment – RMB and inflation. CNY depreciation against USD has been notable this year (CNY is down over 1% versus USD YTD). This becomes even more striking when we look at CNY on a trade-weighted basis (CNY has underperformed peers this year). If continued, we believe that CNY depreciation or relative underperformance will also spur further strong-side intervention activity from the EM central banks concerned about losing further competitiveness to China. As we have argued in the past, CNY depreciation has tended to act as a floor of sorts for broader EMFX appreciation.

Given relative outperformance and past sensitivities to appreciation, it is no wonder that Latin American policymakers are again at the forefront of this latest intervention episode. But this time around, Brazil – where officials originally discussed the so-called Currency War – is conspicuously silent, given its satisfaction with a BRL that has materially underperformed peers this year. Indeed, we are unlikely to see any meaningful action/noise from Brazilian policy-makers unless we see USD/BRL falling toward 1.95 or thereabouts in coming weeks. Though positioning is very supportive of potential BRL performance, the lack of investor interest in BRL makes this somewhat improbable, unless we start to see meaningful actions taken by other central banks, forcing investors to look elsewhere for potential FX gains.

12


But for countries like Colombia and Chile – which have arguably seen an even stronger appreciation of their currencies, given the lack of interest in BRL of late – the situation is becoming critical. Colombia is taking the most active approach, intervening verbally (both from the central bank and the finance ministry) and likely moving towards a change in its current intervention regime in the near term. At present, the central bank buys at least US$20 million on a daily basis – though this week it has been buying closer to US$300 million. The most likely policy action will be to double the amount of daily interventions to a minimum of US$40 million, though this may not be the only action taken. What has become clear is that the government would like to keep USD/COP pinned around the 1,800 level, and will act if it sees any further appreciation.

Exhibit 7

Colombian Intervention – OTC Net Purchases of USD (in Mn) 500

400

300

200

100

0 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Source: Morgan Stanley Research, Bloomberg

Though the rhetoric from Chilean policy-makers has been less aggressive, noise has been made nonetheless. The chances of seeing a repeat of the 2011 reserve accumulation programme – in which they announced a US$12 billion/year purchasing programme to limit currency appreciation – are non-trivial even though the scope and size may be different, given that the central bank will have a harder time justifying the need for international reserves this time around. As such, we would expect a formal intervention programme in Chile to be implemented only if we see sustained appreciation pressure towards 470 in USD/CLP in coming weeks. Exhibit 6

Peruvian Intervention – OTC Net Purchases of USD (in Mn) 600 400

Playing Intervention Given these dynamics, we see opportunities in relative value in Latin American currencies. Though we recently took profits on our long CLP/COP position (see EM Trade Radar: Positioning for Policy Backstop, July 30, 2012), we see scope for an additional 3% or so performance out of that cross at present. We would also be inclined to use COP to fund MXN (given its no-intervention stance) and/or BRL (given increasing inflation) in the region, given the enthusiasm shown by Colombian authorities of late. As always in these episodes, we prefer to be long currencies of countries unlikely to intervene. Within Latin America, this provides yet another reason to be long MXN (we are currently long MXN funded with JPY for similar reasons as the Japanese are increasingly likely to intervene if we see sustained appreciation pressures on the yen). Though we are certainly mindful of timing mismatches and potential liquidity considerations, we would also consider using COP and potentially CLP to fund longs in currencies like RUB, ZAR and potentially some Asian currencies (KRW) in this context.

200 0 -200 -400 -600 Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12

Source: Central Reserve Bank of Peru

13


Volatility, Correlation, and Risky Assets: The PCA+ Update Morgan Stanley & Co. LLC

Juha Seppala +1 212 761-1949

 There were three significant developments for risky assets this week. First, Morgan Stanley’s Emerging Markets Funding Stress Index fell below 20 for the first time since July 2011. Second, the VIX equity volatility index fell to the lowest level in five years. Third, our measure of cross-asset correlation, the fraction of cross-asset variation explained by the first principal component, fell by more than any time since November 2011.  The correlation in FX markets remains at all-time high. We argue that the record high correlation in FX markets and the record volatility in equity cannot co-exist much longer.  While the uncertainties remain considerable, we argue that the recent rally can last for several more months, implying reduced correlation among risky assets, which tends to support high-beta currencies. In addition, due to elevated cash balances and still light positioning, the potential downside is more limited than in other similar rallies in the recent past.  Last but not least, we provide an update on our PCA+ G10/EM FX fair value model. The model implies that long MXN/JPY, HUF/ILS, and NOK/SEK are the best trades among the 32 currencies we analyze.

That Was the Week That Was There were three significant developments for risky assets during the last week. First, Morgan Stanley’s Emerging Markets Funding Stress Index fell below 20 for the first time since July 2011. Second, on Monday (August 13) the VIX equity volatility index closed at the lowest level in five years. Third, our measure of cross-asset correlation, the fraction of cross-asset variation explained by the first principal component, fell by more than at any time since November 2011. All these developments should be considered riskpositive, in our view. In this research note, we first briefly discuss these developments. We then argue that there is a contradiction between record-low volatility and record-high correlation in FX space. The one billion dollar question is which one is going to give up first. The most likely catalyst is probably going to be developments in Europe which, obviously, are uncertain, but we do expect the ‘Draghi put’ to be successful in the near term.

In addition, we argue that the cash balances and positioning data severely limit the potential downside for risky assets. Finally, we provide an update on our PCA+ G10/EM FX fair value model (see FX Pulse: Predicting Currency Values: The PCA+ Model, July 19, 2012). The model is still bullish on EMFX and bearish on G10. The four currencies which the model is predicting to appreciate the most are MXN, COP, HUF, and NOK. The following four currencies are forecast to depreciate the most: JPY, CHF, SEK, and ILS. The most natural cross-currency pairs to trade based on this are long MXN/JPY, HUF/ILS, and NOK/SEK.

EMFSI Below 20 We have long argued that funding stress is one of the most important if not the most important driver of EM assets, especially EMFX returns (see, for example, EM Profile: Monitoring Funding Markets – EM Funding Stress Index, December 7, 2011). In addition, we have argued that the level of 20 is a critical threshold: When EMFSI is below 20, it has very little influence on the behavior of risky assets. On the other hand, the values above 20 mean that EMFSI almost exclusively drives EM assets (see, for example, EM Quantitative Strategy Update: EM Rates – EM or Rates? January 5, 2012). Our subsequent work in this area has further qualified this result: The values above 30 are the red or danger zone, where EM risky assets perform very poorly. The values between 20 and 30 signal yellow light (caution); risky EM assets tend to shift between risk-on and risk-off regimes (see Global EM Investor: It's a Risk-On/Risk-Off World, July 3, 2012). Finally, the values below 20 mean green light for risky EM assets. Hence, it is definitely worth highlighting that on Tuesday (August 14), EMFSI closed below 20 for the first time since July 2011, as shown in Exhibit 1. Exhibit 1 also highlights how closely EMFSI and USD/EM moved in the past (with EMFSI usually leading USD/EM) and how the two started to diverge in March this year. Based on Exhibit 1, EMFX should appreciate by about 10%. Similarly, regressing USD/EM on EMFSI using weekly data since January 2008 implies 6% appreciation for EMFX.

14


Exhibit 1

Exhibit 3

EMFSI versus USD/EM

VIX Leads EMFX Vol

50

104

25

50 EMFX Vol

VIX Index

102

45

100

40

20

40

15

30

10

20

98

35

96 30

94

25

92

20

90

15

88

Jan-11

Apr-11

Jul-11

Oct-11

Jan-12

EMFSI

Apr-12

Jul-12

USD/EM (LHS)

5 Feb-09

10 Jun-09

Oct-09

Feb-10

Jun-10

Oct-10

Feb-11

Jun-11

Oct-11

Feb-12

Jun-12


…in FX Markets


In the first part of this period, from January 2011 to May 2011, the general EMFX index appreciated by 6% while EUR appreciated by 15%, both against USD.

Exhibit 2

Cross-Asset Correlation and the VIX 75

90

70

80

65

70

60

60

55

50

50

40

45

30

40

20

35

10

30

0

Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 %var explained by the 1st PC

VIX (RHS)


Volatility versus Correlation… Exhibit 2 displays weekly series for our preferred measure of cross-asset correlation, the fraction of cross-asset variation explained by the first principal component. From early 2003 to mid-2008, the correlation between the two series was 0.29, while it has been -0.44 since then. Similarly, the post-financial crisis regime has been characterized by highly elevated levels of cross-asset correlation and occasional large upward spikes in the VIX. Finally, it is worth noticing that currently both series are going down fast. The only previous time we had an episode with low VIX and sharply declining cross-asset correlation was from January 2011 to July 2011.

In other words, even if we don’t have a permanent regime switch to a pre-financial crisis regime, the reduction in crossasset correlation and corresponding risky asset rally can last for several months. It is also worth highlighting that this reduction in correlation has not yet taken place in FX markets. The fraction of variance explained by the first principal component in FX returns, again our measure of cross-correlation, is currently at an all-time high (see FX Pulse: Predicting Currency Values: The PCA+ Model, July 19, 2012, for additional discussion). We suspect it will follow the VIX and cross-asset correlation. While the statistical tests of whether the cross-asset correlation leads the FX correlation or the other way around are inconclusive, the combination of record-low VIX and record-high cross-FX correlation seems to be unsustainable. It should also be mentioned that historically VIX has led EMFX vol (see Exhibit 3). Finally, as discussed below, there are reasons to believe that the volatility in equity and FX markets has been pushed down because investors have less need to hedge against sell-offs, given high cash positions and still relatively light risk positioning.

Cash Balances and Positioning It is practically impossible to obtain hard data on global investors’ cash balances and positioning. However, as a starting point, we can use data on US retail and institutional investor cash balances and IMM data on positioning on highbeta currencies, such as USD/MXN (Exhibit 4 and Exhibit 5).

