TradingFloor.com 2013 Q2 Insights

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Quarterly Outlook · Q2 · 2013

Q2 Insights

The end of the free ride
Equity Insights FX Insights Macro Insights Commodity Insights

Another positive year

Trees still don’t grow to the sky

Modest uptick in growth

Tail-end risks leaving little room to the upside

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So, it’s the end of the free ride as we know it. Or at least it should be. In economics, the term “free rider” is used to describe a person who benefits from a variety of resources or services without paying for them. As we move into the second quarter of 2013, the concept can be seen everywhere, from competitive devaluations to lack of reform in the US and Europe, not to mention the failure of the European Council to agree on a bailout programme and public sector resistance to much-needed reforms. But where to from here? World growth is being lowered and fiscal deficit projections are on the rise. Sure, the stock market might be upbeat, but that is another example of the free-ride concept – and, it has to be said, it has become a refuge in itself. There is no doubt that the economic crisis is in a tailspin and politicians are standing idly by. And with all eyes on Germany and its September election, it has to be asked: will Germany write a big cheque and save the single-currency bloc? The facts state otherwise, while this hope is based yet again on a “free ride” that there will be a German willingness to help. Always. Throw in the Cyprus bail-in, which created no winners, and the conclusion is that European decision-making has been left bleeding and without hope of recovery. The lack of coherent policies raises serious concerns over who will pay for future bail-ins. Overall, this adds weight to our general theme of a stronger USD and our belief that much of the investment return for the rest of the year will come from foreign-exchange exposure. That said, we are seeking a mandate for change, which would be best accomplished by a proactive recognition of the need to reform. And therein lies our optimism: things can’t get any worse.

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STEEN JAKOBSEN
Chief Economist

Peter Garnry
Head of Equity Strategy

John J. HardY
Head of FX Strategy

Mads Koefoed
Head of Macro Strategy

Ole S. Hansen
Head of Commodity Strategy

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Q2 Insights

The end of the

free ride
Three months into the year and we see growth being lowered and fiscal deficit projections increased by all of the Club Med countries, plus France and now also Germany. The International Monetary Fund has lowered world growth and we are looking at a 2013 that is, from the outside, a mirror image of 2011 and 2012.
by STEEN JAKOBSEN, Chief Economist

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A free rider in economics refers to someone who benefits from resources, goods, benefits, or services without paying for the cost of said benefit. This term can best describe how the world in the first quarter moved from a free-riding concept to blatant public disagreement on how to keep the party going. The stock market is hitting new highs but employment and growth, the two factors that really matter in the long term, are hitting new lows month by month. Attempts to free ride can be seen every day in competitive devaluations, lack of reform in Europe and the US, the inability of the European Council to agree on a bailout (or bail-in) programme, the stock market rise, and how interest groups (read public sector) refuse to reform despite the obvious need and greater good of doing so. The economic crisis has evolved into a full-blown political crisis. When government debt becomes too large and the fiscal deficit explodes, it is much more difficult to induce all interest groups to co-operate. The later the financial reconstruction is initiated, the bigger the deficit – and it is more likely to be unsuccessful because of the parties’ lack of “interest”. This is the case in the US and Europe right now: they have bought so much time that the problem has moved from being an issue that could be dealt with to something that must be dealt with. Three months into the year and we see growth being lowered and fiscal deficit projections increased by all of the Club Med countries, plus France and now also Germany. The International Monetary Fund (IMF) has lowered world growth and we are looking at 2013 that is, from the

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outside, a mirror image of 2011 and 2012. But there is one difference: the German election on September 22 – the main event of the year. The German election can’t come soon enough. We need to break this negative cycle that is spiralling out of control, in which politicians are standing idly by. The bet that Germany will, ultimately, write a big cheque and accept fiscal union is prevalent in the market, but perhaps history is better guide. The single biggest “cheque” ever written was the Marshall Plan offered by the US to Europe post-World War II. Its size? An impressive USD 13 billion in a USD 258 billion economy – or, in other words, 5 percent of US GDP. Let’s assume Germany is willing to bail-in the rest of Europe with a number equivalent to the US Marshall Plan: Germany’s GDP is USD 3.6 trillion and 5 percent of this is USD 180 billion, or EUR 140 billion – hardly enough considering it is estimated that between EUR 2 trillion and EUR 3 trillion is what is needed to stop the EU debt crisis once and for all. We are again seeing that hope is based on a “free ride” that there will be a German willingness to help, but the facts state otherwise. The Cyprus bail-in or bailout created no winners – only losers. Nor did it give any credibility to the EU process. It has left European decision-making bleeding and without hope of recovery as the EU Commission and the IMF exchanged harsh words in the name of a power game, never for the sake of future Europeans. We saw in Cyprus how principles go out the door when the Eurozone needs to find a solution that fits the political spectrum. Cyprus was a first in three ways:

• Capital controls: one euro in Cyprus is not the same as one euro in Berlin or Paris any more. You cannot move your money off the island. • Bail-in of senior bondholders: In Greece, it was only junior bondholders. • Bail-in of depositors with more than EUR 100,000 in their accounts. The more serious “violation” is the capital control. An economic and monetary union no longer exists across the Eurozone. The lack of coherent policy solutions raises the question: who is to pay for future bail-ins? Is it open season on uninsured depositors for policymakers? It would appear that this source of revenue is far more efficient, or implementable, than raising other types of taxes in countries such as Italy, Spain, Greece and Portugal. One can speculate that the ultimate goal could be to introduce a Swedish-type banking model financed by a levy on assets from depositors and shareholders. To build a fund big enough to recapitalise all of the banks in the Eurozone, the bill would be EUR 3 trillion, or 30 percent of the bloc’s GDP, according to Citigroup’s chief economist Willem Buiter. I repeat EUR 3 trillion. A deposit tax is already in place in Italy and Spain. Italy has had a 0.015 percent tax on assets under management since December 2011 and only a few weeks ago, the Spanish courts allowed the government to impose a 0.2 percent to 0.3 percent deposit tax.

