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1
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Foreign Exchange Strategy in 2006
Market Update and Trends in Corporate Hedging
Vicky Shields [phone] Vicky.shields_at_jpmorga
n.com
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USD Quick 2005 review

• The trade-weighted dollar rose nearly 3 during
  2005 USD RBEER is now 5.9 below its 10-year
  moving average
• The U.S. current account deficit (at 6.3 of GDP
  in Q2) was more easily funded last year by
  relatively more attractive U.S. yieldsthe U.S.
  policy rate differential with the rest of the
  OECD widened by more than 100bp in the first
  three quarters of the year
• USD-supportive capital flows also resulted from
  HIA JPMorgan estimates cross-border,
  USD-positive flows amounting to USD90-100 billion
  in total, with the bulk coming in H2 2005
• A third capital flow support came from
  petrodollar recycling JPMorgan estimates that
  net oil exporters will have gotten a windfall in
  2006 equal to about 7 of their total GDP. Much
  of that windfall has been put into
  USD-denominated assets

Trade-weighted USD now about 6 below fair value
Capital inflows have risen alongside rate
differential
Source for all charts JPMorgan
1
4
USD Can USD rally continue when Feds tightening
days are over?
Trade-weighted dollar tends to gain at Fed peaks

• JPMorgan believes Fed tightening cycle will end
  (or at least pause) by June 2006 with policy
  rates at 5
• While common sense would suggest high, steady
  rates would be USD-supportive, history suggests
  Fed funds/USD relationship is more complicated
• MXN, KRW and AUD are among biggest losers during
  Fed peak periods back to 1980
• EUR/USD and USD/JPY have shown no clear historic
  correlation with Fed peaks

Cyclical FX have been vulnerable during Fed peak
periods
No consistent EUR and JPY moves vs. USD during
Fed peaks
Source for all charts JPMorgan
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5
What issues could U.S. politicians highlight in
2006?
China Market looking for more

• Despite July 2005 reval, many U.S. legislators
  still want more protectionist legislation risk
  likely to rise during mid-term election season
• Should Fed hikes start to slow pace of U.S.
  growth, protectionism risks will rise further
• While not a consistent relationship,
  protectionist fears tend to weigh on USD
• Protectionism tends to be accompanied by less
  foreign interest in U.S. assets basic balance
  trends would be USD Achilles Heel

U.S. basic balance deficit still a USD drag
Slower growth tends to go hand in hand with
protectionism
Sum of antidumping
Real U.S. GDP growth,
GDP

and CVD orders in effect
115
70
-1
Protectionist
GDP, inverted
-1
110
60
measures
0
USD REER
105
50
-3
1
40
100
2
30
-5
95
U.S. basic balance
3
20
(c/a, FDI, equity)
90
4
10
-7
85
0
5
-9
80
86
87
89
91
93
95
97
99
01
03
05
Q1 99
Q3 00
Q1 02
Q3 03
Q1 05
3
6
EUR Quick 2005 review
Trade-weighted EUR now about 5 above fair value

• The trade-weighted euro fell 6.3 during 2005
  EUR RBEER remains about 5 above its 10-year
  moving average
• EUR hit on a number of fronts last year,
  including
• HIA flows (JPMorgan estimates that around half of
  the total cross-currency HIA is in EUR)
• Jitters around prospects for European integration
  broadly (French non vote)
• Rate expectations following lackluster domestic
  growth (2005 estimated GDP growth of 1.4 is well
  below the previous decades average growth rate
  of 2.1) the daily level correlation between EUR
  RBEER and 10-year aggregate EMU yields was 75
  in 2005

Real broad effective EUR, index
140
130
120
110
10y ma (as of end-2005)
100
90
70
75
80
85
90
95
00
05
HIA contributing to divergence between EUR and
yields
EUR real broad rate, index
10-year EMU yields,
126
3.9
Yield
124
3.6
122
120
EUR RBEER
3.3
118
116
3.0
30-Dec
30-Mar
28-Jun
26-Sep
Source for all charts JPMorgan
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7
How far will ECB raise rates and how will EUR
respond?

• JPMorgan believes the ECB will raise rates to 3
  in 2006, based on
• Perception by ECB that rates are historically low
  and that a normal/neutral level is notably above
  current levels
• Upside inflation risk concerns (the latter due to
  prolonged monetary accommodation, strong credit
  growth, asset price gains, high energy prices and
  global price risks)
• Higher yields, in and of themselves, not
  necessarily EUR positive last five tightening
  cycles have seen mixed reaction in 12 months
  following start of ECB hikes by EUR, both vs. USD
  and on TWI basis
• Politics Italy is due to hold general and
  presidential elections April 9 we see tactical
  downside risk for EUR, as investors may recall
  EUR selling around German election, EU
  constitutional votes and calls by some Italian
  politicians to exit EMU
• Central bank reserve diversification A secondary
  but still EUR-supportive force, we continue to
  see passive diversification by central banks out
  of USD (and often into EUR) we see no reason why
  this trend will not continue in the year ahead

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8
CAD Quick 2005 review
Trade-weighted CAD about 20 above fair value

