INTEREST RATE DIFFERENTIALS & THE MAJORS P.

6
CPI & the PCE
defator p. 13
Will Bitcoin
be a tradable
currency? p. 10
Strategies, analysis, and news for FX traders
July 2014
Volume 11 No. 7
Lower for
longer risks
infation
p. 14
Infation &
currencies
p. 20
2 July 2014 CURRENCY TRADER
CONTENTS
Contributors .................................................4
Global Markets
The big three central banks: Interest rate
differentials and the majors .......................6
While July and August may deliver the
typical summer doldrums for traders, a mix
of factors could inject volatility into the forex
markets this fall.
By Currency Trader Staff
On the Money
Bitcoin far from being a
tradable currency .....................................10
A viable currency must satisfy three
basic criteria. Bitcoin is 0 for 3.
By Howard L. Simons
CPI and the PCE defator ...........................13
Is infation really lurking around every corner?
By Marc Chandler
Behind the curve on purpose ............14
Lower for longer risks infation.
By Barbara Rockefeller
BarclayHedge Rankings ........................18
Top-ranked managed money programs
Advanced Concepts
Additional currencies and infation
expectations .............................................20
Expected monetary policy responses
overwhelm differentials in expected infation.
By Howard L. Simons
Looking for an
advertiser?
Click on the company
name for a direct link to the
ad in this months issue.
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CONTRIBUTORS
4 July 2014 CURRENCY TRADER
Editor-in-chief: Mark Etzkorn
metzkorn@currencytradermag.com
Managing editor: Molly Goad
mgoad@currencytradermag.com

Contributing writers:
Barbara Rockefeller, Marc Chandler
Contributing editor:
Howard Simons
Editorial assistant and
webmaster: Kesha Green
kgreen@currencytradermag.com

President: Phil Dorman
pdorman@currencytradermag.com
Publisher, ad sales:
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PO Box 487, Lake Zurich, Illinois 60047. Copyright 2014 TechInfo, Inc.
All rights reserved. Information in this publication may not be stored or
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The information in Currency Trader magazine is intended for educational
purposes only. It is not meant to recommend, promote or in any way imply
the effectiveness of any trading system, strategy or approach. Traders are
advised to do their own research and testing to determine the validity of a
trading idea. Trading and investing carry a high level of risk. Past perfor-
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For all subscriber services:
www.currencytradermag.com
A publication of Active Trader

CONTRIBUTORS
qHoward Simons is president of Rosewood
Trading Inc. He writes and speaks frequently
on a wide range of economic and fnancial
market issues.
qMarc Chandler (marc@terrak.com) is the
head of global foreign exchange strategies at
Brown Brothers Harriman and an associate
professor at New York Universitys School of
Continuing and Professional Studies. Chandler
has spent more than 20 years analyzing, writing,
and speaking about global capital markets. He is the author of
Making Sense of the Dollar: Exposing Dangerous Myths about Trade
and Foreign Exchange (Bloomberg Press, 2009).
qBarbara Rockefeller (www.rts-forex.com) is an interna-
tional economist with a focus on foreign exchange. She has
worked as a forecaster, trader, and consultant at Citibank
and other fnancial institutions, and currently publishes two
daily reports on foreign exchange. Rockefeller is the author of
Technical Analysis for Dummies, Second Edition (Wiley, 2011), 24/7
Trading Around the Clock, Around the World (John Wiley & Sons,
2000), The Global Trader (John Wiley & Sons, 2001), The Foreign
Exchange Matrix (Harriman House, 2013), and How to Invest
Internationally, published in Japan in 1999. A book tentatively ti-
tled How to Trade FX is in the works. Rockefeller is on the board
of directors of a large European hedge fund.
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the initial investment. Risk capital is money that can be lost without jeopardizing ones fnancial security or lifestyle. Only risk capital should be used
for trading and only those with suffcient risk capital should consider trading. Past performance is not necessarily indicative of future results.
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6 July 2014 CURRENCY TRADER
GLOBAL MARKETS
The big three central banks the U.S. Federal Reserve, the
European Central Bank (ECB), and the Bank of Japan (BOJ)
are all boasting extremely accommodative monetary
policies. The high levels of liquidity from these policies are
sloshing around in the global currency markets and have
created extremely low levels of volatility and stability in
the major currency pairs. There havent been a lot of strong
trends for currency traders to ride in 2014.
Whats really behind the prolonged period of easy mon-
etary policy in the major advanced economies? Is there
light at the end of the tunnel or has secular stagnation
gripped hold of the developed worlds economies? The
Fed is scaling back on its monthly bond purchases, but the
target policy rate remains stuck at 0-0.25%, where it has
been there since 2008. Who are the currency winners and
losers this year based on global interest rate differentials?
How will monetary policy changes this year and next
impact the majors? Lets take a look.
Big picture
According to Nomura, global gross domestic product
(GDP) is estimated to grow at a 3.2% pace in 2014 vs. a
2.9% rate last year. That breaks down to 1.8% for devel-
oped nations and 4.6% for emerging markets. While the
rate of growth is positive and improving slightly, the pro-
longed period of sluggish growth in the advanced econo-
mies begs the question are we mired in secular stagna-
tion or an extended long-term period of slow growth?
The argument of secular stagnation suggests the major
economies will grow very slowly by post-war historical
averages, says Cary Leahey, senior advisor to Decision
Economics. It has happened for the past two decades in
Japan; the worry now is that its spread across the devel-
oped world. The economic downturn from the collapse of
the financial services industry around the globe created a
situation where banks are trying desperately to come up
with unconventional means to get stated interest rates as
close to zero as possible. The actual rates of interest are too
high relative to what the economies need.
Currently, the U.S. Federal Reserves official policy rate
stands at zero to 0.25%, the BOJs rate lies at 0.10%, and
the ECB policy rate is 0.15%. Also, in early June the ECB
shifted to negative deposit rates when it slashed the rate
on bank deposits parked overnight with the central bank
to -0.1% from zero. Market watchers continue to expect
additional moves from the ECB with the potential for full-
scale quantitative easing in efforts to boost the eurozone
economy. Currently, both the BOJ and the Fed are still
engaging in quantitative easing policies or buying assets to
keep interest rates low.
Secular stagnation
There are differing views on whether the U.S. and major
economies have actually entered so-called secular stagna-
The big three central banks:
Interest rate differentials
and the majors

While July and August may deliver the typical summer doldrums for traders,
a mix of factors could inject volatility into the forex markets this fall.