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“ We are looking at a mandate for change. This would best be achieved via a proactive recognition of the need to reform, but change, most likely, will be triggered by another failure, such not keeping Cyprus or Greece in the Eurozone.”

So Cyprus was a first in many ways, but also an extension of practices already in place. Let me warn again: the fact that deposit taxes are currently low should not make you sleep easily. VAT was introduced in Denmark in 1967 at 9 percent, but it has since risen to 25 percent. The point is that deposit taxes are easy to collect, come from the private sector and will be deemed fair by many non-creditors – again back to the free riding. If you have no money in the bank, a deposit tax seems fair and with the present policy of non-reform, this group is getting bigger and bigger by the day. This was best seen in Italy, where Beppe Grillo and his Five Star Movement polled 25 percent with no programme except being anti-establishment. This is a warning for all politicians in Europe. Voters are not going to sit this one out, despite having been free riders for a long time. The ultimate challenge of finding jobs and getting back to normal is now more important than looking for the “system” to bail them out. Since Cyprus, this move should get stronger as savings – if in excess of EUR100,000 – will be targeted by the Eurozone Troika. The EU and its politicians are running out of time. By this time next year, without change and reforms, there will not only be economic consequences to pay, but also political – not only for domestic politicians, but also for their EU counterparts as electorates will have no patience with their plans to have a plan for a plan in 2018. Meanwhile, the short-term solution is for everyone to engage in competitive currency devaluation. Officially, they are all conducting domestic-driven monetary easing, but the flow of capital chasing yield from Japan and the US is now driving locals in Singapore out of their own country. Likewise for

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the man on the street in Zurich, it is getting extremely difficult to maintain a standard of living while non-domiciled foreigners bid up the cost of houses, food, energy and everything else. Another social tragedy. The main beneficiary remains the stock market, which has become a refuge in itself. Many people revert to the Marxist argument that property rights are only truly protected in equity and property, with the US being the main beneficiary. This plays well to our general theme of a stronger USD and we believe that the bulk of investment return for the remainder of 2013 will come from foreign-exchange exposure. We do not see an equity market collapse, but the present level of the S&P index and global stocks almost by nature dictate a pause as we approach expensive levels for stocks, particularly in the context of lower global growth and weaker earnings. For stocks to continue rising, we would need to see a big improvement in economic growth and a major new source of monetary easing beyond the expected rate cut from the European Central Bank. In Q1, the world money printing machine became Japan, so now the race is on for economic conditions to improve before the monetary experiments in the UK, US and Japan fail. The UK will probably try to expand further to become the “new” impulse in Q3 – but probably not fully before the change of Bank of England governor in July. This leaves Q2 vulnerable to more political issues for want of new QE impulses. Most importantly of all, Q2 comes right before the German general election. This means Chancellor Angela Merkel will need to expend great energy in explaining her country’s role in Europe to voters. I do not envy her this task, especially as the crisis radar has already zeroed in on Slovenia as a potential new bailout candidate in the second quarter.

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We are looking at a mandate for change. This would best be achieved via a proactive recognition of the need to reform, but change, most likely, will be triggered by another failure, such not keeping Cyprus or Greece in the Eurozone. However, we also need to learn that failing is a part of life and signals new beginnings. The Kingdom of Spain has been bankrupt 14 times in history and if we look at our own lives, it tells us that we are at our most rationale and logical when we have our backs up against the wall. And therein lies my optimism. As I like to say at the start of my speeches: “I’m the most optimistic I have been in 25 years, only because things cannot get any worse.” The free-riding spree for politicians is over. They now need to do something they have never excelled at: face facts and devise real solutions. As they are unlikely to rise to the task, the micro economy will do it for them instead.

You can follow the effects of these macro events on the financial markets by creating a personalized view on Saxo Bank’s mobile app. download saxo bank’s mobile app here

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Equity Insights

Another positive year
Photo: Songquan Deng / Shutterstock.com

The US remains our top pick among all the developed equity markets simply because it has been by far the best in navigating the financial crisis.
by Peter Garnry, Head of Equity Strategy

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Equities opened the year by surging 10.6 percent (measured in EUR), shrugging off the mass hysteria over the fiscal cliff and Italian elections, which were highlighted as the two main events that could derail stock markets. While the second quarter might not be as good as the first, we expect 2013 to be a good year for global equities and in particular, US equities.

It is hard to be a bear in equities
Global equities are still mean-reverting in terms of valuation and despite the impressive rally, they are still valued minus a half standard deviation below their average valuation in the period 1996 to 2013. Based on our model’s input

factors, global equities would have to rise an additional 12 percent before reaching their average valuation. Given that underlying earnings and cash flows grow in nominal figures in an expanding global economy, the equity return potential is naturally much higher than 12 percent when you take the progress of time into account. If the global economy accelerates to 3.8 percent real growth in 2014 – as our macro forecast currently suggests – then valuation could overshoot, taking valuations above their average some time during 2014. The important price-to-cash-flow ratio is currently reading 8.8 compared with 16.6 at the height of 2007. While equity prices have more than doubled since the bottom in March 2009, this indicates that cash flows have ballooned during the past five years and highlights the corporate sector’s magnificent exercise in shoring up operations. Also adding support from a valuation point of view is the current dividend yield reading of 2.6 percent compared with 10-year government bond yields ranging from 0.5 percent in Japan to 2.2 percent in Belgium among the safe-harbour countries. With the current data on hand, we are confident that global equities will be higher over the next 12 months. While the Italian election and the rescue of Cyprus received massive headline attention, the market’s reaction has not significantly altered our confidence in global equities and we forecast that they will continue to rise. However, the second quarter might be less rosy relative to the first quarter as equity investors will have to see whether the discounted improvement in economic data materialises. But it is worth noting that global equities have seen positive returns in 66 percent of the quarters since 1970; it can be costly to bet against the drift in equities.