15


Exhibit 4

Exhibit 6

US Demand Deposits, Savings Deposits, MMDAs, Money Market Funds

PCA+ Model Predicted 3m Ahead Spot Returns

10,500

$bn

$bn

10,000

TRY ILS RUB PLN HUF CZK RON ZAR KRW INR IDR TWD THB PHP SGD MYR CNY BRL MXN CLP COP PEN ARS EUR GBP JPY CAD AUD NZD SEK NOK CHF

250

200

9,500

150

9,000 100 8,500 50 8,000 0 7,500 -50

7,000

-100

6,500

4-Week Change (Right Axis) Total (Left Axis)

6,000

-150

Jan-06Jan-07Jan-08Jan-09Jan-10Jan-11Jan-12

Spot Return 1.64% -1.67% 0.49% -0.21% 4.95% 1.81% 2.41% 1.70% 2.99% -0.14% 1.87% 2.48% 2.04% 1.03% 0.49% 1.55% 0.13% -0.58% 5.00% 1.37% 4.96% 1.60% -1.22% 1.77% 2.35% -3.01% -1.22% 1.27% 2.29% -1.74% 2.62% -1.98%

Source: Morgan Stanley Research, Haver Analytics


Exhibit 5

Notice that both of these measures imply the risky asset rally can last for some time. Cash balances have been steadily increasing since spring 2010 when the European crisis really came on investors’ radar screens. Similarly, while the IMM positioning on MXN has been increasing recently, it is nowhere near highs reached in spring 2011 or even spring 2012, for that matter. Both these facts imply that even if the rally doesn’t last long, the downside is probably limited.

MXN Positioning 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 -20,000 -40,000 -60,000

IMM positioning USDMXN (inverted)

Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan05 06 07 08 09 10 11 12 Source: Morgan Stanley Research, Bloomberg, IMM

8 9 10 11 12 13 14 15 16

PCA+ Update Last but not least, we provide an update of what our PCA+ model for 32 EM and DM currencies currently predicts on 3m ahead spot returns for each one of these currencies. The model is still bullish on EMFX and bearish on G10. The four currencies which the model is predicting to appreciate the most are MXN, COP, HUF, and NOK. The four currencies forecasted to depreciate the most are JPY, CHF, SEK, and ILS (Exhibit 6). The most natural cross-currency pairs to trade based on this are long MXN/JPY, HUF/ILS, and NOK/SEK.

16


KRW: Off Target Stewart Newnham and Yee Wai Chong 

We discuss why our USD/KRW call is going off target.

trades with a high beta to the global cycle, given that Korea’s exports account for nearly 50% of its GDP (see Exhibit 2). Moreover, since we have expected the global economy to continue to slow further below trend, we thought that this procyclicality would work against the KRW. Exhibit 2

Introduction

KRW FX Returns Are Pro-Cyclical

We are alert to the risk that USD/KRW falls short of our 1,190 end-3Q target. Global headwinds remain a challenge for the KRW, but we concede that they have been less challenging than we had initially thought. This is evident in the fact that Korea’s balance of payments (BoP) support has held up surprisingly well despite a large external shock. At the same time, we note that Korea’s macro dynamics remain neutral for the KRW. We are therefore mindful of the risk that USD/KRW remains in the middle of its technical range rather than breaking to the upside, as we had anticipated.

(%Y)

"KRW FX Returns Follow the Global Business Cycle"

40 30 20

G7 IP Growth

10 0 -10 -20 -30 KRW Currency Returns

-40 -50

KRW Forecast Going Off Course

-60 96

We admit that our USD/KRW call is looking increasingly wayward (see Exhibit 1). Our 1,190 target for end-3Q started to turn sour in early June when the multi-week uptrend broke down. The question we try to answer in this report is why is this happening? Exhibit 1

USD/KRW Going Off Target (USD/KRW)

1,600 1,500

98

00

02

04

06

08

10

12

Source: Haver Analytics, Morgan Stanley Research

Korea’s Export Recession Our concern about the Korean economy’s high beta to the global economy appears warranted: Korea has been hit with an external demand shock, with export growth in negative territory (see Exhibit 3). We therefore expected the effects of the KRW’s pro-cyclicality to show through in the withdrawal of the currency’s BoP and macro-dynamic support, hence our bearish call. Exhibit 3

1,400

"We Admit That Our 1,190 Target for end-Q3 Will Now be A Challenge To Achieve"

1,300

Export Growth Is in Negative Territory 50

(%Y)

40

1,200 +5.3%

30 1,100 20 1,000 Jan-09 Jul-09

10 Jan-10 Jul-10

Jan-11 Jul-11

Jan-12 Jul-12

Jan-13

Source: Bloomberg, Morgan Stanley Research forecast

0 -10

Pro-Cyclicality Working Against the KRW We have been bearish on the KRW for quite a while (see “AXJ: Outlook for 2012”, FX Outlook: The Year of the Dollar, November 28, 2011). The underlying premise is that the KRW

95

97

99

01

03

05

07

09

11

-20 -30

"Export Growth is in Negative Territory - Usually Only Seen in Recessions" Source: Haver Analytics, Morgan Stanley Research -40

17


BoP Support Remains To our surprise, though, Korea’s BoP has actually held up through this external shock. This is demonstrated by the fact that Korea’s current account widened to a record-breaking US$5.8 billion monthly surplus in July (see Exhibit 4). How could this happen if exports are falling so sharply? The answer is that imports are falling even more than exports. For example, exports fell by 1.7%Y in July, but imports fell by 7.2%Y (see Exhibit 5).

Current Account Surplus at Record Levels (US$ billion)

The Financial Account Story We are also mindful that Korea’s BoP position has been improved by capital inflows.

Exhibit 4

The Drag of Recycled Export Revenues Generally, Korea’s financial account has moved into a large deficit (see Exhibit 6). But this is to be expected, as a large current account surplus necessitates more recycling of export revenues into investment opportunities overseas.

"Korea's Current Account Surplus Reached a Record Monthly High in July"

8

June. Machinery equipment, manufactured materials and chemicals – all proxies for capital goods – were down 12.6%Y, 16.8%Y and 9.9%Y, respectively. This infers to us that domestic demand in Korea is displaying a broad-based deterioration. While this is a headwind for the KOSPI, we acknowledge that it is a tailwind for the KRW as it has been key in helping to hold up Korea’s BoP in the face of a large external shock.

6 4 2

Exhibit 6 0 95

97

99

01

03

05

07

09

11

-2

Recycled Export Revenues Have Widened the Financial Account Deficit (US$ billion)

15

-4

Current Account

10

-6


5

Exhibit 5

0 Jan-07 -5

Imports versus Exports

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

(%Y)

60

-10

Imports

Exports

50

Financial Account

-15

40 30

-20

20

-25

"Korea's Financial Account Deficit is Widening, but Not By as Much as the Current Account Surplus. Implication: A Small BoP Surplus"

10 -30

0 -10 07

08

09

10

11

12

-20 -30

"Imports are Falling More Than Exports"

-40 -50


Why Are Imports Falling So Much? Falling commodity prices are playing their role in reducing Korea’s import bill – crude material imports (excluding fuel) fell by 9.9%Y in June. However, the decline in imports is more than just a commodity story. Miscellaneous manufactured articles – a proxy for consumer goods – were down 1.1%Y in


Capital Inflow into the Bond Market However, partly offsetting this recycled exports flows is the foreign investor inflow into Korea’s fixed income markets. Exhibit 7 shows that while foreign portfolio flows into Korea’s equity markets have dried up, fixed income inflows remain quite healthy. We suspect that global investor demand for high-quality credit with deep, liquid markets has made Korea’s sovereign bonds especially attractive in these troubled times. Whatever the catalyst for this capital inflow, it is helping to reduce Korea’s financial account deficit. As a result, Korea’s overall BoP (i.e., current account + financial account) is presently in a modest surplus position – an important driver for the KRW rally, we concede.

18


Exhibit 7

Exhibit 8

Bond Inflows Remain Healthy

Macro Dynamics: Growth versus Trade

(US$, bilions)

80

6

60

"Bond Inflows Have Held Up"

Bonds

(C/A-to-GDP, %)

5

KRW ('09)

40

"Positive M acro Dynamic"

4 "Neutral M acro Dynamic"

20

KRW ('12F)

3

0 01

02

03

04

05

06

07

08

09

10

11

KRW ('11)

12

-20 Equities

-40

KRW ('10)

2

1

"Equity Inflows Have Dried Up"

0 -8

-6

-4

-2 -1

"Negative M acro Dynamic"


2(GDP-Trend, %) 4

0

-60

"Neutral M acro Dynamic"

-2

KRW Unaffected by Growth Risks We are also mindful that the KRW rally is not being particularly hindered by Korea’s macro dynamics. For sure, Korea’s economy is decelerating more rapidly than we had initially thought. Indeed, our Korean economics team has recently marked down its GDP forecast for 2012 to 2.8% from 3.2% (see Korea: Trimming Our Forecasts on Slower Global Growth, August 14, 2012). But while Korea’s GDP growth is anticipated to slow further below trend, our economists are forecasting that the current account surplus will widen even more in 2012 to 3.1% of GDP from 2.9% initially forecast.

Neutral Macro Dynamics We regard this macro dynamic of below-trend growth and external surplus as only neutral for the KRW, not negative (see Exhibit 8). This is because FX returns are not strongly correlated with such a macro-dynamic position. This is in contrast to the ‘negative’ macro dynamic of below-trend GDP growth and external deficit, which is historically correlated with periods of negative FX returns. (Korea in 2008 was a recent example of the impact of a negative macro dynamic – the KRW fell by 28% against the USD.)

