Second Quarter 2011 GTAA Currencies

8/7/2019 Second Quarter 2011 GTAA Currencies

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o a ac casse oca on

GTAACurrencies

March 23rd, 2011

Damien Cleusix

Clue6 Second Quarter 2011

am en c ue .com


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1Executive Summary

CurrenciesThe USD is becoming increasingly undervalued against most currencies. It is at a 40 years low on a real broad trade-

wei hted basis. Its econom is much more d namic and has started to rebalance earlier than other develo ed economies.

Companies have been cutting costs aggressively and are much more competitive in the international markets.

The big problem remains that the Fed is suppressing real government bond yields through quantitative easing. Ceteris

paribus, the USD will have to be more undervalued on a PPP basis to be in equilibrium. Indeed, the deficit of interests

payment foreigners are receiving has to be compensated by a lower price I.e. lower USD (this is another reason why

emerging markets with negative real yields have very undervalued currencies on a PPP basis). At current levels we think the

compensation is large enough.

e ec n ng s pus ng o er en ra an s reasur es o ecome ncreas ng y aggress ve uyer o o wea en

their own currencies. They then have to recycle their newly acquired USD and in so doing are exerting a downward pressureon real rates in the US and thus weakening the USD. This can not last forever. This will end by a radical redesign of our current

monetary system and the sooner the better. The winner Gold.

Sentiment is increasingly supportive for the USD. Speculators had their biggest USD net short position ever a week ago and

have covered a third despite continued USD weakness (a positive divergence. Assets in the the Rydex Weakening Dollar have

surpassed assets in the Rydex Strengthening Dollar fund but have yet to spike briefly higher as they usually do when the USDdecline exhausts itself.

There is a big global short USD position which is growing by the day as the increase in foreign central bank reserves can

not be completely explained by their current account balance and the net foreign direct investments. Hot money is flowing

to emerging markets and we are on the look out for canaries


A new Homeland Investment Act could be voted in the month to come which could offer some support for the USD as it did


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2Executive Summary

at the end of 2004, while oil price rising further might reach a level where its historical highly negative correlation with the USDturns positive as it does when oil price rise enough to break the back of the macro up cycle.

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more if you are Greek). Yields spreads remain favorable and in synch (which is even more important) but the spread momentum

has been faltering in the past 2 weeks despite M. Trichet "strong vigilance".

Sentiment is not supportive with Speculators having accumulated a large net long position and a short-term positive risk

reversal divergence.

The Euro has been supported by the strong growth in emerging markets and the rapid inflows of hot money. Indeed

exports to emerging markets are contributing strongly to the recent performance of the European core area and Emerging

entra an s are usy re a anc ng t e r currency o ng towar greater vers cat on even t ey not t ey wou ave to

sell some USD to keep the mix stable). We should also remember that a big chunk of emerging markets credit expansion is andhas been financed by European banks. So if emerging markets slow down is larger than most expect (our scenario) Europe

and the Euro are likely to suffer much more than the US and its currency.

The trend is up but extended. We would exit long positions at least until we get an upside break. We would sell 1.5-3% OTM

calls with 1-3 months maturity and would start to build an outright short position on a move below 1.39 and increase it if it

moves below 1.375. We would use an initial stop at the high the Euro will make before it move below our trigger zone (so not1.4248 but higher or lower depending where the current intraday rebounds stop).

Longer-term we maintain that the Euro could fall below 1. We think that it will bottom near 0.7 if it survives. Crazy? We met

the same skepticism when we forecasted a rise above 1.5 when the ECB started to intervene when it was hovering near 0.85

almost 10 years ago. While supportive political decisions might be taken in the near future (but it seems they won't as is usual) ,


e pro ems won sappear an w come ac a er o un em. e sys em, o po ca an nanc a as o ereformed but we will probably need a new crisis.


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3Executive Summary

The Yen overvalued by at least 25%. And the authorities have now started to intervene again (this time jointly) putting animplicit floor below 80. The potential sterilization of the BOJ Yen selling and increase in the size of its balance sheet relative to

other countries should push the Yen lower. With regard to repatriation, it is a myth. There are no data confirming it after the

. . .

There is a big non-commercial net long position which is diverging with price (net long position not increasing on Yen

strength). Housewives have a huge net short position against the USD, the AUD and most other currencies. Position that

large have historically led to Yen weakness in the short-term.

There are/have been continued big inflows of hot money in the past 8 of months with the Yen rising despite the broad balance

of payment registering a deficit of more than 5% of GDP.

e wou nee a rea a ove . or a c ear c ange n e cyc ca ren . n en, our s ra egy s o se owns e

volatility (USD/JPY puts with strike from 80.5 and below and 1 to 3 months to expiry). We would get outright long (theUSD/JPY) on a move above 84.5 with a stop at the rising 65 days exponential moving average or on a new move below 80.5.