BY CURRENCY TRADER STAFF
CURRENCY TRADER July 2014 7
tion, and its likely only time will tell.
Weve had a long period of slow growth, says Jay
Bryson, global economist at Wells Fargo Securities.
Business fixed investment hasnt been strong. One of the
things that drives long-term growth is the growth of the
labor force and productivity growth.
Slow business investment in turn leads to slower pro-
ductivity. Currently, U.S. productivity growth stands at
1.4% on a year-over-year basis, notes Bryson. That com-
pares to an average of 2.3% per year during the last expan-
sion cycle in the U.S. from 2003-2007.
Nonetheless, Bryson is optimistic that the outlook is
improving. His firm forecasts global growth at 3.4% this
year and 3.8% in 2015, which
compares to the long-term
global GDP average of 3.6%
over the last 40 years. During
the 2004-2007 period, global
GDP was growing about 5%.
That [was] a boom, Bryson
says. We arent booming, but
we are growing.
Ryan Sweet, director at
Moodys Analytics, weighs
in. We dont subscribe to the
idea that the U.S. economy
is headed for a long period
of secular stagnation, he says. In order to buy into that
argument, Sweet notes that policy makers both fiscal
and monetary would need to step back from efforts to
boost demand. It would be politically unpopular to take a
laissez-faire approach, he says.
Nonetheless, Sweet admits that weve been in this rut
for a long period of time with U.S. GDP growth stuck at
about 2.0%. We have a significant shortfall in demand.
U.S. businesses are still very cautious in hiring. Consumers
are spending, but not as they did in the past. Theyre
working through the deleveraging process, he says. He
says the demand issue extends globally as well, with
Europe now emerging slowly from its second recession
and the slowdown seen in the Chinese economy. From
the U.S. perspective, we arent getting demand needed
from abroad to support exports, he explains. Over the
last several years, pessimism has become very popular.
People have forgotten that the U.S. economy can grow
north of 4%. Sweet is optimistic that housing will contrib-
ute to economic growth this year and over the next two
years helping to drive the overall GDP rate higher.
Interest rate differentials
With expectations for U.S. growth to pick up, the Federal
Reserve is seen as being on auto-pilot in its reductions
of monthly bond purchases. It is estimated that the current
program of quantitative easing will wind down this fall.
Through late June, the Feds balance sheet stood at $4.368
trillion and will continue to grow until the QE program
officially ends.
However, even once the official bond purchases con-
clude, the Fed still faces a historically unusual monetary
policy exit. The Fed is in uncharted
territory, Sweet says. This tighten-
ing cycle will be significantly differ-
ent from the past cycles. He laid out
the steps the Fed will need to under-
take in the months and years ahead,
which include reducing the size of
the Feds balance sheet, locking up
excess reserves to prevent them from
flowing out into the economy too
quickly, and normalizing interest
rates.
Also, there are many questions
about how the Fed will move for-
ward with this tightening cycle. Currently, Sweet pegs
the odds at 50-50 that it will switch away from the federal
funds rates as its primary policy rate. He points to other
options such as the repo rate or the IOER (interest on
excess reserve rate) as other key tools. The Fed will have
to be crystal clear about how it will use its various inter-
est rates, he says. If the Fed switches its primary lever, it
will increase uncertainty.
With the Fed attempting to navigate a likely complicated
exit strategy, other central banks around the world are also
in various stages of their monetary policies. Forex traders
will be watching for signs of impending policy shifts to
gauge potential impact on the underlying currencies.
Forex action
Looking ahead, the relative trajectory of central bank bal-
ance sheets could be a key driver for currency movement.
Currently, the Fed is tapering by $10 billion per meet-
ing, says Richard Franulovich, chief currency strategist at
The Federal Reserve
is seen as being on
auto-pilot in its
reductions of monthly
bond purchases.
8 July 2014 CURRENCY TRADER
GLOBAL MARKETS
Westpac Banking Corp. There is a steady pace of buying
by the BOJ and the pedal is on the floor as far as the ECB
is concerned. The ECB could see an expansion of their
balance sheet by $500 billion euro. With the euro trading
around 1.36 in late June, Franulovich sees potential for the
currency to fall to the low 130s this year.
Of the three, the Fed is the one that is moving toward
a less accommodative stance, as it continues to pare back
bond purchases, Bryson says. The ECB is probably years
away from hiking rates. They could become more accom-
modative this fall. They could go to full bond purchases
this fall. The bias has become more accommodative. The
BOJ continues to expand its balance sheet. There is a lot
of volatility in the economic data as a result of the recent
consumption tax hike, but they wont be moving to a less
accommodative stance anytime soon.
Vassili Serebriakov, forex strategist at BNP Paribas,
pointed out that monetary policy differentials remain
important drivers in forex trade: Looking at the curren-
cies that are doing well this year, New Zealand is the best
performer since the start of the year and its central bank is
raising rates. The British pound has been doing well over
the past several weeks, a reflection that markets are start-
ing to anticipate a rate hike by the end of the year. It will
be important for the dollar as well especially if the Fed
were to hike earlier than markets are expecting, he says.

