CURREN CIES

Curr
rrenc
cy Ma
arke
et Mo
onito
or
3rdQua
arter20
014

OCTOBE
ER 6, 2014
4
Sandra Ro

Bluford
B
Putna
am

Executive Dire
ector

Ch
hief Economist

FX Research & Product Develo

opment

Re
esearch & Produ
uct Developmentt

011 44 203 37
79 3789

+1
1 212 299 2302

sandra.ro@cm
megroup.com

bluford.putnam@c
cmegroup.com

The big story in the FX markets during the 3rd quarter 2014 was a significant
rally in the value of the U.S. dollar (USD) relative to other major and emerging
market currencies. This strength was driven by an improving economic outlook
on a nice rebound in GDP after a weak but weather-driven 1st quarter along
with continuing growth in the labor market.
This document reviews the macroeconomic factors that underlie these trends
including a look at growth in various national economies, monetary policy,
current and capital account flows. We further consider the impact of the socalled carry trade and purchasing power parity theory as they impact FX
markets.

The Sep-14 unemployment rate was reported at

5.9%, a significant downtick from the Aug-14 figure
of 6.1%. Thus, the labor market is improving a bit
faster than projected by the FOMC. The Committee
had projected an unemployment rate of 5.9-6.0% by
the end of 2014 and 5.4-5.6% by the end of 2015.
These figures were revised downwards from
previous estimates of 6.0-6.1% and 5.4-5.7%,
respectively. 2

9%

0%

8%

-2%

7%

-4%

6%

-6%

Real GDP (SA)

Q1 14

Q2 13

Q3 12

Q4 11

Q1 11

Q2 10

4%
Q3 09

-10%
Q4 08

5%
Q1 08

-8%

Unemployment Rate

Source: Bureau of Economic Analysis (BEA)

& Bureau of Labor Statistics (BLS)

The FOMC acknowledged these conditions in its

release following the September 16-17th meeting
economic activity is expanding at a moderate pace.

10%

2%

Q2 07

Second quarter GDP was last reported at +4.6%,

representing a significant rebound from Q1-14s
weather-driven decline of 2.1%.
Still, the 3rd
quarter concluded on a bit of a sour note with a
release as the Federal Open Market Committee
(FOMC) reduced its GDP growth estimates
subsequent to the September 16-17th meeting. The
FOMC is now projecting GDP growth of 2.1-2.3% in
2014 and 2.6-3.0% in 2015. These figures are

11%

4%

Q1 05

The 3 quarter of 2014 saw moderate economic

growth along with decelerating improvement in the
unemployment
rate.
International
tensions
continued to flare up in the Middle East and Ukraine,
which led to some relatively small price spikes.
Still, it could be characterized as a quiet quarter with
generally low volatility on a buoyant equity market
with reasonably stable rates and a moderately
strong U.S. dollar.

Qtrly Change in GDP

rd

Growth and Employment

6%

Unemployment Rate

Growth and Employment

Q3 06

We also 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).

downwardly revised from June projections of 2.12.3% and 3.0-3.2%, respectively. 1

Q4 05

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).

Economic Projections of Federal Reserve Board

Members and Federal Reserve Bank Presidents,
September 2014, September 17, 2014.
Ibid.

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

Jan-13

Jan-11

Real Retail Sales SA

Sep-13

Vehicle Sales

9
May-14

10

$150
May-12

$155
Sep-11

11

Sep-09

12

$160

May-10

13

$165

Light Vehicle Sales

Similarly, corporate profitability has rallied to $1.84

trillion by Q2-14, representing a new all-time high
and eclipsing the previous high of $1.80 trillion seen
in Q3-13. This corporate success has, of course,
contributed to a buoyant stock market trading near
all-time highs by the end of Q3-14.
Industrial Sector Activity

82%
80%

100

78%
76%

95

74%
90

72%
70%

85

68%

Capacity Utilization

105

66%

Index of Industrial Production

May-14

Sep-13

Jan-13

May-12

Jan-11

80
Sep-11

Real retail sales were reported at $187.2 billion in

Aug-14 and +2.51% on a year-on-year (YOY) basis
over the Aug-13 figure of $182.6 billion. Similarly,
light vehicle sales were reported at 17.5 million units
in Aug-14, representing an impressive +8.9%
advance over the Aug-13 sales figure of 16.0 million
units.

14

$170

Jan-07

The FOMC further suggests that [h]ousehold

spending appears to be rising moderately and
business fixed investment is advancing, while the
recovery in the housing sector remains slow. 4
Indeed, many economic indicators have recovered to
eclipse their pre-financial crisis highs. This includes
measures of consumer spending as well as industrial
production.

$175

Source: U.S. Census Bureau and Dept.of Commerce

Industrial Production Index

This observation is underscored by a continued low

labor force participation rate. While unemployment
was last reported at 5.9%, only 62.7% of the
population is employed. This represents the lowest
rate since 1978 and has declined from the 63.2%
reported a year earlier in Sep-13.

15

Jan-07

Unemployment Rate
Labor Force Partcipation
Source: Bureau of Labor Statistics (BLS)

16

$180

May-10

Jan-14

Jan-13

Jan-12

Jan-11

Jan-10

Jan-09

Jan-08

Jan-07

Jan-06

62%
Jan-05

4%
Jan-04

63%

Jan-03

5%

17

$185

Jan-09

6%

18

$190

Sep-09

64%

Consumer Sector Activity

$195

May-08

65%

7%

Jan-09

66%

8%

May-08

9%

Sep-07

67%

Labor Force Participation

10%

Jan-02

Unemployment Rate

68%

Sep-07

Employment Statistics

11%

The Index of Industrial Production was reported at

104.1 in Aug-14 or +4.6% on a YOY basis.
Capacity utilization down ticked from a high of
79.1% in Jul-14 to 78.8% in Aug-14. Still this
represents an advance of 0.8% over the figure of
78.0%, as reported one year earlier in Aug-13.
Thus, we strain towards the key mark of 80%, which
is often considered a key inflection point above
which point production bottlenecks and inflationary
pressures are generally thought to emerge.

