THE_GLOBAL_FX_MONTHLY_ANALYST：LOW_VOLATILITY_IDIOSYNCRATIC_FX_MOVES_AND_THE_FISCAL_CLIFF-2012-11-14.ppt

,november 9, 2012 the global fx monthly analyst economics research low volatility, idiosyncratic fx moves and the fiscal cliff thomas stolper, fx market volatility has declined further and now stands at levels last seen during the peak of pre-crisis fx carry trading. a disruptive fiscal cliff scenario in the us is now the main risk that could push fx volatility higher. the us debt ceiling debate and downgrade in mid-2011 contributed to a trade-weighted usd rally of about 7%. should fx volatility remain at the current very low levels, idiosyncratic factors will likely become more visible. the recent divergence between the inr and zar, historically two correlated currencies, is a good example. we review a number of currencies that have displayed interesting moves recently to see if these can continue or if they are likely to revert. we distinguish between directional views, currencies where we see a,+44(20)7774-5183 goldman sachs international robin brooks (212) 902-8763 goldman, sachs & co. themistoklis fiotakis +44(20)7552-2901 goldman, sachs & co. fiona lake +852-2978-6088 goldman sachs (asia) l.l.c.,notable skew in risks and non-stories where the market may be disappointed relative to expectations. george cole +44(20)7552-3779 ,average fx volatility has declined further and is now at levels only seen,goldman sachs international,very briefly before the global financial crisis. the impact on individual currencies of swings in global risk sentiment is becoming smaller and investors tend to focus more on idiosyncratic moves as a strategy to generate returns. in that context, we review some of the most interesting country-specific stories in fx, which we broadly classify into directional views: currencies where we see a notable skew in risks and non-stories where the market may be disappointed relative to expectations. beyond the focus on idiosyncratic moves, it is also important to monitor risks that could potentially lead to a sudden rise in fx market volatility. we have discussed these risks in the past and continue to focus on the us fiscal cliff as a potential source of temporary risk aversion. investors should consider this report as only a single factor in making their investment decision. for reg ac certification and other important disclosures, see the disclosure appendix, or go to /research/hedge.html.,the goldman sachs group, inc.,goldman sachs,3,4,24,55,56,59,65,66,67,68,69,70,71,2,november 9, 2012 contents recommended fx trade ideas risk scenarios and idiosyncratic fx moves g3 us dollar euro japanese yen europe, middle east & africa british pound czech koruna hungarian forint israeli shekel norwegian kroner polish zloty russian ruble south african rand swedish krona swiss franc turkish lira americas argentine peso brazilian real canadian dollar chilean peso colombian peso mexican peso peruvian new sol venezuelan bolivar asia australian dollar chinese yuan hong kong dollar indian rupee indonesian rupiah korean won malaysian ringgit new zealand dollar philippine peso singapore dollar taiwan dollar thai baht interest rate forecasts gs sentiment index (imm) fx currents gs trade-weighted indices gs anecdotal flows m&a pipelines gsdeer key economic data gdp growth (%ch yoy) consumer prices (%ch yoy) current account balance (% of gdp) foreign exchange reserves (us$bn) government debt as % of gdp policy rate forecasts exchange rate forecasts euro crosses dollar crosses disclosure appendix goldman sachs global economics, commodities and strategy research,the global fx monthly analyst 18 18 20 22 24 25 26 27 28 29 30 31 32 33 34 35 35 36 37 38 39 40 41 42 43 43 44 45 46 47 48 49 50 51 52 53 54 57 61 61 63 65 71 72 73,6,5,3,november 9, 2012 recommended fx trade ideas our recommended top trades for 2012,the global fx monthly analyst,trade 1. close protection on the itraxx europe xover index 2. close short 10-yr german bunds 3. close long eur/chf 4. close long s&p tsx vs nikkei, fx unhedged 5. long cny, myr vs gbp, usd 6. close long july 2012 ice brent crude oil futures,opened 30-nov-11 30-nov-11 30-nov-11 30-nov-11 30-nov-11 30-nov-11,at 759 2.28 1.226 100 100 107.80,now at n/a n/a n/a n/a 101.5 n/a,potential gain -3.4 % -3.5 % -1.7 % 4.70 % 1.50 % 11.6 %,tactical fx trade performance 2012,number,cum return,avg return,avg duration,all trades profitable loss-making,11,6.7% 16.9% -10.2%,0.61% 