EFTA00610276

Deutsche Bank Markets Research r4 Global Foreign Exchange FX Spot 9 January 2014 FX Blueprint Thin end of the wedge Theme #1: Holler for dollars: Buy USD vs. NZD, CHF, SGD, buy EUR/USD risk 'Research Team reversal London Theme #2: Play it again, san: Buy USD/JPY Bilel Hafeez Theme #3: Home Counties trump Mounties: Buy GBP/CAD James Malcolm Theme #4: Swiss -Out: Sell CHF/NOK Henrik Gullberg George Sarevelos Theme #5: Dingo unchained: Buy AUD/NZD Siddhanh Kapoor Theme #6: SEK to score with thaw: Sell EUR/SEK, buy EUR/NOK put Oliver Harvey Theme #7: Trend not bitter end: Follow trend in JPY and CAD Nicholas Weng Theme #8: Balti not faulty, China still finer: Buy USD/INR put, buy USD/SGD, sell USD/CNH, sell JPY/KRW New York Theme #9: Pole dances, TRY trips: Sell EURIPLN, sell USD/ILS, sell EUR/HUF, Alan Ruskin sell EUR/RUB, buy USD/TRY Daniel Brehon Theme #10: Pesos no prickly pair. Buy MXN vs. USD, CLP, RUB, buy CLP/COP Dreusio GiacomoIli Guilherme Marone Theme #11: Vol to roll: Buy EUR/USD FVAs, USD/JPY vol swaps and risk reversals, AUD/USD puts Singapore Sameer Goel Ma'like Sadie!eye Perry Kojodjojo Sydney Adam Boyton Tokyo Teisuke Tanaka Head of FX Strategy Bilel Hafeez Deutsche Bank AG/London DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 054/04/2013. EFTA00610276 9 January 2014 FX Blueprint: Thin and of the wedge Overview Sticking to regime change; dollar uptrend A neat way of playing the lead-lag between different 2013 marked a fundamental regime change from the segments of the market to the normalization in crisis-prone 2008-2012 period. The dollar's correlation developed markets is to buy the Norwegian krone and to equities flipped, the euro-area avoided a crisis and sell the Swiss franc. The former saw a large unwind of the Fed announced a rolling back, rather than an post-crisis safe-haven inflows last year, while safe- expansion, of QE. If there was a locus of crisis it was in haven flows to Switzerland have yet to be unwound. emerging markets, which felt the shock of Fed taper. We should start to see this happen in 2014. Elsewhere This could hint that the 1990s dynamic of first half in Europe, the Swedish krona should do well as the dollar weakness and developed market crises and Swedish economy finally catches up to German and US second half dollar strength and emerging market crises economic strength. could be repeating itself. Asia-Pac winners and losers We therefore remain committed dollar bulls. If last year In the Asia-Pacific region, one of the largest cross was all about the US long-end being re-priced on taper, moves in 2013 was AUD/NZD, but we expect a major 2014 will mark the re-pricing of the US short-end. reversal this year. Aside from attractive valuations, the December's Fed decision therefore represents only the rates markets will likely price a more hawkish RBA thin end of the wedge for US interest rate compared to an already aggressively priced RBNZ. normalization and its effect on markets. This should We'd look for the Korean won to outperform the allow the USD to strengthen against the core European Japanese yen on an improving current account, a pick- hold-outs to dollar strength, the euro, Swiss franc and up in global growth and a robust domestic financial pound. The equity flow picture should finally move in system. The Singaporean dollar will struggle as favour of the US as slow-moving capital adjusts to the valuations are stretched, household debt is elevated new DM regime. Our favourite expression of dollar and the currency is closely tied to the overall dollar strength would be to buy it against the three most trend. Finally, we'd still buy CNH as the current over-valued currencies in the world, the New Zealand account, inflation and likely capital inflows are Dollar, Swiss franc and Singaporean dollar. supportive, though we remain wary of the carry unwind dynamics seen in the currency. Yen trend still down While we are looking for a reversal in core European Fragile EM; strong EM currency trends, on the yen we remain firmly in the The Indian rupee is the only 'fragile five' currency we bearish camp and look for a trend extension from last like to be long. Current account improvement, portfolio year. What adds to our confidence is that major yen inflows after last year's reduction and beneficial policy turns tend to see the yen move by 43% on average,and action adds up to a bullish case. By contrast, the we're nowhere near such a move yet. On fundamentals, Turkish lira and South African rand should continue to the BoJ is also conspicuous amongst the major central struggle as their current account dynamics are poor. banks in ramping up QE, the basic balance of While both Indonesian rupiah and the Brazilian real also payments is heavily negative and foreigners have yet to suffer from rickety current accounts and domestic unwind their safe-haven inflows to Japan that were dynamics, better valuations and high carry may prevent accumulated in the crisis years. excessive weakness. Not all EM is bad. We like the Polish zloty, Israeli shekel and Mexican peso. The first on growth, the second on commodities and third on Rest of G10 We underestimated UK growth in 2013, but for 2014 expected FDI and cyclical pick-up. we intend not to miss the changes in the UK economy. The starkest one will likely be the pick-up in inflation, Last year's Blueprint's Trades which will only add to expectations of a more hawkish Our trades from the last Blueprint were mixed. Our best Bank of England. The pipeline for FDI into the UK also trade was going long MXN/BRL (+7.1%) while our looks good. The main weakness for the pound remains worst was being short TRYIZAR (-3.6%). Overall, 6 of the current account deficit, so as a FX trade we like to the themes made money while 4 lost money. Overall, buy the pound against another current account deficit our 10 themes made a 0.47% average retum. currency, the Canadian dollar. Helping the bearish CAD case is that expectations of a hawkish Bank of Canada Bi!al Hafeez, London appear overdone given the disconnect between the US and Canadian economy, the likely reversal of the surge of bond inflows seen since 2008 and a turn lower in commodity prices. Page 2 Deutsche Bank AG/London EFTA00610277 9 January 2014 FX Blueprint: Thin end of the wedge Theme #1: Holler for dollars ▪ We expect the Fed and a recovery in US equity 'Curve Flattening Very Bullish USD inflows to be the two main pillars of support for the dollar in 2014. Buy USD vs. NZD, CHF and SGD on ChingelnDAYerounicifferentmoves in 2yr-10/rUSyleidcufve cycle and extreme valuation. 20ra 19804orisy e The Euro-area current account remains supportive 2096 'Etetbtlorr II for the euro, but tight liquidity is fully priced, the 15% 10% risk of negative rates is material, portfolio inflows 6% are peaking and we are reaching the 20% FX over- 0% valuation bound. Buy 12m EUR/USD 1.4011.31 risk reversals for zero cost. -10% 'Growth' •15% Don't Rely on Fed Dovishness -2096 Last year was all about pricing out QE, even though -25% tapering is just beginning. The overwhelming message Beer Twist But Beer ai TNSt Flatten linen Flatten Steepen Steepen Steepen is that the market front-runs major events, and that the timing of re-pricings is very unpredictable. Just as 2013 Sourer Ocuadre Sank iMf was about QE unwinds and higher long-end yields, we think this year will be about the re-pricing of "low for long" and higher short-end yields. 'UST Selling Last Year Offset By Cash and Hedging First, US short-end expectations are exceptionally C..sourative US short-term ponfoho flows Immlo & ST benign. The market is not pricing the first rate hike until 2000 loans, Do USD) Q3 2015, just in line with FONT projections, and by 1800 which time a simple linear extrapolation of the US 1600 unemployment rate takes us well below 6%. Second, 1400 the US yield curve is close to all-time steepness 1200 extremes. On the one hand, this means that the risks 1000 are skewed towards flattening, historically one of the 800 most supportive yield curve environments (chart 1). On 600 the other hand, the forwards are extremely high, 400 suggesting that even if these are realized, the US dollar 200 will climb up the carry ladder and drop-out of the bottom-3 yield ranking by year-end. 94 96 98 00 02 04 06 08 10 12 Foreigners to Come Late to the Party SOU/014 Ditatitho Hunk abentre RAMC* LP, ONIStehat The second building block to our bullish USD view is our positive outlook on growth and by extension US Equity Valuations Not Extreme, Inflows Should Recover equity inflows. 2013 stood out for large dollar cash accumulation, on the back of UST liquidation and an —Relative P/E ratio, US vs world•, 12m lead Ohs adjustment of USD hedge ratios (chart 2). The year has 1.2 Net equity inflows Ohs, % gross flowsl f 120% also stood out for record outflows from US equities as Americans have invested large amounts offshore and 1.t 70% foreigners have refused to engage in the S&P 500 rally. 1.0 But looking at relative valuations, outflows have overshot what is a relatively benign valuation picture 0.9 20% for US stocks. Using the average P/E ratio of Hong Kong and UK stocks as a global proxy, we find that 0.8 -30% valuations are close to the medium-term average (chart 0.7 3). The odds therefore seem skewed towards higher -80% equity inflows into the US, which combined with a 0.6 flatter US curve should see an improvement in portfolio flows that was lagging this year. 0.5 I 130% 96 97 98 99 00 01 03 04 05 06 07 08 10 11 12 13 14 Swear thvescne Bonk lleamingMime t0 'we pan*oddby the ME end*op Sang I Deutsche Bank AG/London Page 3 EFTA00610278 9 January 2014 FX Blueprint: Thin end of the wedge Hard to See EUR Story Get Any Better IEUR/USD Still Tracking Rate Differentials The EUR was the star performer in 2013, despite a strong dollar elsewhere. The Euro-area's large current 1.0 EUR/USD Ohs) 0.1 account surplus has helped, which has pushed the mplied 2yr E R/USD yields (rhs) 1.38 basic balance into positive territory and in the past has 0 been associated with broad-based EUR-appreciation. It 1.36 is for this reason that we expect the EUR to continue to 1.30 -0.1 hold up relatively well against many G10 FX. Looking at 1.32 drivers more relevant to EUR/USD however, the positive factors that have driven strength versus the 1.3 -0.2 dollar have peaked. 