Retail Sales (Bil $)

On balance, labor market conditions improved

somewhat further; however, the unemployment rate
is little changed and a range of labor market
indicators suggests that there remains significant
underutilization of labor resources. 3

Capacity Utilization

Source: St. Louis Federal Reserve FRED Database

3

Federal Reserve Press Release dated September 17,

2014.
Ibid.

A buoyant stock market has, of course, contributed

to a tremendous wealth effect.
This is

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

$1,800

80%

$1,600

60%
40%

$1,400

20%

$1,200

0%

$1,000

-20%

$800

-40%

$600
Q1
Q4
Q3
Q2
Q1
Q4
Q3
Q2
Q1
Q4
Q3
Q2
Q1
Q4
Q3

04
04
05
06
07
07
08
09
10
10
11
12
13
13
14

-60%

Annual Change
Corporate Profits (Bil)
Source: Department of Commerce

Still, a certain sense of glumness seems to hang

over the market, driven by a skewed distribution of
this wealth. The value of U.S. residential real estate
owned by households was reported at $22.9 trillion
as of Q2-14 but this remains 7.8% less than the
pre-crisis high of $24.9 trillion as of Q4-06. Perhaps
even more significantly, real household income
remains well below pre-crisis highs and has
generally been headed in the wrong direction.

Inflation
The Fed reiterates its focus on employment coupled
with an inflation target, suggesting that [w]hen the
Committee
decides
to
remove
policy
accommodation, it will take a balanced approach
consistent with its longer-run goals of maximum
employment and inflation of 2 percent. 5
Inflation is currently running a bit below that 2%
target. The Consumer Price Index (CPI-U) and core
CPI ex-food and energy were both reported at an
annual rate of +1.7% for Aug-14.
Similarly,
Personal Consumption Expenditures (PCE) were
recorded at +1.6% in Aug-14 on a YOY basis while
core PCE ex-food & energy checked in at +1.6%.
Personal Consumption Expenditures
5%

Real Median Household Income

$57,000
$56,000
$55,000

4%
3%
2%
1%
0%

-1%

$54,000

Jan-14

Jan-13

Jan-12

Jan-11

Jan-10

Jan-09

Jan-08

$51,000

Jan-07

Jan-04

$52,000

Jan-06

-2%

$53,000

Jan-05

Annualized Change

100%

$2,000
Pre-Tax Profits (Billions)

U.S. Corporate Profitability

120%

1999 peak of $56,080. More affluent Americans

invested in stocks have realized significant benefits
reflected in household net worth, noting that
approximately 10% of households own 80% of all
stocks. But these benefits do not appear to be
flowing down to middle or lower class citizens,
creating a widening income void between the
classes.

Year-on-Year Change

underscored by reported on household net worth

which rallied to a record $81.5 trillion by Q2-14 and
a cheerful University of Michigan Consumer
Sentiment Index last seen at 81.2.

PCE
Core PCE
Source: Bureau of Economic Analysis (BEA)

$50,000
$49,000
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013

$48,000

Source: FRED Database

Real, or inflation-adjusted, median household

incomes were reported at $51,939 in 2013. While
this is a bit of an improvement over the trough of
$51,017 seen in 2012, it remains well below the

All of these measures fall slightly short of the Feds

target of 2%. The Fed is projecting PCE inflation
and core PCE inflation to run at 1.5-1.7% and 1.51.6% in 2014, respectively. Projections for 2015 are
similarly modest at 1.6-1.9% for both PCE and core
PCE inflation. But with capacity utilization straining

Ibid.

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

up towards the key 80% mark, inflation could

perhaps become a cause for some concern on the
part of the Fed sooner than anticipated.
Monetary Policy
The Fed continues to wind down its QE program.
The program had called for the monthly purchase of
$85 billion of Treasuries, agency debt and agency
mortgage backed securities (MBS), in an attempt to
keep intermediate- to long-term rates at modest
levels. But the Q4-13 saw the Fed begin to taper
the program by $10 billion per month.
Consistent with expectations, the Fed decided to
make a further measured reduction in the pace of its
asset purchases.
Beginning in October, the
Committee will add to its holdings of agency
mortgage-backed securities at a pace of $5 billion
per month rather than $10 billion per month and will
add to its holdings of longer-term Treasury
securities at a pace of $10 billion per month rather
than $15 billion per month. 6

improvement in labor market conditions and

inflation moving back toward its longer-run
objective, the Committee will end its current
program of asset purchases at its next meeting
[scheduled for October 28-29, 2014] 7
The conclusion of QE may presumably set the stage
for possible target Fed Fund rate hikes. In the
meantime, we are holding steady at 0-25 basis
points as the Fed will assess progressboth
realized and expectedtoward its objectives of
maximum employment and 2 percent inflation. This
assessment will take into account a wide range of
information, including measures of labor market
conditions, indicators of inflation pressures and
inflation expectations, and readings on financial
developments.
The Committee continues to
anticipate that it likely will be appropriate to
maintain the current target range for the federal
funds rate for a considerable time after the asset
purchase program ends, especially if projected
inflation continues to run below the Committees 2
percent longer-run goal, and provided that longerterm inflation expectations remain well anchored. 8