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US equities head towards unknown territory
The US remains our top pick among all the developed equity markets. The reasons are quite simple. The US economy has been by far the best in navigating the financial crisis, with good private sector growth in employment and profits while deleveraging households’ balance sheets. Additionally, the public sector has cut down on spending and workers, which, combined with nominal GDP growth, has significantly healed the fiscal budget over the past 12 months. Recently, more economic indicators are signalling that the economy is increasing its horsepower. Based on current economic data, managements’ earnings guidance, rolling realised volatility and valuations, we see a high probability that US equities will continue to rise. On March 28, the S&P 500 hit a new all-time high, eclipsing the previous record set on October 9, 2007, when the index closed at 1,565.15. This is, of course, only the price index. Measured by total return, that is, reinvesting the dividends, the index reached an all-time high in the third quarter last year. The past couple of years have been a rollercoaster and the 12-month forward P/E ratio, a good gauge of valuation and confidence, has bounced back from its lows of about 11 times forward earnings during the high point of the Eurozone crisis in 2011 to about 14 times as of late March 2013. In late February, we updated our year end mid-point forecast for the S&P 500 to 1,640 based on current 12-month forward earnings of 111.65, 5 percent growth in forward earnings in 2013 and forward P/E expansion to 14 times.

“ With the current data on hand, we are confident that global equities will be higher over the next 12 months. While the Italian election and the rescue of Cyprus received massive headline attention, the market’s reaction has not significantly altered our confidence in global equities and we forecast that they will continue to rise.”

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European equities discount a better future
While unemployment is still climbing, signalling recessionary economies throughout most of the Eurozone, European equities have surged by about 25 percent since late May last year. Equities are forward-looking and, as such, lagging indicators like unemployment are irrelevant. Only the future matters and here, European equities are voting for an improving economy in Europe despite what the mainstream media wants us to believe. The real-time GDP tracker €-coin rose for the seventhconsecutive month to -0.12 in March, its highest reading since May 2012 and a signal of overall improving conditions despite the worse than expected PMI figures for March. Despite a weak Eurozone economy, European equities could still have a good year with positive returns as the major indices more than ever reflect the global economy and not so much the domestic economy. The current 12-week rolling realised volatility spread between high beta stocks and low volatility stocks is at very low levels, implying calm waters. As such, we expect a modest drawdown should equities retreat in the second quarter. If we get a setback in US equities, we expect it to be triggered by some external shock to confidence from the Eurozone crisis, which still looms as the main downside risk. Some analysts have speculated recently that US equities have entered a bubble phase. Based on current valuations, specifically the price-to-cash-flow ratio and James Tobin’s Q Ratio, which was published by the Fed, our best judgement is that US equities are far from being in a bubble. In our previous quarterly outlook, we courageously forecast that peripheral European equities could be this year’s winners based on our mean-reversion theme. Our case was built on a stabilising Eurozone that would return to positive growth in late 2013. Despite a political vacuum following the Italian election and the rescue of Cyprus with its controversial levy on deposits above EUR 100,000, European equities have held up and the MSCI Euro index, capturing 90 percent of the total Eurozone market capitalisation, is up 1.7 percent this year. However, a basket invested equally in Greek, Irish, Portuguese, Spanish and Italian stocks would have returned 5 percent, with Italian stocks the biggest drag on performance.

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a platform to end deflation, the JPY has weakened. Its decline gathered more steam when the Bank of Japan in January launched its new monetary framework for the future including a 2 percent inflation target. Starting in mid-November, the JPY is down 18.7 percent and 19.8 percent against the USD and EUR respectively. As a result, the Nikkei stock market index has taken off like a rocket, gaining 43 percent since midNovember and 19.3 percent this year. The six-month gain is the biggest on record since the fourth quarter of 1972. What does the rally spell for the future of Japanese equities? Are they finally set for a secular bull market? That might be too premature to expect. The problem for Japan is that the weakened JPY might be good for exporters, but the country imports a lot of energy, which will now increase in price and hit both consumers and domestic-oriented businesses. There is no easy cure in economics and the weak JPY will not be the rosy one-way road Japan thinks it might be. Neither Cyprus nor the Italian election has made us change our forecast that peripheral European equities have a good chance of being the best performing markets this year. Progress is evident in many of these countries with Ireland coming back to the bond market, Portugal ahead of its plan for fiscal consolidation, Spain’s labour costs declining fast and thus improving the country’s competitiveness, and Italy reaching record 12-month rolling exports in January. Such facts are testament that these countries are coming back from the abyss. The Nikkei index is furthermore valued way above the MSCI World on multiple metrics including earnings, cash flows and dividends. Sell-side analysts also have very bullish estimates for earnings, which they project to grow 30 percent annualised over the next two years. These estimates seem a bit overstretched given that our estimate for Japan’s GDP growth in 2013 is 1 percent and the global economy 3 percent. With global inflation expected to be about 3 percent in 2013, analysts must be forecasting big currency gains or significant market share gains for foreign-focused Japanese companies. This is too optimistic in our view and we expect Japanese equities to enter a more modest phase, in which Japanese investors will analyse the weak JPY’s real impact on earnings and sales.

Are Japanese stocks leaving the shadows?
Since mid-November last year, when it became evident that Japanese Prime Minister Shinzo Abe would win the election on

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How did our tactical calls from Q1 perform?
In our first quarter outlook, we took a more tactical angle providing some strategies for January. We argued that historically there has been a mean-reversion effect in the first month of the year, with the biggest loser in the previous year being the winners in the first month and vice versa. A basket of the five-worst performers in Europe and the US respectively would have returned 11.6 percent measured in EUR compared with 2.1 percent for the MSCI TR World Euro index in January. The opposite basket, selling the previous year’s winners, would have gained 2.2 percent, so here the strategy did not work in our favour.

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global unpredictability?
Time for a cool-headed bank.
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Trees still don’t grow to

The risk appetite sentiment will likely falter in Q2. And this perhaps is due to three reasons: seasonality, worries over the US Federal Reserve slowing the liquidity gravy train and ongoing European Union woes. In terms of seasonality, the past three Q2s in a row have been quarters of transition to sideways markets or worse after strong Q1 rallies in risky assets.
by John J. Hardy, Head of FX Strategy

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In our Q1 outlook, I highlighted that multi-year lows in FX implied volatility and opined that this simply could not continue given the macro backdrop. Indeed, we did see a moderate comeback in volatility in Q1, but not the broadbased comeback I envisioned. Rather, it was one that was mostly limited to developments for the EUR, GBP and JPY. In the second quarter, look for the narrow rise in volatility to begin to broaden with additional USD strength, a wild ride for the JPY and commodity dollar weakness being the main themes.

