CME Group Currency Market Monitor Q4 2012

CURRENCIES

Currency Market Monitor 4th Quarter 2012

JANUARY 11, 2013

John W. Labuszewski Sandra Ro Bluford Putnam

Managing Director Executive Director Chief Economist

Research & Product Development

312-466-7469

[email protected]


011 (44) 203-379-3789

[email protected]


212-299--2302

[email protected]

1 | Currency Market Monitor 4th Quarter 2012 | January 11, 2013 | © CME GROUP

An ongoing debate has long persisted in the global

currency or FX markets – is FX an “asset class” akin

to stocks and bonds? While practitioners and

academics may debate this point at length, perhaps

the most practical answer is – does it really matter

provided that investors may draw a return from

currency investments?

The performance of the currency or FX markets is

found in the exchange rates and cross-rates

associated with the world’s myriad currencies. The

total return associated with a currency is driven by

interest income associated with fixed income

instrument investment in the particular currency; as

well as pure price performance.

Many fundamental factors, including national

economic conditions, monetary and policies, current

and capital account flows, to name just a few,

impact the returns associated with the world’s

currencies.

This document represents a review of these factors

as they played out in the most recently completed

calendar quarter. We include consideration of the

so-called “carry trade” as well as a look at the

theory of “purchasing power parity” as it impacts FX

markets.

While we cover activity in a broad spectrum of

currencies, we focus on the currencies underlying

some of the most liquid of CME Group FX futures.

This includes the U.S. dollar (USD), Euro (EUR),

Japanese yen (JPY), British pound (GBP), Swiss

franc (CHF), Canadian dollar (CAD), Australian dollar

(AUD) and Mexican peso (MXN).

In addition, we have special interest in the

currencies of significant emerging market economies

including the Brazilian real (BRL), Russian ruble

(RUB), Indian rupee (INR) and Chinese yuan or

renminbi (CNY) – the so-called “BRIC” nations.

Finally, we highlight several CME Group FX Indexes

including a USD Index, a Carry Trade Index,

Commodity Country Index and BRIC Index.

Market Fundamentals

As a general rule, FX analysts will evaluate the

fundamental value of any particular currency by

reference to a number of national economic factors.

These factors including growth and inflation

prospects; monetary and fiscal policies; and, current

and capital account balances.

To illustrate, we include a brief discussion of the

economic situation prevailing in the United States as

of the conclusion of the most recently completed

calendar quarter. Of course, the U.S. dollar (USD)

may be just one side of any currency pair that may

be traded using CME Group FX futures.

A brief summary of economic conditions in various

nations, organized along similar lines, is included in

Appendix 1 of our document below. One may

compare and contrast these conditions as they exist

in the two countries whose currency pairing you may

be interested in to draw an appreciation of the

fundamental factors that impact currency markets.

Growth and Employment

Market action during the 4th quarter 2012 was

colored by the state of the U.S. economy. The

Federal Reserve did a good job in articulating the

major economic issues during the quarter, so we

frame the following analysis accordingly.

In September 2012, the Fed announced its

intentions to “increase policy accommodation by

purchasing additional agency mortgage-backed

securities at a pace of $40 billion per month … [it]

also will continue through the end of year its

program to extend the average maturity of its

holdings of securities … These actions, which

together will increase the Committee’s holdings of

longer-term securities by about $85 billion each

month … should put downward pressure on longer-

term interest rates … [and] … support mortgage

markets.” 1

These policies seem to have exerted some positive

impact as the Fed observed in December 2012 that

“economic activity and employment have continued

to expand at a moderate pace in recent months,

apart from weather-related disruptions. Although

the unemployment rate has declined somewhat

since the summer, it remains elevated. Household

spending has continued to advance, and the housing

1 Federal Reserve Press Release dated September 13,

2012.


sector has shown further signs of improvement, but

growth in business fixed investment has slowed.

Inflation has been running somewhat below the

Committee’s longer-run objective, apart from

temporary variations that largely reflect fluctuations

in energy prices. Longer-term inflation expectations

have remained stable.” 2

Reviewing the Fed’s findings, we see that 3rd quarter

2012 GDP was last reported in December at an

encouraging +3.1% and up from the 2nd quarter’s

anemic figure of +1.3%. The unemployment rate is

generally trending down but up-ticked to 7.8% in

December from November’s read of 7.7%.

While the unemployment rate generally appears to

be headed in the right direction, this optimism is

2 Federal Reserve Press Release dated December 12,

2012.

tarnished by the Bureau of Labor Statistic’s Labor

Force Participation Rate figure. This statistic

continues to slip and is most recently reported at

63.6% in December, down two notches from 63.8%

in October.

Real personal consumption expenditures (PCE) have

advanced remarkably since the height of the

subprime crisis. In fact, the November 2012 PCE

report of $9,686.6 billion represents a new high

water mark for this statistic. But these expenditures

have come at the expense of generally declining

personal savings, reported at 3.6% in October 2012.

It is not entirely clear the extent to which the Fed’s

policy with respect to mortgage financing is

responsible, but the housing market has indeed

shown clear signs of improvement. This is

evidenced by an upturn in housing activity with

building permits, housing starts and housing

completions noticeably improving.

Building permits were reported at 899 thousand

units in November and up 75% from the May 2009

trough of 513 thousand units. Similarly, housing

starts and completions were reported at 861

thousand and 677 thousand units, respectively, and

up 80% and 33% from their lows recorded over the

past several years.