Benchmark U.S. Rates

6%

Federal Receipts vs. Expenditures

(Annualized in Billions)

5%

$4,000
$3,000

4%

$2,000

3%

$1,000

2%

$0

1%

-$1,000
-$2,000
-$3,000

Further, [t]he Committee will closely monitor

incoming information on economic and financial
developments in coming months and will continue its
purchases of Treasury and agency mortgage-backed
securities, and employ its other policy tools as
appropriate, until the outlook for the labor market
has improved substantially in a context of price
stability. If incoming information broadly supports
the
Committees
expectation
of
ongoing

Q4 13

Q1 13

Q2 12

Q3 11

Q4 10

Q1 10

Q2 09

Q3 08

Q4 07

Q1 07

Fiscal Policy
The Fed continues to suggest that [f]iscal policy is
restraining economic growth although the extent of
restraint is diminishing. 9 Total Federal government

Ibid.

Q2 06

Fed Total Recepits

Fed Total Expenditures
Net Lending/Borrowing
Source: Bureau of Economic Analysis (BEA)

Q3 05

2-Yr Treasury
10-Yr Treasury

Q4 04

-$4,000
Q1 04

Jul-14

Jul-13

Jan-14

Jul-12

Jan-13

Jan-12

Jul-11

Jul-10

Jan-11

Jul-09

Target Fed Funds

5-Yr Treasury
30-Yr Treasury

Jan-10

Jan-09

Jul-08

Jul-07

Jan-08

Jan-07

0%

Ibid.
Ibid.
Ibid.

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

expenditures (annualized and seasonally adjusted)

were at $3.934 trillion in Q2-14 and up 1.9% from
Q1-14s $3.859 trillion.
Total Federal receipts were last reported at $3.308
trillion in Q2-14 and up 1.3% from Q1-14s $3.264
trillion. This results in a Q2 shortfall of $626.3
billion and a slight uptick from Q1s $594.7 billion.

Foreign investors turned their attentions to the U.S.

equity marketplace in 2013 as a net $522 billion
flowed into stocks on the strength of a sustained bull
market continuing through Q3-14.

Net US/Foreign Capital Flows

(Billions USD)

$1,200
$800

Current & Capital Account Flows

$400
$0
-$400

(Billions USD)

Thru Jul-14

2013

2012

2011

2010

2009

2008

2007

But despite the gains realized in equities in 2014 to

date, foreign investors withdrew some $0.8 billion
from equities in factor of pushing $108 billion into
U.S. Treasuries.
This was likely driven by
international tensions along with concerns over a
possible correction given that U.S. equities have
advanced to new all-time highs.

-$40
-$80
-$120
-$160
-$200

Mutual Fund Flows

Q4 13

Q1 13

Q2 12

Q3 11

Q4 10

Q1 10

Q2 09

Q3 08

Q4 07

Q1 07

Q2 06

Q3 05

Q4 04

Q1 04

-$240

Source: Bureau of Economic Analysis (BEA)

The
U.S.
Treasury
Departments
Treasury
International Capital (or TIC) 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.
U.S. vs. overseas capital flows have generally been
characterized over the past decade by substantial
influx of funds into U.S. Treasuries. This trend
peaked in 2010, as overseas investors net purchases
totaled $704 billion in U.S. Treasuries, but tailed off
to $433, $417 and $43 billion in 2011, 2012 and
2013, respectively.

2006

US Treasuries
US Gov't Agencies US Corporates
US Stocks
Foreign Bonds
Foreign Stocks
Source: U.S. Treasury TIC Database

Balance on Current Account

$0

2005

-$800
2004

The current account deficit improved to $98.506

billion in Q2-14 from Q1-14s $102.111 billion. This
represents a 20.5% decline from Q1-12s postfinancial crisis peak of $123.962 billion.
It
represents a far greater improvement relative to the
>$200 billion deficits witnessed in the pre-crisis era
of 2005-06.

The flow of equity and fixed income investments

may be examined per data published by the
Investment Company Institute (ICI) which tracks
activity in the mutual fund industry. 10
Some $50.8 billion was invested into equity funds
during 2014 through July.
However, this
represented a net withdrawal of $13.9 billion from
U.S. equity funds and a net addition of $64.7 billion
into
overseas
equities,
despite
the
strong
performance of the U.S. stock market and the U.S.
dollar.

10

These indicators are often highly correlated with price

action as retail investors may chase the market by
buying in response to a bull trend. Or, they may
exhibit a herd mentality by liquidating investments in
response to significant market breaks.

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

Bond funds attracted some $60.4 billion in additions

in 2014 through July, despite the fact that many
anticipate rising rates and declining fixed income
values as the Fed winds down its QE programs and
possibly considers federal fund rate hikes.
Equity Fund Cash Flows
(Billions USD)

$40

expected to grow at a +3.03% rate in 2015 relative

to 2013s rate of +1.74%.
GDP growth has slowed in many of the emerging
economies but such growth has nonetheless
generally surpassed that of the DMs. This will likely
continue to be the case per most forecasts, albeit
the gaps may narrow.

