Nomura_NOLIC_Oct2010

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FX Insights

Any authors named on this report are research analysts unless otherwise indicated.Please see analyst(s) certification(s) and important disclosures starting on page 8

N O M U R A S I N G A P O R E L T D

O C T O B E R 1 9 , 2 0 1 0

Flipping NOLI Cautious on most risky currencies

The markets seem to imply that NOLI Nomuras leading indicators

should be higher. That is, Flipping NOLI finds that current market prices

imply a higher NOLI than the most recent reading.

In fact, a rise in the leading indicators seems unlikely, as NOLI (and most

of itslargely second derivative components) seems in a clear downtrend,

having peaked in April/May.

Hence, we are increasingly cautious about the status of risky currencies.

Indeed, taking an arithmetic average of the past six recession episodes

when market-implied NOLI rose above (a declining) actual NOLI, risky

assets have tended to underperform.

This concern over the fate of risky FX is already somewhat reflected in our

portfolio, where we have recently recommended some USD calls versus

the majors, a short AUD/USD position and some short positions in

EEMEA.1

We hesitate to introduce a generalized bearish stance on all EM however,

as the long Asian FX trade may have further to run2.

That is, in the short run, diplomatic pressure on Asian countries to accede

to appreciation seems likely to intensify in the lead-up to and during the

G20 meetings in Seoul (11-12 November), while pressure on China may

be especially intense until beyond the New Year, given a proposed state

visit by Hu Jintao to the US in January.

By way of additional caveat, and beyond the Asian axis, there is a risk that

we are missing the forest for the trees. Potential output growth (and thus

long-term asset returns) is much greater in emerging markets, and sell-

offs have been short-lived (and are likely to be in the future, absent a

major shock).

In addition, it seems likely that (and this is the experience of the earnings

season so far) SPX earnings will again beat published consensus. Almost

80% of companies reporting have beaten consensus so far, and this week

sees a very intensive period of earnings reports.

Finally, although we would argue that reasonable expectations for QE2

are already priced-in, Fed Chairman Bernanke has an admirable record of

surprising the market, and beyond a short-lived upside correction in the

USD, we are relatively bearish USD.3

1) Please see:G10 Portfolio Update: Heightened risk of USD short-covering after Bernanke: Go short

AUD/USD(18 Oct 2010);EMFX Portfolio Update: Buy USD/CEE basket(12 Oct 2010);G10 PortfolioUpdate: Buy USD calls vs CHF, AUD and JPY (10 Oct 2010); FX Insights: USD weakening moveenters its final phase(4 Oct 2010).2) Please see Asia: Revisions to our USD/Asia forecasts(15 Oct 2010).3) A weak USD is in itself a risk positive event. It is associated with stronger risk assets in the minds ofthe market, with global rebalancing and reduced balance sheet pressure for those EMs with USD-denominated debts.

Simon Flint+65-6433-6504

[email protected]

Kewei Yang+65-6433-6246

[email protected]

Prateek Gupta+65-6433-6197

[email protected]
http://www.nomura.com/research/getpub.aspx?pid=395946http://www.nomura.com/research/getpub.aspx?pid=395946http://www.nomura.com/research/getpub.aspx?pid=395946http://www.nomura.com/research/getpub.aspx?pid=395946http://www.nomura.com/research/getpub.aspx?pid=394908http://www.nomura.com/research/getpub.aspx?pid=394908http://www.nomura.com/research/getpub.aspx?pid=394908http://www.nomura.com/research/getpub.aspx?pid=394660http://www.nomura.com/research/getpub.aspx?pid=394660http://www.nomura.com/research/getpub.aspx?pid=394660http://www.nomura.com/research/getpub.aspx?pid=393689http://www.nomura.com/research/getpub.aspx?pid=393689http://www.nomura.com/research/getpub.aspx?pid=393689http://www.nomura.com/research/getpub.aspx?pid=393689http://www.nomura.com/research/getpub.aspx?pid=393689http://www.nomura.com/research/getpub.aspx?pid=393689http://www.nomura.com/research/getpub.aspx?pid=394660http://www.nomura.com/research/getpub.aspx?pid=394660http://www.nomura.com/research/getpub.aspx?pid=394908http://www.nomura.com/research/getpub.aspx?pid=395946http://www.nomura.com/research/getpub.aspx?pid=395946