1.28 1.26 -0.3 First, interest rate differentials should turn lower over 1.24 2014. Looking across different tenors as well as bond -0.4 versus implied forward yields, we find that the euro is 1.22 most sensitive to short-dated forward-implied yields. 1.2 -0.5 Last year short-end European yields moved higher not Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 only on the back of ECB LTRO liquidity withdrawal, but Sono Damen, &trot Consenws economy, tr ancectormegotions as the cross-currency basis also moved back to flat for the first time since 2008 (chart 1). For this year, the risks are skewed the other way. There is less than IPortfolio Inflows Into Euro-Area Peaked 200bn EUR of excess liquidity left, EONIA is back to the refi rate and cross-currency basis is flat, so there is no 400 Euro - World Business Surveys (Ihs) -20 room left for higher short-end European yields. In Net Portfolio flow, inveretd outho 300 -15 contrast, the ECB retains a strong easing bias and -10 negative rates or additional liquidity injections remain a 200 strong possibility. 100 -5 0 0 On the flow side, the best is behind us as well. Portfolio 5 inflows into the Euro-area have been dominated by -100 10 equity, but cumulative purchases are now back to -200 trend and on a relative valuation basis Euro-area 15 equities are at a 10-year high. On the outflows side, 300 20 European offshore investment remains very pro-cyclical, -400 25 so an improving cycle should lead to a pick-up in Euro- -500 30 area outflows (chart 2). Add to that the peak in the 08 08 10 11 12 13 current account surplus on the back of recovering &am basset* (WA Scoarteg fa no, 0' domestic demand and the risk of additional ECB easing, and we like buying a 1.42p/1.34c EUR/USD risk reversal for zero cost. INZD, SGD, CHF Most Expensive FX in the World (a) Other Dollar Crosses to Short 30 PPP valuation adjustedforproductivity Looking outside of EUR/USD, NZD, SGD, and CHF are I 20 -. and terms of trade (BEER) our top shorts. The Swiss franc is a higher beta version of EUR/USD, with valuations more stretched and 10 greater potential for capital outflows. NZD and SGD are JIllrrr the most over-valued currencies in the world, having lagged all other FX in the USD appreciation that has -10 - materialized so far. We therefore like buying USD vs. NZD, CHF and SGD. This basket has a steady —80% -20 correlation with both the narrow and broad USD trade- -30 weighted indices over the last ten years. 00 George Saravelos, London, -50 ou_occ<noomm-zleceoavo>-zei.oiln-a.ler4r4ticca ,..aaD Bilal Hafeez, London, zvmw D..cE,cr.dpeori ev, r2v mo Ea-ni optuE-lozo,c d mgvo.mucen vz Somas OwitstAo Byµ libonits7 Fiume fit Page 4 Deutsche Bank AG/London EFTA00610279 9 January 2014 FX Blueprint: Thin end of the wedge Theme #2: Play it again, san We always suspected 2013 would be special, and in this publication a year ago urged investors not to wait 'What happens in year after big" USD/JPY move? for a dip in USD/JPY to buy. We highlighted the 6 ongoing deterioration in Japan's balance of payments Trend reverses Trend continues and huge pent-up energy in risk-averse short-term s - capital flows post-GFC. We noted how sentiment was shifting but investors seemed overly cautious, and 4 pointed out that trend turns are typically worth 20.25% on a first-year basis - basically what ensued. It didn't matter that we couldn't anticipate the BoJ's radical departure or mixed Fed signals on QE. The associated 2 • swings in risk appetite and positioning created some bumps in the road. But a single-minded focus and conviction ultimately paid off big time. 0 -25%-301-15%-10%-5% 0% 5% 10% 15% 20% 25% 50% 35% Last year's gain now appears to be this year's pain. The yen posted its largest percentage point loss in 34 years Scum.: &vow,. Bent Boor nnFaience UP. • &.c. N/ ass POSt Sot kgego and the Nikkei its biggest rally since 1972. Both go into the New Year on their highs, even as WY JGB yields ILong-term trends in USDJPY are within 5bp of their end-2012 level. Few savor the Date Rate Log chg Months prospect of chasing or fighting such markets. 13/01/1971 358.44 14/03/1973 254.45 -34% 26.0 The trend is yet young 08/12/1975 306.84 19% 32.8 Still, outsized (10%+) moves in USD/JPY have extended 30/10/1978 177.05 -55% 34.7 in the following year twice as often as they retraced: 12 04/11/1982 277.65 45% 48.1 times versus 6 since 1971 (top chart).1 We think this is 25/11/1988 121.10 -83% 72.7 a multi-year-trend, and historically such moved have 17/04/1990 160.20 28% 16.7 cumulatively been worth 43% (log terms) with a 19/04/1995 79.75 -70% 60.1 standard deviation of 20%, typically lasting for just over 11/08/1998 147.66 62% 39.7 three years (see chart 2). Mechanically speaking, that 26/11/1999 101.25 -38% 15.5 would take spot to 116 in December, and well through 31/01/2002 135.15 29% 26.2 most conceptions of 'fair value.' One should not shy 17/01/2005 101.69 -28% 35.6 from forecasting such things, because overshoot is 22/06/2007 124.14 20% 29.2 very much the norm for FX (chart 3). 31/10/2011 75.35 -50% 52.3 Abs avg 43% 37.7 Base money differentials matter, will grow Stdev 20% 16.7 As far as the eye can see policy settings also imply it. 20/12/2014 116.00 43% 38.6 Deputy Govemor Iwata argued in October that past San Ammo. Gant &bombe.Memo UP experience both in the US and Japan show QE works mainly via changes in the money stock. (Hence the importance of the BoJ's commitment to doubling the monetary base; he asserts 'the current level of the IFair value contestable, overshoot is not monetary base is irrelevant.') Time lags in transmission 160 mean its impact - including on the yen (top chart over 150 page) -- will build even as the initial expectations boost 140 from 'shock and awe' ebbs. Consequently, markets 130 need not fear the absence of further easing by the Bank 120 if, as seems likely, the consumption tax hike in Q2 110 passed smoothly. Governor Kuroda has also made clear 100 that Japan's massive money expansion will continue 90 until the 2% core CPI target is not only achieved but REER (2005*100) deemed secure on a sustainable (medium-term) basis. 80 — — — Polynomial trend (3) 70 • — Linear trend 60 • 71 74 77 80 83 86 89 92 95 98 01 04 07 10 13 Scurry Oeinschr Bret 8bombeep 'mane LIP xFor the Nikkei the same stets using a 20% threshold are 5 and 10, i.e., only halt as many large moves continue. Deutsche Bank AG/London Page 5 EFTA00610280 9 January 2014 FX Blueprint: Thin end of the wedge External accounts highlight major vulnerability 'Relative base money growth will only point higher Japan's balance of payments still promises a brisk tailwind for yen weakness. The trade account has 30 140 deteriorated further, against most expectations of 20 130 stabilization. This is overwhelmingly an oil and gas story, though lackluster external shipments and 120 10 strengthening domestic demand are supplementary 110 issues. Net FDI outflows a similar-sized drag that is 0 only likely to get bigger even if the current account 100 gradually improves. That reflects a massive cost-of- -10 90 funding advantage spurring catch-up after Japanese -20 corporates have been risk averse and lagged their — ease money Pp 80 competitors in overseas expansion over the last two (%YoY.1N-LtS) -30 70 - USCUPY (RHS) decades. Overall it leaves Japan's 'narrow basic balance' in a pretty neutral state (middle chart). -no 60 00 01 02 03 04 OS 06 07 08 09 10 11 12 13 14 Cross-border portfolio flows have also had little impact Santa Oaercaraant abaft." &Awe CP on the yen thus far. Foreign equity inflows seem to have been largely hedged and new bond outflows were 'Narrow basis balance still under pressure limited to banks' offshore treasury activity. Henceforth, real money inflows to Japanese stocks should pick up, JOY aril, 3mma but will probably be balanced by growing Japanese 3.0 ! outflows into foreign bonds and stocks - the latter encouraged by the new NISA scheme and more 2.0 - aggressive GPIF portfolio adjustment away from JGBS. 1.0 That would leave the financial account's short-term loans balance as largest swing factor again. It captures 0.0 carry trades and foreign asset hedging activity and responds to risk aversion and investor's perception of l iTransfe s -1.0 long-term interest rate differentials. It is several orders i' of magnitude larger than other BoP components and ncome -2.0 II seen in stock terms retains scope for several hundred Goods & services —1 m(6nvina) billion dollars of yen-selling unwinds (lower chart). 3.0 02 04 06 08 10 12 Abenostics abound Same' Dana* awe Seam:Keg "'nano, CP Conventional market tops are characterized by hubris in the mainstream which creates unquestioning acceptance of a 'new status quo.' By contrast, most 'Financial account's 'other investment balance' is key forecasts for Japanese asset prices strike us as intensely conservative as there is tremendous 30 Ise foreign asset 60 — Short-term loans skepticism that the country's long-term prospects have (WY aril, commutative) hedge demand 70 really been changed by the advent of Abenomics.2 20 - USD1PY (RHS, inverted) 80 Inevitably there will be bumps along the way, and 10 90 nobody should expect a free lunch. But until the basic 100 tenets of what remains a uniquely favorable backdrop 0 110 of fundamentals and potential flows are challenged or •10 • 120 overshadowed (geopolitics, anyone?), encourage investors to replay last year's template as this year's and 190 -20 basic game plan. We expect FX-equity correlations to unwinds 140 Carry trade extends. remain extraordinarily high and volatility to stay -30 150 elevated. Our end-2014 and 2015 USD/JPY forecasts of 96 98 00 02 04 06 08 10 12 14 115 and 120 are reiterated with upside risks. &Knee' Deutsche aset 8boftwg 'nine.