$30

Actual & Forecast GDP Growth

$20
$10
$0
-$10
-$20
-$30
Jul-14

Mar-14

May-14

Jan-14

Nov-13

Jul-13

Sep-13

May-13

Jan-13

Mar-13

Nov-12

Jul-12

Sep-12

Mar-12

May-12

Jan-12

-$40

Domestic Equities
Foreign Equities
Source: Investment Company Institute (ICI)

Global Economic Performance

2013

2014 (f)

2015 (f)

2.36%
2.01%
-0.37%
1.53%
1.74%
1.88%

2.71%
2.48%
1.05%
1.50%
3.38%
1.66%

2.58%
2.45%
1.49%
1.24%
3.03%
3.11%

2.49%
1.07%
1.30%
4.70%
7.70%

1.14%
3.08%
0.96%
5.10%
7.30%

2.59%
3.62%
4.36%
6.60%
7.60%

Source: Global FX Analyst, Goldman Sachs (July 15, 2014)

NOTE: (f) = forecast data

Emerging market (EM) economies grew quickly even

in the wake of the subprime crisis. But growth in
the EM countries is now decelerating while many
analysts look for relatively modest economic upticks
in the developed (DM) economies.
Equity & Bond Fund Cash Flows
(Billions USD)

$80

2011
2012
Developed Markets (DMs)
Australia
2.59%
3.61%
Canada
2.53%
1.71%
Euro Area
1.63%
-0.60%
Japan
-0.45%
1.45%
UK
1.12%
0.28%
US
1.85%
2.78%
Emerging Markets (EMs)
Brazil
2.73%
1.03%
Mexico
4.04%
3.98%
Russia
4.29%
3.44%
India
7.70%
4.80%
China
9.3%
7.70%

$60

Trade surpluses, that have supported some EM

economies notably including China, have generally
contracted since the pre-financial crisis era,
representing a headwind for the value of many EM
currencies. On the other hand, trade deficits in the
U.S. and Europe have generally declined over the
same period.
Actual & Forecast Current Account Balance

$40

(as % of GDP)

$20
$0
-$20
-$40
-$60
Jul-14

May-14

Mar-14

Jan-14

Sep-13

Nov-13

Jul-13

Mar-13

May-13

Jan-13

Sep-12

Nov-12

Jul-12

Mar-12

May-12

Jan-12

-$80

Equity Funds
Bond Funds
Source: Investment Company Institute (ICI)

GDP Growth in the Euro area and the U.S. is

expected to improve to +1.49% and +3.11% by
2015 from 2013s -0.37% and 1.88%, respectively.
While Japanese growth is expected to tail off a bit to
+1.24 in 2015 from +1.53% in 2013, the UK is
6

2011
2012
Developed Markets (DMs)
Australia
-2.76%
-4.19%
Canada
-2.75%
-3.42%
Euro Area
0.11%
1.46%
Japan
2.15%
0.99%
UK
-1.46%
-3.83%
US
-2.96%
-2.84%
Emerging Markets (EMs)
Brazil
-2.12%
-2.41%
Mexico
-1.07%
-1.27%
Russia
5.56%
3.63%
India
-3.40%
-5.00%
China
1.90%
2.60%

2013

2014 (f)

2015 (f)

-3.23%
-3.23%
2.39%
0.68%
-4.51%
-2.39%

-2.10%
-2.40%
2.90%
0.11%
-4.17%
-2.58%

-3.22%
-1.76%
3.10%
0.96%
-3.57%
-2.92%

-3.62%
-2.06%
1.72%
-2.60%
2.10%

-3.67%
-1.81%
1.36%
-1.90%
2.10%

-3.75%
-1.47%
-1.28%
-2.80%
2.10%

Source: Global FX Analyst, Goldman Sachs (July 15, 2014)

NOTE: (f) = forecast data

Forecasts suggest that the U.S. trade deficit may

revert back to higher levels in coming years while

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

the European trade surplus expands. The Chinese

surplus is expected to stabilize as a percentage of
Chinese GDP but note that Chinese GDP is
expected to advance at rates in the 7% vicinity,
resulting in sizable increases in the surplus
measured in absolute terms.

Indian rupee (INR) at -2.54%. The Chinese yuan

(CNY) managed to post an advance at +1.05%. 12
The particularly poor performance of the RUB is, of
course, linked to continuing economic sanctions in
the wake of the Crimean and Ukraine crisis.
Total Return

Price Performance
The factors discussed above exert an obvious impact
upon the price performance of the U.S. dollar vis-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. 11

The carry trade has been one of the most popular

long-term FX trading strategies over the past
decade. A carry trade is deployed by borrowing in
countries with low nominal interest rates to invest in
countries with high nominal interest rates.
Thus,
one sells the low-rate currency and buys the
high-rate currency.

CME USD Index

Carry trade

1,250
Long
Short
14.3% EUR 100% USD
14.3% JPY
14.3% GBP
14.3% CHF
14.3% CAD
14.3% AUD
14.3% CNY

1,200
1,150
1,100

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 including exchange rate
fluctuation plus interest accrual.

1,050
1,000
950

Jul-14

Jul-13

Jan-14

Jan-13

Jul-12

Jul-11

Jan-12

Jul-10

Jan-11

Jul-09

Jan-10

Jul-08

Jan-09

Jul-07

Jan-08

Jan-07

900

The CME USD Index ended Q3-14 at a value of

1,088.10 and up from Q2-14s ending mark of
1,025.85, for an advance of 4.61%. Over the same
period, EUR has turned in a spot return of -7.75%
vs. USD; British pound (GPB) is at -5.22%;
Japanese yen (JPY) is at -7.59%.
The GBP
experienced some extensive buffeting during the
period leading up to the failed Scottish vote for
independence.
Among EM currencies are the Brazilian real (BRL) at
-9.51%; Russian ruble (RUB) at -14.19%; and,

11

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.