The weak and the strong in Q1
The EUR topped out in January, as the European Central Bank’s (ECB) balance sheet was reduced by the early repayment of some of the vast three-year Long-Term Refinancing Operations (LTRO). The currency then quickly transitioned to pronounced weakness for the balance of Q1 on the anticipation and then reality of the Italian election. And then there was Cyprus, but more on that later. The other big downers were the JPY and GBP. “Abenomics” in Japan, ugly UK numbers and Carneyanticipation saw two turbo-charged JPY and GBP carry trades in January and February. Complacency in asset markets was another key driver for these trades. Now for the strong currencies of Q1: the all-important US dollar managed to rally despite the Fed having fired both barrels of its monetary shotgun in late 2012, while the improved US economic environment also supported the greenback. Elsewhere, we saw standout strength in AUD, NZD and SEK – even to new outright long-term highs for AUD and NZD. Their extremes of strength were a celebration of global easy

“ As we enter Q2 amid widespread complacency, the old ‘risk appetite’ meme hasn’t only been playing second fiddle, it’s been entirely kicked out of the orchestra. The market appears dangerously convinced that central banks will simply not allow any risk to materialise for asset markets, so why even bother to worry?”

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JPY vs risk appetite: The JPY hasn’t just been about “Abenomics”, but also the market’s embrace of a new carry trade opportunity: it’s been easy to sell the currency when the central bank (BoJ) is promising the most aggressive money printing.

JPY vs. interest rate spreads: Japanese longer yields have collapsed as investors anticipate that the Bank of Japan (BoJ) will purchase debt at the long end of the curve, weakening the JPY from an interest rate spread perspective. From here, Japanese yields can hardly go lower and complacency can hardly get more extreme, so we’ll either need to see heavy lifting from the BoJ and/or higher government bond yields outside Japan to provide the fundamental drivers for more JPY weakening in the short to medium term.

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liquidity and continued complacency. In addition, the currency war/competitive devaluation aggravated their strength as the central banks in these countries proved “hawkish”, which these days means simply declaring neutral policy outlooks, rather than any discussion of actual rate hikes.

to do well – the outlook from here is win-win. The JPY is set to be the “G10’s Loki” for some time as we may see a very rocky path for JPY crosses as Abenomics moves from the anticipation phase to the rubber-meets-the-road phase. The outlook for the EUR is perhaps the least certain, but a good deal of pessimism is already priced in for the single currency. In the background, the systemic nature of risk on/risk off seems to have been banished, but could be ready to emerge again now that complacency has reached such remarkable extremes. The longer the risk bubble inflates, the higher the potential magnitude of volatility when it does return.

Q2: A quarter merely of transition or outright reversal?
So as we enter Q2 amid widespread complacency, the old “risk appetite” meme hasn’t only been playing second fiddle, it’s been entirely kicked out of the orchestra. The market appears dangerously convinced that central banks will simply not allow any risk to materialise for asset markets, so why even bother to worry? That sentiment will likely falter in Q2. And this perhaps is due to three reasons: seasonality, worries over the Fed slowing the liquidity gravy train and ongoing European Union woes. In terms of seasonality, the past three Q2s in a row have been quarters of transition to sideways markets or worse after strong Q1 rallies in risky assets. This year’s Q1 run-up has been the largest of them all and could also run into major headwinds due to the second of our drivers: a transition in Fed policy towards a less accommodative stance. More on that in the US dollar section below. Meanwhile, EU worries are nothing new and they will remain on the table through the German election in September. Overall in Q2, the G10 smalls that performed so well in Q1 will likely begin to range trade in the best of circumstances and sell-off brutally in the worst. The US dollar should continue

USD: Rally to extend
The macro environment offers a win-win set-up for the USD from here. In the optimistic scenario, the USD rises because the US recovery continues to take hold in coming months, further encouraging anticipation that the Fed will begin to unwind some of its accommodation as early as later this year, possibly by reducing the rate of its mortgage-backed securities and US treasury buying, established at USD 85 billion per month last December. Fed chief Ben Bernanke himself has spelled out this scenario. Thus, the Fed would be the first super-major central bank to begin to unwind accommodation. Other supports for the USD on this front are the incredible comeback in energy production, the ongoing reduction of the current account deficit from this and from the reshoring of some production. A potential dark horse support for the USD would be the return of US foreign corporate wealth if the government launches a new Homeland Investment Act profit repatriation scheme.

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The more pessimistic scenario for the near term also supports the USD. In this scenario, economic recovery hopes don’t pan out, perhaps due to the accumulative effects of the tax cut expiries and fiscal austerity in the wake of the sequestration process and further budget austerity in the pipeline. So even with no change in Fed policy, this could hit asset markets rather hard, which would tend to support the USD from a safe-haven angle. Alternatively, even if the economy merely stumbles along and slowly improves, if asset markets don’t take a breather, the Fed may feel forced to finally back off some of its open-ended QE programme in recognition that its policy has overheated credit markets and generated dangerous “reach for yield”. Any actual or anticipated real reduction in Fed easing will apply pressure on global risk appetite via the reduction in liquidity.

of the Cyprus bailout/bail in. Will direct “wealth confiscation” develop as a meme from here as a way to fund the restructuring of our over-indebted economies going forward, rather than on a tide of printed money? There is the possibility that Europe could limp along until the German election in September. If a new full-fledged EU crisis hasn’t broken out before that critical event, we would expect a rapid move towards whatever solution for Europe awaits in the months that follow – either with an Angela Merkel mandate or more chaotically due to the potential for splintering German politics.

