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MORGAN STANLEY RESEARCH

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

November 27, 2013

Currencies
Global

FX Pulse
Selling Season for EUR
Trading FX Markets:
Yield Curves Signal FX Moves. Relative yield
curve shifts are moving to the forefront among G10
FX drivers, as forward rate guidance caps front-end
yields near the effective zero bound. Against this
backdrop, expectations for a taper-driven relative
steepening of the US curve could be a key FX driver
in coming months, lifting the USD broadly. The JPY
and the dollar-bloc currencies are most vulnerable to
a steeper US yield curve, reflecting a combination of
leverage, over-investment and external liabilities.
Disinflation Risks and Monetary Policy. Deflation
risks signal currency downside where central banks
have the flexibility to undertake offsetting policy
easing. We have already entered a long USD/SEK
position, expecting the negative October CPI print to
prompt Riksbank easing in December. Today, we
add a long USD/CHF recommendation ahead of
next week’s Swiss CPI data.
In This Week’s Edition:

Trade Recommendations
Closed Trades
Long EUR/JPY

Entry

Stop

Target

Take profit if hit target 139, stop

Active Trades
Short USD/KRW 1M NDF
Short EUR/GBP
Long USD/JPY
Long USD/RUB
Long USD/SEK
Short EUR/USD
Limit Orders
Buy USD/CHF
Options Trades
Long USD Put/CNH Call

of 138 or close at WMR on 28-Nov-13
Entry
Stop
Target
1063
1080
1000
0.8480
0.8420
0.8100
97.50
99.40
105.00
32.66
32.00
34.60
6.56
6.46
6.90
1.36
1.38
1.27
Entry
Stop
Target
0.9030
0.8880
0.9700
Entry Date Expiry Date
Strike
31-Oct-13
10-Jan-14
6.1000

See page 12 for more details. Changes in stops/targets in bold italics.

MS Major Currency Forecasts
4Q13

1Q14

2Q14

3Q14

1.30
105
1.58
0.95
1.05
0.93
0.83
137
0.82
1.24
8.60
7.70

1.27
110
1.57
0.98
1.08
0.91
0.82
140
0.81
1.25
8.60
7.60

1.25
114
1.55
1.02
1.10
0.88
0.80
143
0.81
1.27
8.50
7.50

1.24
117
1.53
1.03
1.12
0.85
0.78
145
0.81
1.28
8.40
7.55

EUR/USD
USD/JPY
GBP/USD
USD/CHF
USD/CAD
AUD/USD
NZD/USD
EUR/JPY
EUR/GBP
EUR/CHF
EUR/SEK
EUR/NOK

Note: Forecasts for end-of-period. G10 forecasts updated September 26, 2013

EUR has moved back into focus, with EUR/USD
revisiting pre-ECB rate cut levels. As we had
predicted, the 25bp refi cut failed to trigger a durable
EUR-weakening trend, as persistent LTRO
repayments tightened excess reserves, supporting
Eonia. In addition, to reduce their dependency on
ECB funding, Banks are cutting their FX assets in
preparation for the ECB’s Asset Quality Review.
Bank repatriation flows appear to have lifted
EUR/USD well above levels suggested by interest
rate spreads, and we take this opportunity to
establish a short EUR/USD position and take profit
on our long EUR/JPY position. Widening growth
differentials should weaken EUR/USD over the
course of 2014. And concerns that a deflationdriven rise in EUR real interest rates would bolster
EUR appear unfounded – the evidence from Japan
and Switzerland is not compelling.