Winners and losers
Market watchers have been anticipating the expectation of
U.S. Fed rate hikes to strengthen the dollar for months, and
that remains a key forecast going forward. The dollar has
eked out some modest gains, Sweet says. But, markets
are watching central banks to see which starts to exit first.
Right now, it seems like it will be the Bank of England, the
Fed, and the ECB; the Bank of Japan will be well behind
everyone else. The dollar will do fairly well over the next
couple of years as we start to see interest rate differentials
swing in favor of the U.S. as the Fed begins raising rates.
Serebriakov points to the pound and New Zealand
dollar as currency winners and the euro and yen as cur-
rency losers based on the interest rate differential outlooks
ahead.
Bryson agrees. The euro should be a loser; the yen
should be a loser. In the near term, with Fed rates at zero,
the Brazilian real and Mexican peso will strengthen vs.
the U.S. dollar. But as we get closer to the Fed pulling the
trigger and hiking rates, we should see those currencies
weaken, he says.
Volatility ahead
Currency markets have been mired in one of the longest
periods of low volatility seen in years.
Volatility is continuing to grind lower to multi-year
lows. Its clearly unsustainable and below long-run aver-
ages, Franulovich says, noting that as of late June, the
one-month implied volatility rate in the euro had fallen
to its lowest levels since mid-2007. However, he saw the
potential for volatility to pick up as the Fed approaches the
end of its tapering. The end of the program could dam-
age risk appetite, he says. Markets are not as forward
looking as we think they are. The reality that the Fed is no
longer effectively underpinning markets could give the
dollar a further boost. The reality of it could be a rocky
program. The Fed is expected to bring its monthly bond
buying purchases down to zero around October.
If the expected pace of Fed rates hikes moves forward,
it could also inject some volatility into the forex markets.
The markets have the fed funds rate south of 2% at the
end of 2016. But the Feds projections have it closer to
2.5%, Sweet says. Inflation has accelerated over the past
few months. Inflation is going to overshoot the Feds target
at 2%. The Fed will quickly have to get aggressive, because
the economy will be at full employment by 2016.
So, dont be surprised if Fed rate hikes materialize
sooner than expected. Given the economys near-term
prospects, the Fed will have to raise rates more aggres-
sively than they are leading on right now, Sweet says. He
pegged the fed funds rate at 1% by the end of 2015 and
north of 3% by the end of 2016.
While July and August may deliver the typical summer
doldrums for traders, a mix of factors could inject volatility
into forex markets this fall.
y
CURRENCY TRADER July 2014 9
Enron had a trading platform called Enron Online during
its glory days of the late 20th and early 21st centuries. The
company held itself out as a market maker across all man-
ner of exotic options, most of them hard to price and many
of them at the 200% or so volatilities for which power mar-
kets are famous.
One of these markets was bandwidth, which can be
thought of as a service where the buyer exercises a fixed-
price call option on the seller. It was a
difficult market to understand, since you
can keep adding bandwidth, it cannot be
stored, and its value turns to zero once
demand drops. I decided then, what-
ever the bandwidth market would do, it
would do without me. My thoughts on
Bitcoin are similar, even though I have
some philosophical sympathies for it.
Money
Money is supposed to represent three
broad purposes: a medium of exchange,
a store of value, and a unit of account.
Essentially, people create economic value and then want to
swap their creation for those of others. Barter was the first
way of doing this, but if you have an economy of N goods
and services, you need to establish (N
2
-N)/2 barter rates
between them.
However, if you create one good money in which
all other goods and services can be priced, you only need
N prices. Moreover, if the supply of that money can be
aligned with the quantity of goods and services, you can
achieve some measure of price stability.
Two other issues arise. First, those words on a Federal
Reserve note (aka a dollar bill) This note is legal ten-
der for all debts public and private actually mean
something. The seller of goods and services must accept
it in payment if offered. Second, just as we entertain the
fiction a share in a money-market mutual fund has a $1
fixed value and therefore triggers no capital gains and
losses when bought and sold, we entertain the fiction
that a dollar today is the same as one
yesterday and one tomorrow, to avoid
taxation.
We all know matching the money
supply to the growth of the economy
is easier said than done, and has been
forever. People thought gold an
almost magical commodity in the sense
it is rare, durable, easy to work with,
and readily distinguishable from other
metals was the perfect store of value.
It could be adulterated to a point, but
unless someone found new gold mines,
the supply could not expand at officials
whims.
You should not cry for either Argentina or the gold
standard. While central bankers could not print gold,
miners could find it or conquistadores could steal it; both
produced inflationary pressures. In between these supply
shocks, deflationary pressures reigned as the supply of
goods and services could expand far faster than the money
supply could.
Money does not have to be state-issued. Banknotes
were used frequently in the 19th century, but they had an
10 July 2014 CURRENCY TRADER
Bitcoin far from being a
tradable currency
A viable currency must satisfy three basic criteria. Bitcoin is 0 for 3.
BY HOWARD L. SIMONS
ON THE MONEY
information-cost problem: You had to know the credit
quality of each bank, and you had an incentive to pay with
lower-quality notes and to get paid with higher-quality
notes. Hence the famous Greshams Law: Bad money
drives out good.
Because the government can mandate legal tender, and
if the government ceases to exist its citizens have other
problems, the notes issued by the central bank have the
lowest cost of information and the lowest risk in transac-
tions.
Offsetting these attributes, of course, is the risk of the
government trying to repudiate its debts by debasing the
currency. Today you hear Federal Reserve officials speak
of debasing the currencys value by more than 2% per year
as a national goal as opposed to prima facie evidence of
sociopathic behavior.
Is Bitcoin money?
A guy walks into a bar. He orders a drink and tries to pay
with Bitcoin. The bouncer indicates this thought process is
unsound. After all, the bar does not have to accept Bitcoin
and the patron has no legal standing to compel it to do
so. Bitcoin fails the medium of exchange part of moneys
definition and will continue to do so until laws are passed
making it legal tender.
What about the store of value part? Volatility, as every
trader learns the hard way, can be your best friend or
your worst enemy. Bitcoin has some real problems in this
area, as evidenced by its price history since May 22, 2013,
when the Federal Reserve began discussing tapering its
quantitative easing program. If we accept the fiction that
a dollar has a fixed store of value whose daily changes in
purchasing power are small enough to ignore, we place
its standard deviation of daily returns at some level near
zero. For the sake of intellectual honesty, if we ever enter a
period of hyperinflation, that standard deviation of daily
returns will rise.
Lets add gold and the U.S. dollar index to the compari-
son. Their standard deviations of returns over this same
period (since May 22, 2013) were 1.15% and 0.36%, respec-
tively. The dollar index is less volatile than gold because
we are measuring the dollar relative to other paper curren-
cies managed by similar-thinking central banks, while the
dollar price of gold measures absolute changes in the old
barbarous relic. The standard deviation of Bitcoins returns
was a lusty 8.73%. This is far closer to a commoditys real-
ized volatility than a currencys.
We can illustrate Bitcoins wild ride in two related ways.
The first is by charting its price and that of gold and the
dollar index on a common logarithmic scale reindexed to
May 22, 2013 (Figure 1). The dollar index, a popular trad-
ing vehicle, looks flat on this basis while golds volatility
is at least visible. Bitcoins volatility has been large and
two-way. (Notice the two missing days in the Bitcoin price
series. When was the last time the dollar had a missing
day?)
CURRENCY TRADER July 2014 11
FIGURE 1: BITCOIN TOO HOT TO HANDLE: PRICE
ON THE MONEY
12 July 2014 CURRENCY TRADER
Mapping the 30-day close-to-close realized volatility of
these three markets over the same period shows Bitcoins
realized volatility is more than one order of magnitude
larger (Figure 2). This high and two-way volatility cre-
ates an oscillation in Greshams Law unanticipated by Sir
Thomas Gresham in the 16th century: If you think Bitcoin
is in an uptrend, you do not want to spend it but rather be
paid in it, and vice versa for periods when you think it is
going down. Restated, if Bitcoin is accepted more widely
and its price starts to rise as golds did from 2001-2011, it
will quite literally disappear from commerce because its
fans will hoard it. An unseen currency fails the unit of
accounting aspect of money.
Signaling
Just as the real value of 19th century populists call for
cheaper money, exemplified in William Jennings Bryans
1896 Cross of Gold speech, was a signal to authorities
the persistent deflationary pressures of the gold standard
might cost them their jobs, their heads, or both, the real
value of Bitcoin and other virtual currencies might be to
signal to authorities we cannot allow central banks to keep
engaging in de facto monetization of government debt.
This is a real value; whether policymakers and central
bankers will respond to it is uncertain.
Will Bitcoin become a viable currency? I doubt it, for
the simple reasons it is not legal tender, has tax issues, is
a poor store of value and unit of account, and it is simply
too volatile to avoid unmanageable incentives either to
hoard it or unload it. (I assume some of Bitcoins unmen-
tioned snafus will be solved over time.)
Finally, please ask yourself why you dont use gold
coins, always alleged to be a stable store of value. The
answers are simple and go right back to the difficulties
involved in commerce, taxation, your physical safety, and
the divisibility of gold into small units of exchange. If
gold a tangible commodity that is universally recog-
nized, everywhere coveted, and understood completely
is not used as a currency, why should you expect a digital
phantasm with none of those historic advantages to suc-
ceed?
y