This impetus has further been felt in housing values

where the S&P/Case-Shiller Housing Indexes have

posted some nice gains over the past few months.

While the October 2012 read on the Composite

Index of 10 urban cities remains 29.8% below its

all-time peak observed in June 2006, it has

4%

5%

6%

7%

8%

9%

10%

11%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

Q1 0

5

Q3 0

5

Q1 0

6

Q3 0

6

Q1 0

7

Q3 0

7

Q1 0

8

Q3 0

8

Q1 0

9

Q3 0

9

Q1 1

0

Q3 1

0

Q1 1

1

Q3 1

1

Q1 1

2

Q3 1

2

Unem

plo

ym

ent

Rate

Qtr

ly C

hange in G

DP

Growth and Employment

Seasonally Adj Real GDP Unemployment Rate

Source: Bureau of Economic Analysis (BEA) & Bureau of Labor Statistics (BLS)

1%

2%

3%

4%

5%

6%

7%

8%

9%

$8,900

$9,000

$9,100

$9,200

$9,300

$9,400

$9,500

$9,600

$9,700

$9,800

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Pers

onal Savin

gs R

ate

PC

E (

Bil $

)

Personal Consumption & Savings

Personal Consumption ExpendituresPersonal Savings Rate

Source: St. Louis Federal Reserve FRED Database

0

500

1,000

1,500

2,000

2,500

Jan-0

4

Sep-0

4

May-0

5

Jan-0

6

Sep-0

6

May-0

7

Jan-0

8

Sep-0

8

May-0

9

Jan-1

0

Sep-1

0

May-1

1

Jan-1

2

Sep-1

2

000 U

nits

Housing Activity

Building Permits Housing Starts Completions

Source: Dept. of Housing & Urban Development (HUD)


rebounded 7.0% from its low water mark recorded

in April 2012.

While news on the consumer front has been upbeat,

it is not clear that the business sector has kept pace

with the consumer sector as the Fed observed. The

Index of Industrial Production improved to 97.5090

in November from 96.4932 in October. Still, the

Index remains well below pre-crisis levels in excess

of 100.

Similarly, capacity utilization has rebounded but

remains below the pre-crisis peaks above 80.0%.

The figure was most recently reported at 78.4% in

November and up from November’s 77.7%.

Corporate profitability improved 18.6% from the 2nd

to 3rd quarters 2012 to check in at $1,752.2 billion.

Inflation

These business conditions seem to be contributing to

the controlled inflation the Fed describes in its

December report. November CPI fell to 1.8% on an

annualized basis, down from 2.2% in the previous

month. Much of this was driven by declining energy

prices. Still, CPI ex-food & energy fell to 1.9% from

2.0% on an annualized basis in November from

October.

Monetary Policy

While the Fed observes some improvement in

economic conditions, it nonetheless “remains

concerned that, without sufficient policy

accommodation, economic growth might not be

strong enough to generated sustained improvement

in labor market conditions. Furthermore, strains in

80

120

160

200

240

280

320

Jan-0

0

Nov-0

0

Sep-0

1

Jul-

02

May-0

3

Mar-

04

Jan-0

5

Nov-0

5

Sep-0

6

Jul-

07

May-0

8

Mar-

09

Jan-1

0

Nov-1

0

Sep-1

1

Jul-

12

S&P/Case-Shiller Housing Indexes

Los Angeles San Diego San Francisco

Denver Washington DC Miami

Chicago Boston Las Vegas

New York Comp-10

Source: Standard & Poor's

66%

68%

70%

72%

74%

76%

78%

80%

82%

80

85

90

95

100

105

Jan-0

7

Jul-

07

Jan-0

8

Jul-

08

Jan-0

9

Jul-

09

Jan-1

0

Jul-

10

Jan-1

1

Jul-

11

Jan-1

2

Jul-

12

Capacity U

tilization

Industr

ial Pro

duction I

ndex

Industrial Activity

Index of Industrial Production Capacity Utilization

Source: St. Louis Federal Reserve FRED Database

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

Q1 0

4

Q4 0

4

Q3 0

5

Q2 0

6

Q1 0

7

Q4 0

7

Q3 0

8

Q2 0

9

Q1 1

0

Q4 1

0

Q3 1

1

Q2 1

2

Pre

-Tax P

rofits

(Billions)

Annualized C

hange

U.S. Corporate Profitability

Annual Change Corporate Profits (Bil)

Source: Department of Commerce

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

Jan-0

4

Aug-0

4

Mar-

05

Oct-

05

May-0

6

Dec-0

6

Jul-

07

Feb-0

8

Sep-0

8

Apr-

09

Nov-0

9

Jun-1

0

Jan-1

1

Aug-1

1

Mar-

12

Oct-

12

Year-

on-Y

ear

Change

Consumer Price Index (CPI-U SA)

CPI - All Urban Consumers SA CPI ex-Food & Energy SA

Source: Bureau of Labor Statistics (BLS)


global financial markets continue to pose significant

downside risks to the economic outlook.” 3

Thus, the Fed intends to continue its mortgage

purchasing programs. The Fed further hones its

focus on labor markets, suggesting that if they do

not “improve substantially, the Committee will

continue its purchases of Treasury and agency

mortgage-backed securities, and employ its other

policy tools as appropriate, until such improvement

is achieved in a context of price stability.” 4

The Fed further intends to maintain target Fed Funds

at 0-25 basis points “at least as long as the

unemployment rate remains above 6-1/2 percent.” 5

This linkage of monetary policy with a stated target

for unemployment is quite significant.