FX Market Overview

P2

EUR/USD Topping Out

P6

Strategic FX Portfolio Trade Recommendations

P12

G10 & EM Currency Summary

P15

Global Event Risk Calendar

P17

FX Volatility/Carry Grids, Tactical Indicators

P19

MS FX Positioning Tracker

P22

Macro Forecasts

P23

FX Bull and Bear Projections & Forecasts

P24

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

MORGAN STANLEY RESEARCH
November 27, 2013
FX Pulse

FX Overview
Ian Stannard, Meena Bassily
• Relative yield curve shifts are having an increasing impact on
FX markets, we believe…
• …with the CAD and JPY standing out as the most vulnerable
to a relative steepening of the US yield curve. We maintain
our long USDJPY and EURJPY positions.
• Incorporating highly leveraged economies into the equation
suggests that the SEK should also be added to our list of
vulnerable G10 currencies. We remain long USDSEK.
• We also find that the AUD is becoming sensitive to yield
curve dynamics, but shifts in Chinese rather than US yields…
• …thus, we maintain our bearish stance towards AUD as
Chinese financial conditions continue to tighten.
• We believe that EURUSD is now topping out and maintain
our newly established bearish strategy.
• We add a bullish USDCHF recommendation to our portfolio.
• Several EM policy makers have kept to dovish biases, with
the Bank of Thailand and National Bank of Hungary cutting
rates this week.
• The technical backdrop for EM currencies continues to slowly
worsen, and with little evidence of a pick-up in fundamentals,
we keep to a bearish outlook. We stay long USD/RUB.

tapering, especially if accompanied by enhanced forward
guidance, could see the US yield curve steepening (See US
Interest Rate Strategy Insight, Pulling on a String, November
22, 2013). Hence, we maintain our bullish USD stance and
expect gains to be emphasized against the CAD and JPY,
with potential for EURUSD and GBPUSD to come under
pressure.
We also examine the potential vulnerabilities of currencies to
a rise of yields and steepening of yield curves via private debt,
as we believe that countries with higher levels of leverage,
especially where this has been used for unproductive
investment, are likely to be particularly vulnerable. Using
measures such as overall levels of private sector debt, net
international investment positions and growth in investment to
GDP relative to overall GDP growth, we find that the
commodity-related currencies stand out as being the most
exposed, along with the Scandinavian currencies.
Taking these metrics together, we believe that the CAD, JPY
and SEK are likely to be the most vulnerable among the G10
currencies once tapering expectations intensify. Hence, we
maintain our long USDSEK and USDJPY positions and our
short EURUSD strategy. We take profits on our EURJPY long
position and also add a long USDCHF recommendation to our
portfolio this week.
Exhibit 1

Gross Private Debt (% of GDP)
Yield Curve Sensitive Currencies
Relative yield curve dynamics are becoming an important
driver for FX, we believe, with the major currencies now
increasingly sensitive to the relative changes in the slope of
yield curves. While the CAD and JPY remain the most
sensitive of the G10 currencies to relative changes in yield
curves, we note that this is an increasingly important influence
on EURUSD and GBPUSD.
This renewed sensitivity of currency markets to yield curve
dynamics comes in an environment where changes in global
policy are likely to have a significant impact on bond markets.
With many of the G10 central banks continuing to employ a
dovish stance, including various forms of forward guidance to
signal a lower for longer rate policy and to maintain control of
the front end of the yield curve, there is potential for yield
curve steepening to take place. This is likely to be most
emphasized in the US as the tapering debate gains
momentum. The Fed’s QE is one of the strongest forms of
control of the longer end of the yield curve, hence the start of

.

Source: Haver Analytics, Morgan Stanley

AUDCNY Pushing Lower
We identify the AUD as vulnerable from a private leverage
point of view, although the sensitivity of AUDUSD to relative
yield curve shifts is lower than it is among its commoditycurrency peers. However, we find that the AUD is sensitive to
developments in Chinese yields, and the recent rise in

2

MORGAN STANLEY RESEARCH
November 27, 2013
FX Pulse

While the AUD does not show up on our Investment/GDP
growth metric as particularly vulnerable, the extent and
effectiveness of business investment in Australia has been
raised by policy makers as an issue. The RBA noted in its
minutes from the November 5 meeting that investment in the
mining industry is declining and has highlighted that
investment projects are starting to be shelved. Australia’s
investment boom has been led by the resource and mining
industry, which has become highly dependent on demand
from China. The rebalancing of the Chinese economy and the
downward pressure on commodity prices has the potential to
leave some of the most recent investment decisions
appearing to be a misallocation of capital.