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Global FX Research

October 19, 2010Nomura 2

Flipping NOLI markets imply a higher level of NOLI

The markets seem to imply that NOLI Nomuras leading indicators should be

higher. That is, Flipping NOLI finds that current market prices imply a higher

NOLI than the most recent reading.4

As Exhibit 1 shows, the gap between NOLI and the implied level of each asset

class has consistently narrowed, and in aggregate has now turned positive. The

current gap based on the aggregate model is positive 0.15 standard deviations, towhich equities and FX contribute most significantly.

Exhibit 1. Consistent results based on a stacked set of univariate Flipping NOLI

Note: This chart has data up to 18 October 2010. We include SP500, MSCI global, MSCI EM, STXE600 and DAX as equity variables, CDX/Itraxx generic 5Y and Moodys AAA/BAA spreads to 10YTreasury as credit variables, AUD/NZD/KRW as FX variables, US generic 1s2s and 5s10s spreads asrates variables and CRB index for commodities. Market prices on the 11

thof each month are used to

calculate implied levels for comparison with NOLI of previous month. Readings on charts are gapsbetween market-implied NOLI and NOLI in standard deviations. Source: CEIC, Bloomberg, Nomura.

but NOLIs declining trend is still intact

However, this seems unlikely, as NOLI (and most of its largely second derivative

components) seems to be in a clear downtrend, having peaked in April/May.

As Exhibits 2 and 3 show, NOLI peaked over April/May and dipped further to

102.8 in September. With more data contributing to this reading, we find it unlikely

that NOLI can alter its downward direction in the near term.

4) Flipping NOLI is created by running rolling univariate regressions with a five-year window on eachvariable in each asset class (and constrains the coefficients to have economically meaningful values).Data samples in the window have exponential decaying weights. We average the model estimates forNOLI in each asset class. We produce the final market-implied NOLI with model estimates of five assetclasses (equities, rates, credit, FX and commodities). See Appendix 1 for details.

-1.5

-1.0

-0.5

0.0

0.5

1.0

Equities

Credit

FXRates

Commodities11-Feb-10

11-Jul-10

11-Aug-10

11-Sep-10

18-Oct-10

98

99

100

101

102

103

104

105

1976 1982 1987 1993 1998 2004 2009

NOLI Aggregated Univariate Model


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Exhibit 2. Table of NOLI components

Source: CEIC, Bloomberg, Nomura. September NOLI is a pre-assessment based on seven components.

Exhibit 3. NOLI seems to be in a downtrend

Note: This chart has data up to August. Source: CEIC, Bloomberg, Nomura.

and risky assets often underperform when this occurs

The fact that the market appears to be pricing in a rising NOLI while it seems likelythat NOLI will continue to fall, suggests one should be cautious about the status of

risky currencies.

Indeed, we find that taking an arithmetic average of the past six recession

episodes when market-implied NOLI rose above (a declining) actual NOLI, risky

assets tended to underperform.

In Exhibit 4, the performance of risky assets (equities, FX, commodities, credit and

rates) is analyzed around the point where market-implied NOLI crosses the NOLI

from below. We summarize the performance of various asset classes from six

months prior to six months after the crossover which happened around previous

US recessions.5

5) Crossover months considered for analysis are Dec 1961, Jun 1969, Aug 1976, Sep 1981, Dec 1991and Aug 2000. We calculate the monthly returns (or bp for credit and rates) of the asset classes andremove the long-term trend (for equities and commodities) if required. The long-term trend is theaverage monthly return over the 2-year window around the crossover point. The 2-year window hasbeen considered to start 12 months before and end 12 months after the crossover point.