An alternate version of this articles appears in the August issue
of Active Trader magazine (www.activetradermag.com). Howard
Simons is president of Rosewood Trading Inc. For more information
on the author, see p. 4.
FIGURE 2: BITCOIN TOO HOT TO HANDLE: VOLATILITY
CURRENCY TRADER July 2014 13
Recently, observers have been warning of inflation risks
lurking around every corner. With the consumer price
index (CPI) rising above 2%, could they finally be right?
Not so fast. The Federal Reserves 2% inflation target
doesnt apply to the CPI. Since mid-2012, the Fed has iden-
tified the core PCE deflator as its preferred inflation mea-
sure, and theres a significant difference. The PCE measure
of inflation tends to be lower than the CPI measure.
In part, the two measure different things. The CPI is cal-
culated by the Bureau of Labor Statistics of the Department
of Labor. The PCE is calculated by the Bureau of Economic
Analysis at the Commerce Department. An important
methodological issue is the weights for the different com-
ponents. The CPI uses the same weights for several years,
while the PCE deflator uses current and preceding expen-
ditures to calculate the weights. One implication of this is
that the PCE measure also allows for substitution of goods
with rising prices for similar goods with stable or falling
prices.
When it comes to health care expenditures, which played
a large role in the sharp downward revision of Q1 GDP,
CPI and PCE measure somewhat different things. The CPI
calculus includes only the expenses employees pay, while
the PCE deflator also includes money that employers
spend for their employee health care.
The CPI is calculated based on surveys of more than
14,000 families and 23,000 businesses they patronize
some 80,000 consumer items. Sales tax is included too.
The PCE deflator calculation is completely different,
though both the producer price index (PPI) and CPI mea-
sures are used. Essentially, and at the risk of over-simplify-
ing, the PCE deflator is derived from production, which is
at the producer price level. The PCE methodology converts
the producer priced goods/services into consumer prices,
adding profit margins, taxes, and transportation costs.
Other data is incorporated, too. For example, it incor-
porates the monthly retail sales report, and the price
of food grown and eaten on the farm comes from the
U.S. Department of Agriculture. The dealers margin on
used vehicles is pulled from the National Auto Dealers
Association.
The core measure strips out food and energy, mostly.
Restaurant meals have been redefined to be food services
and are now included in the core PCE measure. Pet food
is also included, seemingly as part of the pet expenditures
rather than as part of the food budget.
Over the past 10 and 20 years, headline CPI has aver-
aged 2.4%. The PCE deflator has averaged 2.1% and 1.9%
for the 10 and 20 year periods respectively.
It is widely documented that for at least the past half
century, headline inflation converges to core inflation (and
not the other way around). This may help explain why the
Federal Reserve prefers core measures.
Figure 1 shows the core CPI (white) and core PCE defla-
tor (yellow) over the past 20 years. Over the past five
CPI and the PCE deflator
Is inflation really lurking around every corner?
BY MARC CHANDLER
continued on p. 19
ON THE MONEY
The European Central Bank cut rates in early June,
as expected, and the Federal Reserve Open Market
Committee continued tapering on the path toward nor-
malization, i.e., higher rates. Recently, the majority of
Bloomberg survey analysts had the euro at 1.2500 by year-
end. But in Figure 1 a weekly chart of the EUR/USD
from the peak in May 2011 at 1.4939 to the third week of
June 2014 the euro fell to the lowest low (1.2040) on the
European peripheral sovereign debt issue near the end of
July 2012. Relative growth and differences in monetary
policy had nothing to do with the exchange rate. The
euros recovery has not been a straight line, to be sure, but
technically, its a classic uptrend over nearly two years
characterized by a series of higher highs and higher lows.
We can draw a red support line and a projected resistance
line, and they are nearly parallel with the linear regression
channel. Fans of Fibonacci will enjoy seeing the retrace-
ment of the down move exceeding the 61.8% retracement
line.
The important point is that this does not look like the
chart of a currency about to take a tumble down to 1.2500.
Monetary policy vs. economy
The euro rising when it should be falling is one of those
often-seen instances of perversity in the FX market. One
potential explanation is that while we have divergence in
monetary policy, we have a different divergence in eco-
nomic growth trajectories. European growth momentum
is on the rise, if barely above stall speed, while growth
may well be on the downswing in the U.S. European gross
domestic product (GDP) growth is tepid at best only
0.20% quarter-over-quarter in Q1 but accelerating to 1.2%
for the 2014 year, according to
the Organisation for Economic
Co-operation and Development
(OECD). Meanwhile, U.S. 2014
GDP should end up at least at
2%, according to the International
Monetary Fund (IMF), but this a
downgraded estimate from earlier
forecasts of 2.8%. Even the Fed
downgraded the 2014 growth fore-
cast from 2.9% to 2.2%. But keep
in mind that after the 1% contrac-
tion in Q1, the implication is that
the remaining three quarters will
be quite strong. If Q1 is revised
On the Money
14 July 2014 CURRENCY TRADER
ON THE MONEY
Behind the
curve on purpose
Lower for longer risks inflation.
BY BARBARA ROCKEFELLER
FIGURE 1: EUR/USD, WEEKLY
Source: Chart Metastock; data Reuters
to -1.5%, to get a full year at 2.2%
would require 3.4% over the rest of
the year.
European growth accelerating,
U.S. growth decelerating is this
a recipe for a rising euro? It looks
that way. Emerging from recession
is more currency-favorable than
having reached recovery but then
faltering.
Euro recovery?
Figure 2 supports the idea of a euro recovery, but its
tricky. The hand-drawn support line is broken to the
downside. The breakout comes after a double top that was
confirmed when the price fell below the center low of the
M formation (topmost horizontal gold line). But traders
declined to test the most recent lowest low from February
(bottom horizontal gold line). We might think its touch-
and-go at this point in time another retracement exceed-
ing the Fibonacci 61.8%, too, by the way but the real
message of this chart is that the euro/dollar is only a little
under the green 200-day exponential moving average and
it may end up being a coin-toss which way it goes now. We
FIGURE 2: EUR/USD, DAILY
Source: Chart Metastock; data Reuters
THESE RESULTS ARE BASED ON SIMULATED OR HYPOTHETICAL PERFORMANCE RESULTS THAT HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE THE RESULTS SHOWN IN AN ACTUAL PERFORMANCE RECORD, THESE RESULTS
DO NOT REPRESENT ACTUAL TRADING. ALSO, BECAUSE THESE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THESE RESULTS MAY HAVE UNDER-OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET
FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED OR HYPOTHETICAL TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION
IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THESE BEING SHOWN. THE TESTIMONIAL MAY NOT BE REPRESENTATIVE OF THE EXPERIENCE OF OTHER CLIENTS AND