As such, carry traders implicitly discount classical

exchange rate theories by assuming that the interest
rate relationships may endure over extended periods
of time. I.e., low-yielding currencies that are sold
will not advance; or, high-yielding currencies that
are purchased will not decline.
Total Currency
Return

Price Movement
+ Interest

As a practical matter, such relationships have been

known to endure for extended periods of time. E.g.,
vast sums were invested in the carry trade prior to
the outbreak of the subprime crisis, often by
shorting the low-yielding Japanese yen (JPY) and
investing in other high-yielding currencies.
Appendix 2 depicts the total return associated with
various currencies relative to USD in Q3-14. Among
the DMs, the EUR generated a total return of -7.72%
for the quarter; GBP at -5.09%; and, JPY at -7.59%.

12

The spot return of a currency, or the outright price

movements, is distinguished from the total return
which includes price movements plus interest accrual.

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

To the extent that interest rates remain at near zero

levels in these mature economies, the total returns
are not much different than spot returns as reported
above.

at 809.65 and down 2.26% from Q2-14s mark of

839.83. Thus, the carry trade as a strategy does
not appear to have worked well at all in the postfinancial crisis era.
Purchasing Power Parity
The purchasing power parity (PPP) theory dates to
the 16th century and the School of Salamanca but
was further developed in the early 20th century by
economist Gustav Cassel. 14 It is based upon the
assumption that exchange rates are in equilibrium
when purchasing power is equivalent amongst
various countries.

But interest accruals may exert a much greater

influence in less mature economies. The BRL posted
a total return of -7.06% for the quarter; RUB was
seen at -12.11%; INR at -0.39%; and, while the
CNY checked in at +1.51%.
CME FX Carry Index

1,050
1,000

On a granular level, PPP is based Adam Smiths 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.

950
900
Long
Short
16.7% BRL 50% USD
16.7% AUD 50% EUR
16.7% ZAR
16.7% NZD
16.7% TRY
16.7% MXN

800
750

Jul-14

Jan-14

Jul-13

Jul-12

Jan-13

Jul-11

Jan-12

Jan-11

Jul-10

Jul-09

Jan-10

Jul-08

Jan-09

Jan-08

Jul-07

Jan-07

700

If inflation
decreases

Currency value
should decline

The CME FX Carry Index represents a basket of equally

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

Currency value
should advance

Thus, if inflation as measured by an inflation index

increases, the value of the currency should decline
to maintain price equilibrium. Similarly, if inflation
declines, the value of the currency should advance.

The CME FX Carry Index follows the performance of

a basket of currencies offering relatively high rates
and have historically generated favorable total
returns. 13 The CME FX Carry Index closed Q3-14

850

13

If inflation
increases

14

dollar (NZD), South African rand (ZAR) and 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 high local
interest rates during the post-financial crisis era through
2010. The short components of the index were identified
because of the low interest rates offered.
See
Cassel,
Gustav,
Abnormal
Deviations
in
International Exchanges (December 1918).

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

The theory of PPP is closely related to 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. Thus, one expects that the value of
a currency with a low nominal interest rate will
increase into the future. Or that the value of a
currency with high nominal rate will 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

If inflation
decreases

Rates

decrease

Currency value
should decline

Currency value

should advance

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.
Norwegian krone (NOK) stands out as the most
over-valued currency per this analysis at +28.97%.
NOK is followed by Swiss franc (CHF) at +23.48%;
New Zealand dollar (NZD) at +14.86%; Icelandic
krona (ISK) at +12.57%; and, the Australian dollar
(AUD) at +12.43%.
Under-valued currencies include Turkish lira (TRY) at
-66.69%; Polish zloty (PLN) at -62.53%; South
African rand (ZAR) at -61.73%; Hungarian forint
(HUF) at =58.75%; and, the Russian ruble (RUB) at
-55.73%.

The IFE suggests interest rates and exchange are

negatively correlated.
Similarly, PPP suggests
inflation and exchange rates are negatively
correlated. As such, the IFE theory is generally
consistent with the PPP theory.

PPP numbers across all currencies have generally

fallen significantly over Q3-14, noting that these
figures are all measured relative to the USD.
Of
course, the USD exhibited notable strength during
Q3.

Putting the classic PPP theory 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 used in this regard.

One may wish to create baskets of several

currencies to buy and sell on the basis of this
analysis in order to diversify risks. However, it is
important to recognize that currencies might remain
over- or under-valued 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.

OECD - The Organization for Economic Cooperation 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 Economists Big Mac PPP
methodology compares the price of a (almost)
universally available product with verifiable pricing
in the form of the McDonalds Big Mac hamburger
in various countries.
All three methodologies may readily be referenced
on Bloomberg quotation devices. Appendix 3 below
provides data from all three methods. Further, we
9

Commodity Countries
Top performing currencies are often found in nations
whose national income is tied heavily to commodity
production.
Commodity prices have sometimes seen steep
advances during the past decade as seen in the rise
in the value of energy, grain, livestock, precious
metals and industrial metals. Price advances have
frequently been fueled by demand from EM
economies, although some of these trends have
corrected in the past couple of years with EM
deceleration and as new sources of supply have
come on board.
The CME FX Commodity Country Index tracks a
basket of currencies from nations that rely heavily

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

upon the exportation of commodities and other raw

materials. 15 The CME FX Commodity Country
Index closed Q3-14 at 819.92 and down 7.21% from
Q2-14s 883.60. This may largely be attributed to a
weak oil market, driven by new sources of supply
relative to stabilizing demands in the EM countries.