> CP 2 For a convincing exposition of this assertion, see Kuroda's recent speech: James Malcolm, London, (+44)20754 50884 https://www.boi.or.iaten/announcements/pressAoen 2013/clata/ko131225 Taisuke Tanaka, Tokyo alacif Page 6 Deutsche Bank AG/London EFTA00610281 9 January 2014 FX Blueprint: Thin end of the wedge Theme #3: - Home Counties trump Mounties • Inflation risks and potential FDI inflows should keep sterling supported this year, but a widening IInflation Could Be Here Sooner Than Market Expects current account deficit and stronger USD will 58.0 , Emplyt PMI, 9m lead constrain gains versus the euro and dollar. We are —GBP AWE reg pay, priv moderately bearish EUR/GBP and GBP/USD, 56.0 forecasting 80p and 1.54 by end-year respectively. 54.0 • As an outright trade we prefer buying GBP versus 52.0 CAD, on which we are more bearish. It remains 50.0 vulnerable to an equally-large current account deficit, QE-flow unwinds and unwinding internal 48.0 imbalances. 46.0 The UK domestic demand cycle has kicked in quicker, 44.0 stronger and more sustainably than anticipated. We 42.0 see inflation and FDI inflows as being the major source of upside risk for GBP next year. 40.0 Jan-01 Mar-03 May-05 Jul-07 Sep-09 Nov-11 San' Sabaf AfarsItpreway. 1W Inflation, not deflation to be theme in 2014 Last year was all about UK growth expectations. This year, the risk is attention turns to prices. First, even IFDI Upside Risk To GBP Next Year though recent inflation prints have surprised to the so downside, pipeline pressure is building. Productivity is 0Budget ler UK Trees end wwwww. hived IndtritMent. MAO GBP not recovering as quickly as the BoE is expecting, so leading to a much faster than expected drop in the unemployment rate. In turn, wage inflation could 11 40 accelerate sharply in 2014 (chart 1). Second, the starting point of inflation is much higher in the UK than 30 the rest of G10. Any turn in the trend will focus minds much more quickly than elsewhere. With the first BoE rate hike still only priced for mid-2015 (a bit earlier than 20 the Fed), there is plenty of potential for near-term yield support as price pressure builds. 10 Outside of monetary policy, FDI is another source of 0 — support. Excluding the Verizone-Vodafone deal, UK 2008 2000 2010 2011 2012 2013 inbound has been muted by pre-crisis standards. Souses Asses &int Doemeerd 'Mang LIP But UK deal-flow is pro-cyclical, tracking the broad trends in equities and global transactions well. IEUR/GBP Holding Up Better on Back of Flow Our equity analysts are positive on both this year. Add to that the UK government's increasing dedication to EUR/GBP (6m lag, Ms/ 130 attracting foreign investment - particularly into the —RICS House Price Balance (rhs, inverted) publicly-owned banks - (chart 2) and FDI stands out as 1 90 a potential additional source of support for GBP in 2014. 0.9 Current Account Deficit Will Constrain Gains vs. EUR 30 0.8 On the flipside, the UK recovery is happening for the "wrong" reasons. Domestic demand, not exports are -20 driving the cycle. The current account deficit is 0.7 deteriorating and stands in contrast to the US and Euro-area. This goes a long way to explain the lag in 0.6 EUR/GBP versus cyclical indicators (chart 3). This is reflected in our conservative EUR/GBP forecasts: we see a slow grind lower to 0.80 by the end of the year, 0.5 12( with GBP/USD revisiting the low 1.50s on the back of a 94 96 98 00 02 04 06 08 10 12 strong USD. Soutar Disney Gant ow-vow guano, LIP Deutsche Bank AG/London Page 7 EFTA00610282 9 January 2014 FX Blueprint: Thin end of the wedge CAD Flow Picture Very Negative We are more bearish CAD. Speculative shorts are building, but on the portfolio flow side, the balance of IUK Inflows Could Improve, Opposite of Canada payments is characterized by a large overhang of fixed 1100 2500 Cumulative bond inflows, income inflow positions as a by-product of Fed QE (chart 4). Canada benefitted from close to 280bn of 1000 local currency, bn "excess" inflows over the 2010.2013, which have 900 2000 -750bn plugged a sharply wider current account deficit similar (UK) in size to the UK. The UK, in contrast, has suffered from 800 1500 1 a lack of inflows in recent years (chart 4). While FDI 700 and underweight fixed income positions have the +280bn 600 (Canada) 1000 potential to "plug" the UK deficit, the risks appear skewed the other way in Canada. 500 400 change relative On the monetary policy side, Canada doesn't appear to trend well placed to benefit from an improving US cycle 300 either. Rate expectations are already running ahead of 200 0 the Fed and BoE by a quarter, and given the BoC's 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 renewed dovishness there is limited potential of these Sown. a* it. rlater Rea&Ye.: Nig happening sooner. Indeed, the correlation between US and Canadian data surprises has dropped off sharply over the last few years, pointing to the divergent trends !GBP/CAD 'Current Account Neutral' Cross in local housing markets and domestic leverage. To boot, Canadian terms of trade have clearly peaked 10 Current account deficits., (my bn (chart 6), with the currency moderately expensive versus non-energy commodity prices and supply glut in North America oil production providing an additional headwind. Big picture, GBP/CAD is a dollar-neutral cross, with correlations with other USD crosses all lying below 50% over 1-3 year time horizons and zero correlation with the broad USD TWI since 1995. The relative performance between UK financials and Canadian stocks does a decent job of explaining big picture turns since the early 1990s. The cross remains more than 20% below its pre-crisis average suggesting plenty of potential for upside as the respective domestic stories play out. 90 91 92 93 95 96 97 98 00 01 02 03 05 06 07 08 10 11 12 Source' °math, eant atiOntteep Aveiro UP George Saravelos, London, Oliver Harvey, London, IUSD/CAD Following Commodity Prices Lower IGBP/CAD a Beta Neutral Cross 95 97 99 01 03 05 07 09 11 13 0.85 45( 2.8 i —GBP/CAD Ohs) 1 —UK fina cials/Toromo stock index (rhs) 0.95 2.6 0.9 40( 1.05 2.4 0.8 1.15 35( 0.7 2.2 1.25 0.6 30( 2 1.35 0.5 1.8 1.45 25( 0.4 1.6 0.3 1.55 20( 1.4 0.2 1.65 — USD/CAD (Ihs, inverted) — BoC Non-energy Commodity Price Index irhs 15( Sewn Amuse-ftBIM Soutar Akan» &Mc &bombers Fran. UP Page 8 Deutsche Bank AG/London EFTA00610283 9 January 2014 FX Blueprint: Thin end of the wedge Theme #4: - Swiss out We can think of three reasons to go short CHF/NOK. INOK one of highest betas to US cycle, CHF lowest 1. The relative cycle is supportive of rate differentials. 35% FX correlations to quarterly US GDP Ekon 1990 Inflation is at a much higher starting point in Norway ARom2000 30% than in Switzerland, leaving the Norges Bank much less room to manoeuvre than the SNB in the event of 25% upside surprises to import prices or stronger European 20% growth. Market pricing in Norway has evolved rapidly from three months ago, with the first hike now 15% expected in Q3 2015 rather than Q1 2014, more or less la% in line with the Norges' own projections. NOK is also much better placed to benefit from a stronger US cycle with one of the strongest correlations to US growth, and CHF one of the weakest. One risk is house prices, which have risen precipitately in Norway over the last 4% five years, a sharp reversal of which could weigh on -10% domestic demand and prompt Norges' dovishness. We AUD sec NOK 1420 GaP CAD EUA 01f JPY think the risks of this are slim, however, (see theme #6), San O.41tithe Sent Scone., name, LP and moderate falls will be welcomed by the central bank as skimming froth from the market. 'Norway flow reversal nearly done, Swiss yet to begin 2. Swiss safe-haven unwind should follow Norway's. not 00,110P4 1yµ9. % GDP Like Switzerland, Norway experienced large-scale safe 5% 9,titualend. not path:. flows haven inflows as a consequence of the financial crisis, 0% helping to pause customary current account surplus recycling. In the latter's case, these inflows have largely reversed, to the tune of NOK 190bn on a 2y/2y 5% basis). This has been one of the primary recent drags on the krone, but appears to have largely run its course, in contrast to Switzerland where it has yet to begin. 3. CHF also more vulnerable to domestic outflows. As well as the foreign inflow, Norway and Switzerland both saw significant repatriation of domestic assets -36 from abroad. Again, this flow has long turned in .40% -30% Norway but not yet in Switzerland. One possible J96.99 4000 M.042 OCI-03 May-0500006 Jul-013 Feb.m 500-11 catalyst will be stronger price pressures next year on San Dames bee. /900M00/0 rename LP the back of more robust growth. This should erode real returns Swiss domestics have enjoyed on already some of the most expensive assets in the world. Historically, IMore Swiss inflation means CHF weakness Swiss capital flows have been counter-cyclically related 40000 - S'etknitted NM Pt.ddio DAWNS .1 to prices (chart 3). Indeed, CHF performance closely 20000 — $wesCn yin. inverted ths Ob tracked changes in real yields last year. By contrast, 0 while conventional Norwegian outflows have resumed, 0 NOK is more protected by surplus savings being -20.000 invested by the oil fund. -40.000 06 40.000 Along with the above, CHF/NOK appears fundamentally misaligned with traditional drivers like oil/gold. Finally, 40.000 the trade benefits from being USD and EUR/USD -1000r= neutral (with a 15 year correlation of 16% and -11% 2 respectively). -120.000 .140.000 Oliver Harvey, London, J0400 A.900 514102 04103 KUrf05 Occ.c5 Ja.ce Feb.10 Sip11 San 0.34rtiOre Seat abaft.. name, 1.1 Deutsche Bank AG/London Page 9 EFTA00610284 9 January 2014 FX Blueprint: Thin end of the wedge Theme #5: Dingo unchained • 2013 saw the largest fall in AUD/NZD in over 28 Figure 1: Large declines in AUD/NZD usually see years. Behind the fall in the cross was a significant bounces move in interest rate differentials. • With the cross near record lows we think the risk / Annual Amp In AUD/NZI3 reward from here favors AUD/NZD upside. As a AG result we would be long AUD/NZD at current levels. 