Overview

Japan's FX interventions pushed $/JPY 3.5% off its lows as of yesterday's NY close. As Thomas Stolper discussed in his FX Views and Fiona Lake in yesterday's Global Markets Daily, we expect this intervention approach to likely succeed eventually given the fundamental backdrop of the Yen's substantial overvaluation. In the near term however, we could still see new lows in $/JPY driven by the impact of potential US QE, persistent trade surpluses and the markets possibly testing the authorities' intervention resolve. Elsewhere, price action was relatively muted as FX markets traded in a relatively tight range while US equities grinded slightly higher.

However, after all the excitement in $/JPY yesterday, the cross was calm today with no further intervention from the Japanese authorities. The CNY printed yet another new low today, however the rest of $/Asia went sideways. However the NZD weakened notably after the RBNZ kept rates on hold at 3% but issued a relatively dovish statement. The bank remains in hiking mode, but anticipated tightening is less than previously. Finally, the RBI was more hawkish than expected hiking the repo rate by 25bps and the reverse repo by 50bps (the latter was the main surprise), thus narrowing the policy corridor. The INR has appreciated slightly as a result. We are ever so slightly under water on our short INR/KRW trade which was opened at 25.11 and is now trading at 25.13.

There is a slew of other central bank meetings scheduled for today. We also get other central bank meetings in Chile, Switzerland and Turkey today. We expect a 50bps hike in Chile. No change is expected for Switzerland but any comment on CHF strength will be interesting. No change is expected in Turkey.

We also get a raft of US data today. Q2 balance of payments is released from which we can calculate the latest BBoP number for the US. TICs data will also give us a read on the underlying capital flows situation in the US. We also get jobless claims, PPI and the Philly Fedwhere we will be focusing particularly on the new orders/inventories component.

2. 'Decoupling' by any other Name Would be Just as Sweet

There continues to be keen focus on ways to differentiate countries or the ability to 'decouple' in a US slowdown. Decoupling by definition means 'to separate or disconnect' and has been pointed out as a rather inaccurate term for the scenario we are describingwhich is really the resilience of the rest of the world to a US slowdown. As Dominic Wilson pointed out in a recent Daily, it is highly unusual for significant parts of the global economy to separate from each other completely. The real issue at hand is how we gauge the relative resilience of each country. This degree of perceived resilience offers relative opportunities across asset markets.

Themos Fiotakis recently discussed the EM exposure to a US slowdown via the trade channel. As discussed before, there are various metrics one can use to differentiate countries' exposure to a US slowdown, trade being one, financial linkages and the type and severity of the shock being examples of others. Domestic demand strength is also a differentiating factor in a country's resilience to external slowdown risks. We examine this here, alongside the FX market implications.

Stronger domestic demand all else equal provides a bigger buffer to overall growth from external shocks. Strong domestic growth brings a different set of policy responses, including the need for tighter financial conditions via rate hikes and possibly accompanied by greater tolerance for currency appreciation. In such instances of strong domestically driven growth, FX appreciation can also be seen as a transmission channel to help allocate resources from the tradable to the non-tradable sector.

3. Drawing on Strength from Within

We looked at final domestic demand (private and government consumption and fixed investment ex inventories) across the different countries. We have focused on the share of contribution from final domestic demand to latest Q2 real GDP yoy growth here, which also allows us to make a better comparison across different levels of growth globally.

In EM, Chile, Poland, Philippines, Israel, Brazil and Turkey all stand out with final domestic demand contributing more than 100% of GDP growth in Q2. This means that the boost from final domestic demand for these countries outstripped the drag from the other components of net exports and inventories. The middle of the pack comprises mainly of NJA economies, for which a relatively large proportion of headline GDP growth in Q2 came from final domestic demand - around 60-90%. Singapore is an exception here, with final domestic demand making up only 15% (2.7 percentage points of Q2's 19% yoy GDP growth) as inventories and net exports proved to be the major drivers. Rounding off the EM countries are Hungary and the Czech Republic which come in at the bottom of this measurefinal domestic demand is still a negative drag on overall GDP growth. (Note we have excluded Russia, Mexico, South Africa and New Zealand, which have yet to release the demand-side GDP components for Q2.)

Among the G10 countries, Australia, Canada, Sweden come out on top. Final domestic demand in Australia and Canada accounted for more than 100% of overall GDP growth in Q2. Sweden is not too far behind at 70%, seeing a very strong recovery which has been highlighted in a recent piece by our European economics team (see European Weekly Analyst, Sep 9 2010). Not surprisingly, all of these countries have also embarked on rate hike cycles.

4. to Offset External Risks, Alongside Other Considerations

Stronger domestic demand is generally supportive of currency appreciation, especially in the current context of external slowdown risks. An additional consideration though is the sustainability of this domestic demand-led growth going forward, especially when taking into account external positions and funding constraints. Overly strong domestic demand leading to a deteriorating external position could trigger FX weakness if capital inflows are insufficient to fund the growing external deficit. Australia and India, for example, both exhibit strong domestic demand and have current account deficits but the healthy BBoP (current account+net FDI+portfolio inflows) surplus due to large offsetting capital inflows leaves Australia further from funding constraints compared to India.