Source: Haver Analytics, Morgan Stanley Research; F = Morgan Stanley Research forecasts

The Risk of Sticking in the Middle of the Range With the BoP support holding up and the macro dynamics neutral, we concede that the fundamentals are not aligned to derail the current KRW rally. As a result, we are mindful of the risk that USD/KRW undershoots our 1,190 forecast by end3Q. Indeed, we admit that USD/KRW may well end the quarter towards the middle of its multi-year, 975-1,165 down channel, instead of breaking to the upside, as we originally projected. Exhibit 9

USD/KRW Is at Risk of Remaining in the Middle of the Range (USD/KRW)

1,600

1,500 "The Risk is That USD/KRW Remains in the Middle of Its Range, Rather Than Breaking to the Upside"

1,400 Multi-year Down Channel

1,300 1,190 Objective

1,200

1,100

1,000 Jan-09

1,100

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12


19


Capped Downside Risks for USD/KRW

Bottom Line

Mind you, we do not see USD/KRW heading significantly lower from current levels – not unless there was a significant global policy reflation led by the Fed and the ECB. Our belief is that the BoP support for the KRW is not strong enough to drive a vigorous rally (see Exhibit 10). Furthermore, the KRW rally could lose interest rate support if the BoK continues on its easing cycle. In addition, we think that the KRW rally could quickly reverse if there was another bout of global riskaversion that caused capital flight. Given the unresolved situation in the euro area, we think that the risk of this happening remains quite high.

Our USD/KRW 1,190 target for end-3Q is challenged by the fact that Korea’s BoP has held up during the global downturn and the macro dynamics remaining neutral.

Exhibit 10

The KRW’s BoP Support Is Not Substantial (US$, billion)

15

"Korea's BoP Surplus is Modest. This Will Make It Difficult for the KRW to Stage A Vigorous Rally, in Our View."

10 5 0 07

08

09

10

11

12

-5 -10 -15 -20


20


Strategic FX Portfolio Trade Recommendations Evan Brown, Yee Wai Chong, Meena Bassily

Widening Yield Spread to Support USD/JPY

Entry: 78.50, Stop: 78.10, Target: 82.00

130

83

USDJPY (lhs)

Limit Order: Buy USD/JPY

82

US 10-year yields rose over recent weeks as risk sentiment stabilized and US economic data improved. As we expect the US elections to constrain the Fed from launching another round of unsterilized asset purchases, we think US yields have further to rise as QE expectations are priced out. Long USDJPY also makes sense in an environment of benign investor sentiment; with few key risk events over coming weeks, we favor this trade near-term.

US-Japan 10y Sprd (rhs)

120 110

81 100 80 90 79 80 78

70 60

77 4/1

5/1

6/1

7/1

8/1

TW AUD High Relative to Rate Spreads

Entry: 1.1650, Stop: 1.1550, Target: 1.3000

A$ AND SHORT-RATE SPREAD INDEX 81

Limit Order: Buy EUR/AUD

As we expect the EUR to rally near-term, we examine currencies that look stretched against the common currency. We believe safe-haven flows have driven AUD well above what is justified by fundamentals and look for some correction. Ongoing deterioration in China’s economic data does not bode well for AUD.

BASIS POINTS 600

75

500

69

400

63

300

57

*GAP BETWEEN 4QTR-AHEAD SHORT-RATE FUTURE FOR AUSTRALIA VERSUS MAJOR TRADING PARTNERS

200

51 100 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

15 Aug 2012

Enter: Short GBP/RUB

EM Growth and Inflation Forecasts, 2012

Entered: 50.20, Stop: 51.50, Target: 44.00 While we are constructive on CEEMEA currencies in general, RUB remains one of our preferred longs in the region. Russia has been one of the strongest-performing economies in EM this year, and our economists think the Central Bank of Russia will launch a tightening cycle next month, (see Russia Economics: CBR Poised to Tighten... but Not Just Yet, August 9). Our economics team does not forecast hikes from any other central bank in the world, and should the generally stable carry-seeking environment persist, RUB (which is already the highest carry currency in the region) looks set to benefit.

)

21


10 Aug 2012

Entered: 0.7850, Stop: 0.7750, Target: 0.8200

Enter: Long EUR/GBP

GBP has been supported by safe-haven flows throughout the eurozone sovereign crisis. We now think some of these flows may flip as the ECB aggressively supports peripheral debt markets. Indeed, our flow of funds analysis shows that recent flows into the UK are largely short term in nature, and thus more likely to reverse. Also, fundamentals based on interest rate differentials suggest that GBP needs to adjust.

EURGBP Has Diverged From Forward Rate Differentials 1 0.8 0.6 0.4 0.2 0 -0.2 -0.4 -0.6 -0.8 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 1Y1Y Differential

10 Aug 2012

Enter: Short AUD/NOK

9 Aug 2012

0.92 0.9 0.88 0.86 0.84 0.82 0.8 0.78

EURGBP (RHS)

AUD Overvalued in July 2011 Simulation

Entered: 6.26, Stop: 6.3150, Target: 5.95 China’s economic data continue to print weaker than expected, as the country’s slowdown continues. We think a slowing Chinese economy will hurt AUD, given Australia’s dependence on exports to the country, relative to its commodity peer Norway. Moreover, our valuation models signal an overvalued AUD and an undervalued NOK (See Gauging Safe Haven Flows-Driven Mispricing, Aug 8, 2012). Meanwhile, our FX Macro Opportunity Monitor shows that this trade is sensitive to macro factors but has a negative beta to global risk sentiment. As many of our other trades are long risk, we think this provides a reasonable hedge to our portfolio. For more, see Back to Macro: Introducing an FX Opportunity Monitor, August 2, 2012.

Mexico PMIs Well Above Expansionary Threshold


Manufacturing and Non-Manufacturing PMIs (Seasonally adjusted, diffusion indices, 3mma) 58

Enter: Short GBP/MXN

We remain constructive on MXN due to Mexico’s positive growth story and because the country’s policymakers tend not to intervene in currency markets (in contrast to several LatAm peers). We like to fund this trade in GBP, as we forecast further sluggishness in the UK economy and a reversal of safe haven flows in the near-term (see Reversing Safe Haven Flows: Sterling Leads the Bearish Ranking, Aug 9, 2012).

56 54 52 50 48 46

Manufacturing

44

Non-manufacturing

42 Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul05 05 06 06 07 07 08 08 09 09 10 10 11 11 12 12

22


03 Aug 2012

Hold: Long CHF/JPY

CHFJPY Trades Near Strong Technical Support


Technical indicators, including the upward trend in the 14 day RSI, suggest CHFJPY has reached a bullish trading signal. CHFJPY is more than a pro-risk trade, as the structure of the currencies’ safe haven inflows differs. For details, see CHFJPY Set to Rally (July 30, 2012).

115 110 105 100 95 90 85 80 75 70 65 2007

CHFJPY

2008

2009

2010

2011

RSI - 14 Day

75 55 35 15 2007

2008

2009

2010

2011

02 Aug 2012

Spot: 1.2141, High Strike: 1.2650, Low Strike: 1.2151, Cost: 0.63%, Knock Out Barrier: 1.2013

EUR Trades with Peripheral Spreads 10 yr spread over Bund, bp, Inverted Scale 100

1.5

200

1.45

Hold: EUR/USD Call Spread

We believe the EUR is heading towards a tradable rally. In focusing ECB policy on the transmission mechanism, and specifically, on reducing widening EMU yield spreads, the ECB has indicated it will do what is necessary to support capital markets, which will be EUR positive. However, given the limited nature of our EUR optimism, as we think ultimately a fiscal and banking union is needed for a long-term solution, we like to position via options, particularly as vol remains surprisingly cheap.

300

1.4

400

1.35

500

1.3

600

1.25 Spain

700 Jun-11

02 Aug 2012

Hold: GBP/USD Put

Spot: 1.5552, Strike: 1.5112, Cost: 0.60% The UK economy continues to disappoint – GDP was much worse than expected in the second quarter – and the recent PMI manufacturing number was the worst since 2009. Our UK economists have revised down their growth forecasts and are now looking for a contraction in 2012. They have also penciled in more QE from the BoE and another 25 bp rate cut by the end of the year. We position for this move via options given vol is cheap at the moment, and the option gives us some protection against a technical bounce.

Italy

EURUSD (RHS)

Dec-11

1.2

Jun-12

UK PMI Manufacturing Lowest since 2009 Index 65 60 55 50 45 40 35 30 Mar-06 Dec-06 Sep-07 Jun-08 Mar-09 Dec-09 Sep-10 Jun-11 Mar-12

23


14 Jun 2012

Hold: Long 3m USD put/MYR call spread

9 Aug 2012

Entry (spot): 3.176, High Strike: 3.131, Low Strike: 3.04, Cost: 0.80% We like tactical long positions in AXJ currencies. While we are still mindful of potential downside tail-risks from the ongoing Eurozone credit turmoil, we believe ECB President Draghi has at least temporarily lessened tail risks. We choose to express our bullish view through a 3m OTM MYR call-spread because 1) the MYR had underperformed despite having relatively sound fundamentals; 2) Malaysia is one of the most open AXJ economies and hence will benefit more from any potential global reflation; and 3) the call-spread is downside-protected and costeffective – it can generate a risk reward of 3.7x if USD/MYR hits 3.04 at expiry.

Entry (spot): 1.245, Strike: 1.265, Cost: 0.71%

USD/MYR Upside Momentum Is Retracing from Stretched Levels (USD/MYR 3M Rolling Return, %)

15

10 (2005-2012 Average)

+2sd

5 +1sd

0 -1sd

-5

-2sd

-10 05

06

07

08

09

10

11

12

USD/SGD Implied Volatility and Skew Are at Historically Low Levels (Vol, %)

Hold: Long 3m USD call/SGD put

Despite recent SGD strength, we think it is prudent to roll our existing SGD downside hedge for another three months. This is because the slowing external environment poses significant growth and BoP headwinds to Singapore’s open economy. At the same time, we are mindful that the MAS could end its policy tightening in the fall if demand-pull pressures on inflation begin to ease. We therefore believe USD/SGD will likely rebound from the 1.24 YTD low. We prefer to express our view via an OTM SGD-put, taking advantage of the historically low vol and skew.