THE TESTIMONIAL IS NO GUARANTEE OF FUTURE PERFORMANCE OR SUCCESS. TECHNICAL ANALYSIS OF STOCKS & COMMODITIES LOGO AND AWARD ARE TRADEMARKS OF TECHNICAL ANALYSIS, INC.
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16 July 2014 CURRENCY TRADER
ON THE MONEY
can write equally plausible scenarios for a renewed drop,
or for recovery back to near 1.4000.
The net non-commercial position as of the June 16, 2014
Commitments of Traders Report is indeed a short one
(61,835 contracts), and increasing in the prior few weeks,
but this pales in comparison to the net short of 155,066
contracts the week of July 23, 2012.
See Figures 3 and 4. The deduction
is that the sovereign debt situation
was a crisis and it takes a crisis to
propel the savvy hedge funds trad-
ers into really short positions. What
we have now is divergence and
befuddlement, but not a crisis.
No answers from the Fed
We have a distinct lack of clarity
from the Fed. The primary message
in the Feds statement was lower
for longer and Chairwoman Janet
Yellen made a point of saying that
inflation was not a worry because
the data was noisy, nor was mis-
pricing in asset markets (i.e., bubble
denial). The members estimates of
when rates would rise and by how
much did show a bigger, faster rise,
but Yellen brushed off the dots on
the forecast charts, too. The com-
mittee sees the median Fed funds
rate higher in 2015 at 1.125% from
1% in earlier forecasts. For 2016,
the forecast is 2.5% from 2.25% in
the March forecast. But the median
projection for the longer term is
3.75% from 4% earlier. This is not
really hard to grasp rates will
be higher initially but not reach
the 4% long-term average as fast
as earlier thought, due to slower
growth. Some analysts say the
bias toward higher rates sooner
arises from just a few hawks (who
understand the averaging process
and could have written down a
higher number to get exactly this effect). We never get
identifiers for the dots.
Within hours of the Yellen press conference, the yield
on the 10-year note fell 7 bp to 2.58%. This is not as low
as 2.40% seen on May 29, which surpassed the Oct. 23,
2013 lowest low at 2.471%. Its also quite far from 3.03%
FIGURE 3: COMMITMENT OF TRADERS NON-COMMERCIALS
EURO FUTURES
Source: Oanda
FIGURE 4: COMMITMENT OF TRADERS NET NON-COMMERCIALS
OVER FOUR YEARS
Source: Oanda
CURRENCY TRADER July 2014 17
seen at year-end. The yield has
been wobbling along under 2.70%
for several weeks, even spending
three days below the 200-day mov-
ing average (Figure 5). Clearly the
bond market thoroughly believes
lower for longer.
Inflation concerns
Increasingly, however, the bond market also thinks the
Feds dovish stance is behind the curve. Labor market
slack and barely rising wages are indeed a constraint on
the Fed, but inflation is not zero. In fact, inflation is a real
worry. When the latest CPI hit exactly 2% the Feds
target it was dismissed as just one months worth of
data. Besides, the Fed prefers the Personal Consumption
Expenditure (PCE) deflator, and thats only 1.6%, although
its expected to rise to 1.8% in June. Its conceivable that
secular stagnation will morph into stagflation. Secular
stagnation is worse than a regular recession because its
not open to monetary policy fixes, and stagflation is worse
than secular stagnation because only one side can win.
Its a zero sum game in which the monetary policy fix of
higher rates may cure inflation but also drive the economy
back into recession. If the Fed doesnt address inflation,
recovery may proceed but if inflation rears its ugly head
its very, very hard to kill.
How much fear should we have that inflation is coming?
One good fear measure is, of course gold. The gold gang
famously got it wrong on the Feds QE causing inflation,
since it takes the multiplier effect to convert an increase
in the money supply to activity and
we didnt get that the velocity of
money sank and remains low. But
oil price rises due to the geopoliti-
cal problems in Russia/Ukraine and
the Middle East have the potential to
drive inflation higher everywhere
not just in the U.S. In the gold chart
(Figure 6), prices jumped above the
green 200-day moving average and
are nearing the April intermediate
high ($1331.40, Comex futures basis).
It remains to be seen whether gold
will continue higher on the geopoliti-
cal story and draw hedge funds and the public alike back
in.
The price of oil
That makes the price of oil a centerpiece. Periodically,
we get a flurry of stories asserting that oil price rises
dont have the same effect now as they did in the 1970s
because oil consumption is a smaller percentage of GDP,
and besides, the U.S. is nearing self-sufficiency in energy.
These denials of the correlation between oil prices and
inflation are true, but not always useful. For one thing,
not every country became more energy efficient, and the
U.S. imports vast amounts of goods from everywhere.
Also, oil is the starting point for a long supply chain that
runs to chemicals and plastics, asphalt and road materials,
synthetic fibers, and so on. Granted, 74% of oil is used in
the form of gasoline, distillates, and jet fuel, so transporta-
tion heads the list, but transportation is a big industry in
the U.S., affecting everything from eBay to getting build-
ing supplies from Point A to Point B, not to mention food.
Its simply ridiculous and patently not valid to assert that
a giant rise in the price of oil will not have an inflation-
FIGURE 5: REUTERS 10-YEAR NOTE YIELD INDEX
Source: Chart Metastock; data Reuters
FIGURE 6: GOLD FREAKING OUT (COMEX FUTURES BASIS)
Source: Chart Metastock; data Reuters
18 July 2014 CURRENCY TRADER
ON THE MONEY
ary effect. The economists problem is figuring out how
much of one, and truth be told, the models today are not
very convincing. The Cleveland Fed, for example, has an
ivory-towerish paper saying you can forecast actual future
inflation better by excluding oil prices. This is more likely
an indictment of modelling, not of the role of oil prices in
inflation.
Moreover, the fallout will harm the working and middle
classes disproportionately in the form of higher gasoline
and heating oil costs. The
share of gasoline and heat-
ing oil could rise from 4% on
household income to 6-10%.
Considering that wage growth
is less than 1% p.a., this means
the consumer will feel even
more strapped, pulling the
economy down. We already
saw this effect during this
past exceptionally cold winter,
which accounts in part for
the 1% drop in GDP. In other
words, energy costs can be just
as bad for production and pro-
ductivity as bad weather.
So, if oil is such a horrible
threat to the U.S. economy,
why is the Fed sticking to
lower for longer? Probably
because it feels it has no
choice. This is the same reason-
ing behind dividing CPI into
headline and core versions,
core excluding energy and
food, since the government,
including the Fed, cant affect
those prices unless it imposes
price controls. Nobody in the
U.S. today would stand still
for price controls, which are
seen as suitable only for war-
time (and notably failed when
Nixon tried them in 1973).
Talk of inflation and the Fed
behind the curve is possibly
premature, but not unrealistic. Inflation fear is scattered
and limited so far. But if it were to become more main-
stream and widespread, the dollar will surely become the
subject of sell-offs.
y