2.81% -2.04%,27 days 33 days 20 days,recent tactical fx recommendations,description,day,open,time,day,close,time,open quote,close quote,potential return,long short short short long long,eur usd usd mxn aud basket (nzd, rub, sek, krw, myr, clp),usd myr (expiry 29mar12) php (expiry 04apr12) clp jpy usd,18-mar-11 31-mar-11 07-apr-11 06-jun-11 29-jun-11 10-aug-11,“10:06“ “01:58“ “05:57“ “12:22“ “09:03“ “14:20“,23-sep-11 04-aug-11 04-aug-11 10-aug-11 18-jul-11 14-sep-11,“17:00“ “21:36“ “21:36“ “17:09“ “17:00“ “17:00“,1.4085 3.0660 43.1300 39.9703 85.7802 100.0000,1.3517 3.0270 42.7300 38.2700 83.5749 97.7400,-4.03% 1.29% 0.94% 4.44% -2.57% -2.26%,short usd, eur short aud,sgd, myr jpy,18-oct-11 31-oct-11,“00:11“ “16:02“,01-jan-12 02-nov-11,“00:00“ “16:34“,100.0000 82.7092,99.0000 80.7573,1.01% 2.42%,long short short short long short short short short long long long,rub usd, eur usd usd eur gbp try usd gbp nzd eur eur,huf sgd, myr mxn cad usd nok brl jpy nok usd usd cad,09-nov-11 01-jan-12 25-jan-12 25-jan-12 25-jan-12 22-feb-12 19-mar-12 22-mar-12 15-jun-12 18-jun-12 02-aug-12 22-oct-12,“11:16“ “00:00“ “20:17“ “20:17“ “19:43“ “18:15“ “12:24“ “14:19“ “12:52“ “01:23“ “17:55“ “22:02“,06-dec-11 18-jan-12 15-feb-12 10-feb-12 15-feb-12 14-mar-12 17-apr-12 06-jun-12 16-jul-12 21-jun-12 19-sep-12 07-nov-12,“17:00“ “12:36“ “13:35“ “17:00“ “13:35“ “15:29“ “16:42“ “14:04“ “17:00“ “19:54“ “11:30“ “17:00“,7.4200 99.0000 13.0300 1.0056 1.3059 8.8696 1.0000 82.8900 9.3319 0.7906 1.2153 1.2959,7.1550 97.1702 12.7387 1.0016 1.3086 9.1208 1.0336 78.9800 9.5215 0.7877 1.3021 1.2722,-3.57% 1.88% 2.29% 0.40% 0.21% -2.75% -3.25% 4.95% -1.99% -0.37% 7.14% -1.83%,source: goldman sachs global ecs research please see our global markets daily and trade updates for changes in these live trading strategies, as they change in line with market developments and our views. goldman sachs global economics, commodities and strategy research,4,november 9, 2012,the global fx monthly analyst,risk scenarios and idiosyncratic fx moves average fx volatility has declined further and is now at levels only seen very briefly before the global financial crisis. the impact on individual currencies of swings in global risk sentiment is becoming smaller and investors tend to focus more on idiosyncratic moves as a strategy to generate returns. in that context, we review some of the most interesting country-specific stories in fx, which we broadly classify into directional views: currencies where we see a notable skew in risks and non-stories where the market may be disappointed relative to expectations. beyond the focus on idiosyncratic moves, it is also important to monitor risks that could potentially lead to a sudden rise in fx market volatility. we have discussed these risks in the past and continue to focus on the us fiscal cliff as a potential source of temporary risk aversion. 1. volatility at new post-crisis lows volatility continues to decline in fx markets and has now reached levels that have not been seen since the heyday of fx carry (and vol selling) in the years preceding the global financial crisis (gfc). our transaction-volume-weighted gx fx volatility index over a three- month window currently stands at 6.6% realised and 7.4% implied. lower average levels of volatility have only been seen from mid-2006 to mid-2007. exhibit 1: real and implied fx volatility* remain low,30 25 20 15 10 5 0,realized volatility implied volatility,2000,2001,2002,2003,2004,2005,2006,2007,2008,2009,2010,2011,2012,*transaction volume weighted average 3-month volatility across the most liquid g10 and em exchange rates. source: gs global ecs research, bank for international settlements (bis) to some extent these low levels of volatility are a reflection of the fact that the global macro picture is uninspiring. emerging evidence of improving cyclical dynamics, as reflected in our global leading indicator (gli), is offset by expectations of slower trend growth in china and prolonged fiscal contraction in europe. reflecting these offsetting influences, cyclical assets and risk sentiment have stabilised after decent rallies since the middle of the year, and this stabilisation in risky asset performance has likely translated into reduced fx volatility. another influence has been increased fx policy activism; some historically volatile currencies, such as the brl or try, stand out as particularly heavily managed at the moment. beyond direct fx intervention, increased