For equities, the performance is considered to be average returns of five indices (SP500, MSCI World,MSCI EM, STXE600 and DAX) after removal of the long-term trend. For commodities, monthly returnsof the CRB commodity price index (after removal of long-term trend) are taken as a proxy. Averageperformance of risky currencies (AUD, NZD and KRW) is taken without removal of any trend for FX.Average changes of spreads of 1s2s and 5s10s are taken for rates and average of spreads of AAA andBAA over 10s are considered for performance of credit. Basis point changes in the spreads representmonth-over-month performance.

Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10

US ISM Manufacturing PMI SA 52.4 55.2 53.7 54.9 58.4 56.5 59.6 60.4 59.7 56.2 55.5 56.3 54.4

US University of Michigan Survey of Consumer Confidence Sentiment 73.5 70.6 67.4 72.5 74.4 73.6 73.6 72.2 73.6 76.0 67.8 68.9 68.2

US US Durable Goods New Orders Total ex Transportation MoM SA 2.9 -0.9 2.5 1.6 -0.6 2.1 4.9 -0.9 1.4 0.2 -2.1 1.7 -

EU EC Manufacturing PMI Overall Index 49.3 50.7 51.2 51.6 52.4 54.2 56.6 57.6 55.8 55.6 56.7 55.1 53.7

EU ZEW German Expectation of Economicc Growth 57.7 56.0 51.1 50.4 47.2 45.1 44.5 53.0 45.8 28.7 21.2 14.0 -4.3

EU IFO Germany Manufacturing Ex Food Business Expectations 2.1 6.1 11.8 10.6 13.2 14.5 14.9 20.4 20.8 17.5 23.1 22.3 18.1

JP Nomura/JMMA Seasonal PMI 54.5 54.3 52.3 53.8 52.5 52.5 52.4 53.8 54.7 53.9 52.8 50.1 49.5

JP Japan Economy Watchers Survey: Outlook 44.5 42.8 34.5 36.3 41.9 44.8 47.0 49.9 48.7 48.3 46.6 40.0 41.4JP Japan Producer Inventory Shipment Ratio SA 2005=100 120.9 118.7 115.5 110.0 108.0 108.3 102.3 103.5 108.5 106.7 108.2 107.2 -

Summary NOLI 102.3 102.6 102.8 103.0 103.1 103.2 103.5 103.5 103.5 103.4 103.2 103.1 102.8

Summary NOLI, MoM chg 0.5 0.3 0.2 0.2 0.1 0.1 0.3 0.0 0.0 -0.1 -0.2 -0.1 -0.3

NOLI Components

98

99

100

101

102

103

104

105

1976 1981 1986 1991 1996 2001 2006 2011

NOLI


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Exhibit 4. Performance of risky assets around crossover of market-implied NOLI and

NOLI

Source: Bloomberg, Nomura. See Appendix 2 for a further breakdown of performance. Note forinstance that we were only able to use two periods to test FX, versus the full six for equities.

As expected, risky assets (the composite of equities, commodities and FX) tendto outperform before the crossover. However, risky assets steadily underperform

their long-term trend following the crossover. Equities underperform significantly,

and are down by 4.8% in six months.

It is observed that risky FX tends to rally quite strongly before the crossover, rising

6% in six months leading up to the crossover. But the rally loses its momentum

and starts trading sideways after the crossover of market-implied NOLI and actual

NOLI. Commodity prices rise modestly until the crossover and trade sideways

after the crossover of market-implied NOLI and NOLI.

Rates spreads follow a steepening pattern following the crossover, largely

because of aggressive rate cuts by central banks during downturns. However, we

should not necessarily expect a similar trend in the current situation as the shortend of the curve has already been cut close to zero. Therefore, a further

deterioration in outlook may push the curve into bull flattening. Even if the Fed

adopts large-scale asset purchases to reflate the economy, the yield curve is

unlikely to steepen as normal, especially at the front end, in our opinion.

