9 January 2014 FX Blueprint: Thin end of the wedge Theme #9: Pole dances, TRY tr€ps • Go long PLN and HUF, buoyed by competitive REERs and proximity to strong German demand, and stay short TRY, as reserves are insufficient to act as a buffer and where external deficits require further adjustment to restore competitiveness Aggregated EMEA FX correlation (3m rolling correlation of daily changes) have dropped to levels only seen once post-crisis (prior to the Fed opening the door to tapering last May). The stand-out underperformer is TRY, undermined by risk spreads on both sovereign and corporate bonds having widened on domestic political instability that has already claimed the jobs of a few ministers. At the other end we have ILS and PLN outperformance, but HUF has also has performed reasonably well, largely unchanged vs the USD over the past month. More divergence with idiosyncratic factors playing a greater role is something we have argued for some time, and although disrupted by the 'taper tantrum' in O2/Q3 2013 in particular, the trend is intact. With the Fed pushing fewer (but still a lot) of dollars into the global economy, it still makes sense to avoid currencies with large C/A deficits, and/or those where indebtedness has risen substantially (be that public and/or private). However, in economies where FX weakness in 2013 was more a function of weak growth/policy rate cuts, higher yields should not be damaging as long as the rise in yields is orderly and reflects improved growth prospects. Export oriented economies with competitive real exchange rates and limited balance sheet risk should benefit from a sustained global recovery. In EMEA this is likely to translate into more divergence between PLN & HUF (benefitting from relatively competitive REERs, a strong German economy and export led recoveries), and the ILS (where the BoP effect will maintain appreciation pressures) on the one hand, and on the other CZK (sustained