activism by policymakers to reduce volatility in other asset classes also affects exchange rates: fed qe3 purchases of mbs on an open-ended basis, the ecb standing ready to buy short-dated government bonds, bans on naked cds, to name but a few. goldman sachs global economics, commodities and strategy research,5,november 9, 2012,the global fx monthly analyst from an fx investors point of view, the question is how to position in this low volatility environment. we think two strategies are fundamental. first, risk scenarios need to be tracked, as a sudden adverse shock to risk sentiment could lead to a similarly sudden rise in fx volatility. in recent fx monthlies we have highlighted some key risks into year-end. of these, the fiscal cliff is now the main concern. the second strategy is to focus on idiosyncratic developments, i.e., currency-specific drivers that have been less important for investors in recent years. a large part of finding fx strategies in the years since the global financial crisis has been the ability to catch the latest swing in risk sentiment because a large number of currencies mechanically responded to risk-on/risk-off. in this context, we have repeatedly illustrated the high correlation across currencies. however, if volatility remains low more permanently, the importance of changes in risk aversion will likely decline relative to the country-specific forces. put differently, the signal-to-noise ratio improves in a low volatility environment and country factors suddenly matter more than global risk sentiment. a good example is the recent divergence between the inr and the zar, two relatively high beta currencies, which diverged sharply in performance on the basis of country-specific factors. we will discuss a selection of country-specific dynamics in a separate section below. exhibit 2: our gli points to an improvement in the global cycle 20 15 10 5 0 -5,-10,gli headline,-15 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 source: imf, national sources, gs global ecs research high volatility has historically been the enemy of carry strategies, as these have underperformed pretty systematically during periods of risk aversion. and low volatility has historically been associated with relatively high fx carry returns and even higher sharpe ratios. but, interestingly, this no longer holds. despite near-record-low volatility in fx markets, diversified carry strategies continue to perform badly, as can be seen in exhibit 3. our fx carry basket has essentially been flat-lining since 2009. the fact that low volatility has been accompanied by very low interest rates across the board has reduced a key source of carry returns. to some extent, this is a tautology but much of the academic research on carry returns focuses on volatility and risk aversion, and much less on interest rate differentials. while average interest rate differentials remain as low as they are currently, it will remain challenging to see the performance of fx carry strategies improve notably, in our opinion. goldman sachs global economics, commodities and strategy research,95,6,november 9, 2012,the global fx monthly analyst,exhibit 3: fx carry returns remain low 255 235 215 195 175 155 135 115 goldman sachs fx g10 & emerging markets carry index 75 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 source: goldman sachs global ecs research. 2. the dollar and the fiscal cliff in the last couple of fx monthlies, we have highlighted a couple of key risks into year-end and into early 2013. in particular, we highlighted an escalation of the euro area crisis, an escalation of geopolitical tensions in the middle east and the fiscal cliff in the us. the latter in particular has the potential to lead to broader usd strength initially, potentially followed by a similarly sharp sell-off in the dollar. the logic of this price action closely follows the pattern of markets temporarily losing confidence in the ability of polarised policymakers to compromise. during this period it may look as if the fiscal cliff is becoming reality and that the economy could face a negative fiscal shock of up to 5% of gdp. the temporary negative response in cyclical assets would likely also trigger a broader usd rally. after that, when policymakers do find a compromise, possibly helped by the market concerns reflected in cyclical asset weakness, risk sentiment could improve rapidly and the usd would weaken again. the election