• CAD gained nearly 4 against each USD and on a
  trade-weighted basis last year thanks to
• Rate expectations The BoC raised policy rates
  100bps in 2005 the current rate is 3.5 and
  JPMorgan expects more hikes to come (with rates
  reaching 4.5 in 2006)
• MA flows Canada enjoyed strong MA inflows last
  year, mainly centered around commodity-related
  businesses
• Commodity prices the BoCs commodity price index
  (which includes coal, crude oil, gas, gains and
  oilseeds, livestock and fish, minerals and forest
  products) rose nearly 40 in 2005 roughly 11 of
  Canadas GDP comes from commodity-related exports

Real effective CAD (BoC index)

110
105
100
95
10yma
90
85
80
75
80
85
90
95
00
05
Canada firms sentiment underscores need to
tighten rates
BoC Business Outlook Survey of firms facing
labor shortages restricting ability to meet
demand
68
63
58
53
48
43
38
33
28
98
00
02
04
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9
CAD Commodities, broad USD and pension flows key

JPM commodity forecasts suggest higher USD/CAD in
2006

• Looking at the year ahead, USD/CAD will depend
  mainly on three factors
• Broad USD correlation USD/CAD and the broad real
  USD TWI have had a daily level correlation of 96
  since 2000 we see broad USD flat/slightly lower
  in 2006 as rate differentials begin to narrow
• Commodities Expectations for global growth and
  commodity prices together will strongly influence
  coming BOC policy rate moves. JPMorgan is upbeat
  on global growth but sees some moderation in
  commodities that are key for Canada
• Pension-related flows After lifting the limit on
  foreign holdings, Canadian pension funds are
  expected to buy as much as CAD67 billion in
  overseas assets over the coming few years
  (according to government sources)

BoC commodity price index and USD/CAD

250
1.05
BoC CPI
USD/CAD
1.15
210
1.25
170
1.35
1.45
130
1.55
90
1.65
95
96
97
98
99
00
01
02
03
04
05
06
Pension flows from Canada may weigh on C/A surplus
USD/CAD
CAD-US equity flow differential,
USD mm, 3mma
Equity flow differential
1.1
USD/CAD
6,000
1.2
1.3
1,000
1.4
-4,000
1.5
-9,000
1.6
95
96
98
00
02
04
Source for all charts JPMorgan
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10
JPY Quick 2005 review and thoughts for 2006
Yen divergence from stocks reflects foreigner FX
hedging

• The yen dramatically underperformed expectations
  in 2005. The yen fell 15 versus USD and 10 on a
  trade-weighted basis. This is more striking given
  the fact that local growth sentiment
  strengthened, helping lift the TOPIX more than
  34. Why the divergence?
• Foreign equity flows have been increasingly FX
  hedged
• China reval smaller/later than expected many JPY
  proxy trades were unwound
• Greater risk appetite among both local and
  foreign investors saw yen used as funding
  currency
• JPMorgan expects Japan to raise interest rates in
  Q4 2006 for first time since autumn 2001. Even if
  rate change is small, history suggests the
  symbolic, sentiment impact could affect capital
  flows, with Japanese keeping more money at home
• Fewer capital outflows will add further to
  Japans already supportive basic balance backdrop
  (4 of GDP in 2005)

Real broad effective yen, index
TOPIX

86
1,600
JPY
84
1,500
82
1,400
80
78
Equities
1,300
76
1,200
74
72
1,100
Dec 31
Mar 24
Jun 15
Sep 06
Nov 28
Source JPMorgan
Japanese retail investors continue to seek yield
overseas
Total amount of investment trusts launched (3mma,
JPY bn)

120
70
20
Oct 04
Dec 04
Feb 05
Apr 05
Jun 05
Aug 05
Source JPMorgan
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11
Broad USD trend Plenty of pluses and minuses to
add up in 2006
USD negatives
USD positives

• Peak U.S. rate differential has tended to see USD
  rise, on average, versus EUR and JPY
• Petrodollar recycling has seen some
  diversification but appears to still greatly bias
  USD
• Political concerns in Europe and Latin America
  may provide at least tactical USD upside risk
  during 2006
• Large corporations and economists already pricing
  in modest USD weakness some bad news is
  discounted

• U.S. balance of payments backdrop remains bleak
  higher U.S. rates may increase private saving,
  but public saving unlikely in aftermath of
  hurricanes and pre-elections
• Capital inflow from Homeland Investment Act
  repatriation coming to an end
• Central bank reserve diversification is slow, but
  continuing away from USD
• Mid-term U.S. election years have typically seen
  slower U.S. growth and lower USD
• Recession fears may limit foreign interest in
  U.S. assets

Bottom line for dollar in 2006 the balance of
forces could simply result in choppy, rangebound
trading, but history suggests a tipping of the
balance is more likely
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12
Why hedge?
The EUR has moved in a 35 range against the USD
in the last three years
6 EUR appreciation in 2 months
14 EUR appreciation in 6 months
5 EUR appreciation in 3 months
19 EUR appreciation in 6 months
5 EUR appreciation in 2 months
5 EUR depreciation in 3 months
19 EUR appreciation in 6 months
12 EUR depreciation in 4 months
7 EUR depreciation in 4 months
7 EUR depreciation in 3 months
8 EUR depreciation in 4 months
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