Indeed, this is an important caveat to our conclusion that the Fed, in changing

the normal dynamic of the rates markets, is providing further impetus to other

risky assets in a generalized reflation trade.

That said, although we would view QE2 as extremely important in boosting risky

assets through the asset substitution effect, we are concerned that there are limits

to how much it can be expected to boost growth expectations, and, for G3 risky

assets at least, this should be a binding constraint.

-60

-48

-36

-24

-12

0

12

24

36

-6m -5m -4m -3m -2m -1m 0m 1m 2m 3m 4m 5m 6m

92.5

95.0

97.5

100.0

102.5

105.0Equities FX Commodity

Risky Asset Credit (LHS) Rates (LHS)

bp


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Appendix 1 Flipping NOLI calculations

We run rolling univariate regressions with a five-year window on each variable in

each asset class (and constrain coefficients to be economically meaningful). Data

samples in the window have exponential decaying weights.

We average the model estimates for NOLI in each asset class.

We produce the final market-implied NOLI with model estimates of five assetclasses (equities, rates, credit, FX and commodities).

The caveat is that decaying parameters have a significant impact on the result.

We decide to use a set of weights which can cover 99.9% of weights in five-year

data. With this new approach, we have a tendency to put more weight on recent

data, because we are more interested in the short-term interaction between NOLI

and the market-implied level.

Appendix 2 Performance of risky assets around a crossoverpoint

The detailed performance of various risky assets around a crossover point istabulated below. An important limitation to the analysis was the restricted number

of historical observations we had for accomplishing a meaningful statistical

analysis. The instances were limited for risky FX6

(AUD, NZD and KRW), credit7

and rates8.

The individual asset level performance is a plain average of the various sub-

indices performance around each of the crossover point e.g.. for equities

performance is average returns of 5 indices (SP500, MSCI World, MSCI EM,

STXE600 and DAX). The aggregate performance of the asset classes (termed as

risky asset) is computed as an arithmetic average of returns for equities,

commodities and FX for the same period. The exhibits below show the monthly

returns for each of the asset class after removal of long term trend (for equities

and commodities) around each of the crossovers.

Exhibit 4. Performance around crossover of market implied NOLI and NOLI Risky Asset9

Source: Bloomberg, Nomura.

6) Any observation beyond the 1990s is not considered for FX due to major differences in FX policyregimes around the world. KRW performance has only been considered post-2000 for similar reasons.

7) The limited history of credit spreads resulted in the inclusion of only the two most recent samples(Dec 1991 and Aug 2000).

8) For rates spreads we have considered the samples of Sep 1981, Dec 1991 and Aug 2000.

9) Risky asset performance around each crossover point is an arithmetic average of performance ofequities, commodities and FX (subject to availability) e.g. we do not have the record for performance ofFX around the Dec 1961 sample, so that reading is an average of equities and commodities only. Theoverall performance around a crossover point is, as shown in the penultimate row, an average ofperformance around each historical crossover point. The values in each row are the returns for thatparticular month over the previous month, with 0 being the month in which the crossover happens.The last row is an index level performance for easy understanding.

Date -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Dec-61 -1.11% 0.61% -2.64% 0.04% 2.65% -0.04% -1.79% -0.11% 0.79% -1.94% -2.71% -4.63% -1.00%

Jun-69 -1.06% 1.73% -0.54% 1.62% 1.49% -0.19% -2.51% 0.33% 1.62% 1.69% 3.09% -2.88% 0.80%

Aug-76 0.62% -1.11% 1.25% 3.08% 2.20% -4.70% 0.99% -4.23% -0.69% 2.31% 1.30% 1.36% 0.58%

Sep-81 4.47% -2.50% 0.53% -0.04% 1.91% -3.46% -0.05% -0.62% -0.62% -1.19% 1.46% -2.80% 3.33%

Dec-91 -2.60% 0.67% 0.28% 0.19% 0.66% -1.82% 3.41% 1.02% -0.30% -0.76% 1.42% -0.60% -1.54%