view. Sweden also had the highest growth of investment to
GDP relative to overall GDP growth in the last year,
something we view as a potential signal of unproductive
investment, which could also leave the SEK vulnerable in an
environment of less favourable funding conditions. Indeed, we
have already identified the SEK as vulnerable to the
disinflationary pressure being generated in the Eurozone (see
FX Pulse Disinflationary Spillover, November 24, 2013), which
could prompt the Riksbank to take further action, with a
potential rate cut. Indeed, the CPI decline back into negative
territory over the past month has generated increased market
expectations of further monetary policy easing in Sweden.
Our economics team believe that the Riksbank could act with
a 25bps easing as early as the December 17 meeting (see
European Economics Rethinking Central Bank Action,
November 25, 2013), leaving the SEK exposed to the
increasingly negative fundamental backdrop. Hence, we
maintain our bullish USDSEK position.
Exhibit 3

Eurozone and Swedish CPI
4.0

5

Eurozone CPI (y/y)
(RHS Scale)

3.5

4

3.0
3
2.5
2

Percent

Although the Chinese media (e.g., China Securities Journal)
have suggested that the deleveraging process should be
slowed down, this is currently not being reflected in market
developments, and the continued tightening of financial
conditions via both the exchange rate the higher interest rates
will have a direct negative impact on the AUD, in our view.

2.0
1.5

1

1.0

0

Exhibit 2

AUDCNY and Australia-China 10-Year Yield Spread

0.5

Sweden CPI (y/y)
-1

0.0

1.75

7.50

-2

-0.5

1.50

7.25

1.25

7.00

AUDCNY

-1.0

-3
99 00

01

02

03

04

05

06

07

1.00

6.75

Percent

Chinese rates, along with the appreciation of the CNY, have
resulted in a tightening of financial conditions, providing a
negative environment for the AUD. Indeed, Chinese 10-year
yields have continued to push higher, providing support for
the CNY, which is likely to be a negative for the AUD.
AUDCNY is likely to head back to the recent lows in our view
(see Exhibit 2).

08

09

10

11

12

13
Source: Reuters EcoWin

Source
6.50

0.75

6.25

0.50

6.00

0.25

5.75

0.00
-0.25

5.50
5.25
5.00
Apr

Australia-China 10Year Yield Spread

-0.50
-0.75

Jul

Oct
11

Jan

Apr

Jul
12

Oct

Jan

Apr

Jul
13

Oct
Source: Reuters EcoWin

Source: Reuters Ecowin, Morgan Stanley

Leveraged SEK at Risk
Sweden also stands out as a highly leveraged economy with
the highest level of private sector debt in the G10 (see Exhibit
1), where the steepening of global yield curves has the
potential to generate a negative impact on the SEK, in our

CAD: Change of Behaviour
While the major currencies have seen a general increase in
their sensitivity to relative changes in yield curves, the highest
betas among the G10 remain with the commodity-related
currencies. Interestingly, the CAD stands our as being the
currency that is most vulnerable to a relative steepening of the
US yield curve. Canada is also ranked second on our relative
investment to overall growth metric (second behind Sweden),
highlighting the potential that recent investment in Canada
could have been unproductive.
Hence, we anticipate a change in the CAD’s behaviour from
previous cycles. Historically, the CAD would have been seen
as a beneficiary of a US recovery, with the Canadian

3

MORGAN STANLEY RESEARCH
November 27, 2013
FX Pulse

economy viewed as being able to gain from the strong links to
the US. However, a relative steepening of the US yield
curves, in anticipation of the Fed starting to taper, would now
be expected to put the CAD under pressure – especially in an
environment where the BoC has implemented a more dovish
tone – rather than benefiting from the US growth dynamics.

USDJPY Still on the Rails

Exhibit 4

Foreign Purchases of Japanese Equities and
USDJPY
3.5

105

3.0
100

Foreign Purchases of Japanese
Equities (4-week sum) (rhs)