200 As shown in Figure 1, 2013 marked the 'worst' year for 160 the AUD/NZD cross since at least 1986. Interestingly, in lae prior years when the cross has fallen over 10% the subsequent year sees a significant bounce back. The bet 00 „Ir i_ta 'II.- i 1 13.5% fall in 1987 to 1.0959 was followed by a bounce 60 of 23.5% in 1988; while the 12.7% fall in 2002 (to 1.0727) saw a 6.7% bounce in the following year. With 100 the cross ending 2013 at 1.0850 after a 14.0% decline, -160 history would suggest some likelihood of a significant -200 move higher in AUD/NZD over 2014. IS Iwo tOM WA 'Oct 2010 2014 Savertv Da en.amt lkentargFano, ty Of course there is much more to FX than history. From a more fundamental perspective we see a number of reasons to expect a move higher in the AUD/NZD cross 'Figure 2: The cross is also at an extreme through the course of 2014. AUD/N213 The first is valuation. As Figure 2 shows, the AUD/NZD cross has traditionally found a base around 1.05 (with just below here therefore likely to serve as a good level to set any stop). Our valuation metrics (as published in Exchange Rate Perspectives) also find NZD the most over-valued of the G10 currencies on a PPP and BEER basis. The NZD is around 33% 'expensive' on a PPP basis, versus the AUD which is 26% 'expensive'. On a BEER basis the NZD is 22% 'expensive', versus the AUD which is only 5% above 'fair-value'. 106 As far as 'big picture' drivers of the AUD/NZD cross are PAA36 MAN MO93 WV UN 01 Mr OS Vs CO UM 13 concerned, it is hard to go past interest rate differentials as shown in Figure 3. Looking a little more &wet DivetAOLIS.M. 1160nodat MannLP closely at the last few data points in that chart it also appears that AUD/NZD has 'overshot' interest rate differentials to the downside. Indeed, the current IFigure 3: Interest rate differentials are the key driver interest rate differential would appear to be more AUO/N20 ar4 interact rate offactit,ats consistent with the cross trading around 1.13 versus its 2.50 current level. We should not, of course, rule out ~4tcnlm 1e]1 interest rate differentials 'catching up' to the cross. --4in MAW. 41111eGnIar PPM ZO2 That would require, however, markets to price even 1.50 more tightening for the RBNZ, and/or easing from the I.00 RBA. On the outlook for the kiwi central bank our central J 050 0.00 view remains that we will see 75bps of policy 020 tightening over the course of 2014. Market pricing is a little more aggressive than that, with a little over 100bps of hikes priced for 2014. On the RBA the 1.06 market is essentially priced for no change in rates in 54006 50207 54409 54000 Sao 10 Sep 11 Sao 12 Sp10 Sep 1 Australia over the coming year - something consistent SWAY Data@ Sont Stowlarg foam CP Page 10 Deutsche Bank AG/London EFTA00610285 9 January 2014 FX Blueprint Thin end of the wedge with our own view. That said, the Australian rates Figure 4: Once the RBA is 'done' easing, Australian market has a tendency to sell off considerably once it rates usually (and often incorrectly) price a lot of hikes becomes clear than an easing cycle in Australia is over. (Figure 4). As to what might spark such a sell-off; an Mat* pdong anus the RBA cab ire improvement in the labor market stands as one clear 112001 possibility. RBA action - and market pricing for the 1100. RBA - is often driven by conditions in the labor market. AM.." Loh. As Figure 5 shows, our tracking of 11 different monthly 1003 one el 00 C. th< Jm to* to I •a Y, t indicators of labor demand and sentiment suggests a pick-up in the pace of employment growth over coming months. All up, we therefore see the risks being skewed toward a narrowing of the front end interest rate differential between Australian and New Zealand, something that would be supportive of our long AUD/NZD stance. sop St* Ww4 20, Finally, it would be remiss of us not to consider the Jan 116 An16 Jm01 Janie .1m01 Jor.00 MIPS JMO: Ante -Sill Jan', outlook for China when discussing any view on AUD, Spar' Dena &w* ScoategFaroe:CP either against the USD or crosses. Our house view remains quite constructive on China, with GDP growth expected by DB to continue its recovery towards 8.6% 'Figure 5: The labor market might be the catalyst in 2014. Despite the modest decline in the December PMI reading, our local economists note that the PMI's Momay newspaper end 'cameo:poss.business kinnkis and consumes nnys canted to Australian amslayrnont growth Q4 average reached 51.3, O.5pts above the Q3 average which suggests that Q4 IP and GDP growth are unlikely to have decelerated from that seen in Q3. Looking forward, stronger external demand should see an acceleration of GDP growth over 2014. If this view on China is correct, then it should be supportive of the AUD given the tendency of the market to see the Aussie as a China proxy (see Figure 6). We are; however, a little cautious about overplaying any impact that stronger growth in China may have on the AUD, given that Australia's key commodity export to China (iron ore) is likely to be moving into an oversupply situation this year. We should note here Sown Macho 8sat, Stoomberg flan* f* .414 Ara M4& Oeltelt. W8C-Aff that while many analysts focus heavily on relative commodity prices when considering the AUD/NZD Figure 6: Stronger growth in China could also help cross; we are inclined to think that the true importance of commodity prices is captured through the influence AUD on interest rate differentials. In other words, we take the view that the impact of divergent commodity price 12 —0-Ms nSBC PM13rnih *mg* r 26 trends is likely to have already been captured by interest rate differentials. 8 16 4 All up, some recovery following the sham fall in 2013, 5 the favorable valuation backdrop, and the risk that the 0 interest rate differential moves in the AUD's favor over 4 -4 coming months has us long AUD/NZD. -15 Adam Boyton, Sydney, -26 2005 2007 2009 2011 2013 SMANV Dana* &rot ScoartargFnlnro ffr Deutsche Bank AG/London Page 11 EFTA00610286 9 January 2014 FX Blueprint: Thin end of the wedge Theme #6: SEK to score with thaw • The krona is not the main culprit of a lukewarm Figure 1: Albeit with a lag, the Swedish PMI is likely to Swedish recovery. Rather the latter reflects a broader trend of DMs losing market share to EMs. follow USD and DEM PMIs higher ▪ But global recovery still positive for the high beta 70 - Swedish economy and SEK. Moreover, global 65 - growth is equity supportive which is bullish SEK. 60 — Swedish growth numbers have disappointed repeatedly 55 — over the past 6-9 months, causing market participants to scale down their expectations for growth and policy 50 — normalization. This has in turn resulted in a gradual 45 — weakening of the SEK from around 8.40 vs. the EUR back in March/April last year to current levels around 40 - 8.90. Disappointing growth numbers are a reflection of 35 - subdued industrial activity, which in a small open 30 - economy like Sweden has also been weighing on consumer sentiment, job growth and domestic activity. 2005 2006 2007 2008 2009 ' 2010 I 2011 ' 2012 I However, blaming the disappointing industrial activity San Detach. Bart &bombs" Rare LP on a strong krona is difficult when the currency is undervalued on all metrics (PPP, BEER, FEER), and the SEK REER not historically strong. Instead, the country IFigure 2: Exports of Goods & Services, Percent of GDP breakdown of imports in Germany and Norway, oe Sweden's key export markets, shows developed FUR markets continuing to lose market share to developing 50 JK countries, suggesting the latter can now compete in major Swedish export areas like "machinery & 40 GBP-IMCAD 4101 transport equipment" where they previously have been small players. This is backed up when looking at hard 130 data, with rising German imports mainly benefitting Central and Eastern Europe. The CE-4 market share of 20 total German imports post-crisis has risen by 50% to around 12% of total. Meanwhile Norwegian imports are 10 showing a similar but broader trend towards 0 developing countries (including Asia) and away from 2011 the rest of the Nordics, Eurozone, US and UK. This of course very much goes against the popular view that sows. amanita Bat &owners Ramos LP DM imports might be decoupling from EM exports. Nonetheless, whilst losing market share means an Figure 3: SEK trade-weighted (TCW) & the US ISM ongoing global recovery will be less of a driver of Swedish GDP growth, it will still be growth supportive, and given the degree of openness in the Swedish economy, more so than in most of the rest of G10. This is SEK positive, partly because it will mean market participants will have to re-assess the policy outlook, but more because it should translate into similar growth in corporate revenues. With Swedish stock valuations only in line with the longer- term average, this should also translate into higher equity prices. Global growth and higher equity prices are typically associated with a stronger SEK, and are factors more 2000 2002 2009 2M6 2008 20111 2012 2014 important than [an orderly] tumaround in the interest — US ISM mfg rate cycle in the US. Target a gradual move to 8.55 in — Sweden TON Index. Thy (inverted site lower Sex = stronger SEK.I. ns EUR/SEK, with a stop @ 9.15. In options a3m EUR/SEK 8.65 put costs an indicative 52bp, and can be largely awn. Gewalt S,.,& 8bomOtvg 'awe CP financed by selling a 3m EUR/SEK call with a strike around the more than 2y highs @ 9.15. Page 12 Deutsche Bank AG/London EFTA00610287 9 January 2014 FX Blueprint Thin end of the wedge • Norges bank to continue to balance falling house prices vs. sticky CPI. Figure 4: Norway, Real Estate Prices, All Residential Buildings, Total & YoY • NOK cheap, but investors wary of jumping back in 35000 untess/until Norges Bank and/or crude provide support supportive. In Norway, the mainland economy has been growing 20- 15 -I 30000 25000 around 2.0-2.5% YoY for most of the last couple of to years, with the recent PMI and manufacturing output 200000 suggestive of continuing improvement going forward. # 5 Norges Bank's focus is balancing the declining housing isocioa market against sticky inflation at the consumer level. 