Aug-00 1.10% -0.50% 1.01% 1.97% -0.25% 0.56% 2.73% -1.50% 0.45% -0.58% -3.31% 0.81% -0.76%

Risky Asse t (in %) 0.24% -0.18% -0.02% 1.14% 1.44% -1.61% 0.46% -0.85% 0.21% -0.08% 0.21% -1.46% 0.23%

Ris ky As se t Inde x 98.77 98.59 98.57 99.71 101.15 99.54 100.00 99.15 99.36 99.28 99.49 98.05 98.28

Risky Asse t


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Exhibit 5. Performance around crossover of market implied NOLI and NOLI Equities10


Exhibit 6. Performance around crossover of market implied NOLI and NOLI Commodities11


Exhibit 7. Performance around crossover of market implied NOLI and NOLI

FX12


10) For equities, performance is considered to be average returns of five indices (SP500, MSCI World,MSCI EM, STXE600 and DAX; subject to data availability) after removal of the long-term trend e.g. forAug 1976 we only have data for SP500, MSCI World and DAX indices. An average of these three isconsidered a proxy for equities around the Aug 1976 data point. The long-term trend has beenremoved by considering the average performance of each index in a two-year window around the

crossover point. As before, the last row is an index-level depiction of average performance of equitiesaround a crossover point.

11) For commodities, a similar treatment to equities was followed with the CRB commodity price indexconsidered a proxy for performance and removing the long-term trend.

12) The analysis of FX performance was limited due to major shifts in policy regimes. Only AUD andNZD are considered for Dec 1991 and AUD, NZD, KRW for Aug 2000 crossover analysis.

Date -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Dec-61 -4.72% 2.22% -4.93% 1.81% 6.62% -1.22% -2.63% 0.49% 0.52% -3.72% -5.45% -7.32% -0.67%

Jun-69 -1.96% 3.81% -1.91% 3.21% 2.85% 0.65% -5.45% 1.89% 2.81% 2.96% 4.52% -4.06% 1.00%

Aug-76 1.41% -2.92% -0.03% -2.49% 1.31% -0.69% -0.37% -4.34% -1.27% 2.85% 1.04% -3.43% -1.10%

Sep-81 4.55% -2.36% 2.01% -0.78% 1.52% -6.42% -0.58% -0.89% 1.94% -4.37% -0.98% -2.24% 3.10%

Dec-91 -3.39% 1.37% 0.55% -2.08% 1.47% -5.46% 7.56% 2.24% -0.45% -0.02% 2.12% -2.17% -2.92%

Aug-00 2.89% 0.03% -4.88% 3.59% 0.75% 0.32% 0.56% -8.16% 2.67% 0.45% -2.95% 1.56% -4.31%

Equities (in %) -0.20% 0.36% -1.53% 0.54% 2.42% -2.14% -0.15% -1.46% 1.03% -0.31% -0.28% -2.94% -0.82%

Equitie s Inde x 100.50 100.86 99.33 99.87 102.32 100.15 100.00 98.55 99.57 99.27 98.99 96.12 95.33

Equities

Date -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Dec-61 2.50% -1.00% -0.34% -1.74% -1.32% 1.14% -0.95% -0.71% 1.06% -0.16% 0.02% -1.94% -1.33%Jun-69 -0.16% -0.36% 0.82% 0.03% 0.13% -1.04% 0.42% -1.24% 0.43% 0.42% 1.66% -1.69% 0.60%

Aug-76 -0.16% 0.69% 2.53% 8.66% 3.08% -8.71% 2.35% -4.12% -0.11% 1.78% 1.56% 6.15% 2.25%

Sep-81 4.40% -2.64% -0.96% 0.70% 2.29% -0.49% 0.47% -0.36% -3.17% 1.98% 3.89% -3.35% 3.56%