Barbara Rockefeller (www.rts-forex.com) is an international econo-
mist with a focus on foreign exchange, and the author of the new
book The Foreign Exchange Matrix (Harriman House). For more
information on the author, see p. 4.
BarclayHedge Rankings:
Top 10 currency traders managing more than $10 million
(as of May 31 ranked by May 2014 return)
Trading advisor
May
return
2014 YTD
return
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mgmt.
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1 P/E Investments (FX Aggressive) 4.67% -2.70% 3400.0
2 CenturionFx Ltd (6X) 4.57% -11.77% 30.0
3 First Quadrant (TCA L/S USD 20%) 3.85% 15.31% 40.0
4 ROW Asset Mgmt (Currency) 3.66% 9.54% 11.0
5 Presagium Master Fund LP 3.43% 1.10% 25.0
6 P/E Investments (FX Standard) 3.08% -1.71% 3400.0
7 Gables Capital Mgmt (Global FX) 3.00% -7.58% 42.0
8 Cambridge Strategy (Asian Mrkts) 2.93% 1.20% 75.0
9 Civic Capital (Curr. Fund Ltd) 2.85% -3.13% 1141.0
10 Cambridge Strategy (Emerging Mkts) 2.84% 2.14% 560.0
Top 10 currency traders managing less than $10M & more than $1M
1 MFG (Bulpred USD) 19.60% 18.23% 1.7
2 Whitmore Capital LP 5.32% -8.25% 6.1
3 Hartswell Capital Mgmt (Athena) 4.10% -2.08% 1.0
4 Hartswell Capital Mgmt (Apollo) 2.64% 0.47% 3.1
5 TrueAlpha Capital Mgmt (Gl Currency) 1.82% 1.47% 2.4
6 KSA Consulting Network (Delta FX) 1.62% 2.01% 6.8
7 JP Global Capital Mgmt (Troika I) 0.81% -4.12% 1.0
8 Rhicon Currency Mgmt (Sys. Curr.) 0.16% -2.30% 10.0
9 MDC Trading 0.16% 1.53% 2.5
10 Investment Capital Adv (Managed Accts) -0.04% 3.56% 3.9
Based on estimates of the composite of all accounts or the fully funded subset method.
Does not reflect the performance of any single account.
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
CURRENCY TRADER July 2014 19
years, the core PCE has undershot core CPI by
0.2% on average. Over the past ten and 20 years,
the undershoot has been 0.2% and 0.4% respec-
tively. The persistent lower estimates of the PCE
deflator means the Federal Reserve is likely to
tolerate what may appear to be an overshoot of
CPI.
There appears to be two elements that pro-
duce a more subdued rise in the PCE measure.
One is the substitution effect that is not incorpo-
rated into the CPI measure. The other is the way
hospital expenses and airfares are calculated.
The consensus calls for the May core PCE
deflator to rise to 1.6% in May from 1.4% in
April. If accurate, it will keep this measure 0.4
percentage points lower the core CPI. It is con-
sistent with the Feds assessment that the econ-
omy is evolving toward the Feds mandates.
Some observers will make hay of the substantial
contraction in Q1 GDP, but this too should not
alter the outlook for Fed policy. The Feds eco-
nomic mandates are on employment and prices
and both did indeed move in the (Feds) desired
direction in Q1 and appear to have done so fur-
ther in Q2.
y

