How to Position for the Coming Year

For the third time we present our FX Top Trades for the coming year. In 2010 and 2011 our top trades delivered an average return of 3.7% and 3.5%, respectively, with a hit ratio of 80%. Like the last two years, the trade ideas are based on a number of global themes. In 2012, we assume that: (i) recession fears are excessive, (ii) global monetary easing will continue, (iii) the EMU crisis will continue but the euro will not break-up, (iv) volatility will stay high, (v) the dollar will face a structural headwind and (vi) we will see continued FX interventions. In the table below, we list 10 trade recommendations and
plot them against different themes.

There is no hedging or portfolio element built into the 10 trades and the return potential is based on a risk/reward ratio of approximately 1:2. We present six spot/forward trades and four option-based recommendations. The latter are used primarily to utilise attractive option market pricing, express a view on volatility or lower spot exposure or hedge tail risks in our trade recommendations. Often we run an active trade management and reserve the right to book profits or take losses at any time should the underlying fundamentals change. We plan to follow up on the trades with P/L updates and so on.

In general, for the third consecutive year we take a non-bearish view on the market, though this time we are more cautious. We are certainly not overly optimistic about growth or risk appetite with the eurozone in recession and the debt crisis still roaring its ugly head but we do argue that an overly negative economic and financial outlook is priced into financial assets. Indeed, we see some similarities to the beginning of 2009, when the market feared a severe economic depression that never materialised. However, that said, we have this time included option strategies that take a more cautious view on the market. The last two years have also taught us that guarding against tail-risk events is
important.

See also the presentation FX Top trades 2012, 14 December (easy accessible overview of the trades).



Looking back at our 2011 Top Trades

Our FX Top Trades for 2011 were overall quite successful, with eight out of 10 trade recommendations resulting in a profit. The hit ratio was equivalent to the one we had in 2010.

The average profit of our Top Trades for 2011 was 3.5%, just a little lower than the 2010 figure of 3.7%. In our view, this is good in a year with risk sentiment in the driving seat and so many unexpected events. Our spot strategies generally performed better than our option strategies but many of the trades could have been done in either the spot or the option market. We managed the trades actively and booked profit when judged it was appropriate – an approach we intend to maintain in 2012.

This year has in many ways been a strange year; despite big moves where several currency pairs reached uncharted levels, most ended up almost unchanged on a year ago. Year to date, nine out 10 currencies in the G10 have moved less than 3% against the euro – only the JPY has appreciated more, with a 5% return for 2011. Expected volatility is about the same as it was late last year.

Our best-performing trade recommendation was short TRY/BRL from 1.132. We booked an 11% profit when we met our target at 1.00 in late May but, in retrospect, we should have moved the target as the pair fell below 0.90 in August, i.e. for what could have been a 20% profit. However, a bird in the hand is often worth two in the bush. The second-best performing trade recommendation was a bought 3M 11.15 GBP/SEK put option financed by two sold call options. We closed the first half early because the trade made a flying
start but let the other half run to maturity. In total, that yielded 6.9%.

Our commodities basket (long AUD, MXN, RUB versus short GBP, JPY, USD)
delivered a nice 5.7%, while our bearish 6M USD/CHF seagull generated 4.6%. Worth mentioning is also our recommendation of buying NOK versus selling CZK, which had a rough start but ended up delivering a 4% profit. The timing was excellent, with our recommendation to buy a 6M 1.40 EUR/USD call when the pair was trading around current spot; the pair peaked at 1.48 in early May and has retreated almost ever since. Two trades did not perform well: our 3M/8M 86.5 USD/JPY calendar spread and our bought 1Y 260.75 EUR/HUF put option. Safe-haven demand and rising risk aversion resulted in JPY appreciation despite it already trading at expensive levels. We – and most
others – must eventually realise that it is notoriously difficult to trade the JPY due to its many peculiarities. Hungary had to get IMF help and the HUF lost 8% against the EUR, which was not our central projection.


Theme #1: Excessive recession fears

According to the OECD composite leading indicator framework, the global economy has entered a „slowdown phase‟ – characterised by below-trend and decelerating growth. This is the most negative of the four business cycle phases and tends to be associated with underperformance in risk assets, lower bond yields and higher volatility. An important question for 2012 is, therefore, whether the global macro environment will continue to weigh on risk assets? In our opinion, not necessarily.

This is not because the global economy is expected to see a strong recovery – almost certainly it will not – but because markets have already discounted a European recession and weak global growth – not only on the currency market but also across asset classes.