JPY: The Loki of the G10
Market synergies favoured a weaker JPY to an overwhelming degree in the first quarter as rising complacency and the aggressive Japanese government and BoJ rhetoric on JPY weakening was a match made in heaven. The brutal move in the JPY bottomed out in early March in recognition that everything thus far had been anticipation rather than reality. Just before we go to press, the BoJ unleashed a massive easing programme that is three times larger than the Fed’s current balance sheet expansion in domestic GDP terms, easily outstripping market expectations. At first blush, the market is celebrating the liquidity generated by this move. But this reaction pattern may change soon. In Q2, the market may stop playing the JPY weakening as a boon to risk appetite and stimulus for a new carry trade and begin to worry that the Bank of Japan’s moves risk destabilization – whether in Japanese bond markets or trade relations. At some point, if the risk appetite/JPY weakening trade decouples, we

EUR: The tension mounts
The EUR was on a wild ride in Q1. It rose sharply as the ECB’s balance sheet shrank due to LTRO early repayments, but then fell on the uncertainty generated by Italy’s election results and the Cyprus solution, which saw the Troika going after bank depositors to help fund the bailout due to the nation’s status as a tax haven with an over-sized banking sector. From here, the EU will have a hard time restoring confidence in the currency as we have the interminable wait until the German elections in September and the unknown path for Italy to boot. As well, France’s economic trajectory is a growing worry, while tiny Slovenia will likely need a bailout. And don’t forget Spain, where new bank scandals could hit at any moment and the social fabric is being sorely tested with every passing month. The most interesting thing going into Q2 is the advent

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could see sharp wild two-way oscillations in the JPY within the context of overall JPY weakening as the market struggles to find a new paradigm, and particularly if other Asian powers’ grumblings over the BoJ’s new policy escalate to protectionist threats.

safe havens were out of favour and some Swiss banks began announcing they would charge negative interest rates on deposits. But renewed Euro zone troubles quickly scotched the EURCHF rally, as did the Swiss National Bank’s (SNB) failure to provide any hint that a raising of the floor was imminent. EUR uncertainty from here will likely also mean CHF uncertainty. The SNB will remain determined to defend the 1.20 floor in EURCHF and if it is under pressure, we can expect a new tool kit of options for discouraging capital accumulation in Swiss banks, whether punitive negative deposit rates, or capital controls or the like. In the longer term, the franc remains woefully overvalued, but determining the timing of a potential weakening is fraught with uncertainty – perhaps we won’t get much movement until after the German elections.

GBP: Down but not out
The pound simply fell apart in early Q1 as the market punished those currencies where central banks looked the most likely to continue to print money and delve even deeper into the monetary policy toolbox. It’s anticipated that the arrival of new Bank of England (BoE) governor Mark Carney this summer could bring even more extreme monetary policy accommodation or experimentation – possibly even the untested Nominal GDP level targeting. Also weighing on sterling is the fact that the UK’s huge current account deficit has somehow not even moved in the right direction despite the tremendous sterling devaluation since the global financial crisis. I think much of the GBP weakness has also been a result of strong risk appetite and carry trading behaviour. Going forward, I’m looking for a range to develop against the EUR between perhaps 0.8500 and 0.9000, and I have revised down my GBPUSD forecasts due to the differences in potential central bank policy and as the UK’s twin deficits aren’t improving.

Commodity dollars: AUD, CAD and NZD
The Antipodeans, AUD and NZD, have done it again this year – posted new long-term highs versus a basket of the rest of the G10 currencies. But this strength will fade and we will see these currencies weakening back into the range at best and falling steeply at worst. That is based on assumptions that the China recovery potential is overrated, that the Reserve Bank of Australia’s (RBA) self-congratulatory stance on its success in stabilising things with its rate accommodation thus far is premature, and that risky assets can hardly be expected to repeat their strong Q1 performance (AUD and NZD are normally positively correlated with risk appetite). In addition, the big Australian mining stocks are on the defensive again and a worrying drought has settled over New

CHF: Passive aggressive
The Swiss franc appeared to be on the cusp of joining the JPY and GBP as a carry trade funding currency early in Q1 as

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Zealand which could threaten its milk exports. Besides, both countries’ central banks will push back very hard if market circumstances push their currencies stronger from here. CAD underperformed as the Bank of Canada (BoC) was forced to recognise that Canadian fundamentals have weakened sharply lately and as it backed off previously more hawkish rhetoric. The long bout near and below parity for USDCAD has hollowed out the Canadian economy. And because the BoC has long been forced to keep an inappropriately accommodative stance to avoid an even stronger currency, a credit and housing bubble of scary proportions has inflated. A long and ugly post-bubble environment awaits Canada, a process that may finally be underway. This will see its currency weaker.

AUD is at it again. The above chart shows AUD indexed versus an evenly weighted basket of the rest of the G10 currencies. Since 2010, the AUD has been making peak after peak, but the rallies always seem to slip. Look for a repeat of this behaviour this time around – as well as the risk of a more significant selloff if the expectations of Fed perma-easing supporting global liquidity suffer a paradigm shift.

SEK and NOK: SEK overachieving
For SEK, the Riksbank is caught between the rock of a domestic credit bubble and the hard place of SEK strength from less dovish posturing in Q1. The latter must give and SEK will be summarily knocked off its pedestal sometime in the next quarter or two. The SEK is NOT a safe haven, not when the currency isn’t particularly liquid and the country faces a long hangover from a housing and credit bubble that may finally be cresting. The NOK is the currency to prefer of the two – also with a domestic credit bubble, but perhaps less dependent on external factors than Sweden. One important risk for NOK, however, is in energy markets if they continue to correct lower should global demand prove less robust from here.