0 t0000 With house prices having slowed to largely flat on the year, representing a 3-3.5% drop from the peak in Q3 -5 5000 last year, and headline CPI back in line with the Bank's -10 0 2.5% target (from 3.2% YoY in August), Norges Bank is 2001 2003 2005 2007 2009 2011 2013 20 5 erring on the dovish side, arguing that the rise in [core] inflation is transitory. Indeed, according to the Bank's Swat LIPataltil0 Beak IMF projections, core inflation is expected to drift back up over the next few months, reaching a peak just above 'Figure 5: EUR/NOK and Crude oil the inflation target of 2.6% in April/May, before dropping down and remaining just below 2% up until lob 30 the end of 2015. House prices meanwhile, are seen 40 9.5 - 50n slowing further, to -2.5% to -3.0% YoY in H1 2014, before returning to positive YoY growth in early 2015. 9.0 - 60c 70 8,5 - 80c The risk to Norges Banks's finely balanced outlook for 90 7 gi inflation and housing is twofold. First is a scenario in 2 to - 100 which past and current FX weakness feeds through to 1102. imported inflation, thus preventing core from 7.5 - 120 moderating in line with Norges forecasts. If the Bank 7.0 - 130 then feels compelled to hike rates at a time when house prices already are declining, that would 2009 2010 2011 2012 2013 exacerbate the decline and not be currency supportive. —010,04 Brent, Close, USD, its —EUR/NOIC actual. Ito An alternative risk scenario is if the house price falls feeds on themselves. With policy rates already as low &wore DeoYene Bork Eitiomewg Fount* CP as 1.50%, and with core CPI projected at or above target over the next 3-6 months, there would be limited scope for policy to provide a stopgap. While the above scenarios are not our baseline, they will continue to be Figure 6: Core inflation - actual and Norges Bank's a key factor in the Norges Bank's decision-making projection process, with monetary policy likely to be stuck between a fear of adding to the decline in house prices 3.5 on one hand and sticky inflation on the other. 3.0 We 2.5% Mete target Meanwhile crude is likely to continue to flatline in the 2.5 relatively tight $90 to $110 range of the past few years. 2.0 Monetary policy and crude are therefore unlikely to 1.5 provide much in terms of direction in the NOK. However, given recent depreciation cannot be 1.0 explained by fundamentals, with the Norwegian unit 0.5 arguably oversold even when taking into account the JMS/MSJstSJ IMMS ,I biSJM market's now very dovish outlook for Norges Bank 2038 2009 2010 2011 2012 2013 2014 policy and flat oil prices, we are cautiously constructive. - CPI-ATE (adjusted for taxes and exch.:Jog energy). YoY On balance we anticipate very gradual downside in NO,GIGS BanKs paecbon EUR/NOK from current levels. A 3m EUR/NOK put @ 8.25 costs an indicative 76bp. Alternatively, finance it &wow dissent &mit elocintlxvg finance to by selling a 3m EUR/NOK 8.65 call. Henrik Gullberg, London, 194/ Deutsche Bank AG/London Page 13 EFTA00610288 9 January 2014 FX Blueprint: Thin end of the wedge Theme #7: Trend no bitter end In 2007 we replicated a RBA study that claimed non- commercial "profit seekers" made money on their IMM Figure 1: Absolute = ($mil) of Profit-Seekers and positions at the expense of commercial "liquidity Liquidity-Seekers Using G5 IMM Data (1993-2013) seekers". 3 The striking conclusion is that currency speculators generally know the correct direction of G5 18 - USD mm (1993-2013. except euro 1999-2013) currencies and investors can profit from knowing their oNon-Commercial /Profit-seekers positions (although these signals are less useful in E 12" 4,, practice since IMM data is lagged three days). aCommercial/Liquidity-seekers o. 8 - In a sense, money is "left on the table" by commercial O foreign exchange users, and to a lesser extent by foreign bond and equity investors, which can be earned Cs. 0 by non-commercial actors that provide liquidity to currency markets. These profit seekers collect FX risk 4 premia in the same manner Keynes first identified when describing risk transfer in commodity markets.' -12 - 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Soutar Daunts &M. lboomberg Feigned LIP Profit Seekers Made Money in Every Year since 2003 By our calculations, non-commercial positions made money in every year since data was first released in Figure 2: Speculators had the correct EUR positions in 1993, mainly at the expense of commercial users 2010-11 and a large JPY short in 2013 (dealers also made money).' In recent years profits have come from timing big EUR/USD moves (2010-11) 12 USD mm (1993-2013. except euro 1999-2013) and catching last year's USD/JPY rise. These MI numbers more closely resemble pre-crisis profits than 8 the outsize gain in 2008 (reflecting higher FX volatility) and the nearly flat 2009 period (probably due to an unexpected GBP rebound). 0 IS MI Eroded As Speculators Accumulate Positions? Our analysis rests on the crucial assumption that profit seekers accumulate positions over the course of the • Non-commercial /Profit-seekers week at the average price. By contrast, live trading • Commercial / Liquidity-seekers metrics such as the Parker Index of currency manager AUD GBP CAD JPY CHF EUR returns show a loss since 2011 as currency volatility Source DArtne.he BanA. Stomotvg Foram UP has overwhelmed macro trends (with the exception of USD/JPY in 2013) even as the correlation between weekly IMM In and Parker returns remains positive. Figure 3: The Parker Index of currency manager returns It is possible that intra-week volatility causes profit has lagged IMM in recent years despite continued seekers (especially momentum traders) to "buy high and sell low" relative to WVAP and that IMM is positive correlation between them eroded when currencies trade in a choppy range. Average IMM Cum P&L (5100m. 810 Fortunately for investors FX volatility continues to fall 45 — Parker Index Uan-2003 = 0.1hs) 100% and promising trends (JPY, CAD) have emerged. 40 — IMM P&L v. Parker (12m corr, rhs) - 90% 35 80% Daniel Brehon, New Yor; 70% 25 60% 20 50% -' IS 40% 10 " -F 30% :•••••'*".. 3 See Kearns and Manners (2004), "The profitability of Speculators in 5 - 20% Currency Futures Markets-. Reserve Bank of Australia: and Bilal 10% Hafeez 120071, "Currency Markets: Is Money Leh On the Table?" -5 0% 4 Keynes. M. 11930). ilise on Money". London: Macmillan, 03 04 05 06 07 08 09 10 11 12 13 5 We calculate weekly by determining the notional value of Sarre' Oeutsche Bre* 8bomberg Amino> ELP positions on Tuesday and assuming longs and shorts are accumulated (or squared) at the average price over the course of the week. Page 14 Deutsche Bank AG/London EFTA00610289 9 January 2014 FX Blueprint: Thin end of the wedge Theme #8: Balti not faulty, China yet finer 2013 saw Asian FX fracture into a North and South Indian exports have been a bright spot in Asia complex. Relative sensitivity to the yen, the EM debt bubble, and the developed world equity/growth cycle 15 YoY expons growth —Noah Ave %Ft 1W, CH/ all served to discriminate the two intra-regional groups 3mma 1981 at different points during the year. Ultimately, the North 10 -India emerged fairly unscathed, while the South cheapened significantly. Indeed, much of South Asia FX still faces a host of challenges from political instability (THB), offshore debt holding overhang and weak commodity prices (MYR, IDR). However we refrain here from adding to shorts against most of this group, given a mix of large valuation adjustments, expensive carry, 5 and/or improving policy responses that is shifting the risk-reward. We concentrate instead on currencies like -10 INR where fundamentals have improved sufficiently to Jan-12 Jan-13 Jul-13 go long, and on SGD, where persistent overvaluation &sacs &wadi.Bonk Illoomfrarg Finance it and exposure to a broadening in USD strength out to low-yielders favors a short bias. In North Asia, we stay short USD/CNH, but are mindful of the large build up in [The outlook for debt flows is asymmetric in India positioning. We favor a short JPY/KRW position to 140 INR aoae express our positive view on Korean fundamentals. — Fil hdcings of Indian GSecs 120 - — — — 0uota Iron tor G-Sees The rupee has had a makeover 100 After spending three years as one of the world's worst performing currencies, the rupee should fare better in 2014 for three main reasons. First, India has seen large improvement in her external balances. The trade deficit, which is the only driver of the CAD, has almost halved from its peak. While gold import compression has 40 driven most of the trade improvement and could face slippage, exports and services have also been bright spots. Second, even as India's portfolio flow dependence is falling, both debt and equity flows could see positive swings. After aggressive debt outflows Swear Octants.Bruit COSt SUM between May-Nov 2013, offshore holdings have fallen to *core levels; indeed, foreigners returned as buyers in December. With large unallocated limits, a more IBroad consensus on SGD's overvaluation positive duration view, and the possibility of index inclusion and/or Euroclearability, India could attract 30% %OverM)/Unden-lvaluaticu vs. USD money. The key swing factor for equities will be general elections in May. To be sure, this is a binary 20% event; but hopes of a pro-growth stable coalition could 10% boost inflows in the run-up to elections. Third, RBI's swap activities have been a success adding to reserves. 