Global FX Strategy

FX Markets Weekly
November 25, 2009

Kenneth Landon (1-212) 834-2391

Arindam Sandilya (1-212) 834-2304
JPMorgan Chase Bank

Risk Scenario 1: Global Inflation Starts Chart 1. OECD CPI, 1971-2009

Major Uptrend 18%

16%
14%
• OECD CPI has turned negative for first time in
12%
post-Bretton Woods era
10%
• Massive deficit spending and debt monetization 8%
increases chance of inflation turning higher 6%
4%
• EUR, CHF and Gold options stand out as cost-
2%
effective instruments to hedge inflation risk
0%
-2%
Massive deficit spending with concurrent aggressive debt
monetization in many countries around the world has Jan-71 Jan-77 Jan-83 Jan-89 Jan-95 Jan-01 Jan-07
caused concerns among investors that inflation could move Source: J.P. Morgan, OECD
much higher over the coming three to five years. Recent
manifestations of those concerns have been a rebound in Chart 2: DXY dollar index in 12-months before & after bottom of
OECD CPI cycle (rebased to 100 at bottom of cycle)
commodities prices and moderately rising inflation
breakeven rates. 125 Jan-73 Apr-79
Mitigating inflationary expectations is the widespread belief Apr-86 Mar-94
that a trend increase in the general price level is unlikely
Oct-06 Av erage
during a period of low rates of resource utilization.
However, the level of resource utilization does not occur in
a vacuum. If demand for cash liquidity declines along with 100
a reduction of risk aversion accompanying a pick-up in
global growth, then central banks will be challenged to
withdraw the appropriate amount of money from the
system. Central banks’ withdrawal of liquidity in an amount
insufficient to balance a possible decline in demand for 75
money could result in higher rates of inflation. Even if -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
inflation does not immediately show up in indices such as x -ax is: months from bottom of inflation cy cle
CPI, hard assets would perform well if that were to occur. Source: J.P. Morgan

In any case, the purpose of this section is not to debate the Chart 3: Gold in 12-months before & after bottom of OECD CPI cycle
theoretical arguments for either higher or lower inflation. (rebased to 100 at bottom of cycle)
Rather, the focus is on a risk scenario in which inflation
starts to move higher and exceeds current expectations. As Jan-73 Apr-79
Chart 1 shows, global inflation, as proxied by OECD CPI, 250
Apr-86 Mar-94
has fallen to the lowest levels in the post-Bretton Woods
200 Oct-06 Av erage
era. In fact, since June 2009, OECD nations have witnessed,
on average, mild deflation as measured by CPI. With gold
and commodities prices once again trending higher, the 150
move into mild deflation is not likely to be a long-lasting
phenomenon. If so, then an inflection higher in the major 100
inflation cycle could occur over the course of 2010.
50
As shown in Chart 2, the dollar DXY index tends to decline
in the 12 months before and after major bottoms in OECD -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
CPI. The mirror image of the dollar’s decline in FX markets x -ax is: months from bottom of inflation cy cle
is also evident in Chart 3, which shows the price of gold Source: J.P. Morgan
over the same time periods. Gold performs well in the year
before and after major inflection points in global inflation.