Calculations performed by Danske Equities show that the US and European stock markets are pricing >50% probability of not only a global recession but also of a decline in global growth to just 1%. On the currency market, long dollar positions as reported in the IMM data are near record levels and above the starting point for the past two recessions (see chart below) and on the money market German T-bills are trading with negative interest rates. Overall, market positioning appears fairly stretched, with investors very underweight risk.



As a result, it might only take a stabilisation in global macro data to trigger relief in risky assets – and a stabilisation at low growth levels is exactly what our Economic Research team forecasts. The European recession is expected to deepen but we still look for the US economy to sustain positive growth rates. US economic data has indeed surprised positively over recent months and, while it remains too early to call a trough in the Asian slowdown, we doubt that Emerging Markets growth will slow enough to trigger a global recession.

The absence of a global recession does not imply a recovery in economic data, however, and overall we expect the bearish macro environment to remain going into Q1. As a result, we recommend taking only selected and smaller than usual risk-on positions near term – at least until more clarification has been reached on the EMU debt crisis. Consider scaling into risk-on positions.

With Europe in recession and EMU tail-risks likely to remain, we doubt that 2012 will prove as positive for risk assets as 2009 and 2010. However, investor positioning is already stretched and, in our view, the market is pricing in too high a probability of a global recession. We expect a stabilisation in macro data during 2012 to provide moderate support to risk assets and thereby also FX carry strategies, as well as the cyclical currencies being supported by the strongest fundamentals.

Theme #2: Global monetary easing

It was not generally expected that central banks globally would ease monetary policy in 2011. However, as the economic outlook deteriorated in Q3, it became clear that monetary conditions were too tight to deal with the renewed threat of an economic downturn – at least in an environment of general fiscal tightening. Going into 2012, it is widely expected that further monetary easing will be applied around the globe, which leads to the questions: how will monetary conditions be eased further, who will ease the most and what impact will global monetary easing have on exchange rates?

As US growth is likely to be decent next year, the Fed is not expected to loosen monetary policy further in the near term. Unemployment remains well above the structural level, however, which implies that additional stimulus during 2012 should not be excluded – indeed, this appears very likely when looking beyond the next couple of months.

The Bank of England (BoE) is likely to continue with its quantitative easing programme, which is due to amount to £400bn by the end of 2012. Undoubtedly, in our view, this would weaken the pound and add to inflation. Effectively, the BoE is targeting nominal GDP growth but still communicating commitment to the inflation target of 2%.

The Swiss National Bank could very well lift the floor under EUR/CHF, as the franc remains too strong and deflationary risks persist. The Bank of Japan is probably paying close attention to the Swiss experience and could well introduce a de facto floor below USD/JPY. An escalation of asset purchases and FX interventions would, however, be likely to be employed first.

The Swedish Riksbank and Norges Bank are likely to use only traditional central bank measures and reverse the tightening conducted from late 2009 to early 2011. In our view, the SEK and NOK will naturally be at risk as central banks cut rates and the eurozone backpedals but remains protected due to steady economic growth and healthy balances.

We expect the Danish central bank to follow the European central bank closely but respond swiftly by reversing the latest rate cuts if the current high demand for DKK abates.

The actions of the ECB in 2012 are by far the hardest to predict. We feel certain that the ECB will deliver at least one more 25bp rate cut and remain confident it will keep official rates low in both 2012 and 2013. The ECB is likely to be reluctant to introduce a much more aggressive bond-buying programme but the question is how long the ECB can afford not to cushion a potentially deep recession. We apply a positive probability to a European QE programme in 2012, as the ECB has done less than other central banks to boost the economy and thereby has greater potential. Perhaps somewhat counter intuitively, such a programme could strengthen the euro if it reduces the heightened risk premium, currently attached to the euro.

The recent actions of six of the major global central banks to cut the funding cost of dollar liquidity shows that central banks are not out of ammunition as sometimes reported. Some central banks can still cut rates and all can apply more quantitative easing, despite already having done much. New monetary policies are being considered – nominal GDP targeting and employment targeting are candidates to replace inflation targeting. An active central bank approach to exchange rates to address imbalances is becoming more accepted internationally. We believe central banks will be even more innovative in 2012 than in 2011; certainly, in our view, this represents a big event risk in the currency market.


Theme #3: EMU crisis to continue but EMU break-up is not expected


This has been the hardest year for the euro ever. The eurozone has been on the verge of collapse and financial markets lost confidence in several member states‟ ability to service soaring debt levels going forward. What started in 2010 as a small problem with Greece spread to the peripheral countries about a year ago and has now infected the very core of the eurozone. Politicians have continually underestimated the seriousness of the situation and so far have failed to deliver a convincing and sustainable solution to the crisis. The emergency institutions are, in the markets, generally perceived as being too small and insufficient to deal with a large-scale crisis, which means that the eurozone crisis will remain an important theme also in 2012.