0% Concerns about oil USD demand appear exaggerated, and its return to the market in November did not raise -10% volatility. Majority of their obligations to buy USD HRelatIve PPP ahead of imminent swap repayments have been met. ofteladve FEER -20% • BEER We are long a 6M USD/INR 62 put with an RKO at 57. • Average -30% SGD no longer king SGD CNY PHP TH8 MYR KRW TWD IDR INR We have seen a long USD/SGD view as a good 'long- Swat Owititilo Beak Ilbonthirp 'nano.U.P. CSC haul' trade to play for USD strength and US yield re- pricing. However, the lesson from 2013 was that USD/SGD took its cues more from the USD/G10 TVVI than its USD/Asia peers which often behaved Deutsche Bank AG/London Page 15 EFTA00610290 9 January 2014 FX Blueprint: Thin end of the wedge differently. Our view that USD strength will broaden Inflation trajectory to guide USD/CNY fixings out to G10 low-yielders like EUR, and continue to gain ground against the JPY is thus an important tailwind 12.0% for USD/SGD. SGD is also one of the most overvalued currencies globally, with consensus across a broad 10.0% range of models. Moreover, domestic vulnerabilities 8.0% have built up in Singapore over the QE years from high household debt to bubbly property prices that leave her 8.0% exposed to inevitable short-end rates normalization. 4.0% We are long USD/SGD looking for a move above 1.30 this year. 2.0% 0.0% RMB appreciation remains in play -2.0% -2 We expect RMB appreciation to persist in 2014 despite 2007 2008 2009 2010 2011 2012 2013 2014 2015 a strong USD environment. With global growth ••••• •CtstY appreciation vs USD IPBoC fixings) Chirta CPI RHS) gradually recovering and Asian exports likely to catch up, we look for a healthy current account surplus for Sweat DatarS GEC China ($220bn, 2.2% GDP). In addition, expectations of further increases in offshore investment quotas (i.e. RQFII) on the back of capital account liberalization, IPositioning is short USD/CNY and likely more in CNH should mean that portfolio inflows pick up, putting further appreciation pressure on RMB. With the 1.0 Long USD/CNY appreciation trend intact, and carry potentially set to 0.6 become more attractive as authorities push forward DO with interest rate liberalization; we are likely to see speculative flows into China persist. Inflation will be a -0.6 key driver of the pace at which this appreciation is -1.0 permitted by the authorities. The main risk to our view 1.6 is from the sizeable nature of short USD positioning in this pair - both in the offshore and onshore markets. In -2.0 the event of weaker economic data driven by tight monetary conditions and reforms, we could see a .2s Shaft IJSCUCNY pickup in volatility. For now though, we stay short 12M 3.O Jan-10 Jan-11 Jan-12 Jan 13 Jan-1. USD/CNH with a target of 5.95. SD/CNY positioning JPY/KRW heading back to single-digits sourer &IOWA. &a* AMP] paY The won's fate in 2014 remains a struggle between strong underlying fundamentals, and the defensiveness [Korean shipping and construction orders remain strong of the central bank in the face of concerns about a weakening yen. The fundamental story is supported by 120.0 aShipbuilding orders 1) continuing improvement in the current account; 2) LISObn • Overseas coretruction orders high leverage to the global growth/trade upturn; and 3) 100.0 strength of the domestic financial system as a result of the macro prudential policies implemented post-2008. 80.0 Given the strength in export orders in construction and shipping and the resulting hedging pressure, as well as 60.0 the record levels of USD deposits held by Korean corporates, there is likely to be persistent pressure on 40.0 • the currency to appreciate. BoK on the other hand is unlikely to abandon its conservative stance on the won, given concerns about upside to exports being 0D - competed away by a cheapening yen. We have seen OD 1 I 1 I 1 I I 1 21 such concerns drive the policy response function in 1997 2000 2003 2006 2009 2009, in mid-2012 and again last year. Given the expected strength in the broader dollar, and the BoK's Source °AMOY Bahl, GEC reaction function, we see better risk reward to express the view of fundamental strength in KRW via JPY/KRW downside. We target a clean break of the psychological Melillo Sachdeva, Singapore, +65 6423 8947 10 level, with a near-term target of 9.75. Perry Kojodjojo, Hong Kong, +852 2203 6153 Page 16 Deutsche Bank AG/London EFTA00610291 9 January 2014 FX Blueprint: Thin end of the wedge Theme #9: Pole dances, TRY trips Go long PLN and HUF, buoyed by competitive (Average correlation within EMEA FX (daily changes) REERs and proximity to strong German demand, and stay short TRY, as reserves are insufficient to 0.8 - act as a buffer and where external deficits require further adjustment to restore competitiveness 0.7 - 0.6 - Aggregated EMEA FX correlation (3m rolling correlation of daily changes) have dropped to levels only seen once 0.5 - post-crisis (prior to the Fed opening the door to be 0.4 - tapering last May). The stand-out underperformer is TRY, undermined by risk spreads on both sovereign 0.3 - and corporate bonds having widened on domestic 02 - political instability that has already claimed the jobs of 0.1 - a few ministers. At the other end we have ILS and PLN outperforrnance, but HUF has also has performed 0.0 reasonably well, largely unchanged vs the USD over the 2003 2008 2013 past month. More divergence with idiosyncratic factors Sam' pastas,&nit lawnIxeg "'nano, LP playing a greater rote is something we have argued for some time, and although disrupted by the 'taper tantrum' in O2/Q3 2013 in particular, the trend is intact. 'Cheap & cyclical EM FX With the Fed pushing fewer (but still a lot) of dollars into the global economy, it still makes sense to avoid Pre cs currencies with large C/A deficits, and/or those where car • • • indebtedness has risen substantially (be that public PEN • and/or private). However, in economies where FX SRL Cl• Mfg • TRO weakness in 2013 was more a function of weak growth/policy rate cuts, higher yields should not be X • 1011 RUB • * WNW and cyclNal EN FX damaging as long as the rise in yields is orderly and • * • reflects improved growth prospects. Export oriented ZAR • too. • HUT economies with competitive real exchange rates and i vizt • • • • limited balance sheet risk should benefit from a TRY RON sustained global recovery. r..20 • In EMEA this is likely to translate into more divergence 0 10 20 30 40 50 60 70 80 90 100 Exports % of GDP between PLN & HUF (benefitting from relatively competitive REERs, a strong German economy and Santa. Lit•agno dalµ abom's• Fano. LP export led recoveries), and the ILS (where the BoP effect will maintain appreciation pressures) on the one hand, and on the other CZK (sustained CNB 'Polish competitiveness helping market share intervention) plus TRY & ZAR (vulnerable to a tightening of global liquidity on insufficient FX reserves). 80 - The Russian RUB meanwhile, will be stuck somewhere 70 - in between, supported by low balance sheet risk and 60 - attractive carry but undermined by the threat of lower 50 40 - oil prices and the lack of credible reforms. 3° -- a) 20 0 From red-hot to stone cold to - Growth is picking up. Poland will benefit not only from 0- strong German demand but also a healthy banking -10 - system, with domestic credit now grinding higher. Any -20 sign of demand-led inflation will make the NBP uncomfortable so Poland is likely to be one of the front- 5pAs:ims .ims .ims:ims 2009 2010 2011 2012 2013 runners in this tightening cycle. Also, longer-term valuation points to 'fair-value' around 3.80, suggesting — Total German Imports — German imports from Poland that in an environment of stronger demand the Bank is unlikely to be sensitive to zloty appreciation. Go long Swat Datserso Bonk abornfrarg Amine* IP PLN vs EUR, target 3.95 with a stop @ 4.30. Deutsche Bank AG/London Page 17 EFTA00610292 9 January 2014 FX Blueprint: Thin end of the wedge History provides us with good templates of economies 'Strong and persistent FDI inflows into Israel where oil/gas findings resulted in a significant contribution to the BoP and persistent appreciation 4 - (NLG & NOK). Also, Bol governor Flug acknowledged as much on Nov 19h when she argued that the current intervention policies are only "acting to give the business sector time to adjust to the trends derived from [long term economic] forces". Buy ILS vs USD, 40- • -1 targeting 3.35 with a stop @ 35750. Having reduced rates aggressively since mid 2012, the NBH adopted a more conservative policy approach, 2004 2006 2008 2010 2012 with financial stability moving back up the agenda. Real yields remain among the most attractive globally. — Net Transactions. Direct Investment retail sales are growing YoY, the PMI firmly is in • Israeli Direct Investment Abroad expansionary territory, unemployment has fallen and • Foreign Direct Investment the C/A balance is in surplus. Be long HUF vs EUR, targeting 290 with a stop 0 305. &tom Clerttene EWA Eitone>crg r'once EP While the ruble trend has been highly negative over the past few months, favourable seasonality going into 'Hungary C/A in surplus and growing Feb/Mar and bearish positioning make us cautiously constructive around current levels. The relatively low 1.0 balance sheet risk, attractive carry, CBR's strong anti- g0.5 - inflationary policy stance, and a robust surplus in the goods balance are other supportive factors. Buy RUB vs. 2 0.0 - EUR, targeting 43.10, stop @ 45.90. f -o.s - III ZAR is cheap but arguably not yet sufficiently, and in g -1 5 - the absence of any meaningful improvement in the external balances there is scope for further weakening 0 -2.0 - in a rising interest rate environment. C/A fundability -2.5 - remains the key risk, with exports so far showing few 1998 2000 2002 2004 2006 2008 2010 2012 signs of improvement from past currency weakness. Even so, there has been some response to stronger — 12m MA • Balance demand from abroad and with global growth Santo' Darnel* Bort 8bonecry bream EP continuing to improve this should be reflected in gradual rand stabilization. Key levels are: a) 10.85, where price action according to our metrics would be 'Turkey's narrow & broad basic balances (12m rolling) severely stretched and thus raise the probability of a significant snap-back, and b) 10.40, which represents 1 130 the lower end of the more recent channel. On a break of either, target a 3% move in USD/ZAR to 10.50 or go 120 10.10 respectively. 