16 14 12

3M ATM Vol

10 8 6 4

3M 25D RR

2 0 Jan-10

6 Jan 2012

Jul-10

Entry: 34.45 (NDF), Stop: 34.15 (spot), Target: 32.00 (spot)

Jan-11

Jul-11

Jan-12

Jul-12

SGD/PHP

36

Hold: Sell SGD/PHP 12M NDF

We use this AXJ relative value position as a hedge against our near-term risk-on view. Philippines’ relatively closed economy will likely protect PHP from the slowing global growth. Singapore’s open economy, on the other hand, leaves it vulnerable to data disappointment or risk-off scenarios. With global economic performance still lackluster and no signs of imminent concerted easing, we believe this hedge is justified. We expect the pair to retrace from the recent high and grind towards the target of 32.0.

35.5 35 34.5

Initial Entry: 34.15

34 33.5 33 -6.3% 32.5 32 New Target: 32.0 31.5 31 Jan-11

Apr-11

Jul-11

Oct-11

Jan-12

Apr-12

Jul-12

Source for all charts: Bloomberg, Haver, EcoWin, Morgan Stanley Research

24


Strategic FX Portfolio Trade Recommendation

Nominal Weight

Notional

Entry Date

Entry Level

Current

Stop

Target

Spot P&L

Carry P&L

Portfolio Contribution

Active Trades Short SGD/PHP 12m NDF Long CHF/JPY

$5.0mn

4.1%

6-Jan-12

34.15

33.76

34.15

32.00 Levels are spot

$10.0mn

8.3%

3-Aug-12

79.15

81.02

78.20

92.00

$232.3k

$78.5k $0.0k

$232.3k -$27.2k

Short GBP/MXN

$10.0mn

8.1%

9-Aug-12

20.50

20.63

22.50

18.00

-$26.8k

-$0.4k

Short AUD/NOK

$10.0mn

8.1%

10-Aug-12

6.2600

6.26

6.3150

5.9500

$8.0k

-$1.6k

$6.5k

Buy EUR/GBP

$10.0mn

8.1%

10-Aug-12

0.7850

0.7825

0.7750

0.8200

-$33.5k

-$0.5k

-$34.1k

Sell GBP/RUB

$10.0mn

8.1%

15-Aug-12

50.20

50.10

51.50

44.00

-$1.9k

$0.0k

-$1.9k

Limit Orders Buy EUR/AUD

$10.0mn

1.1650

1.1708

1.1550

1.3000

Buy USD/JPY

$10.0mn

78.50

79.24

78.10

82.00

Cash

$57.7mn

Portfolio Mark to Market

46.9%

#DIV/0!

Source: Morgan Stanley Research *Stops for all trades are based on spot 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 Performance Data Package contains complete performance statistics. (3) Reported returns are unleveraged. (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 recently (FX Pulse: Watching Europe, October 13, 2011)

Performance on Recommended Discretionary Currency Portfolio and Market Benchmark Simple return, index 135

EUR

130

MXN

125

NOK

120 PHP

115 JPY

110

AUD

105

MS FX Strategic Portf olio

100

GBP

Barclay Currency Fund Index

95

SGD

90

-30

Apr-04

Oct-04

Apr-05

Oct-05

Apr-06

Oct-06

Apr-07

Oct-07

Apr-08

Oct-08

Apr-09

Oct-09

Apr-10

Oct-10

Apr-11

Oct-11

-20

Apr-12

-10 Now

0

10 USD mn

Last Pulse

Simu lat ed M anage d Acco u nt M on th ly Gro ss P erforma n ce - % Ye ar 200 4

Ja n

F eb

M ar

Ap r

Ma y 2.0 3

Ju n -0 .7 3

Jul 1.42

Aug -1.07

S ep -0 .9 0

Oc t 0 .2 3

N ov 0.80

D ec 0.44

Ye ar re tu rn 1 .5 7% 8 .3 5% 2 .1 6%

200 5

0.28

0 .1 1

0.68

-0.63

2.0 8

1.39

-0.2 0

1 .8 4

1.62

0 .1 5

0.85

0.17

200 6 200 7

-1 .1 1 -0 .7 5

1 .7 0 -0.77

4.36 -1 .0 8

-0.37 0 .9 4

1.2 4 0.3 6

-0 .4 4 -2 .0 2

0.52 1.07

-1.47 2 .7 5

-0 .8 5 1.26

-0.84 0 .4 5

- 0.58 1.16

-0 .0 1 0.18

200 8 200 9 201 0

1.07 0.74 -0 .0 1

2 .2 5 -0.97 -0.27

2.72 -0 .1 5 1.71

-1.41 -1.09 1 .1 3

-0.53 0.5 0 1.3 9

1.28 -0 .8 7 -0 .8 6

-0.1 7 0.30 -2.3 6

-0.24 0 .2 2 0 .9 5

-0 .8 6 2.00 0.67

3 .1 2 0 .7 7 -0.30

0.62 1.27 0.13

0.87 0.55 0.66

201 1 201 2

-1 .2 0 0.32

0 .2 9 0 .4 7

-1 .7 1 -0 .4 3

0 .5 1 0 .4 9

-1.11 1.7 6

-0 .3 3 -0 .4 3

0.84 0.20

-1.02

0.50

-1.03

- 0.18

0.44

3 .5 6% 8 .7 2% 3 .2 7% 2 .8 3% -4.00 % 2 .3 7%

Options Trades Trade Recommendation Active Long USD put/MYR call Short USD put/MYR call Long GBP put/USD call Long EUR call/USD put Short EUR call/USD put Long USD call/SGD put

Notional $10.0mn $10.0mn $10.0mn $10.0mn $10.0mn $10.0mn

Entry Date 14-Jun-12 14-Jun-12 2-Aug-12 2-Aug-12 2-Aug-12 9-Aug-12

Expiry Date 13-Sep-12 13-Sep-12 2-Nov-12 5-Oct-12 5-Oct-12 9-Nov-12

Strike 3.1310 3.0400 1.5112 1.2151 1.2650 1.2650

Entry Spot 3.1760 3.1760 1.5552 1.2141 1.2141 1.2454

Entry Vol

Entry Cost

8.80% 7.25% 8.21% 10.65% 10.65% 6.71%

0.94% 0.14% 0.60% 0.87% 0.28% 0.71%

Current Spot 3.1266 3.1266 1.5698 1.2286 1.2286 1.2454

Current Vol 6.75% 6.92% 8.69% 9.65% 9.65% 6.54%

Current Cost 0.66% 0.09% 0.33% 1.65% 0.39% 0.70%

P&L -$244.1k -$42.9k -$233.7k -$13.7k $94.67k -$18.72k $0.00k

*Note there is a knock out barrier at 1.2013 for both EUR/USD calls. Source: Morgan Stanley Research; see notes above.

25


G10 Currency Summary Calvin Tse Improving Data

1.6%

Improving US economic data have benefitted USD via the interest rate channel. Additionally, stronger US growth has reduced the probability of another round of QE from the Fed next month. That said, the markets are likely now paying close attention to US data to determine whether or not the recent upside surprises are ephemeral in nature. However, domestic growth aside, we believe that the general improvement in global risk appetite should weigh on USD, given its traditional funding status.

            

Bearish

Watch: U-Mich, Home Sales, FOMC Minutes, Claims, PMI, Durables

USD

The Draghi ‘Put’

-3.8%

Although the relative EU-US data mix has prompted yield differentials to play in favour of USD and against EUR, we remain near-term bullish on the common currency. Indeed, we view the Draghi ‘put’ as a potential game-changer; should the ECB intervene to cap near-term yields, we believe that this will prompt an unwind of safe-haven trades, benefitting EUR. The market also remains short and, as such, price action is likely skewed to the upside.

            

Bullish

Watch: Trade Balance, PMI, Consumer Confidence, German GDP

EUR

Yield Differentials

-0.9%

With US economic data steadily improving and US yields rising quickly, this should put significant downward pressure on JPY. Indeed, USDJPY is extremely sensitive to interest rate differentials and the cross is currently trading below levels implied by rate fundamentals. Furthermore, we like being short JPY as we believe that the upside in limited. With politics in focus, the probability that the MoF/BoJ intervenes to protect against a strong currency is as high as ever, in our view.

            

Bearish

Watch: Leading Index, All Industry Activity Index, Trade Balance

JPY

Underperformance Likely

-0.8%

The recent strong UK data, including retail sales and jobless claims, are likely to support GBP in the very near term. However, as European tail risks are reduced post-ECB President Draghi’s commitment to the improvement of the monetary transmission mechanism, we believe that safe-haven flows will unwind. The UK has been a strong recipient of these inflows, mostly in money market instruments. Thus, as flows are unwound, GBP is at heavy risk.

            

Bearish

Watch: House Prices, PSNB, CBI Trends, 2Q GDP

GBP

Trading with EUR

4.0%

With both deflationary threats and the central bank’s credibility on the line, we believe that the SNB will maintain its FX policies for the immediate future. In addition, it is likely that the reduction in European tail risks has resulted in less required intervention by the SNB. As such, EURCHF is likely to continue hovering above the 1.2000 floor. With this in mind, and given our tactical bullish view on EUR, we believe that CHF will gain in lockstep.

            

Bullish

Watch: M3, Real Estate Index, Trade Balance

CHF

Above Trend

-3.0%

BoC Governor Carney recently spoke with a hawkish tone, commenting that Canada’s growth is “above trend”. With growth steady and a strong housing market supporting bank lending, we believe that it is only a matter of time before interest rates rise to meet the trend in growth – which should be CAD-supportive. In the week ahead, CPI and retail sales are important releases to watch, especially given the recent rhetoric from the central bank.

            

Bullish

Watch: BoC CPI Core, Retail Sales

CAD

Heavy Inflows

7.4%

AUD is vulnerable in the context of an improvement in the euro area. Many investors played EUR weakness via short EURAUD positions, using AUD as a quasi-safe haven. As the ECB targets peripheral bond spreads, we look for investors to unwind this position, weighing on AUD. As such, should the risk rally that we envisage come to fruition, we believe that AUD is likely to lag the gains seen in other high-beta currencies.