Fiscal Policy

The 2013 “fiscal cliff” provided further economic

apprehension in December 2012 as executive and

legislative branches of government struggled to

reach an accord on taxes and spending cuts. By

early January, an agreement had passed both House

and Senate consideration.

This bill includes higher taxes on individuals

reporting $400,000+ and married couples with

$450,000+ in income and increases the dividend tax

from 15% to 20% on those taxpayers.

3 Ibid.

4 Ibid. 5 Ibid.

Consideration of budget issues is, however,

postponed until March.

The fiscal cliff weighed on consumer sentiment as

evidenced by the dramatic decline in the Thomson

Reuters/University of Michigan Index of Consumer

Sentiment. The figure plummeted from 82.7 to 74.5

between November and December 2012. This

decline came despite the fact that household net

worth has been climbing nicely over the past several

quarters. Fading consumer confidence is further

reflected in preliminary reports of disappointing

holiday retail sales. Flying in the face of these

reports, however, is generally strong automobile

sales.

The Federal spending deficit appears to have

stabilized after increasing into the neighborhood of

$1.2-$1.4 trillion beginning in 2009. The 2012

deficit may be expected to fall within the same

general range. Future deficits will be a function of

both economic and political considerations.

The federal government is, of course, aware of the

magnitude of the fiscal situation and has attempted

to curb spending within the context of the so-called

“fiscal cliff” tax and spending negotiations. While

progress has been made to forestall the expiration of

the Bush administration tax cuts as of this writing,

the spending debate has been postponed until March

2013, as discussed above. Further drama may be

anticipated in the form of a renewed debate on the

debt ceiling in coming months as well.

50

55

60

65

70

75

80

85

90

95

100

$40

$45

$50

$55

$60

$65

$70

Q4 0

4

Q3 0

5

Q2 0

6

Q1 0

7

Q4 0

7

Q3 0

8

Q2 0

9

Q1 1

0

Q4 1

0

Q3 1

1

Q2 1

2

Consum

er

Confidence I

ndex

Household

Net

Wort

h (

Tri

llio

ns) Net Worth & Consumer Confidence

Household Net Worth Consumer Confidence Index

Source: U.S. Federal Reserve & FRED Database

-$1,600

-$1,400

-$1,200

-$1,000

-$800

-$600

-$400

-$200

$0

$200

$400

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Federal Surplus/Deficit(Billions USD)


Current & Capital Accounts

In addition to the troublesome fiscal deficit, the U.S.

faces a significant trade deficit as reflected in the

current account balance. While the trade deficit

diminished in the immediate wake of the subprime

crisis, it is growing once again although it has not

yet breached pre-crisis levels. Still, the deficit

strains upwards to 4.0% of GDP in 2011 and the

highest amongst all G10 nations.

Some improvements in these figures seem to be

developing as the trade deficit decreased to $107.5

billion in the 3rd quarter from $133.6 billion in the

first quarter. The decrease in the current account

deficit may be attributed to a declining deficit on

goods and an increase in the surplus on income.

In addition to monitoring current account activity,

we may likewise study capital account flows. The

U.S. Treasury Department’s Treasury International

Capital (or “TIC”) database represents a ready

source of information. This database tracks flows

into and out of the U.S. The data is broken into

foreign stocks, foreign bonds, U.S. stocks, U.S.

corporate bonds, U.S. government agencies and

U.S. Treasuries.

Foreign investors acquired some $432.6 billion in

U.S. Treasuries, on a net basis during the first 10

months of 2012. Clearly USD-denominated

investments, specifically in the form of U.S.

Treasuries continue to be regarded as a “safe

haven” investment despite the unusually low yields

currently prevailing in the marketplace. While the

2012 inflows are unlikely to match the 2009 or 2010

investments of $538.4 and $703.7 billion,

respectively, the number is substantial and

supportive of the Treasury market.

European Sovereign Debt Crisis

In addition to developments specific to the U.S.

economy, the currency markets continue to be

colored by a number of fundamental news events

including the ongoing European sovereign debt

crisis.

German Chancellor Angela Merkel warned in an

address to usher in the new year that “the crisis is

far from over” and that a final resolution of the

issues will require “a lot of patience.” But she

further indicated that “the reforms that we’ve

introduced are beginning to have an impact.”

-$250

-$200

-$150

-$100

-$50

$0

Q1 0

4

Q3 0

4

Q1 0

5

Q3 0

5

Q1 0

6

Q3 0

6

Q1 0

7

Q3 0

7

Q1 0

8

Q3 0

8

Q1 0

9

Q3 0

9

Q1 1

0

Q3 1

0

Q1 1

1

Q3 1

1

Q1 1

2

Q3 1

2

U.S. Current Account Deficit(Billions USD)

Source: Bureau of Economic Analysis (BEA)

-$800

-$300

$200

$700

$1,200

2003

2004

2005

2006

2007

2008

2009

2010

2011

Thru

10/1

2

Net US/Foreign Capital Flows (Billions USD)

US Treasuries US Gov't Agencies US Corporates

US Stocks Foreign Bonds Foreign Stocks

Source: U.S. Treasury TIC Database

1.20

1.25

1.30

1.35

1.40

1.45

1.50

Jan-1

1

Mar-

11

May-1

1

Jul-

11

Sep-1

1

Nov-1

1

Jan-1

2

Mar-

12

May-1

2

Jul-

12

Sep-1

2

Nov-1

2

Euro/US Dollar Exchange Rate


Germany has, of course, taken on the bulk of the

burden in funding the European Stability Mechanism

as a standing bailout fund. That move, along with

the European Central Bank’s plan to purchase

soveriegn debt securities – a European quantitative

easing program if you will – has gone far to stabilize

the region and bolster the value of the Euro during

the latter half of 2012.