110 Turkey's lira remains vulnerable to a tightening of 100i- a:3 global liquidity due to its sizeable C/A deficits and/or 90 g-4 short-term external debt repayments in an environment of rising global yields. Add to that ongoing domestic 8-5 80 political uncertainty and TRY should remain under -6 70 pressure. Stay long USD/7RY, target 2.250, stopping at 2005 2007 2009 2011 2013 2.1350. — TRY NEER. ens • Broad Basic Balance (CIA • FDI • Palbea flows), Its • Narrow Bow Balance (CIA + FOB Ills Henrik Gullberg, London, +(44) 20754 59847 Source Douteaso Sank avec...Lew 'ewe,. LP Page 18 Deutsche Bank AG/London EFTA00610293 9 January 2014 FX Blueprint: Thin end of the wedge Theme #10: Pesos no prickly pair e Cyclical Lat Am FX offers value in an environment of strong US/global growth. IA better starting point for valuations e Stay long MXN vs. USD, COP and RUB on back of FDI inflow pre-pricing and oil production prospects. Long CLP/COP should benefit from terms of trade and political uncertainty in the latter. Stay cautious on BRL because of structural concerns, weak fundamentals and less BCB intervention appetite. After 2013's annus horibills, we anticipate Lat Am FX to offer more value over the coming months. The reaction to December's Fed tapering decision suggests markets have fully incorporated expectations of higher long-end US yields. Going forward, we expect currency performance to be closer to fundamentals and less sensitive to the re-pricing in US rates. That said, Savor &lathe Bak successful forward guidance, at least in the short term, is a necessary condition for La Am performance in 2014. Growth surprises in the US should then in principle benefit currencies with strong export ICLP to benefit most from global growth bounce exposures that have already seen considerable 70% NON* FX correlations to yoy GDP LUSA adjustment. From this point of view, CLP, PEN and GO% Centre MXN have the highest betas to the global cycle with 50% aw:asas % GDP the latter particularly well placed to benefit from an I I 40% upturn in the US economy. 30% Despite more favorable valuations and possible upturn 20% in some of the local economies, structural concerns '0% and balance of payments dynamics remain headwinds 0% I for the region as whole. Where export-orientated .10% growth is more elusive, such as in the more closed economies of Brazil and Colombia, domestic demand -20% may not be sufficient to provide attractive rates of COP WIZ PUN PEN CLP return for foreign investment against a backdrop of US rate normalization. At the same time, export growth will salcce. aura* am* be insufficient to close current account deficits. Renewed falls in commodity prices also present a risk 'Mexico should begin to close FDI gap for COP, PEN and CLP, although our base case is that better China growth will provide a boost for the latter. 0.40 1 —Average Latin America, cum/ague FIJI inflows Mexico, cumulative FDI inflows Tuming to individual currencies, we remain bullish on the Mexican peso. First, the energy reform passed in December is more ambitious than expected. Licenses and production sharing contracts, rather than the originally proposed profit sharing regime, increase the potential for FDI inflows. While we do not expect the first inflows until 2015, academic research into IME flows and the relationship between exchange rates and commodity prices suggest that FX markets may 'pre- price' expected capital flows meaning that continued momentum over secondary legislation will be more important than deal announcements per se" It is worth noting that Mexico has foregone the bonanza in FDI. Jan-03 Apr-04 Jul-06 Oce06 Janal Apr-09 Jul-Ill °cell &wee. dissent &wit atom:Km Aran, CO e See, for example. D8 Commodities Quarterly, Trading industrial metals ratios in a rising USD environment, Aso Fu, June 2013. Deutsche Bank AG/London Page 19 EFTA00610294 9 January 2014 FX Blueprint: Thin end of the wedge enjoyed by its neighbors over the past decade, a result of onerous regulation and weak productivity growth. Basic balance suggests still scope for BRL downside We anticipate that this FDI gap will begin to close as — B.nilbwad basic balance, % GDP 2013's reforms bear fruit. - USD/B1% Ohs, matted) 1.30 7% Second, growth is set to be sharply stronger. Our economist has noted that the main reason behind the I80 disappointing performance of Mexican manufacturing relative to the US this year was the lack of growth in high-value sectors to which the Mexican economy has 2 30 become more sensitive. We do not anticipate this dynamic to continue. At the same time, the drag 280 caused by last year's lack of government spending will end, with the IMF showing Mexico to possess one of 0% the most positive fiscal impulses in EM next year. We 130 therefore like to be long MXN against USD, targeting 12.50. Given the positive outlook for oil production and -2% FDI, we also like playing MXN strength against other oil Oct-99 Aug-DI Jun-03 Apr-06 FS-07 Dec-08 Clet-10 Aug-12 producers, in particular COP and RUB. swam Dames: exit leogratelg Monte LP In contrast, the Brazilian real will likely face another challenging year. The current account has only 'Elections not good for BRL and COP improved modestly in spite of significant FX adjustment and the income balance remains a concern as a decade FX returns, 6m prior to general election of large scale FDI inflows are 'paid back.' Moreover, 10% while FX reserve coverage remains ample, the BCB has 0% 1 signaled it will adopt a more cautious stance over FX Il• ' intervention over the course of the coming six months, -10% as the central bank's swap book grows to up to 25% of -20% total reserves. Finally, the upcoming election is unlikely to result an improvement in positive sentiment around -30% the govemment's fiscal policies. We expect USD/BRL -40% to trade in a high (2.25-2.50) range, ending the year at 2.40. -50% - Regarding the Andeans, we foresee a difficult period -60% ■Colombia is Brazil for COP and a better backdrop for CLP and PEN. With -70% respect to COP, the upcoming election year also 1994 1999 2002 2006 2010 represents a concern, with President Santos facing a Saucca. Damen. &me Stoareergfrence LP strong challenge from the populist right. There are also question marks surrounding the outcome of peace negotiations with the FARC. Exports are expected to suffer as Venezuela's economic crises drags on. Combined with a muted outlook for oil prices, this suggests the COP will likely be the best short among Lat Am currencies next year. We like to play this versus a rather depressed CLP, which should benefit from a possible upturn in China and possible lower oil prices. PEN should also be helped by the uptick in growth (especially after last year's slowdown) and spillover effects from the expected increase in copper production. Altogether we like to be long MXN vs COP and RUB, long CLP vs COP, long PEN and see BRL underperforming the forwards while possibly trading in a 2.25-2.50 range. Guilherme Marone, New York, Oliver Harvey ,London, Page 20 Deutsche Bank AG/London EFTA00610295 9 January 2014 FX Blueprint: Thin end of the wedge Theme #11: Vol to roll • We see relative value opportunities in vol surface 'Changes in 3M implieds over the past year distortions; specifically buying EUR/USD FVAs, USD/JPY vol swaps and risk reversals, plus 3% AUD/USD puts cheapened with AUD/CAD KOs Trade 1: Hedge against event-risks with EUR/USD 2% FVAs: Despite potential catalysts such as the US fiscal impasse and EU political uncertainty, EUR/USD implied vol remained subdued in 2013, and was predominantly driven instead by rates volatility. With the USD10Y Treasury note yield expected to touch 4% on growth acceleration this year EUR/USD implieds should be supported. Correspondingly, this suggests that owning EUR/USD vol remains a useful -0.6% -1% blunt hedge against tail risks with significant impact 0 0 0 0 on rates volatility in the US and EU. Potential catalysts include growth momentum deceleration in gw = ; sy 2.40 a the US, an excessive rates rise following the tapering Swett Dame!. Bmtl. Bloont0e0 Anne. LP process forcing the Fed to backpedal, and ECB easing in Q1 on falling inflation expectations. Currently, outright long the vol swap is less attractive 'Vol slope for EUR/USD is historically flat given implieds have been well bid since December. Instead, consider owing a 3M in 6M EUR/USD FVA at 16 T T —8.50% on the USD vega notional to exploit the Is flatness of the implied volatility slope (chart 2). 