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Trading themes in Q1 2013
The ideas below are likely to do well if the general scenario outlined above proves correct, and poorly if not – save perhaps for the long USDJPY idea. Long USD versus a basket of AUD, CHF and SEK: The USD will remain on the mend, the AUD will range trade at best, the Riksbank will be forced into the competitive devaluation game, and CHF may either do nothing or weaken if global complacency continues. Long GBP, NOK and EUR against AUD and NZD: A contrarian call – sticking our necks out here – but the motivation for this is quite simply that the status quo of Q1 will not continue. Short CHFJPY: This is a short-term idea aimed at the 92.5095.00 zone in CHFJPY on the possibility that the effects of Abenomics are over-anticipated for the next quarter or so. Long USDJPY on dips: With a double underline under “on dips”. We’re likely to see wild swings in JPY crosses in the coming months, USDJPY will likely be a lower beta trade than other crosses and could present more attractive levels to get involved as the market tries to sort through the implications of what the BoJ has unleashed. Saxo Bank has been the leader in the FX markets for the last 25 years. The wide range of FX crosses allows you to execute a broad range of strategies no matter where the markets move. Discover more about FX

Chart of forecasts
Currency Pair EURUSD USDJPY EURJPY GBPUSD EURGBP EURCHF USDCHF AUDUSD USDCAD NZDUSD EURSEK EURNOK 3 months 1.23 95 117 1.48 0.83 1.22 1.00 0.98 1.05 0.77 8.60 7.40 6 months 1.18 100 118 1.46 0.81 1.25 1.06 0.92 1.10 0.72 8.80 7.50 12 months 1.12 105 118 1.40 0.80 1.30 1.16 0.80 1.16 0.64 9.00 7.60

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Macro Insights

Modest uptick in growth

The low-growth environment continues in developed economies and is not expected to be much stronger this year as several economies engage in fiscal consolidation, notably in peripheral Euro area economies, but also in the US.

by Mads Koefoed, Head of Macro Strategy Global economic conditions continued to improve towards the end of last year and into the first few months of 2013. This was fuelled by robust activity in emerging markets and the US, which has shown remarkable resilience in the face of the looming sequestration. But while data continues to signal robust activity globally, suggesting that slower growth is not in the cards, the evidence for a significant strengthening of global demand also looks weak. We forecast a mild uptick in growth this year, rising to 3.4 percent from 3.2 percent last year.

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Developed economies battling fiscal consolidation
The low-growth environment continues in developed economies, which recorded growth of just 1.3 percent last year as the Eurozone fell back into recession. Growth is not expected to be much stronger this year as several economies engage in fiscal consolidation, notably in peripheral Euro area economies, but also in the US. In fact, a comparison between the major Eurozone economies, the UK and the US reveals that the latter ranked third behind Spain and Italy when it came to reducing public sector spending last year. Meanwhile, the UK, France and Germany all saw increased public consumption – in that order. Public spending declined 1.8 percent in the US in 2012 and

further retrenchment will take place this year due to sequestration. Nevertheless, we expect moderate growth to continue in 2013 to the tune of 2 percent, from 2.1 percent last year, before accelerating to 3 percent in 2014. Although the removal of the payroll tax cut eats into private consumption, continued improvements in the labour market, which saw an average of 183,000 payrolls added per month last year, will aid private consumption. The position of US households is also helped by the improving housing market. Rising prices are lifting homeowners out of negative equity (1.8 million in 2012 alone), helping to repair the battered private sector balance sheet. Add to this the activity in the housing sector, which on its own will add to GDP through residential investment. Last year’s contribution of 0.3 percentage points is expected to be topped in 2013.

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The US economy may not be exactly stellar, but at least moderate growth is on tap. The outlook is decidedly more downbeat across the Atlantic, where the Eurozone must resign itself to the fact that the recession is destined to continue. We expect economic activity to decline 0.3 percent in 2013 after last year’s drop of 0.5 percent, while the unemployment rate will rise throughout the year and average more than 12 percent. The resulting slack in the economy will keep inflation subdued. The economies of Italy and Spain will remain weak, but it is the French economy that concerns us most, particularly because of the French government’s failure to implement reforms. The labour market is too restrictive because of the co-existence of permanent and time-restricted employment. This threatens France’s competitiveness and has sent youth unemployment through the roof with more than a one fourth now jobless. The lack of remedial action risks entrapping the Euro area’s second-largest economy into a low-growth environment for several years to come.

are expected to be less supportive across the spectrum of developing economies. The improved outlook for global trade will help China’s economy return to growth above 8 percent this year. Lending growth remains rapid at 15 percent and financing remains relatively loose, ensuring that domestic demand will support the economy over the coming quarters. In addition, the rather prudent fiscal balance suggests that more can be done in terms of public spending to stimulate growth if deemed necessary by the government. Looking further ahead, things look less rosy, however, and the transition from an export- and investmentled economy to one driven by private consumption is bound to be bumpy and will see annual growth rates decline steadily.

Emerging economies pick up speed
Growth in emerging markets has remained robust due to responsive policies, both fiscal and monetary, and the loss of pace last year was mainly due to lower demand for produce from developed economies. In particular, Eurozone imports were curtailed by fiscal consolidation, down 0.9 percent, while US import growth slowed to 2.4 percent. Although fiscal consolidation continues to affect private consumption and imports, it is expected to lessen, which will aid growth in emerging markets. However, we keep growth expectations below 2010-2011 levels as domestic growth policies this year

“ The US economy may not be exactly stellar, but at least moderate growth is on tap. The outlook is decidedly more downbeat across the Atlantic, where the Eurozone must resign itself to the fact that the recession is destined to continue.”

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Macro Insights

GDP 2012 2013 2014

Upside

Downside

World

2.9

3.0

3.8

Central bank policies have reduced tail risks and increased confidence. Stronger than expected global trade.

Higher energy prices. Credit risks from contagion reappeared in Italy and Spain.

Developing and emerging economies

5.1

5.3

6.0

A faster rebound in the Eurozone will boost exports to the region. Domestic demand remains strong.

Competitive currency devaluations to cause trade disruptions. Renewed tension in the Eurozone to curtail exports to the region. Policies likely to be less accommodative. Lingering uncertainty about fiscal policy to harm both spending and investment. Sequestration to cut into public sector spending. Failure to reduce uncertainty surrounding Cyprus and Italy to weigh on business sentiment. Weaker French private consumption.