1
Global FX Strategy
FX Markets Weekly
November 25, 2009

Kenneth Landon (1-212) 834-2391

Arindam Sandilya (1-212) 834-2304
JPMorgan Chase Bank

As for currency pairs that most consistently perform at Chart 5: USD/CHF in 12-months before & after bottom of OECD CPI
cycle turns in inflation, EUR/USD and USD/CHF stand out Cycle (rebased to 100 at bottom of cycle)
from the crowd, which is shown in Charts 4 and 5.
GBP/USD also performs well, but not as consistently as the 150
former two currency pairs. USD/JPY on average moves Jan-73 Apr-79
lower after inflections in the inflation cycle, but the Apr-86 Mar-94
performance also is not as consistent as with EUR and CHF. 125 Oct-06 Av erage
As expected, the commodities-linked AUD/USD performs
well during major cycle turns in global inflation, but
slightly less consistently than either EUR/USD or
100
USD/CHF (see chart 6)
Investing on the assumption of higher future rates of
inflation requires timing well in advance of the final 75
evidence of such. The question boils down to your
-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
framework for anticipating inflation before the fact.
x -ax is: months from bottom of inflation cy cle
Although we are cognizant of the empirical data indicating
more subdued rates of measured inflation during times of Source: J.P. Morgan
low rates of resource utilization, commodities-based FX can
Chart 6: AUD/USD in 12-months before & after bottom of OECD CPI
still be an attractive investment during those times. cycle (rebased to 100 at bottom of cycle)
Historically, there is little correlation between the level of
resource utilization and future changes in commodities. The 130
Jan-73 Apr-79
key is marginal changes in utilization, which implies that it Apr-86 Mar-94
120
is growth that drives commodities and not the absolute level Oct-06 Av erage
of capacity usage. Given the current low level of resource
110
utilization and on-going global economic recovery, the
likely trend in capacity utilization is higher over the coming
100
12 months, which in turn implies higher commodity-FX
levels. 90
A short position in the USD makes sense if one wishes to
hedge against a possible inflection higher in global 80
inflation. We prefer to express this view through a basket of -12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
long EUR, CHF, and Gold, the historic performance of x -ax is: months from bottom of inflation cy cle
which is illustrated in Chart 7. In the following section, we
Source: J.P. Morgan
discuss cost-effective ways of implementing this strategy.
Chart 4: EUR/USD in 12-months before & after bottom of OECD CPI Chart 7: Basket of EUR, CHF & Gold vs. USD in 12-months before &
cycle (rebased to 100 at bottom of cycle) after bottom of OECD CPI cycle (rebased to 100 at bottom of cycle)
175
Jan-73 Apr-79
Jan-73 Apr-79
Apr-86 Mar-94 Apr-86 Mar-94
150
130 Oct-06 Av erage Oct-06 Av erage

125

100
100

75
70
-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
-12 -10 -8 -6 -4 -2 0 2 4 6 8 10 12
x -ax is: months from bottom of inflation cy cle x -ax is: months from bottom of inflation cy cle
Source: J.P. Morgan
Source: J.P. Morgan

2
Global FX Strategy
FX Markets Weekly
November 25, 2009

Kenneth Landon (1-212) 834-2391

Arindam Sandilya (1-212) 834-2304
JPMorgan Chase Bank

Cost-effective hedges: EUR, CHF & Gold Chart 8: Gold, EUR and CHF calls are the most efficient option-based
inflation hedges for next year
Aside from the responsiveness of potential hedges to an Return on investment from various inflation hedges, calculated as the P/L from
upturn in the inflation cycle, the cost of entering into them buying and holding to maturity a 1Y ATMF option (call or put depending on whether
is a key strategic consideration for portfolio managers. Tail the underlying rallies or sells-off in response to inflation), divided by its current
premium. At-expiry P/L calculations assume that we are at the bottom of inflation
risk hedges are generally executed through low-delta option cycle at present, and that each underlying will evolve over the course of the year
structures that provide lottery ticket style payoffs in the exactly along the average trajectories in Charts 2 through 7. No transaction costs.
event of the unlikely turning imminent. In such a setting,
500%
the cost of hedging is the option premium paid upfront; a
simple gauge of hedge efficiency is the P/L that it stands to 400%
generate in a shock scenario.
300%
Chart 8 ranks the inflation hedges discussed earlier along
such bang-for-buck lines. The starting point of the analysis 200%
is to price up 1Y ATMF options for all assets considered in
100%
the chart, in the correct direction (i.e. call or put) as dictated
by the signs of their betas with respect to inflation. Though 0%
unlikely to be the actual hedge instrument deployed, ATMF
option premia are an acceptable proxy for comparing the -100%
nominal cost of option-based hedging across underlyings. Gold [Gold EUR CHF DXY AUD NZD JPY GBP CAD
Under the drastic assumption that we currently stand at or EUR,CHF]
close to the bottom of the inflation cycle, and that all assets Source: J.P. Morgan
will exactly track the average post-inflation trough
trajectories over the course of the next year as described in
charts 2 through 7, it is then simple enough to compute at-
expiry P/Ls from these options. The cost-effectiveness
tradeoff is captured by a return on investment (RoI) metric,
measured as the ratio of option P/L in an inflation shock to
its upfront premium, and is the variable along which chart 8
ranks our hedge universe.
The message from the chart is unambiguous – gold calls,
followed by those in EUR and CHF, are an inflation
hedger’s best friends, being among a handful of
underlyings where the expected at-maturity RoIs are in
excess of 1. They also have the advantage of not being
traditional risk assets, meaning that hedge gains are likely to
be well preserved even in the unlikely scenario of an
inflation scare morphing into a funding crisis (see Risk
Scenario 2 below), where the resulting volatility might
place more pro-cyclical assets like commodity FX at risk.