            

Neutral

Watch: Westpac Leading Index, Conference Board Leading Index

AUD

Tied to the External Environment

7.6%

NZD remains externally vulnerable, given its reliance upon external funding to finance its current account. An analysis of the New Zealand balance of payments reveals that much of this financing comes in the form of short-term flows which can be easily reversed, and does not bode well for the currency. However, though we remain longer-term bears, reduction of European tail risks should support risk sentiment and, by consequence, the high-beta NZD.

            

Neutral

Watch: PMI Services, Inflation Expectations, Trade Balance

NZD

Quasi-Safe Haven

-6.8%

Swedish growth has continued to surprise to the upside. As such, the Riksbank has been able to remain on hold while rates are cut elsewhere, increasing rate differentials and benefitting SEK. Additionally, due to the pristine rating of its sovereign, Sweden has received safe-haven inflows due to the European crisis. The stickiness of Sweden’s inflows suggests that SEK will remain relatively well insulated should these flows unwind. Thus, SEK should stay relatively supported.

            

Neutral

Watch: Capacity Utilization, Unemployment Rate

SEK

Approaching Norges

-0.9%

Due to Norway’s dual surplus position, AAA rating, tight sovereign CDS spread and yield pick-up, the country should continue to see safe-haven inflows. However, with the Norges Bank rate decision approaching in two weeks’ time, we expect NOK to be especially sensitive to data releases – specifically labour data and 2Q GDP this week. Strong numbers should scale back rate cut expectations and the resulting increase in rate differentials should favour NOK, and vice versa.

            

Charts are 3M performance against USD, as normally quoted

Neutral

Watch: Unemployment Rate, GDP

NOK

26


EM Currency Summary EM Strategy Team USD/EM* CNY

Bullish

 0.5%

We expect the authorities to suspend CNY appreciation against USD as part of the more aggressive easing measures to boost demand growth.

HKD

Bullish

 -0.1%

The USD/HKD peg should remain stable.

INR

Bearish

 1.6%

IDR

Bearish

 1.4%

KRW

Neutral

 -3.6%

MYR

Neutral

 -0.5%

INR is still under pressure due to India’s negative macro dynamic and BoP stress. The policy response so far has also been insufficient, in our view. Indonesia’s current account is moving deeper into deficit. IDR is also vulnerable to capital flight because of heavy foreigner positioning, in our view. KRW’s macro-dynamic and balance-of-payment (BoP) supports are waning because of the slowing global cycle, though its cheap valuation may help to limit the extent of any sell-off. We think that MYR might be over-sold compared to its peers in the region, and may lead to a rebound if global sentiment improves.

PHP

Bullish

 -3.0%

PHP should be supported by a relatively stable BoP and improving credit outlook.

SGD

Neutral

  -2.4%

THB

Bullish

 0.2%

TWD

Bullish

 1.2%

CZK

Bearish

 3.3%

HUF

Bullish

 -3.4%

ILS

Bearish

 4.4%

KZT

Bullish

 1.2%

PLN

Bullish

 -2.6%

RON

Bearish

 6.2%

RUB

Bullish

 1.6%

ZAR

Neutral

 -3.0%

TRY

Bearish

 -2.9%

UAH

Neutral

 0.5%

ARS

Bearish

 3.2%

BRL

Neutral

 -0.4%

MXN

Bullish

 -5.3%

CLP

Bullish

 -5.3%

COP

Neutral

PEN

Neutral

 -1.8%  -2.1%

SGD is exposed to the global growth slowdown and MAS support may fade if inflation retraces lower. That said, SGD should lead the AXJ rebound if there is global reflation. THB is overvalued and susceptible to weaker external demand conditions, but may be supported by positive macro-dynamic conditions (albeit temporarily). TWD will likely be vulnerable due to the weak global cycle and its negative carry. However, we believe that its cheap valuation should provide a margin of safety. CZK should stay under pressure as domestic demand remains subdued, and the CNB stays dovish and biased to FX weakness as a tool to help support the economy via trade. While there will likely be periods of uncertainty, we continue to think that an IMF deal will be reached by the end of September. This keeps us overweight HUF. We think that ILS will underperform peers, given the slowing macroeconomy, dovish Bank of Israel and growing regional security risks. The case for KZT appreciation is not as strong as it once was, though higher energy prices will likely keep the currency supported. We are neutral on KZT. PLN is likely to outperform its CEE peers, given the growth outperformance of Poland. However, the NBP’s next move is likely to be down and this could weigh on the PLN in time. RON remains weak, with external deleveraging and political risks continuing to weigh on the currency. With less intervention from the NBR, we see further RON weakness. RUB remains one of our preferred longs in the region, as the currency is backed by strong fundamentals and a hawkish central bank. We recommend going short GBP/RUB. ZAR remains one of the most volatile EM currencies, and has outperformed during periods of market strength. We stay market-weight, given a still uncertain backdrop. The Central Bank of Turkey's flexible monetary policy approach has prevented aggressive speculation against the currency. We expect this newfound low beta status to remain in place. We expect the FX market to remain stable, and see the risk of resumption of FX pressure for domestic reasons as being moderate in the coming months. NDF-implied yields price in a 50% depreciation. While we expect to see a weaker ARS due to seasonal factors, we think the market’s expectation of a depreciation may be premature. We continue to think that the government will keep the quasi-peg for the time being, reducing interest from the investment community. We see BRL as a defensive currency. We believe that MXN has scope for meaningful outperformance in the near term versus JPY in the better environment for risk. CLP has extended its outperformance on the back of a better tone to copper/commodity markets of late and due to a deal announced by Enersis. We are mindful of Colombia’s pricing in of rate cuts, and do not believe that COP will likely strengthen at these levels, nor significantly weaken on verbal intervention. Strong-side intervention makes us confident that PEN will continue to exhibit a lower beta and outperform if the macro situation deteriorates.

*3 month history

27


Global Event Risk Calendar Evan Brown Date (GMT) 17-Aug Fri

Cc y

Time

(GMT)

Ev ent

Ref. P eriod

CP I Current A ccount Trade B alanc e GDP (Final) Fed's Kocherl akota (non -voter ) spks (Willi ston, ND) U. of Michigan Confidence (P reli m) Leading Indicators

Ju l Jun Jun 2Q Aug Jul

Property P rices

Jul

CA D E UR E UR T WD US D US D US D

13:30 9:00 10:00 8:30 1:00 14:55 15:00

CNY

2:30

NZD

23:30

Performance S ervices I ndex

Jul

CLP E UR G BP I NR J PY T HB

13:30 10:00 0:01 NA 6:00 3:30

GDP Const ruct ion Output Rightmove House Prices CP I Leading Index (Final) GDP

2Q Jun Aug Jul Jun F 2Q

A UD CA D CA D CHF G BP G BP J PY

2:30 13:30 17:45 8:00 9:30 11:00 5:30

RBA Mi nutes Wholesale Sales BoC's Cote spks (Kings ton, ON) M3 PS NB ex Interventions CB I Trends T otal O rders All Industry A ctivity Index

Mtg of Aug 7 Jun

NZD NZD US D

4:00 4:00 13:45

A UD B RL CA D CA D E UR J PY NO K US D US D ZA R

MS forecast

Mark et

P revious

1.5%Y 5.0B -0.16%Y

1.5%Y 10.9B 6.3B -0.16%Y

72.3 0. 2% M

72.3 -0. 3% M

18-Aug Sat 19-A ug S un 54.3

20-A ug Mon

1.7%Q

1.4%Q 0. 1% M 2.3%Y 10.2%Y 92.6 11.0%Q

21-Aug Tue 0. 9% M

Jul Jul Aug Jun

7.4%Y 14.4B -6 -0. 3% M

Credit Card Spending RB NZ 2yr Inf lation E xpectation Fed's Lockhart (voter) spks (Atlanta, GA)

Jul 3Q

0. 8% M 2.4%Y

1:30 13:00 13:30 16:00 10:30 0:50 9:00 15:00 19:00 9:00

Westpac Leading Index IP CAD Inflat ion Retail Sales BoC's Carney spks (Tor onto, O N) German B ond A uc tion (E UR 5B 2yrs) Trade B alanc e Unemployment Rate Ex is ting Home S ales

Jun Aug Jun

Jul Jun Jul

FOMC mi nutes CP I

Mtg of Aug 1 Jul

CHF CNY CNY E UR E UR E UR E UR E UR E UR E UR E UR G BP G BP

7:00 3:00 3:30 7:58 7:58 8:28 8:28 8:58 8:58 8:58 15:00 9:30 11:00

Trade B alanc e Conference B oard Leading E conomic Index

Jul Jul

2. 19B

HS BC Flash Manufacturing P MI French Flash P MI Manufacturin g French Flash P MI S er vi ces Germ an Flash PM I Manufacturing Germ an Flash PM I S er vi ces Flash PM I Com posite Flash PM I Manufacturing Flash PM I S er vi ces Consumer Confidence (P relim) BB A Loans for Hous e Purchase CB I Reported Sales

Aug Aug Aug

Aug Aug Jul Aug

49.3 43.4 50.0 43.0 50.3 46.5 44.0 47.9 -21.5 26.3K 11

NO K NZD SEK S GD

9:00 23:45 8:30 6:00

GDP (Mainland) Trade B alanc e Unemployment Rate CP I

2Q Jul Jul Jul

US D US D US D US D

13:30 15:00 15:00 15:00

Initial Jobles s Claims New Hom e S ales House P rice Index New Hom e S ales

Wk of A ug-18 Jul Jun Jul

A UD A UD CO P E UR G BP J PY US D

0:30 1:00 NA 14:00 9:30 8:45 13:30

RBA's S tevens spks before house Econom ics com mi tee (Canberr a) Conference B oard Leading Index Jun