Dec-91 -4.64% 2.57% 1.48% 1.51% -0.83% -1.40% -0.48% 1.46% 0.60% -2.25% 0.51% 1.76% -2.38%

Aug-00 -0.15% -2.66% 5.80% 2.06% -2.12% 0.03% 4.91% 0.39% -2.65% 3.09% -1.31% -2.07% -0.83%

Commodities (in %) 0.30% -0.57% 1.56% 1.87% 0.20% -1.74% 1.12% -0.76% -0.64% 0.81% 1.06% -0.19% 0.31%

Commodities Index 97.59 97.03 98.56 100.42 100.62 98.88 100.00 99.24 98.61 99.41 100.46 100.27 100.59

Commodities

Date -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Dec-91 0.23% -1.93% -1.20% 1.15% 1.32% 1.40% 3.14% -0.63% -1.05% 0.00% 1.61% -1.40% 0.68%

Aug-00 0.58% 1.14% 2.10% 0.25% 0.61% 1.33% 2.71% 3.28% 1.32% -5.28% -5.66% 2.94% 2.87%

FX (in %) 0.40% -0.40% 0.45% 0.70% 0.97% 1.37% 2.92% 1.33% 0.14% -2.64% -2.02% 0.77% 1.77%

FX Index 94.16 93.79 94.21 94.88 95.80 97.12 100.00 101.34 101.48 98.83 96.85 97.60 99.34

FX


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Exhibit 8. Performance around crossover of market implied NOLI and NOLI Rates13


Exhibit 9. Performance around crossover of market implied NOLI and NOLI Credit14


13) Rates performance is gauged by the average spreads of 1s2s and 5s10s in basis points. A positivenumber means spreads widened from the previous month and depicts curve steepening. The last rowis an average performance of rates spreads around the crossover point, assuming the curve to be at aneutral level at the crossover point. The positive index value after the crossover means that the curvehas steepened.

14) Credit spreads are average spreads of AAA and BAA bonds over 10s. A positive value for aparticular month depicts a widening of credit spreads over the previous month. The credit index shownin the last row is an aggregate performance of the spreads assuming a neutral level at the crossoverpoint. Negative index values (mostly seen prior to crossover) would mean narrower credit spreads thanthe crossover levels and hence higher price levels for AAA and BAA bonds prior to crossover. Wecould say that on an average the prices for these would have fallen leading to the crossover andremained at those levels in six-month periods after the crossover.

Date -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Sep-81 9.00 -24.00 0.50 16.00 5.50 10.50 14.50 -1.00 14.00 -2.50 -11.50 6.00 -8.00

Dec-91 2.30 9.05 -0.80 4.20 10.35 5.80 -5.65 -6.30 -6.85 10.80 -2.65 -1.40 2.85

Aug-00 -12.90 -9.80 16.75 -9.00 3.00 -19.50 -2.25 6.95 -5.10 -0.90 21.60 -1.95 4.65

Rates Spreads (in bp) -0.53 -8.25 5.48 3.73 6.28 -1.07 2.20 -0.12 0.68 2.47 2.48 0.88 -0.17

Rates Spreads Index -8.38 -16.63 -11.15 -7.42 -1.13 -2.20 0.00 -0.12 0.57 3.03 5.52 6.40 6.23

Rates

Date -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6

Dec-91 0.20 7.10 10.10 14.70 2.10 8.80 12.40 -25.00 -23.50 12.10 -6.20 1.80 21.30

Aug-00 31.60 33.60 -3.70 -16.20 9.30 10.80 5.90 4.70 -6.90 16.60 16.70 -3.00 -0.40

Credit Spreads (in bp) 15.90 20.35 3.20 -0.75 5.70 9.80 9.15 -10.15 -15.20 14.35 5.25 -0.60 10.45

Cr edit Spr eads Inde x -47.45 -27.10 -23.90 -24.65 -18.95 -9.15 0.00 -10.15 -25.35 -11.00 -5.75 -6.35 4.10

Credit


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Nomura 8 October 19, 2010

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