This is in evidence when one considers that the

Greek stock market turned in the top performance of

all Eurozone nations in 2012. The ATHEX index of

Greek equities closed out the year +33%,

surpassing the +29% performance of the German

belwether DAX Index in 2012. Still, the ATHEX

remains well above its peak of few years ago.

Price Performance

These factors exert an obvious impact upon the

price performance of the U.S. dollar vis-à-vis other

world currencies. In order to monitor this price

impact, CME Group has developed the “CME USD

Index” as one in a family of similarly constructed FX

Indexes. 6

The CME USD Index generally declined during the 4th

quarter 2012 as European sovereign debt fears were

quelled. Further, concerns about decelerating

6 The CME USD Index represents a basket of equally

weighted positions (as of December 31, 2010) of the USD vs. the Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar (AUD) and Chinese yuan (CNY). It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.

growth in the so-called emerging markets such as

China seems to be abating in recent months. Thus,

investors have become increasingly willing to move

funds out of USD-denominated investments.

Thus, our USD Index remains is hovering just below

1,000 or its (arbitrarily established) value as of

December 31, 2010 and near the bottom of the

range established from 2007 through the conclusion

of the 1st quarter 2011. This long-term USD

weakness may largely be attributed to the weight of

the dual U.S. fiscal and trade deficits as discussed

above.

Total Return

One of the most popular long-term FX trading

strategies over the past decade is known simply as

the “carry trade.” This practice simply suggests

that one might exploit “cost of carry” by borrowing

in countries with low nominal interest rates to invest

in countries with high nominal interest rates. Thus,

one might sell the “low-rate” currency and buy the

“high-rate” currency.

Carry trade � Sell low-rate currency &

buy high-rate currency

By so doing, one hopes to capitalize on discrepant

interest rates, and by implication, divergent

investment opportunities, in the two countries. This

strategy further recognizes that total currency return

consists of 2 components, specifically, exchange rate

or price movement plus the accrual of interest.

Total Currency

Return =

Price Movement +

Interest

The implicit assumption is that these interest rate

relationships will endure. As such, carry traders

implicitly discount classical exchange rate theories

by assuming that the interest rate relationships may

endure over extended periods of time. This

suggests that low-yielding currencies that are sold

will not advance; and, that high-yielding currencies

that are purchased will not decline.

Historically, such relationships have been known to

endure for extended periods of time, reinforcing

interest in the carry trade. In particular, vast sums

of money totaling in the trillions of U.S. dollars were

invested in the carry trade, specifically by shorting

900

950

1,000

1,050

1,100

1,150

1,200

1,250

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

Nov-1

2

CME USD Index

Long Short16.7% EUR 100% USD16.7% JPY16.7% GBP 16.7% CHF 16.7% CAD16.7% CNY


the Japanese yen (JPY) and investing in other

currencies including the Icelandic krona (ISK).

Appendix 2 below depicts the total return associated

with various currencies, relative to the U.S. dollar,

during the most recently completed calendar

quarter. Note the South Korean won (KRW) led the

pack with a quarterly return of +4.99%. The KRW

was followed by the Chilean peso (CLP) at +4.40%;

the Russian ruble (RUB) at +3.84%; and, the

Colombian peso (COP) at +3.04%.

The Japanese yen was a major loser during the 4th

quarter 2012 as its value reversed sharply

downward vs. the USD and other major currencies

with a total return of –10.11%. Other currencies

turning in a weak performance during the quarter

included the Indian rupee (-1.77%), the Icelandic

krona (-1.61%) and the South African rand (-

1.21%).

Because the carry trade has become such an

important and widely followed transaction in the

global FX markets, CME Group has developed the

CME FX Carry Index. This novel index is designed to

follow the performance of a basket of currencies that

offer relatively high interest rates and have, at least

on an historical basis, generated favorable total

returns. 7

7 The CME FX Carry Index represents a basket of equally

weighted positions (as of December 31, 2010) which is effectively long a basket including the Australian dollar (AUD), Brazilian real (BRL), Mexican peso (MXN), New Zealand dollar (NZD), South African rand (ZAR) and

Purchasing Power Parity

The theory of purchasing power parity (PPP) dates to

the 16th century and the School of Salamanca but

was further developed in the early 20th century by

economist Gustav Cassel. 8 The theory is based

upon the assumption that exchange rates are in

equilibrium when purchasing power is equivalent in

the two countries.

On a granular level, PPP is based on the “law of one

price” or the notion that identical products should be

priced at the same level in different national markets

adjusted for exchange rates. Typically, this law is

qualified by the absence of significant trade barriers

or other artificial constraints on commerce.