22-Aug Wed 0.38% M

4. 50M

0.80% 0.33% M 0. 3% M

¥60.3B 3.00% 4. 37M 5.5%Y

23-Aug Thurs

Aug Aug Aug Aug

-47M

365K 4. 3% M

1.1%Q 331M 8.80% 5.3%Y 350K 0. 8% M -8. 4% M

24-Aug Fri

*

BanRep Meeting Belgian B usiness Confidence GDP (Revi si on) BOJ's S hirakaw a spks (Osaka) Durable G oods O rders

0.40% 5.00% -11.3 -0.7%Q

Aug 2Q Jul

1. 6% M

1. 3% M

28


2 6 -A u g S u n G BP

19 :0 1

E UR E UR E UR J PY SEK SEK

9 :0 0 9 :0 0 9 :0 0 7 :0 0 8 :3 0 8 :3 0

H o m et ra ck H ou sin g Su rve y

Au g

-5 .0 %Y

Ge rm an I FO - B u sine ss Clim at e Ge rm an I FO - C urren t Ass ess m en t Ge rm an IFO - E xpe c ta tions M ach in e Too l O rd e rs PP I R e tail Sa les

Au g Au g A ug Ju l Ju l Ju l

10 3 .3 11 1 .6 9 5 .6 -6 .8 %Y .4 %Y -. 4% M

CH F E UR G BP US D US D US D

10 :3 0 9 :0 0 28 -31 A U G 14 :0 0 15 :0 0 15 :0 0

Swit zerla nd to S e ll 3M B ills Eu ro-Zo n e M 3 s. a. (Yo Y) N a t'w id e Hou se p rices ns a (Y oY ) S& P /Ca se -S h ille r H P I Y OY % C o nsu m e r C on fid e nce R ich m on d Fe d M a n ufa ct . In d ex

Ju l Au g 2Q Au g Au g

3.2 % -2.6 % -1.9 % 6 5 .9 -1 7

B RL CA D CA D

16 :3 0 13 :3 0 13 :3 0

C e ntra l B an k Po sts Cu rre ncy Flow s fo r pre v. w e e k In du stria l Pro du ct P rice M o M R a w M at erials Price In d ex Mo M

Ju l Ju l

-0.3 % -4.0 %

CH F E UR E UR E UR NO K SEK US D US D US D US D US D US D

8 :0 0 7 :4 5 9 :0 0 13 :0 0 13 :0 0 10 :1 0 12 :0 0 13 :3 0 13 :3 0 13 :3 0 15 :0 0 19 :0 0

Le a din g In dica to r Bu sin es s Co nf ide n ce Ind ica to r R e tail Sa les s.a . (M o M ) C ons ume r P ri ce I ndex (Y oY) N orw egi an Dep osi t R ate s Swe d en t o s ell B ills M BA M o rt ga g e Ap plica tio ns GDP Q oQ (A nn ual ize d) Pe rso na l Co ns um p tio n C o re P C E Qo Q Pe n din g Hom e Sa les Yo Y Fe d's B ei ge Book

Au g Au g Ju n A ug P

1 .4 3 90 -0.2 % 1. 7% 1 .5 0%

CA D CN Y E UR E UR E UR E UR E UR

13 :3 0 3 0-3 1 A u g 8 :5 5 8 :5 5 9 :0 0 10 :0 0 10 :0 0

C u rre nt A cco un t (B OP ) M e rke l M ee ts C hine s e L ea der s in B e ij ing Ge rm an Un e m plo ym en t C ha n ge (s. a) Ge rm an Un e m plo ym en t R at e (s .a ) Ita lian H o u rly W ag e s Eu ro-Zo n e C on su m er C o n fid en ce Bu sin es s Co nf ide n ce

2Q

E UR G BP G BP G BP

3 0-A ug -5-S ep t 0 :0 1 9 :3 0 9 :3 0

R e tail Sa les (Mo M ) Gf K Con su m er Con fid en ce S urve y M ortg a ge A pp rov als M 4 Mo n ey S u pp ly (Yo Y)

Ju l Au g Ju l Ju l

-0.1 % -2 9 44 .2 K -5.2 %

J PY J PY J PY J PY NO K US D US D

0 :3 0 0 :3 0 0 :5 0 0 :5 0 9 :0 0 13 :3 0 13 :3 0

Jo ble ss R ate N a tl CP I Y oY La rge R e ta ilers' S a le s In du stria l Pro du ct io n (M oM ) U n em p loym e n t Ra te In itial Job les s C la im s C o ntin u in g C la im s

Ju l Ju l Ju l Ju l P Au g Au g Au g

4.3 % -0.2 % -2.6 % 0.4 % 2.7 % ---

B RL B RL CA D E UR E UR E UR INR NO K

13 :0 0 14 :3 0 13 :3 0 10 :0 0 10 :0 0 11 :0 0 6 :3 0 9 :0 0

GDP N e t D e bt /G D P Qu a rt erly G D P An n ua lized Eu ro-Zone CPI E stim a te (Yo Y) Eu ro-Zo n e U ne m plo ym e nt Ra te PP I (Y oY ) GDP R e tail Sa les

2Q Ju l 2Q A ug Ju l Ju l 2Q Ju l

US D US D US D

14 :5 5 15 :0 0 15 :0 0

U . of M ic higa n Confide nc e Fa cto ry Orde rs Fe d's B er nank e sp ks (Ja c ks on H o le, W Y )

A ug F Ju l

3 -S e p 4 -S e p 4 -S e p 5 -S e p

E UR CH F A UD CA D

NA 6 :4 5 5 :3 0 14 :0 0

6 -S e p 6 -S e p 6 -S e p 12 -S e p

SEK G BP E UR NZD

8 :3 0 12 :0 0 12 :4 5 22 :0 0

12 -S e p 12 -S e p 13 -S e p 13 -S e p

E UR E UR CH F US D

NA NA 8 :3 0 17 :3 0

* *

Ge rm an Cons ti tuti onal C ourt E S M R ul ing N e the rl ands G ene ra l El ec tion SN B Ra te s De ci si on FOM C R a te s D e ci sion

13 -S e p 14 -S e p 15 -S e p 19 -S e p

INT E UR E UR J PY

NA 16 :0 0 8 :0 0 5 :0 0

*

G-2 0 Deputy M ini ste rs M tg (through 14 -S e p) EC OFin M ee ting Eu rogroup me e ti ng B oJ Ra te s D e ci sio n

1 2 -O ct 1 8 -O ct 6 -N ov

INT E UR US D

NA NA NA

* * *

2 7-A ug M o n

28 -Au g Tu es

29 -Au g W e d

1 .50 %

1 .5 0%

Au g 2Q S 2Q S 2Q S Ju l

-1. 5% 1.5 % 1.8 % 8.4 %

30 -Au g Th urs -$ 10 .3 B

Au g Au g Ju l Au g F Au g

7K 6.8 % 1 .5 %Y -8 7 .1

31 -Au g Fri .2 %Q 3 5 .10 % 1.9 % 2. 4% 1 1.2 % 2.2 % 5. 3% -1. 1% M --0.5 %

Upc om in g Ev en ts

*

Eu rogroup me e ti ng (tenta ti ve ) GDP R BA Ra tes De c isi on B oC Ra tes De c is ion R ik sb ank R a tes D e ci si on B oE Ra te s De ci sio n EC B Ra te s De ci si on R BN Z R a tes D e c is ion

3 .25 % 1 .00 %

3 .5 0% 1 .0 0%

0 .7 0% 3 .5 0% 1 .0 0%

1 .50 % 0 .50 %

1 .2 5% 0 .5 0%

1 .5 0% 0 .5 0%

2 .50 %

2 .5 0%

2 .5 0%

0 .00 % 0 .1 25 %

0 .0 0% 0 .1 2 5%

0 .0 0% 0 .1 2 5%

0 .50 %

0 .7 5%

0 .7 5%

0 .10 %

0 .1 0%

0 .1 0%

IM F Annual M e eting (thr ough 1 4 - Oc t) EU Su mm er (thr ough 1 9 -O ct) U S D P re sid entia l, Hous e, a nd S ena te El ec tions

* Denotes timing approximate or not confirmed / All times and dates are GMT / Source: Morgan Stanley Research, Bloomberg

29


Cross-Currency Carry and Vol Opportunities Morgan Stanley & Co. LLC

Ronald Leven +1 212 761-3413

Morgan Stanley & Co. International plc

Corentin Rordorf +44 20 7677-0518

Carry – What Moved the Most Since Last Week? ARS was the biggest mover, declining 300bps. IDR’s 270bps was the biggest gain. Overall there was no directional bias.

Key New Valuation Thresholds Reached: Skew is generally normalizing but some bias for more USD call skew and it became extreme vs CHF and COP.

Where Is the Value in Carry? Although INR 3M rates are modestly lower over the past week, carry remains near the recent highs. More important is the severe divergence that has emerged between carry and skew. Skew widened out as carry picked up late last year and, as recently as June, it hit 4% but has plunged since to the current low at just over 1%. So while skew still works against USD puts, the multi-year low implies that USD put spreads are well priced relative to history. This is particularly the case when the still-high level of carry is considered and suggests that put spreads are an attractive way to lock in carry. In this week’s FX Option publication we recommended buying an ATMF INR56.6166 USD put and selling the 3M ATMS INR55.655 USD put. The potential 1.7288 profit is just under double the net cost of 0.8968% which is a relatively high payout ratio for a 3M structure. The risk is restricted to the upfront premium, which would be lost if the INR at maturity was weaker than 0.8968%. 3M net carry for CLP, like for INR, is near the recent highs. But skew, has firmed instead of plunging and, as shown in the heat map on a vol-adjusted basis is in the 90th percentile. The implication is that for CLP USD put spreads are not well priced but risk reversals are relatively attractive. Moreover, we are modestly constructive on CLP which also favors selling the risk reversal. Specifically, in this week’s Option publication, we recommended buying a 25D CLP472.41 USD put and selling the 25D CLP512.46 USD call, which earns net premium of 0.17%. The benefit of the carry and skew is that the long strike is only 2.1% away from spot while the short strike is 6.2% away. While downside is theoretically unlimited, the position would not begin losing money at maturity unless the USD was stronger than CLP513.3 – i.e., the CLP would have to reverse almost the entire two-month rally.

