1. Exchange rate economics: A carry on in France Michael Metcalfe Head of Global Macro Strategy June 2007

2. 1 Puzzles from the world’s largest financial market >Globalisation … but of what? >More floating, but less volatility and more reserves >The great moderation in global economic volatility >Exchange rates and fair value >Why carry is robust and when it will end

3. 2 Globalisation … of capital >Average daily volume in foreign exchange markets is approx. USD2.2trn >That’s roughly the size of the French economy and it is growing 10% pa >Driven by internationalization of portfolio flows

4. 3 Portfolio theory not comparative advantage.. >Pension funds have historically invested in local markets >This is the financial equivalent of sticking all your eggs in one basket >Global equities/bonds offer diversification and higher returns

5. 4 Fixed vs. floating… >More currencies are floating, but actual volatility is lower >More currencies are floating, but central banks are more active than ever Volatility of major currency pairs

6. 5 The great moderation …. >Some macro trends are converging such as inflation, growth & interest rates >PPP, uncovered interest rate parity suggest inflation and rates are the main determinants of currency trends Dispersion across 20 countries 0 2 4 6 8 10 12 14 Jan-96Jul-97Jan-99Jul-00Jan-02Jul-03Jan-05Jul-06 3-mo interest ratesAnnual inflation rates

7. 6 Losing value Dispersion across 20 countries 1.20 1.30 1.40 1.50 1.60 1.70 1.80 1.90 2.00 Jan-96Jul-97Jan-99Jul-00Jan-02Jul-03Jan-05Jul-06 4% 5% 6% 7% 8% 9% 10% Competitiveness proxy (z-score) lhs Current account (%GDP) rhs >But external balances have never been more dispersed >Measures of competitiveness are increasingly stretched >Currency is a major policy issue once again

8. 7 How much for your Big Mac? >Big Mac costs  Y300 in Japan  £1.99 in the UK  US$3.22 in US  EUR2.94 >One £ should purchase  Y151  US$1.61  EUR1.47 >At present one £ will buy you  Y240 (58%)  US$2.00 (24%)  EUR1.49 (1%)

9. 8 UIP & the balance of payments model versus carry >High interest rates or current account deficits should lead to currency depreciation >But the carry trade is now a celebrity … >And a successful one at that

10. 9 Why carry is robust >Covered interest rate parity dictates the forward rate must equal today’s rate adjusted by the interest rate differential  Example today’s rate is JPY240 per £  1-year UK interest rates are 6%, Japanese rates are 1%  Today’s forward rate sets the price of GBP in JPY 1 year from now  This must be JPY228 otherwise a risk free arbitrage exists –If the forward rate is JPY240, I would borrow JPY10mn, exchange it into GBP at today’s exchange rate (JPY240), and deposit £41,667 with a UK bank –In one year’s time I would have £44,167 thanks to the 6% interest, I convert this back to JPY at the pre-agreed JPY240 rate and get Y10.6mn –Y10.1mn repays my loan and interest, JPY0.5mn (£2,083) is my risk free profit >But what is the best prediction of the spot rate in 12-months time ?  Uncovered interest rate parity suggests that the forward rate is an unbiased predictor of the future spot rate

11. 10 Forecast rate bias >In past 10-years Japan has always had a lower interest rate so the forward rate predicts JPY appreciation >The forward has consistently over predicted the ability of the yen to appreciate (so have forecasters) >If the spot is better “forecast” of where we will be in a year’s time carry is perfectly rational * 3-mo consensus forecast from Reuters

12. 11 When does value bite? >If PPP holds the real exchange rate should be constant in the long-run >Real exchange rate fluctuations are large and persistent >Expectations of “value” are not well defined and macro adjustments are slow, which leads to both trends & overshooting Intervention Intervention?

13. 12 FX market puzzles >Globalisation … but of what?  Internationalisation of portfolios is main driver of growth in FX market >More floating, but less volatility and higher reserves  There are fewer pegs  Current account imbalances are leading to a surge in CB reserves >The great moderation in economic volatility  Interest and inflation rates are converging >Exchange rates and fair value  Value and external balances are diverging rapidly >Why carry is robust and when it will end  Uncovered Interest Rate Parity fails in a world of mobile capital flows  At some point high (low) yielding currencies will become so over (under) valued that it will impact monetary policy leading to lower (higher) interest rates and possibly FX intervention