Marc Chandler is head of global foreign exchange strate-
gies at Brown Brothers Harriman. His blog is called
Marc to Market (www.marctomarket.com). For more
information on the author, see p. 4.
CPI and the PCE deator continued from p. 13
FIGURE 1: CPI (WHITE) AND CORE PCE DEFLATOR (YELLOW)
20 October 2010 CURRENCY TRADER
TRADING STRATEGIES
Additional currencies and
inflation expectations
Expected monetary policy responses overwhelm differentials in expected inflation.

BY HOWARD L. SIMONS
20 July 2014 CURRENCY TRADER
TRADING STRATEGIES ADVANCED CONCEPTS
The principal conclusion reached last month (see Major
currencies and inflation expectations, June 2014) regard-
ing currency movements and inflation expectations is
that what should be a simple and straightforward rule
countries with inflation expectations higher than those of
a base country such as the U.S. should have a weaker cur-
rency is actually honored far more often in the breach
than in practice. The relationship is surprisingly anecdotal
and defies the simple precepts of both the interest rate par-
ity model and Fishers Law.
To refresh, the fundamental equation for calculating a
currency forward against the U.S. dollar is:
As there can be only one real interest rate globally for
any maturity, the difference in the two nominal interest
rates has to be the difference in expected inflation. All
other considerations and caveats are the same as used last
month.
A set of five national inflation swap markets and their
associated currencies will be examined here. Two of these
inflation swap markets belong to euro-bloc members
France and Spain; the others are the Swedish krona (SEK),
Israeli shekel (ILS), and South African rand (ZAR). In each
case, the one-year inflation swap differential to the U.S.
dollar (USD) will be mapped against the currency itself
along with a correlelogram extending backward and for-
ward nine months to see whether the changes in expected
inflation lead the currency movement or vice versa. The
correlations when the currency leads the inflation swap
differential are depicted in magenta; the correlations when
the inflation swap leads the currency are depicted in
cyan. The correlelograms are calculated with the currency
expressed in USD per terms so that a higher value is
associated with a stronger currency against the USD.
A strong prior expectation here should be the inflation
swap differential leading the currency with a negative cor-
relation value by 126 to 189 days, or the six- to nine-month
time frame often seen in relative short-term interest rate
differentials. If the currency leading the inflation swap
differential occurs, we have evidence changes in currency
levels affect expected relative inflation differentials.
Individual currency analyses
The SEK-USD inflation swap differential appears to have a
general relationship of a wider differential being associated
with a weaker SEK and vice versa (Figure 1).
Forward = Spot *[
1+r
for
*(
90
360
)
1+r
U. S.
*(
90
360
)
]
CURRENCY TRADER October 2010 21 CURRENCY TRADER July 2014 21
The relationship is a strange one, however (Figure 2).
The SEK has a positive leading relationship to the inflation
differential at a seven- to nine-month lag, but this relation-
ship becomes negative as it approaches contemporaneous
lags; this is equivalent to saying a stronger krona leads to
narrower inflation swap differentials. The opposite occurs
for the inflation swap differential. Here, wider differentials
lead the currency strongly at contemporaneous lead times,
which then start to dissipate rapidly after a three-month
lead. The Riksbank apparently has trained the market to
believe it will react very quickly to falling inflationary
pressures with lower short-term interest rates, but that its
memory is short. Neither are admirable attributes for a
central bank.
The Israeli shekel continues the anecdotal parade. Just as
in the case of the Star Wars planet Tatooine and actual dis-
coveries made by NASAs Kepler satellite of planets orbit-
ing two stars, the ILS trades against the EUR just as much
as it does against the USD (see A currency of Biblical
proportions, Currency Trader, May 2012). A map of the ILS
against the inflation swap differential shows how a weak
but discernible relationship between mid-2008 and mid-
2011 broke down entirely after mid-2011 as the inflation
swap differential collapsed toward zero (Figure 3).
Simple visual inspection tells us the lead/lag relation-
ship between the ILS and the inflation swap differential
should be an odd one, and we are not to be disappointed
(Figure 4). As with the SEK, the currency shifts from a neg-
ative correlation at lags of seven to nine months to a posi-
tive one. The inflation swap level leads the ILS negatively
FIGURE 1: THE SWEDISH KRONA AND
INFLATION SWAP DIFFERENTIAL
TO THE USD
5.75
6.25
6.75
7.25
7.75
8.25
8.75
9.25
9.75
-3.0%
-2.5%
-2.0%
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
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5.5%
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SEK Inflation Differential
SEK
FIGURE 3: THE ISRAELI SHEKEL AND INFLATION
SWAP DIFFERENTIAL TO THE USD
3.20
3.40
3.60
3.80
4.00
4.20
4.40
-9%
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ILS
FIGURE 2: MIXED RELATIONSHIP BETWEEN
INFLATION SWAP DIFFERENTIAL AND
SWEDISH KRONA
-189
-168
-147
-126
-105
-84
-63
-42
-21
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<=== Inflation Swap Differential Leads || SEK Leads ===>
Mixed Relationship Between Inflation Swap Differential And Swedish Krona
FIGURE 4: REVERSING RELATIONSHIP
BETWEEN INFLATION SWAP
DIFFERENTIAL AND ISRAELI SHEKEL
-189
-168
-147
-126
-105
-84
-63
-42
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<=== Inflation Swap Differential Leads || ILS Leads ===>
Reversing Relationship Between Inflation Swap Differential And Israeli Shekel
22 October 2010 CURRENCY TRADER
ON THE MONEY ON THE MONEY
22 July 2014 CURRENCY TRADER
ADVANCED CONCEPTS
out to lags of five months, at which point the correla-
tion starts to rise toward zero. This, too, appears to
describe a situation in which the Bank of Israel has
trained the market to expect a credit-relaxing response
to narrower inflation expectations.
Visually, the South African rand had a strong coin-
cidental relationship to the inflation swap differential
through mid-2013 (Figure 5). This is something of a
surprise given the ZARs susceptibility to news events
such as miners strikes and internal political problems.
The ZAR fell sharply during the second half of 2013
and during the emerging market downturn of early
2014 irrespective of the relative inflation outlook.
We should expect this visual relationship to pro-
duce a negative and relatively symmetric lead/lag
relationship between the ZAR and the inflation swap
differential. This is the case, although the leading rela-
tionship of the ZAR starts to rise more slowly after a
four-month lag (Figure 6). The strong negative correla-
tions near lag zero in both directions are indicative of
the same phenomenon observed for both the Riksbank
and the Bank of Israel: The South African Reserve
Bank has created expectations it will react swiftly to
any change in inflation expectations.
Now lets move to the two Eurozone members
whose inflation swaps exist separately from a national
FIGURE 5: THE SOUTH AFRICAN RAND AND
INFLATION SWAP DIFFERENTIAL
TO THE USD
6.25
6.75
7.25
7.75
8.25
8.75
9.25
9.75
10.25
10.75
11.25
11.75
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
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ZAR Inflation Differential
ZAR
FIGURE 6: RELATIVELY SYMMETRIC
RELATIONSHIP BETWEEN INFLATION
SWAP DIFFERENTIAL AND RAND
-189
-168
-147
-126
-105
-84
-63
-42
-21
0
21
42
63
84
105
126
147
168
189
-0.50
-0.45
-0.40
-0.35
-0.30
-0.25
-0.20
-0.15
-0.10
-0.05
0.00
C
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r
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l
a
t
i
o
n
<=== Inflation Swap Differential Leads || ZAR Leads ===>
Relatively Symmetric Relationship Between Inflation Swap Differential And
South African Rand
FIGURE 7: THE EURO AND FRENCH INFLATION
SWAP DIFFERENTIAL TO THE USD
1.15
1.20
1.25
1.30
1.35
1.40
1.45
1.50
1.55
1.60
1.65 -2.5%
-1.5%
-0.5%
0.5%
1.5%
2.5%
3.5%
4.5%
5.5%
6.5%
J
u
l-
0
4