But the theory of PPP expands the application of the

law of one price from any single good or product to

generalized prices in any particular economy as

measured by inflation indexes, e.g., Consumer Price

Index (CPI) or Producer Price Index (PPI). The

implication of this theory is that inflation rates and

exchange rates should exhibit negative correlation.

Turkish lira (TRY) vs. short positions in the USD and EUR. It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010. The long components of the CME FX Carry Index were selected in light of the high local interest rates that prevailed in those countries during the post-financial crisis era through 2010. The short components of the index were identified because of the low interest rates offered.

8 See Cassel, Gustav, “Abnormal Deviations in International Exchanges” (December 1918).

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

USD-JPYUSD-INRUSD-ISKUSD-ZARUSD-CAD

USDUSD-BRLNZD-USDGBP-USDUSD-MXNAUD-USDUSD-TWDUSD-CNYUSD-ARSUSD-TRYEUR-USDUSD-CHFUSD-COPUSD-RUBUSD-CLP

USD-KRW

Carry Return (Q4 2012)

700

750

800

850

900

950

1,000

1,050

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

Nov-1

2

CME FX Carry Index

Long Short16.7% BRL 50% USD16.7% AUD 50% EUR16.7% ZAR 16.7% NZD16.7% TRY16.7% MXN


If inflation

increases �

Currency value

should decline

If inflation

decreases �

Currency value

should advance

Thus, if inflation as measured by an inflation index

increases, the value of the currency should generally

decline to maintain price equilibrium. Similarly, if

inflation declines, the value of the currency should

advance.

The theory of PPP is closely related to another

classic theory that addresses exchange rate values

known as the International Fisher Effect (IFE). This

theory suggests that the disparity between nominal

interest rates in two countries drive the future path

of exchange rates.

Per this theory, one might expect that the value of a

currency with a low nominal interest rate might

increase into the future. Or that the value of a

currency with high nominal rate might decline.

IFE further assumes that real interest rates (i.e., the

risk-free interest rate less inflation) should generally

be equal across countries. This implies that nominal

interest rates and inflation are positively correlated.

If inflation

increases �

Rates

increase �

Currency value

should decline

If inflation

decreases �

Rates

decrease �

Currency value

should advance

The IFE suggests interest rates and exchange

negatively correlated. Similarly, PPP suggests

inflation and exchange rates negatively correlated.

As such, the IFE theory is generally consistent with

the PPP theory.

Putting the classic theory of purchasing power parity

into practice requires a measurement of inflation in

order to calculate the proportion by which any

particular currency is (theoretically) over- or under-

valued relative to the norm. There are three popular

methodologies that have been referenced in this

regard.

• OECD - The Organization for Economic Co-

operation and Development (OECD) provides data

that is useful in this regard by comparing price

changes in a representative basket of goods in

various countries.

• Bloomberg - Bloomberg offers an analytical tool

that is grounded in a very long-term assessment

of inflation, as measured by either CPI or PPI in

various countries extending from January 1982

through June 2000.

• Big Mac - Finally, the Economist’s “Big Mac PPP”

methodology compares the price of a (almost)

universally available product with verifiable pricing

in the form of the McDonald’s Big Mac hamburger

in various countries.

Actually, all three methodologies may readily be

referenced on Bloomberg quotation devices.

Appendix 3 below provides data from all three

methods. Further, we have taken the average of

the three assessments (where available) for a

variety of national currencies and rank-ordered the

set from most over-valued to most under-valued.

Note that the most over-valued currency, per our

methodology, remains the Norwegian krone (NOK)

at +44.25% relative to the USD. Other highly

valued currencies include the Swiss franc (CHF) at

32.68%; the Australian dollar (AUD) at +26.86%;

the Swedish krona (SEK) at +23.29%; and, the

Danish krone at +19.23%. These overvaluations

advanced a bit during the 4th quarter due to relative

weakness of the USD vis-à-vis the Euro and other

emerging market currencies.

Under-valued currencies per our analysis include the

Hong Kong dollar (HKD) at -50.77%; the Polish zloty

(PLN) at -48.43%; the South African rand (ZAR) at

-46.92%; and, the Mexican peso (MXN) at -46.15%.

One might recommend creating “baskets” of several

currencies to buy and sell on the basis of this

analysis in order to diversify risks to a certain

extent. However, it is important to recognize that

currencies might remain in apparent states of over-

or under-valuation for extended periods of time. In

fact, the carry trade as discussed above, takes a

completely opposite approach to the classic PPP

theory by buying high-rate currencies and shorting

low-rate currencies.


Impact of Commodities

As a general rule, the nations whose currencies have

remained top performers over the past decade may

be identified as those whose national income is tied

heavily to commodity production.

Commodity prices have advanced rather sharply

over the past decade as seen in the rise in the value

of energy, grain, livestock, precious metals and

industrial metals. These price advances have largely

been driven by emerging market demand in nations

including China and India.

CME Group has developed the CME FX Commodity

Country Index to follow the performance of a basket

of currencies from nations that rely heavily upon the

exportation of commodities and other raw materials.

To the extent that commodities have been in great

demand over much of the past decade, these

currencies have, on a historical basis, generated

favorable total returns. 9

The 4th quarter 2012 witnessed declining energy

values. Still, the the CME FX Commodity Country

Index exhibited some gains, attributed perhaps

more so to USD weakness in spite of soft commodity

values.