United States

2.1

2.0

3.0

Housing recovery, job growth to spur demand. Higher house prices to help repair balance sheets.

Euro area

-0.5

-0.3

0.7

Softening of consolidation in Italy to aid private sector spending. Reforms take effect earlier than expected in Spain. Stronger German private consumption. Government and central bank policies remain supportive, including support for housing.

United Kingdom

0.3

0.5

1.0

Further cuts to the budget as targets are missed.

China

7.8

8.2

7.5

Domestic demand to remain strong. Lending growth, money supply growth supportive for economy.

Aggressive measures to curtail speculation to harm growth. Overly hawkish central bank. Weak currency to weigh on local businesses needing foreign input goods. Higher (imported) energy prices to curtail consumption.

Japan

2.0

1.0

1.0

Weak currency to boost exporters.

Notes: GDP (gross domestic product) is real, inflation-adjusted, year-on-year changes in percent. 2012 is actual, while 2013 and 2014 are forecasts.

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Macro Insights

Accommodative central bank policies as far as the eye can see
Last year was a busy year for central banks, with the US Federal Reserve introducing round three of its quantitative easing programme, the European Central Bank (ECB) doing “whatever it takes” in announcing the Outright Monetary Transactions (OMT) programme, while Japan laid the groundwork for “Abenomics”. This year will see supportive policies continue. In spite of moderate growth in the US, the target for the unemployment rate of 6.5 percent is not likely to be reached for several quarters, while core inflation will remain subdued due to excess capacity, meaning that QE3 will continue this year and well into 2014, though the amount could be reduced late this year or in 2014. The announcement of the ECB’s OMT programme has succeeded in alleviating the imbalances in the monetary transmission mechanism as is indicated by yield spreads to Italy and Spain. This has allowed the ECB to shrink its balance sheet because repayments of loans from the two LTRO’s (long-term refinancing operations) began earlier this year. However, turmoil is not far away as the Cypriot rescue mission and Italian elections prove. Cuts to both the ECB’s refinancing (refi) rate and a new round of LTRO are possible tools should

the need arise. So, too, is the step of lowering the deposit rate below zero, but that would land the ECB in even more unconventional waters. Hence, our base scenario is for the ECB to keep rates unchanged as the Eurozone muddles through economic growth kicks in later this year. But should the refi rate be lowered from 75 basis points (bp), we would look for a narrowing of the rate corridor (from plus/minus 75bp) rather than a lowering of the deposit rate into negative territory.

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Commodity Insights

Tail-end risks leaving little room

to the upside

The exuberance of the New Year may have abated, with gold suffering its first back-to-back quarter losses since 2001, but commodities in general could rise slightly in the second quarter.
by Ole S. Hansen, Head of Commodity Strategy Elevated global growth expectations at the beginning of 2013 resulted in a strong start to the year in what was almost a repeat of what happened the previous two years. Investors jumped onboard and in January helped to carry forward key growth dependent commodities such as oil and industrial metals. One key driver that has been absent is the geopolitical worries, which, in previous years, drove oil prices to unsustainable levels before triggering major corrections during the second quarters of both 2011 and 2012. As we enter the second quarter, some of the exuberance has evaporated, with moderate growth in the United States and Japan and, to a certain extent, China being neutralised by another round of European debt worries that kicked off with the Italian election in February and the near collapse of the Cyprus economy in late March. Going forward, the political risk and uncertainty related to both Spain and Italy will continue to create headlines and, at times, create bouts of risk adversity. Despite these concerns, one of the interesting features of the

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first quarter was seeing the decade-long love affair between investors and precious metals begin to break down. Improved US economic data raised speculation about an earlier-thanexpected cessation of quantitative easing and with relative weak physical demand, nominal bond yields became less negative and gold suffered, resulting in the first back-to-back quarter of losses since March 2001.

We see a relative small chance of higher commodity prices going into the second quarter, with tail-end risks, such as Euro area problems, a potential sell-off/correction in stocks and the near-term outlook for global growth, not being strong enough to alter the supply and demand situation. This will result in energy sector looking balanced after being the only sector showing positive performance in Q1 primarily due to a strong rise in Natural gas. Industrial metals are up against oversupply, for example copper, in which increased production in response to higher prices in recent years has seen more supply becoming available. Agriculture markets are looking forward to a potential bumper harvest this summer across the Northern Hemisphere. Combined with increased production in South America, this should help to rebuild depleted global stocks of key crops such as corn, soybeans and wheat. Any repeat of last year’s drought can, of course, not be ruled out and it could trigger a major rally in new crop prices. This is especially so for corn and soybeans, where new crop prices are trading at a considerable double-digit discount to current old crop prices.

“ Continued focus on US economic data probably holds the near-term key and any softness as seen recently could provide gold with the catalyst that has been missed for months.”

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Below, we have highlighted some of the general key drivers that commodity investors should be aware off going forward. Further down, we take a more detailed look at the energy and metal markets.

Commodities Upside risks
Geopolitical events/worries Strikes/labour disputes in key production areas Excessive global liquidity from QE Adverse weather in key growing regions Weaker dollar Rising marginal production costs

Downside risks
Euro area debt crisis escalating

Lack of credit for commodity transactions

Major stock market correction

China’s growth continues to slow Production has caught up with demand, resulting in inventory builds Excessive speculative positioning

Oil markets range bound with risk to the downside
Brent crude oil began the year copying its performance from the previous two years. The raised growth expectations triggered a rally that lasted until mid-February before worries that the price had run ahead of fundamentals triggered a return to the lower end of its established range between 105 USD/barrel and 118 USD/barrel. The mid-price of this range coincidentally corresponds with the average price seen over the past two years.

The spot market tightness in Brent crude oil and the oversupply of WTI Crude oil has begun to ease, resulting in the spread between these two important benchmarks contracting towards 12 USD/ barrel. Increased North Sea production and the high level of refinery maintenance combined with the Euro area recession and political crisis have seen the spread between prompt and deferred futures prices contract. Meanwhile in the US, increased capability to transport oil from the mid-west to Gulf coast refineries has started to alleviate the bottleneck issues that has seen WTI Crude oil disconnect from global prices over the past couple of years. The cost of transporting oil away from the producing areas by pipeline, rail and river comes at a price, which, for now, should limit further contraction of the spread below 10 USD/barrel.