M
a
r
-
0
5

N
o
v
-
0
5

J
u
n
-
0
6

F
e
b
-
0
7

O
c
t
-
0
7

J
u
n
-
0
8

J
a
n
-
0
9

S
e
p
-
0
9

M
a
y
-
1
0

D
e
c
-
1
0

A
u
g
-
1
1

A
p
r
-
1
2

D
e
c
-
1
2

J
u
l-
1
3

M
a
r
-
1
4

U
S
D

P
e
r

E
U
R

O
n
e
-
Y
e
a
r

I
n
f
l
a
t
i
o
n

S
w
a
p

D
i
f
f
e
r
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n
t
i
a
l
,

F
F
R
-
U
S
D

I
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v
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s
e

S
c
a
l
e

FFR Inflation Differential
EUR
CURRENCY TRADER October 2010 23 CURRENCY TRADER July 2014 23
currency. Neither the French (Figure 7) nor Spanish (Figure
8) inflation swap differentials bear much resemblance to
the EUR, nor should we expect either of them to. Countries
without direct control of their own monetary policy and
fettered to partners with widely divergent fiscal policies
and growth trajectories have limited capacity to affect their
own inflation expectations.
In consideration of the above, our prior expectation
should be the euro leads both sets of inflation swap dif-
ferentials more than vice versa. This is accurate, with the
French case being the more direct in this regard (Figure
9). The Spanish case is rather odd in that the correlations
of higher inflation swap differentials to the euro become
increasingly positive with a longer lead time (Figure 10).
This can be interpreted as saying troubles in Spain affect
European Central Bank policy, but only after a delay wor-
thy of the ECBs committee nature.
The overwhelming conclusion from this set of curren-
cies is both the interest rate parity theorem and Fishers
Law are trumped by the expectation of central bank policy
responses. This is the downside of living in a world where
central bankers have become central planners first and
foremost, trying to respond to every development with a
tool (monetary policy), whose outcomes are anything but
deterministic and that operates with those famous long and
variable lags. Is it any wonder we live in a world of rolling
financial crises, bubbles, and busts?
y
FIGURE 9: EURO LEADS FRENCH INFLATION
SWAP DIFFERENTIAL MORE THAN
VICE VERSA
-0.3
-0.2
-0.1
0.0
0.1
0.2
0.3
0.4
-189
-168
-147
-126
-105
-84
-63
-42
-21
0
21
42
63
84
105
126
147
168
189
C
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i
o
n

<=== Inflation Swap Differential Leads || EUR Leads ===>
Euro Leads French Inflation Swap Differential More Than Vice-Versa
FIGURE 8: THE EURO AND SPANISH INFLATION
SWAP DIFFERENTIAL TO THE USD
1.15
1.20
1.25
1.30
1.35
1.40
1.45
1.50
1.55
1.60
1.65 -2.5%
-1.5%
-0.5%
0.5%
1.5%
2.5%
3.5%
4.5%
5.5%
6.5%
J
u
l-
0
4

M
a
r
-
0
5

N
o
v
-
0
5

J
u
n
-
0
6

F
e
b
-
0
7

O
c
t
-
0
7

J
u
n
-
0
8

J
a
n
-
0
9

S
e
p
-
0
9

M
a
y
-
1
0

D
e
c
-
1
0

A
u
g
-
1
1

A
p
r
-
1
2

D
e
c
-
1
2

J
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1
3

M
a
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-
1
4

U
S
D

P
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r

E
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R

O
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-
Y
e
a
r

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S
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p

D
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f
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,

E
S
P
-
U
S
D

I
n
v
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r
s
e

S
c
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ESP Inflation Differential
EUR
FIGURE 10: SPANISH INFLATION SWAP
DIFFERENTIAL AND EURO LEAD
EACH OTHER AFTER LONG LAGS
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
-189
-168
-147
-126
-105
-84
-63
-42
-21
0
21
42
63
84
105
126
147
168
189
C
o
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e
l
a
t
i
o
n

<=== Inflation Swap Differential Leads || EUR Leads ===>
Spanish Inflation Swap Differential And Euro Lead Each Other
After Long Lags