CME Group has further developed the CME FX BRIC

Index to follow the performance of select “emerging

9 The CME Commodity Country Index is constructed to be

effectively long AUD, BRL, CAD, Norwegian krone (NOK), NZD and ZAR vs. a short position in USD. It is (arbitrarily) established at a value of 1,000.00 as of December 31, 2010.

market” economies and their national currencies,

namely the Brazilian real (BRL), Russian ruble

(RUB), Indian rupee (INR) and Chinese yuan (CNY),

that have created much of the demand for

commodities in the world today. 10

The CME FX BRIC Index was essentially neutral

during the 4th quarter but gained some late strength

on abating fears of emerging market economic

deceleration. Still, the BRIC Index is tracking near

the bottom of its long-term range.

Conclusion

CME Group offers a broad array of currency futures

and option contracts covering a wide range of

currency pairings (where one side is the U.S. dollar)

and cross-rate pairings (which do not involve the

U.S. dollar).

These products provide facile and liquid vehicles

with which one may express a view on prospective

market movements. Or, to manage the risks

associated with currency holdings or international

investments during turbulent times.

10 The CME BRIC Index is constructed of equal weightings

of long Brazilian real (BRL), Russian ruble (RUB), Indian rupee (INR) and Chinese yuan (CNY) vs. a short position in the USD. Like other CME FX indexes discussed above, the BRIC Index was equally weighted and calibrated to equal an arbitrary 1,000.00 as of December 31, 2010.

650

700

750

800

850

900

950

1,000

1,050

1,100

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

CME FX Commodity Country Index

Long Short16.7% AUD 100% USD16.7% BRL 16.7% CAD 16.7% NOK16.7% NZD16.7% ZAR

800

850

900

950

1,000

1,050

1,100

1,150

Jan-0

7

Jun-0

7

Nov-0

7

Apr-

08

Sep-0

8

Feb-0

9

Jul-

09

Dec-0

9

May-1

0

Oct-

10

Mar-

11

Aug-1

1

Jan-1

2

Jun-1

2

Nov-1

2

CME FX BRIC Index

Long Short25% BRL 100% USD25% RUB 25% INR 25% CNY


Appendix 1: Summary of World Economic Conditions

Australia Brazil Canada

Growth,

Inflation

& Fiscal

Policy

With China’s growth likely to stabilize in 2013 and global commodity demand to rise, the Australian economy should do well in the

coming year.

Economic growth slowed in 2011, and remained sluggishness in 2012. Lower rates and fiscal stimulus provided in the past year are likely to see their impact in higher real

GDP growth rates in 2013.

Canada’s ties to the US mean that it may benefit from the relatively good expected

performance of the US economy in 2013, now that the US has avoided the worst of the fiscal

cliff.

Monetary

Policy

Short-term interest rates were lowered in 2012 to cushion economic growth without fear

of inflation pressures accelerating. Further rate declines in 2013 are unlikely unless significant currency strength emerges.

The short-term SELIC rate was brought down in 2012 narrowing the premium over the

prevailing inflation rate. Further rate reductions may occur in 2013 if the central bank decides to lean against the wind of

potential currency appreciation.

While the Bank of Canada welcomed the appreciation of the currency through parity with the US dollar, the resulting dis-inflation impact means Canada may need to consider

cutting short-term rates in 2013 given the US Fed’s commitment to zero rates.

Special

Factors

The Australian dollar was once a favorite for the long-side of the carry trade versus the

Japanese yen. With Japan adopting a “weaken the yen” approach to policy, the

Australian dollar may again receive inflows from this source.

The major factor impacting the Brazilian real in 2013 is likely to revolve around the zero interest rate policies of the US, UK, Europe, and Japan, as currency traders expand their

risk appetites for higher rate currencies.

The Canadian dollar may be on the receiving end increased volatility from the coming

debate in the US on raising the debt ceiling. In addition, energy pipeline politics may swing

in favor of Canada in 2013.

China European Union India

Growth,

Inflation

& Fiscal

Policy

Economic growth in 2012 decelerated faster than many had projected or hoped. With new

leadership and a brighter global outlook for 2013, China’s real GDP growth is likely to

stabilize in the 6% to 7% range.

The fiscal austerity related to the sovereign debt crisis will continue to be a major drag on economies within the EU in 2013, even as the debt situation is downgraded from a crisis to a

long-run problem.

Like China and Brazil, India saw a rapid deceleration of economic growth in 2012. India has taken a number of steps in the

direction of policy reform, especially regarding foreign investment, that should work to help

the economy regain its balance in 2013.

Monetary

Policy

The new leadership in China will be putting in place a new head of the central bank.

Expanded bank lending and a push toward more rapid development of financial

institutions is likely.

The ECB is likely to keep short-term rates very low through the year to support the

banking system and to make sure fears of a euro breakup do not come back to haunt the

markets.

The monetary authorities have less scope to lower short-term rates than other emerging

market countries, because of elevated inflation. Nevertheless, rate cuts are possible in 2013, especially if the currency takes a turn

toward appreciation and inflation declines a bit.

Special

Factors

An end to economic deceleration portends a more balanced supply and demand for the RMB, and this may allow for a faster pace toward normalizing the currency in 2013.

Elections in Italy early in the year and in Germany later in the year will add significant

political volatility to the path of the euro.