1,100

CME FX Commodity Country Index

1,050
1,000
950
900
850
Long
Short
16.7% AUD 100% USD
16.7% BRL
16.7% CAD
16.7% NOK
16.7% NZD
16.7% ZAR

800
750
700

Jul-14

Jul-13

Jan-14

Jan-13

Jul-12

Jul-11

Jan-12

Jul-10

Jan-11

Jul-09

Jan-10

Jul-08

Jan-09

Jul-07

Jan-08

Jan-07

650

Conclusion
CME 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.
For more
information
please
visit
our
website
at
www.cmegroup.com/trading/fx.

15

10

The CME Commodity Country Index is constructed to be

effectively long Australian dollar (AUD), Brazilian real
(BRL), Canadian dollar (CAD), Norwegian krone (NOK),
New Zealand dollar (NZD) and South African rand (ZAR)
vs. a short position in the U.S. dollar (USD). It is
(arbitrarily) established at a value of 1,000.00 as of
December 31, 2010.
| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

Exhibit 1: Summary of World Economic Conditions

Australia

Brazil

Growth,
Inflation,
and Fiscal
Policy

Australias economy is growing, but the broadbased decline in global commodity prices could
dampen growth.

Economic growth has been slow in Brazil.

Once the October Presidential election has
been decided, regardless of the outcome, we
expect uncertainties over future policies to
diminish and real GDP growth to start to
improve incrementally in 2015.

Monetary
Policy

Monetary policy has been on hold in Australia.

If commodity prices continue to fall, one can
expect the central bank to consider a rate cut
if the economy weakens.

Special
Factors

Growth,
Inflation,
and Fiscal
Policy

Monetary
Policy

Special
Factors

11

The Australian dollar is considered a

commodity currency, so the risk of
depreciation rises as energy, metals, and
agriculture prices trend downwards.
China
Chinese real GDP may decelerate further to
around 6% to 7% real GDP growth in 2015.
The economy is likely to avoid a hard landing
but continues to face significant challenges.
China typically uses the banking sector to
increase lending activity and help keep the
economy growing. There are signs that this
tool for managing economic activity may not
be working as well given the structural issues
and debt overhang in the banking system.
China has widened the bands for currency
volatility. Nevertheless, we do not think the
demonstration in Hong Kong are likely to slow
down progress to normalizes the currency and
increasing capital flows between China and the
rest of the world.

Short-term interest rates around 10% have

provided some support for the currency. Rate
cuts are possible in 2015 if we are correct that
uncertainties diminish after the October
election.
Post-election, with 10% short-term rates, the
Brazilian real has the potential to appreciate
against the Mexican peso or the Japanese yen,
even in a strong dollar environment.
European Union
Europes economies are struggling. The
banking system remains under-capitalized and
not able to expand lending at a pace to
support stronger growth. 2015 could see
some improvement after the ECB completes its
stress tests and banks make the required
capital adjustments.

Canada
Canada is benefiting from the continued jobs
expansion in the US. A positive decision on
the Keystone pipeline could help the Canadian
dollar, but political uncertainties abound. A
pipeline decision, one way or the other, is
likely after the US Congressional elections in
November 2014.
Canadas short-term interest rates are higher
than in the US but still very low. Some
inflation pressures appear to be developing.
The Bank of Canada may consider a rate rise,
especially if US job growth remains robust.
A rate rise in Canada could add support to the
Canadian dollar, if it comes. A negative US
decision on the Keystone pipeline, if it goes
that way, would hurt the Canadian dollar.
India
Indias elections in May brought in new
leadership and enthusiasm for change. Our
estimates are that real GDP growth will be in
the 5% to 6% range for 2015 and that India
will take some slow steps to ease the
economys heavy regulatory burden.

The ECB has announced plans to purchase

asset-backed securities. If this program could
be coupled with some steps to ease fiscal
policy, it would help. But for now, fiscal policy
remains restrictive in many countries.

Weakness in global commodity prices is likely

to help reduce the inflation rate, along with
the stability of the rupee. There may be room
for more rate cuts in 2015.

With the ECB planning to purchase assetbacked securities coupled with expectations of
a rate rise in the US in 2015, the Euro has
been depreciating. This trend is not likely to
reverse until after the bank stress test period.

The Indian rupee is on the mend. The

elections in May brought the possibility of
meaningful economic reforms. Declining
commodity prices are helpful, too.

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

Exhibit 1: Summary of World Economic Conditions, cont.

Japan

Mexico
st

12

Growth,
Inflation,
and Fiscal
Policy

As consumers sought to beat Japans April 1

hike in its national sales tax, the JanuaryMarch real GDP was exceptionally strong.
That strength was totally offset in the negative
April-June quarter. And, there is another sales
tax increase coming in late 2015.

Mexico is benefiting from improved growth in

the United States. Mexico has also increased
its imports of relatively inexpensive natural
gas through its pipeline links with Texas.

Monetary
Policy

The Bank of Japan is still expanding its balance

sheet aggressively. Unfortunately, this effort
mainly moves government bonds from banks
and pensions into the central bank, but it has
not helped economic growth.

The Bank of Mexico has made cuts in shortterm interest rates, in part, to make sure the
currency does not appreciate too rapidly to
jeopardize trade prospects.

Special
Factors

The Japanese yen remained quite stable from

mid-2013, trading between 100 and 103 yen
per US dollar, until recently when it started a
move toward 108 to 110. The Bank of Japan
probably wants to slow this depreciation for
now and see what it does to future inflation.