Vol – What Moved the Most Since Last Week? Vols were mixed but with a downside bias, the biggest move was COP’s 220bps decline while RUB’s more modest 60bps was the biggest gain.

Key New Valuation Thresholds Reached: Yet more currencies dropped into the blue zone outright: CLP, COP, BRL, EURBRL, BRLJPY, EURILS, EURTRY and TRY. However, vs realized there has been a reversal with a few countries becoming expensive: EURNZD, GBPAUD, GBPCAD, and AUDCHF. Curves continue to steepen: HKD, SGD, COP, BRLJPY and PLN became historically steep at the front end.

Where Is the Value in Volatility? Last week we went long vol via a 1Mx1M FVA but we may have been a bit early in entering the trade. While 1M vol is stabilizing at around 9.0%, 2M vol drifted lower reducing the implied level of the forward vol. Indeed, we are down slightly on the trade but we still think it makes sense to put on the trade and, indeed, the better entry level makes it more attractive. We hope to take profit on a firming of implied vol in the context of these events. We prefer not to take delivery on the FVA as we are not confident there will be a sustained pickup in realized vol. CNY is cheap on both metrics but we are already long vol via a USD put spread we initiated last month. Two of the currency pairs that are historically cheap – USDPHP and BRLJPY – are not liquid enough to make a pure long vol position practical. The remaining cheap vol pair USDBRL is liquid enough to be tradable but we are concerned that the central bank’s current intervention policy is going to keep vols depressed for some time to come. As in the case of INR, USDBRL skew has been dropping which would seem to make USD put spreads more attractive. But the spread is much higher outright at 4.1% points and it is still in the top 30th percentile. Moreover, carry has been drifting lower and is now well below the historical average. Consequently, the put spread does not generate the 2-1 ratio that we generally look for as a threshold. The decline in the risk reversal has also reduced the cost advantage of low delta USD puts; for instance a 3M BRL1.95 (a 17 delta strike) one touch would cost 35% which we do not see as a compelling risk/reward. Carry and volatility heat map is on the following page.

30


Implied Vol Metric 3M Im Vol

1W Chg

5-Year Perc.

Imp vs Real

5-Year Perc.

1Y/3M Imp Rat

RR Metric 5-Yer Perc.

5Y/1Y Imp Rat

5-Yer Perc.

3M 25d RR

RR/ Imp

Carry Metric

Ratio Perc

3M 1W Carry Chg

5-Year Perc.

Vol-Adj. Carry

5-Year Perc.