Our first target would be a move to 93.5-94 and then 100. We would totally hedge the Japanese equity holding of gaijin

investors.

The British Pound is now slightly overvalued and deserve to trade at a bigger discount with lower real short-term yields

than in the US. Many accidents are just waiting to happen with notably the residential real estate market. Authorities will use,among others, a depreciation of the Pound to support the British economy. Yields spreads are not confirming the recent Pound

appreciation.

Speculators are net long but they have sold some on strength which is a bearish divergence. The risk reversal is still in

synch with the cross.


The British Pound is in the middle of its up channel entering an important resistance zone. We might contemplate taking a short


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4Executive Summary

position on a move below 1.60. We are seller of upside volatility on a move above 1.65. We would sell 1.675-1.69 1-3 monthsto expiry calls.

.

already intervened massively and is running out of options (we would not be surprised to see capital controls be introduced on

further strength. They could take the form of a tax on foreign money entering the country or negative yields on CHF

denominated deposit owned by foreign entity). Walls of money are still heading to Switzerland from European banks while

many holders CHF-denominated mortgage in Eastern Europe are slowly but surely getting squeezed. As for the JPY the yields

spreads have not confirmed the recent CHF strength.

Speculators have a huge net CHF long position.

e pa r s very ex en e e ow s an ays exponen a mov ng average. s con gura on as s or ca y e o a

return to the mean. The technical structure remains favorable to the CHF with no identifiable trend change. While we do notusually fight trends, we would take a short position at the current 0.8980-0.9015 level. If we can move above 0.935 and then

0.975, the move could extend to last years high.

Commodities currencies are overvalued The AUD is probably more than 35% above fair value while the NZD is 15-20%

overvalued. The CAD is more than 10% overvalued. They have profited from the "Chinese inventory build-up, Emerging

Markets boom, institutional love affair and more recently QE2 related commodity rally. We think that the latter rally is verylong on its tooth so

Speculators have a large AUD long position while there is a negative divergence building in the risk reversal.

The AUD might be in the process of forming a complex top. It looks distributive to us. Remember that when the AUD


correc s, en s o o ave a wa er a s ape. e can no recommen a ong pos on a s unc ure anymore. e eve oovervaluation and the fragility of the foundation of its strength makes it to risky. We are seller of upside volatility on a move


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5Executive Summary

above 1.02 and would even take a tiny outright short position to profit from the probable RBA selling. We would have to waitfor some technical deterioration before we are willing to fight against the carry with more commitment but a close below the

recent 0.985 lows would be a move in the right direction.

On emerging currencies, we prefer to stay on the sidelines for now as valuation are not attractive and authorities seems

to have decided, especially in Latin America, that their currency will not be allowed to strengthen . If we had to we would

maintain a long position on the Taiwan Dollar and the Singapore Dollar. The more then Yen decline the less attractive the Won

proposition will become so we are no longer recommending the South Korean currency for those who have to be longWe

would not short, however, as the carry is too high for most of them. There will come a time were we will short emerging market

currencies opportunistically, as we last did in 2008 but not yet.



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6

EUR-USD 2 Years Real Rate Differential and EUR/USD

Currencies: Valuations Real Rate SpreadsChart 2Chart 1

Real Effective Exchange RateEUR/USD Fair Value Model

Valuations are not very helpful for short-term forecasts but are essentials to put the short, medium and long-term trends into perspective.

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Source: Clue6Source: Clue6

Germany). We strongly believe that the Euro will ultimately massively undershoot fair value. We maintain our spring 2008 forecast of an ultimate fall below

parity toward the 0.7 level.

Real yields are higher in Europe than in the US and the differential is increasing which has historically been bullish for the Euro (Chart2). Note that t while real

yields tended to leads the cross by approximately 12 months, it has been coincident since early 2005. The coincident relationship can be in part explained by the


increased use by foreign financial companies of the US commercial papers market and the large global short USD position we have documented in the past fewyears.


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7Currencies: Valuations Real Rate SpreadsChart 4Chart 3 USD-EUR 2 Years Yield and Swaps DifferentialUSD-EUR 2 Years Yield and Swaps Differential

-


.

M. Trichet and the ECB, the differential hast not been moving up as quickly as the EUR/USD.

We have not yet a clear divergence as was the case during the preceding turning points but we might be near so one chart to have on its monitor



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8

USD-JPY 2 Years Real Rate Differential and USD/JPY


Real Effective Exchange RateUSD/JPY Fair Value Model

The Ja anese Yen Chart 5 is a roximatel 25% overvalued.


On Chart 6 one can see that real yields are still higher in Japan but the spreads is making lower highs (higher lows on the graph) which can be

considered a mild positive divergence.