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Energy Upside risks
Oil producers need high prices to finance rising government spending Geopolitical tensions from Syria and especially Iran with nuclear issue unresolved New production techniques such as shale oil and deep-water leads to higher production cost OPEC production remains elevated, leaving little room for disappointment elsewhere QE resulting in stronger-than-expected GDP and demand

Downside risks
Deteriorating investor sentiment causing additional speculative long liquidation Non-OPEC supply growth continuing to surprise Surging US shale production reducing imports Faltering Asian demand from China, South Korea and Japan causing destocking European economy deteriorating at a time of improve North Sea supplies High level of refinery maintenance

We believe that global oil markets are currently well supplied, but only because OPEC continues to produce at a rate above its stated target. US production continues to impress and grow, while Venezuela, following the death of President Hugo Chavez, could again potentially become a key supplier to the global market provided it opens up for foreign-direct investments, something that is currently not expected to happen anytime soon. We expect Brent crude to continue being mostly range bound during the second quarter; with the 105 USD/barrel to 115 USD/barrel range seeing most of the activity. The greatest risk, however, will be skewed to the downside because of the ongoing concerns related to Europe.

Precious metals missing a catalyst after tough quarter
The slide in gold prices, which began last October, continued during the first quarter before support once again was established ahead of crucial support at 1,530 USD/oz. Silver performed even worse with the cost of one ounce of gold rising to 57 ounces of silver, the highest since last August and taking it close to its five-year average at 57.75. The industrial credentials that goes with silver helped to attract additional buying, especially through Exchange Traded Products (ETPs), but as industrial metals went into reverse during March, as growth prospects faltered, so did silver.

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Precious Metals Upside risks
Euro area debt crisis escalates once again US growth hits a soft patch – extended QE Strong central bank buying Hedge Funds positioning halved compared with three-year average – room to punch Geopolitical event

Downside risks
Nominal bond yields becoming less negative Subdued inflation outlook

Rising growth expectations

Continued long liquidation from Exchange-Traded Products A stock market correction triggering cross-asset reduction of risk

Gold investors who use ETPs to gain unleveraged exposure to precious metals have been net sellers all year, resulting in the weakest quarter on record for gold ETP flows. During the quarter, some 181 tonnes were pulled compared with positive flows of 87 and 138 tonnes during the previous two quarters (Bloomberg). This reduction, as seen below, has nevertheless only brought holdings down to levels seen last August. It also shows some continued resilience among these investors, many of whom still see gold as a natural inclusion in a balanced portfolio. Its use as a hedge against global tail-end risks created by excessive money printing by central banks in recent years, adds to gold’s appeal.

We see gold trapped within a 270 dollar range and believe that support from the physical market and central bank buying should be enough to arrest any attempts on key support at 1,530 USD/oz. If this level is broken, it could signal a much deeper correction than the one already witnessed. The current US economic expansion is running at a pace that at this stage does not warrant any early exit from asset purchases, something we believe the market has not yet fully taken into account. The lack of strong political management of the Eurozone debt crisis raises the risk of contagion, which also could provide renewed support. However, continued focus on US economic data probably holds the near-term key and any softness, as seen recently, could provide gold with the catalyst that has been missing for

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months. Speculative positioning held by hedge funds in both gold and silver are near the lowest levels since 2006 and any signs of renewed life in the sector will leave many professional investors underexposed, which should help both metals and silver in particular to perform. We lower our average price target for 2013 from 1,740 USD/oz to 1,640 USD/oz on the back of the weak price action during Q1. We see continued rangebound trading during the coming quarter at about 1650. As mentioned before, we are acutely aware of the potential downside risk that gold poses because it has become an emotional trade for many investors. Further price weakness below 1,500 USD/oz will increasingly make this a pain trade as it erodes confidence among many weak longs.

Copper up against increased production and rising inventories
The industrial metals sector is one of the worst performing sectors so far this year. The growth story, which has helped to drive global stocks higher in recent months, has so far failed to lend any support to industrial metals, with the negative performance being driven by lead, zinc and aluminium. This dislocation between stocks and industrial metals, however, is not a new occurrence, with both metal and mining companies and underlying commodities having been dislocated from equity markets for more than a year now.

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Record-high prices before the financial crisis triggered major incentives for mining companies to increase production. The result of these investments is now beginning to translate into bigger supply at a time when China, the world’s biggest consumer of industrial metals, has seen growth slow to the lowest level in more than a decade. In recent months and going forward, its focus has been – and will be – divided between the need for growth, but at the same time having to fight inflation, which has been picking up. Slowing demand from China has led to increased inventories in London Metal Exchange and Shanghai Futures Exchange warehouses (see copper example below) and this supply overhang is likely to keep a lid on prices over the coming quarters. One of the best correlations out there considering the dislocation between stocks and metal prices is currently the one versus Chinese PMI. It shows the continued dependency of demand growth in China, something that has proved difficult to come by in recent months but which should begin to improve given the recent signs of a pick-up in PMI. Worries about elevated inventories and the implementation of measures to contain house price inflation could, however, cause a near-term drag. We see a potential repeat of 2012 with some second-quarter weakness testing the lows from last year, but that should probably be it before a recovery begins after the summer – not least helped by signs of a continued improvement in key economic indicators such as PMI.

Copper Deliverable Stocks
(Metric tonnes)

LME 900000 750000 600000 450000 300000 150000 0
8 9 0

Shanghai

Copper, Inverse, RHS 2000 3500 5000 6500 8000 9500 11000
1 2

8

9

0

1

-0

-0

-1

-1

-1

-0

-0

-1

-1

pr

pr

pr

pr

pr

ct

ct

ct

ct

O

O

O

O

A

Source: Bloomberg and Saxo Bank

A

A

A

go to ole’s blog here

A

O

ct

-1

2

0.8231
as in 2000?
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