India has shown some signs of becoming more friendly toward foreign investment. This is likely to help the rupee to appreciate along with other high-rate currencies in response to the very low rates from the US, UK, Europe,

and Japan.


Appendix 1: Summary of World Economic Conditions, cont.

Japan Mexico Russia

Growth,

Inflation

& Fiscal

Policy

Japan’s economy will be hit in 2013 from phased-in rises in the national sales tax. To offset this, additional spending is likely from

the newly elected Government.

With brighter prospects for economic growth in the US economy and with the worst of the

fiscal cliff being avoided, Mexico should benefit from increased trade with its partner

to the north.

Elevated crude oil prices are benefitting Russia’s economy, but an aging population and a difficult

environment for foreign investment suggest slower economic growth in the years to come.

Monetary

Policy

The Bank of Japan will get a new leader in the spring and the BoJ is being pushed to adopt expansive quantitative easing to weaken the

yen.

Currency strength in 2012 may have the lagged effect of helping to reduce inflation

pressures in 2013. The central bank may be able to make further modest reductions in

short-term interest rates.

Russia has accumulated a large quantity of foreign reserves giving the authorities some

firepower to counter any ruble weakness, if they so choose, during periods of oil market weakness.

Special

Factors

Japan’s outstanding government debt load tops the world tables in debt per person. Only the long-term zero-rate policy keeps the debt overhang from becoming a serious challenge for markets. A policy-induced weaker yen

may well spell increased volatility in the JGB market.

Mexico’s currency has emerged as one of the favorites for the long-side of the carry trade, funded by zero-rate short-term US dollars.

Russia’s energy supply dominance of Europe may be challenged over the next 5-10 years if the

natural gas fracking and supply revolution spreads to continental Europe.

Switzerland United Kingdom United States

Growth,

Inflation

& Fiscal

Policy

Switzerland is not immune to the ramifications of the long-term debt problems facing the European Union. Economic growth will be

constrained for another year.

The UK’s fiscal austerity has constrained economic growth. As we start to look toward

future elections, even well down the road, fiscal policy may get a little less restrictive.

US economic growth in 2013 faces some increased fiscal austerity. On the positive side,

the economy was improving in the second half of 2012, the rebuilding effort from Super-storm

Sandy will help growth, and the worst of the fiscal cliff has been avoided helping to build long-term

economic confidence.

Monetary

Policy

As the EU debt crisis has morphed into a long-term problem, the Swiss have little flexibility and are likely continue to keep a lid on the

Swiss franc relative to the euro.

The Bank of England, now led by a Canadian, is likely keep rates very low and focus its

efforts on financial supervision.

The Federal Reserve has set a target of 6.5% unemployment rate before starting to

incrementally raise the federal funds rate. The last rounds of QE may run their course in 2013 and not be renewed. Even so, the federal funds rate is likely to hold near zero for the whole year.

Special

Factors

The post-2008 financial crisis has led to increased regulation of financial institutions all

over the world. Increased regulation poses additional challenges for the traditional model

of Swiss secrecy and the overall role of Switzerland in the world’s financial system.

Tensions between the UK and the European Union are only likely to intensify. Any push by the EU to impose financial transaction taxes will only worsen tensions. UK politics may lead to a non-binding referendum on EU

membership around 2015.

While the New Year’s Day tax deal avoided the worst of the fiscal cliff, the battle over raising the debt ceiling and cutting spending is likely to be bitterly fought. US Treasuries and the US dollar are likely to be volatile as market participants

trade the political winds.


Appendix 2: Select Currency Performance (4th Quarter 2012)

Currency Ticker Spot Quote

(12/31/12) Quote

Convention 3-Mth Rates

(12/31/12)

Current Quarter Year-to-Date

Total

Return1

Spot

Return2

Interest

Return3

Total

Return1

Spot

Return2

Interest

Return3

Argentine Peso USD-ARS 4.9155 USD per 1 ARS 17.75% 2.39% -4.45% 7.16% 14.82% -12.52% 31.26%

Australian Dollar AUD-USD 1.0394 AUD per 1 USD 3.12% 1.02% 0.16% 0.85% 5.93% 1.82% 4.03%

Brazilian Real USD-BRL 2.0516 USD per 1 BRL Na 0.12% -1.23% 1.37% -2.49% -9.00% 7.16%

British Pound GBP-USD 1.6255 GBP per 1 USD 0.48% 0.67% 0.54% 0.12% 5.43% 4.58% 0.81%

Canadian Dollar USD-CAD 0.9921 USD per 1 CAD 1.16% -0.55% -0.85% 0.30% 4.23% 2.94% 1.25%

Chilean Peso USD-CLP 479.20 USD per 1 CLP Na 4.40% -0.94% 1.39% 14.26% 8.42% 5.38%

China Renminbi USD-CNY 6.2322 USD per 1 CNY 4.55% 1.88% 0.87% 1.00% 2.68% 1.03% 1.63%

Colombian Peso USD-COP 1,767.00 USD per 1 COP Na 3.04% 1.90% 1.12% 14.91% 9.71% 4.74%

Euro EUR-USD 1.3193 EUR per 1 USD 0.10% 2.62% 2.59% 0.03% 2.27% 1.79% 0.47%

Icelandic Krona USD-ISK 128.07 USD per 1 ISK 5.90% -1.61% -2.98% 1.42% 0.72% -4.19% 5.13%