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9Currencies: Valuations Real Rate SpreadsChart 8Chart 7 USD-JPY 2 Years Yield and Swaps DifferentialUSD-JPY 2 Years Yield and Swaps Differential


- .

This has historically led to a weaker Yen. A chart confirmation would pave the way for one of those wonderful trade we strive to find.



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10

USD-GBP 2 Years Real Rate Differential and USD/GBP


Real Effective Exchange RateGBP/USD Fair Value Model

The British Pound Chart 9 is onl sli htl overvalued. We ex ect the currenc to undershoot its fair value b more than 20% before it could


embark into a new structural appreciation course. A fall to parity is not to be ruled out and would imply a 35-40% undershoot to fair value as was

the case in 1985.

The US have a relative real yield advantage which is supporting our forecast of GBP undershoot (Chart 10).



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11Currencies: Valuations Real Rate SpreadsChart 12Chart 11 GBP-USD 2 Years Yield and Swaps DifferentialGBP-USD 2 Years Yield and Swaps Differential


-

differentials.

This has historically led to a weaker Pound.



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12

USD-CHF 2 Years Real Rate Differential and USD/CHF


Real Effective Exchange RateUSD/CHF Fair Value Model

The Swiss Franc (Chart 13) is overvalued by more than 50% which is similar to when it made its last secular top against the USD in 1995.With such a divergence from fair value, we would advise longer-term investors who like to make a couple of move per decade to sell their CHF


pos on an uy . nves ors w enom na e accoun s s ou s op o e ge e r an uy more. w ss pens on un s s ou

increase their real-estate investments in the US or at least start to build the necessary USD cash to be aggressive on further weakness in the US

housing market in the US.

Real yields are higher in Switzerland (Chart 14) but the spreads has been contracting. As with the Euro, the relationships between real yield


sprea s an e ea ec ve xc ange a e s now a mos co nc en . move o a pos ve - sprea s ou e e as na n e

structural upswing coffin.


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13Currencies: Valuations Real Rate SpreadsChart 16Chart 15 USD-CHF 2 Years Yield and Swaps DifferentialUSD-CHF 2 Years Yield and Swaps Differential


- . .

This has historically led to a weaker CHF.



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14Currencies: ValuationsChart 18Chart 17 AUD-USD 2 Years Yield and Swaps DifferentialAUD/USD Fair Value Model

The AUD (Chart 17) is more than 35% overvalued and is an accident waiting to happen There are many reasons for its strength (positive real yield spread, strong economy,

links to China,) but too much istoo much


om na y e s an swaps are verg ng nega ve y an ey ave or more an mon s now ar . a c ou

We have documented in the past the excess of the Australian housing market and the big impact a bursting of the bubble would have on its concentrated and real-estate exposed

financial system. Dont forget that Australian banks are also using more and more the international markets for their short-term liquidity needs. All in all this will end badly, very

badly. Jusquici tout va bien, jusquici tout va bien, jusquici tout va bien limportant cest pas la chute cest latterissage M. Kassovitz, La Haine. Note also that there are

more and more officials warning of the potential disastrous consequences of the current situation (W. McKibbin of the RBA, D. Murray of the Future Fund, ).


Australian pension funds should liquidate their Australian real estate assets and buy similar assets in the US. For AUD-basedinvestors this will be one of the trade of the decade.


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15Currencies: ValuationsChart 20Chart 19 NZD-USD 2 Years Yield and Swaps DifferentialNZD/USD Fair Value Model

The NZD (Chart 19) is 15-20% overvalued.


Nominal yield and swaps spreads have also been diverging negatively (Chart 20).

If you want to be long, do it against the AUD.



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16Currencies: ValuationsTable 1Chart 21 Latin America Adjusted ValuationsPPP Deviation vs. PPP GDP per Capita

Source: IMF, Clue6

Looking at valuations for Emerging Markets can be deceptive. Using PPP, FEER, BEER or other models, most seems to be chronically undervalued.

In 1964, Balassa and Samuelson presented an economic model (today known as the Balassa-Samuelson effect) to explain the Penn effect.

Source: Clue6

The Penn effect was the observation that price levels where systematically higher in richer countries compared to poorer one. Balassa and Samuelson demonstrated that

productivity in tradable goods and as a consequence wages are lower in poorer countries. As a result the relative price of non-tradable to tradable goods and services increase in

richer countries. This lowers the PPP. In the chart 21 we have regressed the PPP implied over/undervaluation with the GDP per Capita (at PPP). The expected strong relation is

apparent.

South American currencies (Table 1) should be avoided and among them the darling of carry trader the Brazilian Real which is probably more than 40% overvalued. If


you had the fact that both the Banco Central do Brasil and the government are actively trying to weaken it, one should stop playing the bigger fool game. Dont short thecarry is too large but there will be much better time to harvest it.