The ECB has been reluctant to rescue the struggling eurozone members and has only done what has been absolutely necessary for most of the year. It tightened monetary policy in H1 and has only just recently lowered the benchmark rate to the level from the beginning of 2011. It has undertaken several non-standard measures but resisted buying government bonds in large amounts. GIIPS bond levels remain at unsustainable levels and 2012 funding programmes are at risk. We expect the ECB to play a more active role in 2012 and follow a broader mandate. Quantitative easing may replace credit easing.

Arguments against a euro break-up

Over recent months we have repeatedly been asked how likely a EMU break-up is and what the financial implications would be? Most likely, we will still be asked these questions in six and 12 months. However, it is dangerous to focus only on that tail-risk.

Indeed, in our view, multiple sovereign defaults, a much deeper recession, or accelerating sell-off in the Italian and Spanish bond markets could easily prove more negative than a break-up scenario where just one EMU member leaves. For now, here are some arguments against an EMU break-up.

The economic and financial impact of a euro break-up would be worse than the
collapse of Lehman Brothers, which led to the most severe credit crunch in modern history. A global recession would be highly likely.

There would be no winners from a euro break-up. Costs would be significant. Negatives would be notable for both peripherals and core countries. The euro still enjoys political support and most eurozone countries appear willing to give up more sovereignty.

The euro may split though; an exit would however be very risky and potentially very costly for any country, perceived strong or weak. EMU tail risks are likely to stay with the market throughout 2012, which supports our themes of high base volatility and a barrier to risk asset upside. On the currency market, a sustained EMU crisis is likely to translate into sustained JPY support – an accelerated
EMU crisis could see JPY demand spike significantly – and for the coming months also EUR/USD downside.

The euro crisis also implies that tail risk will remain even in a bullish market scenario. As a result, we recommend paying the additional cost of hedging the tails when trading euro-sensitive currency pairs. This is why we pay to have a known worst-case loss in our USD/JPY trade and why we recommend a higher notional on the bought EUR/CHF put option in the Swiss deflation trade option alternative.

Theme #4: High base volatility

Looking back on developments in the FX option market in 2011, what strikes us as somewhat surprising is the relatively modest change in implied and realised volatility.

Despite financial markets being hit by multiple shocks – including the Arab spring, the Japanese earthquake, the US debt crisis and the EU sovereign sequel, realised volatility has been nowhere near the levels seen during the height of the financial crisis in 2008.

While demand for insurance has caused implied FX volatilities to trade at a sizeable premium for most of the year, the current level is hardly remarkable in a historical perspective.

There are signs, however, that the directional bias priced on the option market has become increasingly stretched. Looking at volatility adjusted option skews, the pricing in several EUR crosses is currently trading at or above 2 sigmas from their historical mean.

Looking ahead at 2012, the tug-of-war between slowly improving global macro data and high event risk stemming, among other things, from continued sovereign deleveraging, is likely to imply significant swings in the overall level of FX volatility. We expect the global economy to balance on the verge of a slowdown, which is also confirmed by the latest reading on the OECD leading indicator falling below 100. We have looked into the behaviour of realised volatility in the most liquid currency pairs through business cycles since the mid-1970s (using the ECU before the introduction of the EUR). As shown in the
lower chart, the slowdown phase is generally characterised by an above- verage level of currency fluctuations, with realised volatility being 1-3 percentage points higher than in other business cycle stages.

Given this macroeconomic backdrop, we expect even in times when the global economy is not hit by new shocks and when risky assets offer stable performance that the overall level of implied volatility will not correct significantly lower. In other words, the base of volatility is likely to be fairly high, in our view. As euro debt concerns are likely to stay in focus throughout the year, we do not expect a correction in the current significant directional bias priced in on option markets.

Despite numerous shocks to the global economy in 2011, realised volatility was actually quite modest. In the coming year, there are numerous sources of uncertainty and downside risks to global economic growth remain significant. With leading indicators indicating a slowdown in the major economies, the cyclical picture points to an elevated base level of realised volatility. By implication, this points to value in trades that benefit from high volatility. A further implication is that investors putting on directional trades in 2012 be ready to accept fairly wide stop-loss levels.

Theme #5: Structural dollar headwind

The dollar spent most of the last decade in a steep depreciation trend seeing a cumulated decline in the DXY dollar index of more than 30 percent from 2001 until 2010. This structural downtrend was interrupted only by temporary dislocations in relative monetary policy and the introduction of the Homeland Investment Act (2005) and the onset of the Great Recession (2008).