Indian Rupee USD-INR 54.9950 USD per 1 INR 8.75% -1.77% -3.88% 2.20% 5.91% -3.51% 9.76%

Japanese Yen USD-JPY 86.75 USD per 100 JPY 0.09% -10.11% -10.13% 0.03% -11.21% -11.34% 0.15%

Mexico Peso USD-MXN 12.8533 USD per 1 MXN 4.85% 1.00% 0.04% 0.96% 12.60% 8.42% 3.85%

New Zealand Dollar NZD-USD 0.8288 NZD per 1 USD 2.80% 0.55% -0.16% 0.71% 9.68% 6.64% 2.85%

Russian Ruble USD-RUB 30.5250 USD per 1 RUB 7.75% 3.84% 2.15% 1.66% 12.51% 5.28% 6.87%

South Africa Rand USD-ZAR 8.4735 USD per 1 ZAR 5.05% -1.21% -1.88% 0.68% 0.13% -4.53% 4.88%

South Korean Won USD-KRW 1,064.40 USD per 1 KRW 2.72% 4.99% 4.41% 0.55% 11.16% 8.27% 2.67%

Swiss Franc USD-CHF 0.9154 USD per 1 CHF -0.29% 2.65% 2.67% -0.01% 2.70% 2.48% 0.22%

Taiwanese Dollar USD-TWD 29.033 USD per 1 TWN 0.87% 1.19% 0.96% 0.22% 5.20% 4.29% 0.87%

Turkish Lira USD-TRY 1.7836 USD per 1 TRY 6.28% 2.45% 0.76% 1.68% 15.78% 6.02% 9.21%

United States Dollar USD 1.0000 USD 0.32% 0.09% 0.00% 0.09% 0.45% 0.00% 0.45%

Notes

(1) Return from price movement and interest (2) Return from currency price movement vs. USD as “base currency”

(3) Return from interest at prevailing 3-month rates or implied NDF rate

Source: Bloomberg


Appendix 3: Purchasing Power Parity (“PPP”) Analysis (as of 12/31/12)

% Over/Under Valued

Currency Ticker Average OECD Bloomberg

(CPI)

Bloomberg

(PPI) Big Mac

Norwegian Krone NOK 44.25% 39.67% 15.52% 77.57%

Swiss Franc CHF 32.68% 35.70% 23.26% 10.12% 61.62%

Australian Dollar AUD 26.86% 36.91% 33.56% 27.94% 9.02%

Swedish Krona SEK 23.29% 26.70% -3.25% -1.68% 71.37%

New Zealand Dollar NZD 20.82% 21.09% 30.02% 36.37% -4.21%

Danish Krone DKK 19.23% 28.12% 16.37% 17.40% 15.01%

Brazilian Real BRL 12.82% 12.82%

Colombian Peso COP 11.26% 11.26%

Euro EUR 10.58% 6.02% 15.37% 13.36% 7.58%

Icelandic Krona ISK 9.95% 9.95%

Canadian Dollar CAD 7.54% 18.92% 15.99% 5.11% -9.86%

British Pound GBP 6.44% 9.58% 13.46% 2.66% 0.05%

Japanese Yen JPY 0.85% 16.51% 1.61% -0.76% -13.97%

Chilean Peso CLP -1.41% -1.41%

Argentina Peso ARS -11.05% -11.05%

Czech Koruna CZK -16.12% -16.12%

Singapore Dollar SGD -16.56% -16.56%

South Korean Won KRW -25.40% -30.38% -20.42%

Turkish Lira TRY -29.22% -64.42% 5.99%

Phillipines Peso PHP -34.10% -34.10%

Thai Baht THB -38.09% -38.09%

Hungarian Forint HUF -41.47% -67.69% -15.24%

Chinese Renminbi CNY -42.13% -42.13%

Russian Ruble RUB -43.82% -43.82%

Indonesian Rupiah IDR -44.28% -44.28%

Malaysian Ringgit MYR -44.28% -44.28%

Mexican Peso MXN -44.50% -53.77% -35.22%

South African Rand ZAR -46.92% -46.92%

Polish Zloty PLN -48.43% -63.67% -33.19%

Hong Kong Dollar HKD -50.77% -50.77%

Notes

Please note that data regarding all countries is not generally available.

Source: Bloomberg


Copyright 2013 CME Group All Rights Reserved. Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a

percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they

can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All examples in

this brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience.”

Swaps trading is not suitable for all investors, involves the risk of loss and should only be undertaken by investors who are ECPs within the meaning of section 1(a)18 of the Commodity

Exchange Act. Swaps are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for

a swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade

because they cannot expect to profit on every trade.

CME Group is a trademark of CME Group Inc. The Globe logo, E-mini, Globex, CME and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. Chicago Board of

Trade is a trademark of the Board of Trade of the City of Chicago, Inc. NYMEX is a trademark of the New York Mercantile Exchange, Inc.

The information within this document has been compiled by CME Group for general purposes only and has not taken into account the specific situations of any recipients of the information.

CME Group assumes no responsibility for any errors or omissions. Additionally, all examples contained herein are hypothetical situations, used for explanation purposes only, and should not

be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME,

NYMEX and CBOT rules. Current CME/CBOT/NYMEX rules should be consulted in all cases before taking any action.

Documents

CME Group Currency Market Monitor Q4 2012