1Y/3M Crry Rat

1y Carry/ CallSprd

G10

USDCAD

6.8

-0.2

0%

0.9

19%

1.22

98%

1.06

86%

1.4

20%

83%

USDCAD

0.8

0.0

84%

0.12

100%

1.20

1.87

USDCHF

10.1

0.2

10%

1.1

45%

1.16

97%

0.98

94%

1.2

11%

93%

USDCHF

0.8

0.0

75%

0.08

86%

1.33

1.00

USDJPY

7.7

0.1

1%

1.1

41%

1.31

98%

1.27

88%

0.4

5%

13%

USDJPY

0.4

0.0

36%

0.05

64%

1.53

2.00

USDNOK

10.6

0.1

2%

1.1

59%

1.19

100%

0.98

92%

1.5

14%

64%

USDNOK

1.4

-0.1

22%

0.13

63%

0.89

3.59

USDSEK

10.8

0.1

4%

1.1

73%

1.19

99%

0.99

93%

1.5

14%

68%

USDSEK

1.4

0.0

64%

0.13

79%

0.84

3.15

0.1

3%

1.1

33%

1.20

96%

1.15

89%

-1.0

13%

51%

GBPUSD

0.1

0.0

20%

0.02

27%

0.77

2.37

11.1

0.5

2%

1.0

47%

1.18

97%

0.99

98%

-2.3

20%

61%

NZDUSD

2.4

0.0

21%

0.22

77%

1.00

1.10

AUDUSD

10.5

0.5

4%

1.0

50%

1.19

96%

0.97

93%

-2.5

23%

68%

AUDUSD

3.3

0.0

32%

0.31

63%

0.95

2.23

EURUSD

9.9

0.2

12%

1.0

23%

1.16

96%

0.98

91%

-1.7

17%

77%

EURUSD

0.4

0.0

95%

0.04

95%

1.24

2.51

EURAUD

8.9

0.5

3%

1.2

73%

1.18

96%

0.98

87%

1.0

11%

56%

EURAUD

3.8

0.0

58%

0.43

94%

0.98

2.35

EURCAD

8.2

0.1

1%

1.2

77%

1.17

97%

1.00

76%

-0.2

2%

46%

EURCAD

1.3

0.0

98%

0.16

99%

1.20

2.31

EURCHF

3.8

-0.3

4%

10.6

99%

1.76

98%

1.44

94%

-2.0

53%

95%

EURCHF

0.4

0.0

16%

0.09

47%

1.44

3.38

G10

EURGBP

7.2

0.0

3%

1.1

49%

1.20

99%

1.19

93%

-0.5

6%

35%

EURGBP

0.5

0.0

74%

0.08

77%

1.14

2.39

EURJPY

12.2

0.0

17%

0.9

15%

1.15

86%

1.18

61%

-1.9

16%

7%

EURJPY

0.1

0.0

100%

0.00

100%

0.69

2.64

EUR

EURNOK

7.4

-0.1

29%

1.3

93%

1.04

64%

1.05

89%

0.1

1%

0%

EURNOK

1.8

-0.1

85%

0.25

81%

0.97

2.27

EURNZD

9.4

0.5

2%

1.3

93%

1.17

94%

0.98

94%

1.0

10%

49%

EURNZD

2.9

0.0

68%

0.31

80%

1.04

EURSEK

7.9

0.0

46%

1.2

57%

1.03

60%

1.11

99%

0.2

2%

0%

EURSEK

1.9

0.0

95%

0.24

91%

0.93

2.25

GBPAUD

8.3

0.5

1%

1.2

86%

1.25

100%

1.01

89%

1.2

14%

70%

GBPAUD

3.3

0.0

45%

0.39

93%

0.95

2.22

GBPCAD

6.9

0.2

1%

1.3

87%

1.21

98%

0.99

47%

-0.1

1%

5%

GBPCAD

0.7

0.0

78%

0.10

82%

1.27

GBPCHF

7.7

-0.1

3%

1.2

78%

1.29

99%

1.16

87%

-1.6

20%

96%

GBPCHF

0.9

0.0

55%

0.12

74%

1.26

GBPJPY

10.7

0.0

3%

1.0

29%

1.18

86%

1.20

62%

-0.7

7%

1%

GBPJPY

0.5

0.0

19%

0.05

40%

1.35

CHFJPY

12.5

0.0

45%

0.9

27%

1.15

89%

1.03

23%

-0.7

6%

9%

CHFJPY

0.4

0.0

92%

0.03

96%

1.15

AUDCAD

6.7

0.3

1%

1.2

70%

1.28

100%

1.02

96%

-0.8

11%

43%

AUDCAD

2.6

0.0

15%

0.39

79%

0.84

2.02

AUDCHF

9.5

0.5

3%

1.3

88%

1.29

96%

1.09

99%

-1.4

14%

34%

AUDCHF

4.0

0.0

30%

0.43

94%

1.02

1.96

AUDJPY

12.5

0.5

4%

0.9

31%

1.21

92%

1.20

65%

-2.9

23%

27%

AUDJPY

3.7

0.0

20%

0.29

58%

1.00

2.43

AUDNZD

5.3

-0.1

0%

1.2

81%

1.28

99%

1.14

99%

-0.5

9%

99%

AUDNZD

0.9

0.0

46%

0.17

55%

0.80

2.04

NOKSEK

7.1

-0.2

37%

1.2

57%

0.99

36%

1.11

68%

0.3

3%

31%

NOKSEK

2.8

0.0

28%

0.22

73%

1.07

0.02

USDCNY

1.4

-0.1

4%

0.9

0%

1.72

59%

2.86

91%

0.4

30%

62%

USDCNY

1.2

-0.2

79%

0.90

91%

1.15

2.48

USDHKD

0.6

0.0

7%

2.4

79%

1.82

90%

5.26

49%

-0.7

118%

87%

USDHKD

0.1

0.0

6%

0.18

10%

0.87

9.63

, ,

2.41

G10 Crosses ,

9.0

0.0

38%

1.3

42%

1.39

82%

1.32

32%

4.0

44%

72%

USDIDR

5.9

2.7

68%

0.66

79%

0.97

2.00

USDINR

10.6

-0.2

55%

0.8

0%

1.08

52%

1.18

58%

1.3

12%

5%

USDINR

6.9

0.2

73%

0.65

74%

0.87

2.34

USDKRW

8.7

0.0

10%

1.1

54%

1.29

99%

1.26

90%

2.2

25%

30%

USDKRW

2.3

0.1

80%

0.26

98%

0.67

1.78

USDMYR

7.1

0.2

20%

0.9

8%

1.20

93%

1.26

70%

1.7

24%

68%

USDMYR

2.0

0.1

80%

0.28

92%

0.77

1.78

USDPHP

7.0

0.2

8%

1.1

19%

1.17

70%

1.29

61%

1.8

26%

60%

USDPHP

0.8

0.3

24%

0.11

25%

1.12

1.71

USDSGD

5.9

0.0

18%

1.0

9%

1.19

95%

1.41

93%

1.3

21%

77%

USDSGD

0.1

0.0

46%

0.01

52%

4.42

1.66

USDTHB

7.0

0.0

34%

1.3

43%

1.14

50%

1.25

47%

0.8

11%

21%

USDTHB

1.01

2.05

USDTWD

3.8

-0.1

1%

1.1

20%

1.37

99%

1.39

77%

0.6

16%

70%

USDTWD

0.6

-0.4

10%

0.15

19%

1.94

1.61

USDARS

25.0

0.0

85%

16.0

97%

1.40

20%

1.00

5%

10.0

40%

23%

USDARS

28.9

-3.0

80%

1.15

42%

1.07

3.27

USDCLP

11.2

-0.1

14%

1.1

34%

1.13

92%

1.16

80%

3.7

33%

91%

USDCLP

5.2

0.2

94%

0.46

99%

0.82

2.07

LATAM

USDCOP

10.3

-2.2

0%

1.3

34%

1.22

96%

1.14

57%

3.8

37%

94%

USDCOP

4.6

-1.1

58%

0.45

88%

0.73

1.96

USDMXN

12.8

-0.1

47%

1.0

20%

1.09

60%

1.25

79%

3.3

26%

31%

USDMXN

3.5

0.0

34%

0.27

32%

0.92

1.89

USDBRL

11.2

-0.5

8%

0.8

8%

1.17

77%

1.31

77%

4.1

37%

71%

USDBRL

5.8

-0.2

8%

0.52

62%

0.89

1.99

BLOCK

EURBRL

10.8

0.0

7%

0.8

21%

1.13

54%

1.13

28%

4.6

43%

77%

EURBRL

6.3

-0.2

14%

0.58

61%

0.91

2.16

EURMXN

11.3

-0.1

25%

1.2

62%

1.10

65%

1.15

76%

2.8

24%

31%

EURMXN

3.9

0.0

58%

0.35

89%

0.96

1.99

BRLJPY

13.3

-0.3

1%

0.9

15%

1.21

89%

1.33

93%

-4.5

34%

58%

BRLJPY

5.9

-0.2

2%

0.44

71%

0.93

0.61

MXNJPY

14.9

-0.1

20%

0.9

17%

1.10

69%

1.19

83%

-4.0

27%

57%

MXNJPY

3.8

0.0

29%

0.25

68%

0.98

0.45

AXJ BLOCK

USDIDR

, , EMEA

EURCZK

7.4

-0.1

43%

1.1

46%

1.07

89%

1.00

68%

1.9

26%

67%

EURCZK

0.6

0.0

73%

0.08

80%

0.68

1.75

EURHUF

10.8

-0.1

39%

1.0

34%

1.05

70%

0.98

53%

2.6

24%

24%

EURHUF

5.9

0.1

84%

0.55

98%

0.82

2.20

EURILS

8.6

0.3

7%

0.9

19%

1.08

84%

1.08

97%

0.3

3%

19%

EURILS

1.8

-0.1

94%

0.21

94%

0.86

2.24

EURPLN

9.2

-0.1

28%

0.9

21%

1.14

92%

1.00

68%

2.4

26%

57%

EURPLN

4.8

0.0

99%

0.53

99%

0.87

2.13

EURRUB

10.7

0.6

50%

1.0

32%

1.07

20%

1.40

58%

1.3

12%

19%

EURRUB

6.7

0.3

73%

0.63

75%

1.02

2.59

EURTRY

8.8

0.2

3%

1.3

75%

1.23

84%

1.35

43%

2.3

26%

52%

EURTRY

6.3

0.2

29%

0.72

70%

1.02

2.41

EURZAR

13.1

-0.2

24%

1.2

70%

1.09

76%

1.15

54%

2.2

17%

7%

EURZAR

5.4

-0.1

23%

0.41

53%

0.98

2.14

USDHUF

17.6

-0.1

42%

1.0

37%

1.03

68%

0.99

65%

3.5

20%

47%

USDHUF

5.5

0.1

73%

0.31

69%

0.79

2.04

BLOCK ,

USDILS

8.6

0.0

38%

1.0

34%

1.01

63%

1.05

83%

1.6

19%

78%

USDILS

1.3

-0.1

72%

0.15

81%

0.74

1.90

USDPLN

16.1

-0.1

34%

0.9

16%

1.08

85%

0.99

64%

3.5

21%

58%

USDPLN

4.4

0.0

99%

0.27

92%

0.83

1.97

USDRUB

12.3

0.6

54%

0.9

8%

1.07

17%

1.35

53%

2.8

23%

30%

USDRUB

6.5

0.3

72%

0.53

74%

0.98

2.23

USDTRY

9.6

0.0

1%

1.2

79%

1.23

94%

1.28

30%

3.1

32%

78%

USDTRY

6.0

0.1

10%

0.62

67%

0.99

2.12

USDZAR

16.1

-0.2

33%

1.0

31%

1.07

81%

1.11

49%

3.9

24%

44%

USDZAR

5.0

-0.1

1%

0.31

20%

0.95

1.98

Volatility figures shaded in blue are the bottom 15th percentile and those in red are in the top 15th percentile. Carry figures are only highlighted for high vol in red. Bolded shading implies that figures are in the tenth percentile. The percentiles for outright numbers are relative to all monitored currency pairs while the percentiles for percent values are determined by that specific currency pair's two-year history The 1y carry/call spread ratio represents net carry earnings relative to the cost of buying an ATMF option and selling an ATMS option. For this column, currencies are highlighted if the ratio is above 2 and overall net carry is above 150 bps.

Volatility and Carry Global Heatmap

7.7

NZDUSD

USD

GBPUSD

8/15/2012


Note: Access is available to the carry metrics on an interactive basis at:https://secure.ms.com/eqr/quotient/webapp/servlet/IRSHomeServlet Contact your Morgan Stanley sales representative if you do not have access.

31


FX Tactical Indicators Dara Blume Exhibit 1

Exhibit 2

Historical Currency Performance

Risk-Adjusted Five-Year Yields

4%

100

3%

50

2%

0

1% 0%

-50

-1%

-100

-2% SEK CAD NOK AUD NZD CHF EUR DXY GBP JPY Monthly Weekly

-150 Feb-12 USD

Apr-12 EUR

Jun-12 GBP

JPY



Exhibit 3

Exhibit 4

Relative Momentum Indicator

MS GRDI – Standardized

10

3 2

5

1 0

0 -1

-5

-2 -10 SEK

NOK

NZD

AUD CHF Current

EUR CAD Last Pulse

USD

GBP

JPY

-3 Jan-12 Feb-12

Mar-12 Apr-12

May-12 Jun-12


Global Risk Demand Index – US Pat. No. 7,617,143 Source: Morgan Stanley Research

Exhibit 5

Exhibit 6

G10 Surprise Index

IMM Positions Summary ($bn)

0.30

G10 Average

G10 GDP Weighted Average

AUD

0.20

JPY

0.10

MXN

0.00

Jul-12

CAD NZD

-0.10 -0.20 -0.30 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Note: Morgan Stanley Research

GBP CHF EUR -25

-20

-15

-10

-5

5

10

Note: Aggregate USD positioning in nominal terms, see following page for details Source: Bloomberg, Morgan Stanley Research

32


Reading FX Tactical Trade Performance and Indicators The FX Tactical Trade Recommendations page presents the portfolio of tactical trade ideas of the FX Strategy team and the performance of this portfolio over time. 

FX Tactical Trade Portfolio (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 Tactical 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.  The expected portfolio volatility (shown in the bottom right of Exhibit 2) is calculated using the covariance method for Value at Risk (VaR). The 1 Month option implied volatility for each cross and the 3 month realized correlations of daily spot returns are used to construct the covariance matrix for the portfolio.  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 May 2004 in the Discretionary Tradebook 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. 

Historical Currency Performance: Price changes in currency over the past week and past month.



Risk Adjusted Yields: Nominal five year yields adjusted for five year CDS (weighted average for EUR).



Relative Momentum Indicator: Measures the momentum of a currency relative to all other currencies; not indicative of historical performance.



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.



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.



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.

* US Pat. No. 7,617,143.

33


Morgan Stanley FX Positioning Tracker Calvin Tse

Overall Score









Component Scores

This Week

Last Week





USD

3

3

EUR

-6

-6

JPY

2

3

GBP

0

0

CHF

-6

-6

CAD

0

0

AUD

2

2

NZD

-1

-1

NOK

-4

-4

SEK

2

2

Short

Neutral

Long

-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2

3 4 5 6 7 8

9 10

          

Since Monday (August 13), positioning in the G10 currencies remains relatively unchanged. We calculate the largest long position to be in USD. The largest short position in the majors is in EUR. EUR positioning remains heavily short, though it has scaled back over the past couple of weeks. Every underlying component we track confirms this positioning. JPY positioning moved to neutral from long intraweek as our proxy for global macro hedge fund positioning showed selling, and sentiment also soured. We will provide a full updated report and refresh positioning scores for all of our underlying subindicators next Monday.

MS Flow

IMM

Beta

Sentiment

3

2

6

1

USD

-7

-6

-7

-6

EUR

1

0

5

2

JPY

-4

-1

5

1

GBP

-4

-8

-7

CHF

-6

-1

7

CAD

0

0

5

AUD

-5

3

Toshin

4

NZD

-4

NOK

2

SEK

Methodology 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.

34


Macro Forecast Corner Inflation Target Monitor and Next Rate Move

US

Inflation target

Latest month

12M MS fcast

Next rate decision

Current rate

Market expects (bp)

MS expects (bp)

Risks to our call

2.0% PCE Price Index

1.8%

1.8%*

13 Sep

0.15

0

0

-

< 2% HICP (u)

2.4%

1.0%

06 Sep

0.75

-3

-25

-

0-2% CPI (u)

-0.2%

-0.2%

19 Sep

0.05

0

0

-

Euro Area Japan UK

2% CPI

2.6%

2.2%

06 Sep

0.50

-4

0

Canada

1-3% on CPI

1.5%

1.7%

05 Sep

1.00

-1

0

-

Switzerland