The causes of the structural dollar weakness were many and included the correction of a valuation misalignment (EUR/USD traded more than 2 standard deviations below PPP in 2001), a persistent current account deficit that could not be funded by long-term capital inflow (the US BBoP deficit reached more than 5% of GDP in 2009), a strong commodity bull market and on average easier monetary conditions. This depreciation trend slowed, however, with the financial crisis of 2008 and the DXY index has gained 13% since its trough. This leads to the question, how will the dollar perform in the year to come?


In the absence of a global recession and a euro tail-risk event, we expect the dollar to weaken – though by only about 4% in DXY terms. This is not because we are very bullish on risk assets but rather because we still expect weak US fundamentals to drive a dollar depreciation trend in a „normal‟ risk environment.

The US economy not only continues to run a BBoP deficit but the US policy mix also remains dollar negative. Fiscal policy is being tightened in an environment where Congress is unable to reach consensus and monetary policy is expected to be eased further – with a change in the Fed‟s communication tools as a likely first step. Assuming that global macro data stabilise during 2012, this should be sufficient to drive the dollar weaker against the strongest currencies (CAD, AUD, NZD, SEK and NOK) – especially considering that long USD positions are very stretched according to IMM data.

Whether the dollar will also weaken against the euro is a more open question but under the above assumption (no global recession and euro tail-risk events) we would look for EUR/USD to end 2012 higher. Short-term risks are on the downside, however, and we continue to expect EUR/USD to move below 1.30 over the coming months until the new ECB monetary policy regime is fully priced.

We expect weak US fundamentals to drive the dollar weaker in a ‘normal’ risk
environment. Given the still-high euro risks, however, we prefer to position for this via stronger commodity and cyclical currencies (short USD/CAD, long MXN, SGD, AUD versus short USD). EUR/USD risks are likely to remain skewed on the downside near term.

Theme #6: Continued FX interventions

We entered 2011 with a dominant theme of currency wars, as coined by Brazil‟s finance minister Guido Mantega in the autumn of 2010. At that time, the high interest rate countries and large capital inflow recipient countries such as Turkey, Brazil, South Africa were, through various interventionist policies, battling to halt or reverse the strong trend of currency appreciation in the face of quantitative easing in the US.

However, the manufacturing soft patch was exacerbated by the tsunami and with subsequent production disruptions in Japan in the spring, entering H2 the eurozone debt worries became steadily elevated. Therefore, the trend of attempting to ward off currency strengthening in many of the interventionist countries reversed to give away to currencysupportive measures. While some countries engaged in outright interventions in the currency markets (e.g. Russia and Poland) others were using a host of other measures combined with FX reserve sales to curb the pace of currency depreciation. Turkey, for example, initiated a new direction for its unorthodox policies that saw the combination of
reserve rate requirements cuts and use of the o/n rate corridor and FX auctions augmented by direct interventions to support the lira.

However, in both Japan and Switzerland efforts throughout this year have been aimed more consistently towards resisting the strengthening tendency of the two low-yielding, “safe haven” currencies. Japan has intervened four times since September 2010, most recently in October 2011. Both the BoJ and Japan‟s finance ministry regard a stronger JPY as one of the greatest threats to the recovery in the wake of the earthquake. Hence, as in Switzerland, monetary policy in Japan is also increasingly being driven by exchange rate developments with quantitative easing being used to back up intervention in the FX market. Also, the Danish central bank has intervened heavily during 2011 to mitigate the significant flow into Danish bonds and assets.

The purpose of Japanese intervention is officially to stem the appreciation of JPY but in reality the policy is close to attempting to put a floor under USD/JPY. While intervention has not yet used the “big bazooka”, intervention has gradually intensified. We expect Japan to defend aggressively mid-70 levels against the USD and cannot rule out the possibility that the BoJ will eventually use the “big bazooka” – i.e. do a quarter of half Switzerland.

As we enter 2012 and the capital flows seeking “safer” destinations continue to
accompany successive bouts of risk aversion, the interventionist dynamics seen in H2 11 are likely to persist. As the “intervention noise” persists in the background, the tasks of currency risk hedging as well as directional speculation become all the more challenging.

In this respect, we see value in long volatility exposure through bought currency option exposure, as featured in a good number of our strategies. Furthermore, we expect a more ambitious target for the SNB – with the minimum target being lifted over the next six months. With FX intervention set to remain part of the market reality in the coming year, volatility in those currencies that are subject to interventionist policy can also be expected to remain elevated. Hence, long gamma exposure through bought option exposure can be expected to benefit from the elevated volatility base, while also assisting in navigating the significant day-to-day fluctuations and expanding daily trading ranges.