1.0
0.5

85

0.0
80

thousand billions

USD/JPY

1.5
90

-0.5
-1.0

USDJPY

-1.5
-2.0

70
11

12

18000

1.400

Relative EU-US Equity Market
1.375

17000

1.350

16000

1.325

15000

14000

1.300

EURUSD
1.275

13000

1.250

12000

1.225

11000

1.200
Jan

2.0

10

Relative EU-US Equity Market Performance and
EURUSD

2.5

95

75

Exhibit 5

EUR/USD

We made the case in last week’s FX Pulse that a US curve
steeping as a result of the Fed attempting to separate
tapering from tightening via a reinforcement of forward
guidance would be positive for the USDJPY (see The Fed
Won’t Derail USDJPY). We continue to believe this to be the
case, consistent with the relationship between USDJPY and
the relative shift in yield curves. We believe confidence in the
Japanese reform process is being regained. This appears to
be supported by the latest portfolio flow information available
for the week to November 22, which revealed a near record
inflow to the Japanese equity market by foreign investors. The
recent Japanese investor outflow into foreign bonds has also
been maintained. These portfolio flows are consistent with
renewed investor confidence in Abenomics, suggesting that
the JPY is set to come back under pressure, especially as
further policy announcements are expected over the coming
month, including the draft Japanese budget in December.

differential for international investment decisions. Here we
believe there are some interesting developments taking place.
While the US and European equity markets have both rallied
strongly, with European equities even outpacing US equity
market gains in the past six months, we note that US market
gains have been far more broad-based, with the
Advance/Decline indicator moving sharply higher, while in
Europe equity market gains have been far narrower with the
Advance/Decline indicator actually moving lower during the
period of strongest outperformance of the European market.
This suggests that the recent European equity market
performance is likely to have been built on fragile ground,
which could leave the EUR vulnerable. Indeed, we note that
over the past two years EURUSD has tracked the relative EUUS equity market performance closely, suggesting that signs
that the recent European equity market outperformance is
running out of steam could leave the EUR vulnerable.

13
Source: Reuters EcoWin

Source: Reuters Ecowin, Morgan Stanley

Equity Markets Still Important
While we have put increased emphasis on the relative slopes
of yield curves, the relative performance of equity markets will
also remain an important driver for currencies, especially
given the importance now being placed on global growth

10000
Mar

May

Jul
12

Sep

Nov

Jan

Mar

May

Jul
13

Sep

Nov

Source: Reuters Ecowin, Morgan Stanley

EURUSD Topping Out
The upcoming Eurozone CPI data for November is important,
given the sharp decline in the inflation rate in October to
0.7%, which prompted the ECB to cut interest rates. Along
with the overall EMU inflation print, we would recommend
close examination of the CPI reading in individual countries.
The broad-based nature of the disinflationary pressure seen
throughout the Eurozone, including at the core of Europe, will
make it easier for the ECB to act. Indeed, ECB president
Draghi has re-emphasized over the past week that he ECB
sets policy for EMU as a whole. While our economics team
are expecting a slight rebound in the CPI following last
month’s decline, another reading below 1.0% is likely to keep
the pressure on the ECB to take further action. Indeed, ECB

4

MORGAN STANLEY RESEARCH
November 27, 2013
FX Pulse

members have been making a concerted effort since the last
ECB meeting to push the dovish message and to remind
markets that they have further policy options available to
them, including negative deposit rates. However, we would
not expect any further action just yet and our European
economists now expect a further cut in the refi rate by 15bps
to 10bps in the first quarter of next year, keeping the deposit
rate at 0% for the time being. This change in Eurozone rate
expectations is likely to put the EUR under pressure going
into next year once any year-end repatriation related flows
ease. Hence, we maintain our EURUSD bearish strategy (see
“EURUSD Topping Out,” page XX).

Exhibit 6

Local Funds Cash Balances* Continue to Fall
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0

EM Policy Response Remains Diverse
EM central banks have generally kept to dovish policy biases,
expressed via either policy rate cuts or extended forward
guidance, which may help keep the front end of EM local
curves well anchored and prompt a steepening of select
curves. Indeed, this past week both the National Bank of
Hungary and the Bank of Thailand cut interest rates. In the
case of Thailand, the cut was against market expectations for
rates on-hold and adds weight to our preference to buy
USD/THB. While in Hungary the cut was expected, the
accompanying message was more dovish than our
economists anticipated, prompting a change in their forecast
for Hungary’s terminal policy rate from 3.00% to 2.60%, which
adds downside risks to our more constructive HUF outlook.
However, not all EM policy makers have a dovish bias, and in
the case of Turkey and Brazil – where tightening biases have
been put in place – we see this as a positive development for
their respective currencies. Indeed, where economies still
display significant external vulnerabilities and still high
respective inflation levels, we look for tightening biases to
provide more support, though we still look for further
tightening before deviating from our bearish view on both
currencies.