Mexican inflation is well contained. Given that

short-term rates are at or below inflation,
however, the Mexican peso has lost some
ground in the general US dollar rally.

Switzerland

United Kingdom

Growth,
Inflation,
and Fiscal
Policy

Switzerlands economy remains tied to the

struggling nations of the European Union. This
dims their growth prospects.

The UKs growth prospects are steadily

improving. The London housing market is
booming, due to foreign buyers. The budget
deficit as a percent of GDP is also declining.

Monetary
Policy

As the EU debt crisis has morphed into a longterm banking capital adequacy problem, the
Swiss have little flexibility, and they are likely
continue to keep a lid on the Swiss franc
relative to the euro.

The Bank of England may well consider raising

rates now that Scotland has voted to remain
part of the UK. The timing of a rate increase
might come before the May 2015
parliamentary elections.

Special
Factors

The post-2008 financial crisis has led to

increased regulation of financial institutions all
over the world. On net, this increased
regulation poses additional challenges for the
traditional model of Swiss secrecy and the
overall role of Switzerland in the worlds
financial system.

The future of the pound hinges very much on

interest rate expectations, with the possibility
of gains versus the euro and losses versus the
US dollar.

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

Russia
Russias annexation of the Crimea and further
political turmoil in the Ukraine have led to
costs and economic sanctions that possibly
could cause a recession. As winter approaches
there are risks that Russia might curtail gas
deliveries to Europe to counter the pressure
from sanctions.
Russia has had to raise short-term interest
rates to protect the currency during the
Ukraine turmoil. Political risks in Russia,
including potential takeover of foreign assets,
are extremely high.
Over the long-term, the big issue for Russia is
global oil and natural gas prices. Russia has
agreed a deal to ship natural gas to China.
The Iraq turmoil has raised oil prices to
Russias benefit. The fall in global commodity
prices, however, is a big negative for the
Russian economy and currency.
United States
The US economy is doing relatively well. Job
creation is strong and the unemployment rate
has dropped just below 6%. The Federal
budget deficit is likely to be balanced by FY2016. Core inflation, however, remains
subdued and there is not much pressure on
wages.
The Yellen-led Federal Reserve is on track to
end the Bernanke-Feds quantitative easing.
The next decision, which could come soon, is
to stop the re-investment of interest and
principal received on the Feds holdings of
Treasuries and MBS. Then, in 2015, the Fed
may well abandon the near-zero federal funds
rate target.
The debate about when/if the Fed will raise its
target federal funds rate has captured the
mindset of market participants, and led to a
stronger dollar, especially when the economies
of Europe and Japan are struggling and their
central banks are committed to highly
accommodative policies.

Appendix 2: Select Currency Performance

(3rd Quarter 2014)

Currency

Ticker

Argentine Peso
Australian Dollar
Brazilian Real
British Pound
Canadian Dollar
Chilean Peso
China Renminbi
Colombian Peso
Euro
Icelandic Krona
Indian Rupee
Japanese Yen
Mexico Peso
New Zealand Dollar
Russian Ruble
South Africa Rand
South Korean Won
Swiss Franc
Taiwanese Dollar
Turkish Lira
United States Dollar

USD-ARS
AUD-USD
USD-BRL
GBP-USD
USD-CAD
USD-CLP
USD-CNY
USD-COP
EUR-USD
USD-ISK
USD-INR
USD-JPY
USD-MXN
NZD-USD
USD-RUB
USD-ZAR
USD-KRW
USD-CHF
USD-TWD
USD-TRY
USD

Spot Quote
(6/30/14)

Quote
Convention

3-Mth Rates
(9/30/14)

8.1310
0.9433
2.2132
1.7109
1.0671
552.45
6.2046
1,877.50
1.3692
112.86
60.0435
101.33
12.9682
0.8758
33.9783
10.6387
1,011.95
0.8868
29.870
2.1185

USD per 1 ARS

AUD per 1 USD
USD per 1 BRL
GBP per 1 USD
USD per 1 CAD
USD per 1 CLP
USD per 1 CNY
USD per 1 COP
EUR per 1 USD
USD per 1 ISK
USD per 1 INR
USD per 100 JPY
USD per 1 MXN
NZD per 1 USD
USD per 1 RUB
USD per 1 ZAR
USD per 1 KRW
USD per 1 CHF
USD per 1 TWN
USD per 1 TRY
USD

27.20%
2.86%

1.0000

0.56%
1.13%
4.20%
0.03%
5.85%
8.63%
-0.09%
3.29%
3.89%
9.66%
6.40%
-0.05%
0.88%
10.00%
0.28%

3rd Quarter 2014

Total
Spot
Interest
Return1
Return2
Return3
7.10%
-3.50%
10.98%
-6.61%
-7.27%
0.71%
-7.06%
-9.51%
2.71%
-5.09%
-5.22%
0.14%
-4.37%
-4.71%
0.36%
-6.73%
-7.58%
0.92%
1.51%
1.04%
0.47%
-6.29%
-7.28%
1.07%
-7.72%
-7.75%
0.03%
-5.25%
-6.64%
1.50%
-0.39%
-2.54%
2.21%
-7.59%
-7.59%
0.00%
-2.78%
-3.43%
0.68%
-9.98%
-10.85%
0.97%
-12.11%
-14.19%
2.42%
-4.18%
-5.74%
1.66%
-3.66%
-4.11%
0.47%
-7.15%
-7.15%
0.00%
-1.55%
-1.76%
0.21%
-4.78%
-7.01%
2.40%
0.07%
0.07%