14 13 Trade 2: Long JPY volatility on model valuation: 12 Another approach in analyzing volatilities relates to longer-term model valuations. On our framework, 11 USD/JPY 1Y realized vol is estimated at 10.6% (chart 10 3) but could potentially trend higher. Among its core 9 parameters are the Japanese current account (+ve T beta), commodity prices (-ve beta), US core inflation 0 (-ve beta) and the cyclically adjusted P/E ratio for US 7 equities (+ve beta). With the falls in commodities and 6 some eventual improvement in the current account 9M 12M and a higher P/E ratio as the base case for this year, Sweat Moon, RaanatLP Chas 4,0021..waspols 10 tb• xi. 25% Si% 75% wx, 95% pLecoartin Paw OSpalt WM yaws bilse "*1 Inplasert ewax roar,* risks to volatility tilt to the upside. Consider owning a 1Y vol swap, offered at —10.70% of USD notional. 'Modeled 1Y realized USD/JPY vol versus implied Note also that white we have been consistent advocates of AUD and CAD vol over the past year on 22% Y Realised Vol (Model) our analysis of volumes, policy divergence and Y Implied Vol 20% growth rebalancing these arguments are gradually becoming less attractive from a valuation perspective. 18% Switching to long USD/JPY vol would seem to offer a 16% better risk/reward payoff. 14% 12% 10% 8% 6% 4% 90 92 94 96 98 00 02 04 06 08 10 12 14 Samar Anarch, &at 8bombeettirnme LP Deutsche Bank AG/London Page 21 EFTA00610296 9 January 2014 FX Blueprint: Thin end of the wedge Trade 3: Leverage the USD/JPY skew: The supposed stalling of Abenomics 'third-arrow' reforms, 'Weekly change in spot versus risk reversal at extreme uncertainty on tapering and likely poor investor timing in the USD/JPY trade has seen risk reversals 0.18 diverging from spot for much of the second half of 0.16 2013. The current level of divergence, at <1.5% 0.14 percentile over the past decade, is nearing historical 0.12 extremes (chart 4). Since the '08 financial crises there had been only two episodes where this occurred, in 0.10 Q1 2012 and Q1 2013, each time followed by a 0.00 strong reversion of risk reversals to spot. 0.06 0.04 Beyond historical precedent, we see two drivers that 0.02 may propel risk-reversals higher. A steepening of the US yields and further traction of Abenomics would 0.00 argue for a firmer spot-risk-reversal correlation in the -0.02 near term, as uncertainty in both whiplashed riskies 04 OS 06 07 08 09 10 11 12 13 14 for much of H2. Furthermore, if spot moves higher in Salvor MO. diporMenioXnp 3M Neve m'nStair spar nnotAimnao in wile* 6.04Met nwisai line with our forecasts, the impact of hedging of structured notes should then become a stronger driver of mid to back-end risk-reversals. The most 'Spots diverge but implied correlation near highs important driver here is outstanding 25.30Y Power- Reverse Dual Currency notes, of which we estimate a 1.10 120% sizable portion with knock-outs are centered around AUD/CAD 1.00 110% the 112.5-120.0 bucket. Risk reversals should then find support as demand-supply imbalances are 0.90 100% reduced from lesser hedging requirements. 0.80 GM implied 90% 0.70 correlation We thus recommend USD/JPY options that buy the AUD/USO 80% risk reversal targeting the 6M-12M tenors. Consider a 0.60 9-month USD/JPY 109 call funded by selling a 70% 0.50 102/91.50 RKI put for zero cost, off spot ref 104.40. 60% 0.40 Trade 4: Lower USD-CAD beta Implied correlation 0.30 50% between AUD/USD and AUD/CAD has remained 0.20 40% elevated (-86% percentile), which provides sizable Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 cheapening to AUD/USD puts by selling correlation. Salver Dome* &S. licamityp Fawn LP This relationship relates to CAD being perceived as a USD substitute, which we think will not be the case as Fed tapering spurs bond repatriation and 'When returns fall AUD/USD underperforms AUD/CAD underscores policy divergence between the two. Thus, consider a 6M AUD/USD 0.86 put with an 40% AUD/USD 6M retum AUD/CAD 6M return AUD/CAD 0.83 cross knock-out indicatively for AUDJUSI) strike AUD KO brinier. 136bps versus 190bps for the vanilla, off spot refs 30% 0.8920 (-3.6% from strike) and 0.9580 (-13.4% from 20% the barrier). 10% Empirically, since the 1983 AUD floatation AUD/CAD 0% dips have been more constrained than AUD/USD, unsurprisingly given the broad dollar response and -10% cyclical co-sensitivity of commodities (see highlights -20% in chart 3). Historically, a -3.6% AUD/USD put with an -13.4% AUD/CAD KO would have been in-the- -30% money 26.2% of the time, and knocked out 2.7% of the time. -40% ttt ttt 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 Nicholas Weng, London, (+44) 20754 76615 &knew Dana* &test Scoralwg Amnia, CP James Malcolm, London, (+44)20754 50884 Page 22 Deutsche Bank AG/London EFTA00610297 9 January 2014 FX Blueprint: Thin end of the wedge Trade Recommendation Update Trades from September 24 2013 to January 8 2014 Trade Theme Gain/Loss on trades Gain/Loss on theme Long USD TVVI 1 1.14% 0.33% Short EUR/USD 1 -0.48% Long USD calls vs. MYR, BRL, 2 TRY 1.05% 1.05% Long USD/JPY 3 6.3% 6.3% Short CHF TWI 4 0.5% Short GBP/USD 4 -2.5% -1% Long AUD/NZD 5 -3.6 (-4.49%)% -3.6% Short EUR/NOK 6 -1.1% (-3.2%)* Short EUR/SEK 6 -1.6% (-2.19%) -1.35% Short SGD/INR 7 -1% (5%) Long USD/MYR calls 7 2.9% 0.95% Long PLN/CZK 8 7% Long PLN/HUF 8 1.1% Long RUB vs. basket 8 -1.5% (-4.37%) Short TRY/ZAR 8 -3.6% (1.83%) 0.75% Long MXN/BRL 9 7.14% Long CLP/COP 9 -2.44% 2.35% Long EUR/USD vol swap 10 -1.3% Long GBP/USD vol swap 10 -0.8% -0.8% No. of winners: 8 6 No. of losers: 11 4 Hit Ratio 42% 60%, Average gain/loss: 0.38% 0.47% *Indicates MN without risk management Deutsche Bank AG/London Page 23 EFTA00610298 9 January 2014 FX Blueprint: Thin end of the wedge Appendix 1 Important Disclosures Additional information available upon request For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Bilal Hafeez/Alan Ruskin/Henrik Gullberg/James Malcolm/Sameer Goel Page 24 Deutsche Bank AG/London EFTA00610299 9 January 2014 FX Blueprint: Thin end of the wedge Regulatory Disclosures 1. Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at under the "Disclosures Lookup" and "Legal tabs. Investors are strongly encouraged to review this information before investing. 2. Short-Term Trade Ideas Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at 3. 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Before deciding on the purchase of financial products and/or services, customers should carefully read the relevant disclosures, prospectuses and other documentation. "Moody's", 'Standard & Poor's", and "Fitch" mentioned in this report are not registered credit rating agencies in Japan unless "Japan" or "Nippon" is specifically designated in the name of the entity. Malaysia: Deutsche Bank AG and/or its affiliate(s) may maintain positions in the securities referred to herein and may from time to time offer those securities for purchase or may have an interest to purchase such securities. Deutsche Bank may engage in transactions in a manner inconsistent with the views discussed herein. Russia: This information, interpretation and opinions submitted herein are not in the context of, and do not constitute, any appraisal or evaluation activity requiring a license in the Russian Federation. Risks to Fixed Income Positions Macroeconomic fluctuations often account for most of the risks associated with exposures to instruments that promise to pay fixed or variable interest rates. For an investor that is long fixed rate instruments (thus receiving these cash flows), increases in interest rates naturally lift the discount factors applied to the expected cash flows and thus cause a loss. The longer the maturity of a certain cash flow and the higher the move in the discount factor, the higher will be the loss. Upside surprises in inflation, fiscal funding needs, and FX depreciation rates are among the most common adverse macroeconomic shocks to receivers. But counterparty exposure, issuer creditworthiness, client segmentation, regulation (including changes in assets holding limits for different types of investors), changes in tax policies, currency convertibility (which may constrain currency conversion, repatriation of profits and/or the liquidation of positions), and settlement issues related to local clearing houses are also important risk factors to be considered. The sensitivity of fixed income instruments to macroeconomic shocks may be mitigated by indexing the contracted cash flows to inflation, to FX depreciation, or to specified interest rates - these are common in emerging markets. It is important to note that the index fixings may — by construction -- lag or mis-measure the actual move in the underlying variables they are intended to track. The choice of the proper fixing (or metric) is particularly important in swaps markets, where floating coupon rates (i.e., coupons indexed to a typically short-dated interest rate reference index) are exchanged for fixed coupons. It is also important to acknowledge that funding in a currency that differs from the currency in which the coupons to be received are denominated carries FX risk. Naturally, options on swaps (swaptions) also bear the risks typical to options in addition to the risks related to rates movements. Deutsche Bank AG/London Page 25 EFTA00610300 David Folkerts-Landau Group Chief Economist Member of the Group Executive Committee Guy Ashton Marcel Cassard Richard Smith and Steve Pollard Global Chief Operating Officer Global Head Co-Global Heads Research FICC Research & Global Macro Economics Equity Research Michael Spencer Ralf Hoffmann Andreas Neubauer Steve Pollard Regional Head Regional Head Regional Head Regional Head Asia Pacific Research Deutsche Bank Research, Germany Equity Research, Germany Americas Research International Locations Deutsche Bank AG Deutsche Bank AG Deutsche Bank AG Deutsche Securities Inc. 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