0.0
Oct-12

Jan-13

Apr-13

Simple avg

Jul-13

Oct-13

AUM weighted

*Average cash balances as % of total assets.
Source: Morgan Stanley Research, EPFR.

Meanwhile, the technical backdrop for EM currencies more
generally has continued to slowly deteriorate, and with little
sign of a pick-up in fundamentals we keep to a broadly
bearish outlook. We published our monthly Market Technical
Watch this week, with data on positioning by EM dedicated
hard and local currency funds (Market Technical Watch: Cash
Balances Reduce Further, November 27, 2013). The AUMweighted average cash balance for local funds declined
further in October to 5.7%, well below the peak of 8.6% in
June and only slightly above the pre-May average of 4.04.5%, which in light of continued outflows leaves local
markets vulnerable, in our view. Brazil (+3.4%) remains the
most overweight local market, though Russia (+1.3%) has
now overtaken Mexico (+0.9%) for the No. 2 spot. The
overweight positioning of investors on Russian debt helps
support our outstanding recommendation to buy USD/RUB.

5

MORGAN STANLEY RESEARCH
November 27, 2013
FX Pulse

EUR/USD Topping Out
Hans Redeker
• EURUSD has moved back up to pre-ECB rate cut levels.
Predictably, the 25bps refi rate cut failed to develop a
durable EUR weakening impact as the Eonia rate stayed
supported.
• Banks preparing for the Asset Quality Review have reduced
their dependency on ECB funding and….
• …bought EUR to decrease their net foreign asset position.
• The EUR has traded above levels suggested by rate and
yield based models.
• We use this premium to establish a EUR short trade…
• …seeing widening growth differentials weakening EURUSD
over the course of 2014.
• As EMU risks become an outright deflationary case,
investors fear the related rise of real rates will provide EUR
support…
• …but case studies on Switzerland and Japan show that high
real rates decrease the investment outlook and weaken risk
appetite.
• Risk-averse investors invest in domestic risk-free nominal
assets, but the JPY and CHF only started to strengthen when
hedging activities of foreign asset holdings came into play.

of EUR denominated assets, reversing the EUR inflows seen
during summer. We expect EURUSD to initially test 1.29
followed by a decline towards 1.24 later next year.
Positioning is favorable for EURUSD shorts. Real money
accounts are running long EUR denominated asset positions
on a currency unhedged basis, while the many failed attempts
to short the EUR by speculative accounts have made this
group of investors cautious. Exhibit 1 offers some interesting
insights. The one-year sum of EMU’s current account, FDI,
Equity and Bond net inflows has reached levels where in the
past a moderation of inflows has set in, taking the steam out
of the EUR advance.
Many professional investors are concerned that EMU is
becoming similar to Japan, interpreting a deflationary EMU as
a EUR bullish factor. Indeed, real rates in EMU are rising due
to sharply falling inflation rates, and the current account is
increasing. EUR bulls hope the EUR will trade like the preAbenomics JPY, with rising real rates increasing domestic
demand for nominal domestic assets. We disagree with this
interpretation (see Deflation Should Not Buoy EUR: Lessons
From Japan, November 7, 2013).
Exhibit 1

EUR Inflows Have Topped Out, Suggesting at Least
a Corrective Setback

• EMU runs a foreign liability and not a foreign asset position,
suggesting the EUR is not following the path of the CHF and
the pre-Abenomics JPY.
• EURUSD has reached attractive levels for creating short
positions. We take profit on our long EURJPY trade.