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

13

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

2014 Year-to-Date
Total
Spot
Interest
Return1
Return2
Return3
5.00%
-22.64%
35.73%
0.14%
-1.91%
2.09%
4.46%
-3.47%
8.21%
-1.69%
-2.08%
0.39%
-4.24%
-5.13%
0.95%
-9.55%
-12.18%
2.99%
0.01%
-1.39%
1.42%
-2.16%
-4.71%
2.68%
-7.95%
-8.09%
0.15%
-0.43%
-4.72%
4.50%
6.97%
0.07%
6.90%
-3.92%
-3.96%
0.04%
-0.81%
-2.92%
2.18%
-2.47%
-4.94%
2.61%
-11.44%
-17.00%
6.69%
-3.06%
-7.02%
4.26%
1.06%
-0.51%
1.58%
-6.52%
-6.51%
-0.01%
-1.41%
-2.03%
0.64%
1.69%
-5.71%
7.85%
0.19%
0.19%

Appendix 3: Purchasing Power Parity (PPP) Analysis

(as of 9/30/14)

Currency
Norwegian Krone
Swiss Franc
New Zealand Dollar
Icelandic Krona
Australian Dollar
Danish Krone
Canadian Dollar
British Pound
Euro
Swedish Krona
Brazilian Real
Colombian Peso
Singapore Dollar
Japanese Yen
South Korean Won
Chilean Peso
Czech Koruna
Chinese Renminbi
Thai Baht
Phillipines Peso
Argentina Peso
Indonesian Rupiah
Hong Kong Dollar
Malaysian Ringgit
Mexican Peso
Russian Ruble
Hungarian Forint
South African Rand
Polish Zloty
Turkish Lira

ISO
Code
NOK
CHF
NZD
ISK
AUD
DKK
CAD
GBP
EUR
SEK
BRL
COP
SGD
JPY
KRW
CLP
CZK
CNY
THB
PHP
ARS
IDR
HKD
MYR
MXN
RUB
HUF
ZAR
PLN
TRY

Average
25.04%
23.48%
14.86%
12.57%
12.43%
11.86%
5.53%
2.65%
2.41%
1.74%
-3.72%
-14.06%
-22.10%
-23.63%
-23.72%
-31.78%
-32.44%
-41.95%
-42.11%
-47.26%
-50.06%
-51.27%
-51.98%
-53.32%
-54.31%
-55.73%
-58.75%
-61.73%
-62.53%
-66.69%

% Over/Under Valued
Bloomberg
Bloomberg
OECD
(CPI)
(PPI)
28.97%
3.79%
31.28%
17.88%
2.07%
11.98%
26.06%
33.37%
12.57%
24.28%
22.79%
18.17%
23.81%
11.34%
9.66%
9.49%
6.08%
4.29%
11.27%
14.70%
-4.94%
-1.93%
10.01%
4.44%
17.27%
-18.44%
-13.36%

-6.00%
-23.34%

-23.47%

-22.10%

-67.94%
-91.58%
-81.43%
-107.44%

Notes
Please note that data regarding all countries is not generally available.
Source: Bloomberg

14

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP

Big Mac
42.36%
42.67%
-11.98%
-15.53%
2.64%
2.25%
-10.43%
-2.89%
21.47%
-3.72%
-14.06%
-22.10%
-42.95%
-24.09%
-31.78%
-32.44%
-41.95%
-42.11%
-47.26%
-50.06%
-51.27%
-51.98%
-53.32%
-40.67%
-55.73%
-25.91%
-61.73%
-43.63%
-25.94%

CME Group is a trademark of CME Group Inc. The Globe logo, CME, CME Direct and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago
Board of Trade are trademarks of the Board of Trade of the City of Chicago INc. NYMEX and ClearPort are trademarks of New York Mercantile Exchange, Inc. All other trademarks are the
property of their respective owners. Standard & Poors and S&P 500 are trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use by Chicago Mercantile Exchange
Inc.
Futures and options trading is not suitable for all investors, and involves the risk of loss. Futures are leveraged investments, and because only a percentage of a contracts value is required
to trade, it is possible to lose more than the amount of money initially 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 matters pertaining to rules and specifications
herein are made subject to and are superseded by official CME rules. Current rules should be consulted in all cases concerning contract specifications.
The information within this presentation has been compiled by CME Group for general purposes only. Although every attempt has been made to ensure the accuracy of the information within
this presentation, CME Group assumes no responsibility for any errors or omissions. All data is sourced by CME Group unless otherwise stated.
This communication does not constitute a Prospectus, nor is it a recommendation to buy, sell or retain any specific investment or to utilise or refrain from utilising any particular service. This
communication is for the exclusive use of Eligible Counterparties and Professional Clients only and must not be relied upon by Private Clients who should take independent financial advice.
Circulation should be restricted accordingly. Chicago Mercantile Exchange Inc. is a Recognised Overseas Clearing House (ROCH) recognised by the Bank of England. Chicago Mercantile
Exchange Inc., Board of Trade of the City of Chicago and the New York Mercantile Exchange are Recognised Overseas Investment Exchanges (ROIEs) recognised by the Financial Conduct
Authority .
Issued by CME Marketing Europe Limited. CME Marketing Europe Limited (FRN: 220523) is authorised and regulated by the Financial Conduct Authority in the United Kingdom.
Copyright 2014 CME Group. All rights reserved.

15

| Currency Market Monitor 3rd Quarter 2014 | October 6, 2014

| CME GROUP