There are also other factors that need to be considered when we map this differentiation across to implications for asset markets. For FX specifically, our results have to be considered against other key drivers such as BBoP, as well as capital inflows (which Robin Brooks recently looked at in a recent Global Markets Daily), intervention behaviour, positioning, risk correlations and valuations. Our current recommendation to be long KRW vs. INR, for example, reflects our view on relative BBoP fundamentals and intervention policy, despite both having similar domestic demand contributions to overall growth. The exercise we have run here is thus meant as a complementary tool to the suite of metrics in our FX toolkit.

5. FX Strategy Thoughts

We have been using domestic demand strength as one of our criteria when we assess underlying fundamentals for each currency in our selections for trade recommendations. This is reflected in recently-initiated longs in AUD (vs. EUR) as well as our recent recommendation to pay AUD rates via 5-yr swaps, for example. Our recently-closed trade recommendation to be long CLP/MXN was also guided by this assessment of domestic strength, in addition to the extent of linkages with the US economy. The links with the US are an especially important consideration at this current junctureeven for countries with strong domestic demand like Australia and Canada as listed above, there are still opportunities for differentiation between them given their relative exposures to the US; which was the rationale underpinning another of our recently-closed trade recommendations to be long AUD/CAD.

Besides Chile and Poland (the latter being one of our current 2010 Top Trades), we will continue to keep the other countries (such as Philippines, Israel and Turkey) that we have identified on our list in focus. In the G10, besides Australia where we continue to favour longs, Sweden could also continue to justify its currency outperformance, especially in relative value trades. Our Growth 'FX Current' also falls into this category as it selects currencies on the related basis of growth differentiationthis is a recommendation that remains on our Top Trades list for the year.

6. Current Trading Views

The following trading ideas from the Global Markets Group reflect shorter-term views, which may differ from the longer-term "structural" positions included in our "Top Trades" list further below.

In FX: 1. Stay short $/CNY via 1-yr NDFs, opened at 6.7550 on 10 June 2010, with a target of 6.50, and a 1-day stop of 6.83, now at 6.7275.

3. Stay short EUR/AUD, opened at 1.3750 on 9 September 2010, with a target of 1.30 and a one-day stop on a close above 1.4150, currently at 1.3909.

4. Stay short INR/KRW, opened at 25.11 on 13 September 2010, with a target of 23 and a stop on a close above 26, now at 25.1506.

On Rates: 1. Stay short an equally weighted basket of 5-yr CDS spreads in Poland, Korea, China and Czech, opened at an average spread of 115 bp on 17 June 2010, with an initial target of 75 bp and a stop-loss of 140 bp, now at 102.7 bp.

2. Stay short UK inflation vs. long Euro-zone inflation through 5-yr zero coupon swaps, opened on 09 July 2010 at 1.63%, for a target of 1.2% and a close set at 1.85%, now at 1.45%.

3. Stay short 5-yr AUD swaps vs. 6-month rates, opened at 5.09 on 03 September 2010, for a target of 5.60 and a stop on a close below 5.20 (raised from 4.80), now at 5.35.

4. Hold steepeners in EUR 10s-30s vs. flatteners in GBP 10s-30s, opened at -35bp on 03 September 2010, for a target of 0 bp and a stop on a close below -50 bp, now at -29.6 bp.

5. Stay long 10-yr Italy vs. France, opened at 112 bp on 03 September 2010, for a target of 70 bp and a stop on a close above 130 bp, now at 103.8 bp.

6. Stay long 30-yr Greek GGBs, opened at 54c (ask) on 03 September 2010, for a target of 60c and a stop on a close below 50c, now at 55.95c (bid).

Equity Trading Strategies: 1. Go long EEM/SPX, opened at 0.0386 on 14 September 2010, with a target of +9% and a stop of -4%, now at 0.0385.

7. Recommended Top Trades for 2010 (opened on 02 December 2009 unless otherwise stated)

1. Stay short S&P 500 Dec10/Dec11 Forward Starting Variance Swap, opened at 28.20, with a target of 21, now at 29.86.

2. Stay long Russian Equities (RDXUSD), opened at 1645.9 for a target of 2050, now at 1632.42.

3. Stay long GBP/NZD, opened at 2.29, with a target of 2.60, now at 2.1532.

4. Close short 2-yr GBP swap rates vs. long 2-yr AUD swap rates on a 1-yr forward basis, opened at -268.5 bp, for a potential loss of 24 bp (inclusive of carry).

5. Close short 2-yr TRY rates through cross-currency swaps, opened at 8.77%, with a target of 12.0%, for a potential loss of 168 bp (inclusive of carry).

6. Close long 5yr credit protection in Spain vs. short 5yr credit protection in Ireland at 13 bp, opened at 70 bp, with a target of 20 bp, for a potential profit of 2.9% (inclusive of carry).

7. Stay long the GS FX Growth Current, opened at 103.5, with a target of 111.8, now at 104.7.

8. Stay long PLN/JPY, opened at 32.1, with a target of 37.5, now at 28.0840.

9. Stay long Chinese Equities (HSCEI), opened at 12616.01 on 01 April 2010, with a target of 15000, now at 11939.89.