Comprehension
EURUSD is trading at a premium relative to rates and yields.
We investigate the reason for this EUR overvaluation and
conclude that at current levels EURUSD offers good selling
opportunities. Several factors work in favour of a weaker
EURUSD. The Fed is preparing to exit quantitative easing
while the ECB debates measures to ease monetary
conditions further. The US has laid the foundation for an
investment driven economic rebound, while the lack of credit
and fiscal consolidation pressure is likely to keep EMU’s
economic performance subdued. Hence, we project EURUSD
to not only close the current valuation gap; we also expect
wider growth differentials to reduce the relative attractiveness

Source: Reuters EcoWin, Morgan Stanley

The rising current account surplus in Euroland is primarily due
to lack of investment, leading to a sharp decline of imports.
Falling investment does not bode well for employment and
falling employment will increase deflation pressures. Our
research shows that deflation observed in Switzerland and
Japan only led to appreciation pressures on the JPY and the
CHF when locally risk-averse investors currency hedged
foreign asset positions. EMU has no net foreign asset

6

MORGAN STANLEY RESEARCH
November 27, 2013
FX Pulse

position. Instead, it runs a foreign liability position. The EUR
will decrease within a deflationary scenario and hence not
follow the path of the JPY and CHF when Japan and
Switzerland went into deflation.

The AQR and the EUR
EMU has not dealt with the legacy assets linked to the preLehman lending boom. While the US has transferred nonperforming bank assets onto the Fed’s balance sheet via the
TARP program, European banks still struggle with balance
sheet risk. EMU banks’ deposit to liability ratio is at 1.15, while
the US equivalent is currently at 0.8. Banks dealing with nonperforming assets find it difficult to provide sufficient credit,
undermining economic prospects, which will have negative
long-term currency implications, we think.
In the Eurozone, there have been doubts concerning bank
asset quality for some time. The US successfully conducted a
bank stress test once the TARP program was complete.
There have been two stress tests for European banks
(released in July 2010 and 2011), but both tests failed to help
bank business normalize. Now EMU is conducting a third
stress test, the AQR, for which banks will have a snapshot of
their balance sheets taken in December. Notably, the result of
the stress test will not be released before October 2014.

decision yet on how banks’ capital shortages will be funded,
the risk that this will fall on national budgets is significant.
Despite the ECB’s refi cut cheapening ECB funding, banks,
especially in the periphery, have increased the pace of LTRO
repayment. Declining excess liquidity pushing the Eonia rate
higher might have a marginal supportive EUR impact. The
main boost, however, has come from banks reducing their
holdings of foreign assets ahead of December, pushing the
EUR higher, despite adverse rate and yield differentials.

The EUR Premium
Our preferred models for short-term EURUSD valuation all
show this currency pair trading at a significant premium.
Exhibits 3, 4 and 5 show risk adjusted 5-year yield
differentials and 1 year / 1 year forward rate spreads
compared to the exchange rate. All models provide the same
message, namely EURUSD is trading higher than suggested
by fundamentals.
Exhibit 3

EURUSD Premium Shown by the 1y/1y Forward
Rate Differential….

Exhibit 2

EMU’s Banks Net Foreign Asset Position has
Reached EUR 610bln

Source: Bloomberg, Morgan Stanley

Exhibit 4

…the Volatility Adjusted 5-Year Yield Differential …

Source: Reuters EcoWin, Morgan Stanley

Peripheral banks have come under pressure to improve the
appearance of balance sheets ahead of the December
snapshot. Within core countries, political resistance has built
up against using ESM funds to cover eventual capital
shortages of banks. Hence, it is not surprising that peripheral
countries’ governments are asking banks to significantly
improve balance sheets before the stress test. With no
Source: Bloomberg, Morgan Stanley

7

MORGAN STANLEY RESEARCH
November 27, 2013
FX Pulse

Exhibit 5

…and the CDS Adjusted 5-year Sovereign Yield
Differential

Source: Bloomberg, Morgan Stanley

Various explanations are possible. First, EURUSD drifting
away from rate and yield differentials could be due to a
relative shift in the importance of cross border flows away
from fixed income towards equity. Indeed, foreign equity flows
have exceeded inflows seen since the year 2007, but this flow
peaked in September and has eased since then. Exhibit 6
shows the relative performance of equity markets according to
which the outperformance of EMU’s stock market peaked in
September as well. Since then the relative equity performance
chart has rolled over. Nonetheless, EURUSD’s valuation
premium has only emerged since September, suggesting
other factors are driving EURUSD above the level suggested
by interest rate and yield differentials.