outcome in the us keeps the current split in place between a democrat president and senate versus a republican house. with both parties having clashed repeatedly on fiscal policy in the past, it is possible that substantial obstacles remain before a compromise on the fiscal cliff can be reached. in other words, the likelihood of a disruptive fiscal cliff scenario materialising has increased after the election, at least temporarily. and, in any case, the fiscal drag is likely to become greater after the election outcome, as highlighted by our us economists. in order to quantify the potential fx impact of the fiscal cliff, it is difficult to run formal regressions, partly because there have been too few episodes with sufficiently comparable characteristics. in fact, there has possibly been only one: the debt ceiling debate and rating downgrade in mid-2011. during that period, the spx fell by about 14%, while the trade- weighted usd rallied by about 7%. interestingly, the moves were not perfectly synchronised and the majority of the dollar rally occurred about a month after the sharp stock market sell-off. goldman sachs global economics, commodities and strategy research,7,november 9, 2012,the global fx monthly analyst,3. idiosyncratic fx developments despite the decline in overall fx volatility, there have been a number of interesting country-specific developments. each of these has already triggered, or could potentially trigger, some localised trends independent of broader risk sentiment. the easiest way to categorise these trends is in three groups: actual directional views (czk, rub, zar) skew in risks (clp, inr) non-stories where the market may be disappointed (try, brl, cny, jpy) among the directional views, the rub looks to be one of the most attractive currencies, due to strong fx fundamentals and likely further tightening in financial conditions. the czech national bank has just shifted to a stance that explicitly recognises the desire for weaker fx and will likely intervene. and in zar, we think a full reversal of the recent price action is likely once the industrial dispute is settled. among the skew-in-risks cases, the clp stands out because it has outperformed copper prices by a notable margin and the central banks are unlikely to tolerate more clp strength in addition. that said, there may not be an immediate catalyst for weakness. in india, the strong inr rally after a bunch of reform announcements has triggered a temporary pick-up in capital inflows, but now the risk is disappointment in the implementation phase. at the same time, already large trade deficits continue to grow. finally, among the non-stories, we have seen strong focus on the potential for the try and brl to appreciate as activity recovers in both countries. however, the authorities in both countries seem fully committed to preventing any appreciation in the coming months and, possibly, quarters. we also think the hurdle for additional rapid cny appreciation is much higher since $/cny has hit the strong end of the daily trading range. in japan, we seem to face another speculative move higher in $/jpy, with relatively little change in underlying fundamentals. although we see the case for jpy weakness at some stage as reflected in our 5-year forecasts, it is unlikely to be a sharp move higher as a continuation of the recent price action. more detail on country-specific developments below, which follows the ordering in the bullets above: policy choices dictate further czk weakness: the czech republic is a small open emerging economy with a monetary policy constraint mostly encountered in g3 economies currently: as growth dynamics deteriorate, the already wide output gap widens further, yet nominal rates are constrained at the zero bound. more specifically, the czech economy has contracted by around 1% so far in 2012 and the 2013 recovery is expected to be unimpressive given external demand trends. our assessment is that the output gap is still wide, at close to 2% of potential outcome, and the prospects of a rapid closure of the gap are weak. the economy clearly needs easier policy. the central bank recently cut the repo rate to 0.05% from 0.25% earlier and has narrowed the interest rate corridor by pushing down the lending rate from 0.75% to 0.25%. however, the room for the czech national bank to employ traditional policy instruments is becoming more limited. moreover, the czech national bank is unlikely to resort