spring 2010 when EMU’s debt crisis emerged. Hence, the
liability decline seems related to the decline in bank credit,
increasing foreign funding costs. Credit affected banks
increasingly moved towards EUR funding, which now creates
a problem as banks have to prove their resilience. A EUR
funded foreign asset position implies a capital and FX risk,
requiring high equity holdings to protect against potential
losses.
Exhibit 8 is of specific interest as it shows EMU banks were
overfunding foreign asset positions when the EUR was weak
from 1998 to 2002. Obviously banks prepared for an
appreciation of the EUR by overfunding in foreign FX. This
stance worked well. Now banks run an underfunded gross
foreign asset position. Of course, it may be argued banks are
expecting a weaker EUR exchange rate to justify this position.
More likely, peripheral banks seeing their credit conditions
weakening were no longer able to raise foreign currency
denominated funds at the appropriate cost. Anyhow, net
foreign asset positions with their inherent FX risk require
substantial equity holdings at times of stress. Hence, banks
have a high incentive to reduce currency exposure ahead of
the AQR, explaining the current EUR premium. Risk exposed
banks will have to buy the EUR regardless of the costs or the
message provided by rate and yield markets.

Exhibit 7

Banks Net Foreign Asset Position Increase due to...

Exhibit 6

Relative Performance of Equity Markets has Rolled
Over

Source: Reuters EcoWin, Morgan Stanley

Source: Reuters EcoWin, Morgan Stanley

The second explanation may work better. EMU banks have
increased their net foreign asset holdings as foreign currency
liabilities fell faster than banks’ foreign asset holdings. The
decline of foreign currency liabilities started in earnest in

8

MORGAN STANLEY RESEARCH
November 27, 2013
FX Pulse

Exhibit 8

Exhibit 9

…Sharply Falling Foreign Liabilities

Relative Size of Central Banks Balance Sheets and
EURUSD

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

Japanisation and the EUR
Ironically, the fact that legacy assets have left EMU banks in
poor condition lends short-term EUR support, but a weak
banking sector also implies little credit support for the
economy. EMU is increasingly drifting towards deflation.
Some may argue that the JPY and CHF have appreciated
over years with their deflationary economies pushing real
rates up, increasing demand for local nominal assets. Does
EMU’s Japanification mean the EUR will head higher as local
cash demand increases at the same time as monetary
velocity within the deflationary economy declines?
A chart very often shown in this context is the relative size of
central bank balance sheets (Exhibit 9). Indeed, the Fed
expanded its balance sheet at the same time as the ECB cut
its balance sheet. The ECB has reduced EUR supply adding
to deflationary risks, compared to the USD supply increasing
reflationary strategy of the Fed. According to this line of
thought, the ECB’s printing less EUR, combined with rising
real rates boosted by declining inflation, should push up the
EUR. We disagree with this view.

Deflation and excessive inflation are equally the result of
policy mistakes. The moves into deflation of Switzerland and
Japan were due to the SNB and BoJ responding inadequately
to rising real rates, which were moving away from the needs
of the economy. Of course, deflation always starts with output
gaps opening up, but central banks make the difference
between temporary price adjustments or a permanent decline
in prices. In this sense, the ECB shrinking its balance when
real rates were rising over the course of this year looks like a
policy error bearing deflationary consequences.
Japan is the best case to examine for the impact of deflation
on asset prices and FX rates. Deflation undermining corporate
pricing power is outright bearish for local equities, causing the
Nikkei to fall by 70% from top to bottom. When the Japanese
equity market topped out, foreign holdings were high, and fell
not just in relative but in absolute terms for the next 22 years.
The liquidation of JPY denominated assets by foreign owners
may have contributed to the JPY weakness experienced
starting in March 1995, overriding JPY demand due to
declining monetary velocity in Japan caused by a
conservative BoJ.
Japan moved into deflation in 1998, which had very little
impact on JPY trading behavior initially. The JPY appreciated
when foreign rates were falling and it depreciated when
foreign rates were rising. The JPY only appreciated in earnest
once declining foreign interest rates provided Japanese
investors in non-JPY-denominated assets with a means to
reduce their currency risk. The JPY-supportive effects
developed via increasing domestic demand for nominal JPYdenominated assets remained negligible. Europe has no
foreign asset position; hence there will be no need to
currency-hedge non-EUR exposures. But foreign ownership in

9


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