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17Currencies: ValuationsTable 3Table 2 Eastern Europe and Africa Adjusted ValuationsSouth-East Asia Adjusted Valuations

Source: IMF, Clue6Source: IMF, Clue6

South-East Asian currencies (Table 2) have appreciated in the past 9 months. We would exit our long position we advised to take at the height of the crisis early in

2009 on the Singapore Dollar and the Korean Won now. We repeat that the next major move for the Chinese Yuan is a big depreciation so GET OUT . The

Indonesian Ru iah was one of our favorite in the ast but we would exit ositions at current levels as it is now a roximatel 30% overvalued accordin to our

methodology (and over-owned as we have showed in our fixed income and equity sections).

Eastern European currencies (Table 3) where identified as highly undervalued back in January-March 2009 and, after a swing from overvaluation in March-

April 2010 to slight undervaluation early last autumn and at the beginning of this year, are now overvalued again. We would avoid them at current levels as

Hungary will have to be bailed out in the next 24 months (and when it does do not expect investors to be very discriminate toward the region)


South African and Turkey currencies are overvalued and should be avoided.


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18Currencies: Valuations Sentiment

Sentiment

Chart 22-23 ML Fund Managers Survey Valuation Perception

USD

Chart 24 ML Fund Managers Survey Valuation Perception

JPY

Source: MLEUR

, .

Chart 22, 23 and 24 do confirm our valuation analysis.

The USD is undervalued while the Japanese Yen and the Euro are overvalued.



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20Currencies: SentimentEUR/USD and 3 Months 25DEUR/USD and Non-Commercials

Chart 28Chart 27

Risk Reversal

Future Net Position

Similar to the aggregate USD position the non-commercials positioning and price have diverged last week(Chart 27).

Source: Bloomberg, Clue6Source: Bloomberg, Clue6

On the chart 28 (and ensuing risk reversal graphs) one can find where the RR is relative to its short-term (red) and intermediate-term (blue) range.

A move below 0.5 while the cross is making new highs is a bearish divergence with a move to 0 a strong warning. The reverse is true when the cross

is making new lows. The last signals were given at the high in November and a low in June


The risk reversal is diverging for the Euro (Chart 28) and this is a bearish set up.


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21Currencies: SentimentUSD/JPY and 3 Months 25DUSD/JPY and Non-Commercials

Chart 30Chart 29

Risk Reversal

Future Net Position

-


. .

There no short-term risk reversal divergences in place (Chart 30).



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22Currencies: SentimentChart 32Chart 31 TFX Total Retail Yen Net Short Margin PositionTFX Net Retail JPY/USD Margin Position

A lot has been said about Japanese Housewives in the past few years. So lets see what they are up to.

Source: TFE, Clue6Source: TFE, Clue6

They are extremely short the Yen against the USD (Chart 31) after having been very long when the Yen reached 0.94 in April 2010 and short

almost all of the Yen Rally sine 2006. Note that while this data should usually be used as a contrarian indicator, spikes are another matter. Spike in

Yen Short position are usually associated with bottoms for the USD against the JPY. Thee reverse is true at tops.

They continue to play the carry trade in full . They are very long almost all major and carry crosses against the Yen (Chart 32). Here again


spikes (short yen against other currencies) after prolonged decline in the USD against the JPY are usually associated with a future depreciating Yen.


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23Currencies: SentimentGBP/USD and 3 Months 25DGBP/USD and Non-Commercials

Chart 34Chart 33

Risk Reversal

Future Net Position


Non-commercials have a GBP net long position C art 33 . Note t at t ere s a c ear vergence as non-commerc a s are qu at ng t e r ong

position on strength.

There is no divergence on the risk reversal (Chart 34).


C i


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24Currencies: SentimentUSD/CHF and 3 Months 25DUSD/CHF and Non-Commercials

Chart 36Chart 35

Risk Reversal

Future Net Position

-


.

There are no short-term divergence on the risk reversal but note that it is currently higher that in September (Chart 36).


C i


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25Currencies: SentimentUSD/CAD and 3 Months 25DUSD/CAD and Non-Commercials

Chart 38Chart 37

Risk Reversal

Future Net Position


Non-commercials have their biggest net long position on the CAD ever C art 37 .

There are some identifiable divergences on the risk reversal (Chart 38).


C i


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26Currencies: SentimentAUD/USD and 3 Months 25DAUD/USD and Non-Commercials

Chart 40Chart 39

Risk Reversal

Future Net Position

-


.

There is a large medium-term risk reversal divergence (Chart 40). This is bearish for the AUD.



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C i i


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28Currencies: SentimentChart 44Chart 43 USD/JPY FXCM Customers PositioningEUR/USD FXCM Customers Positioning

Source: FXCMSource: FXCM

Forex on-line traders are, on aggregate, on the wrong side of a trend more often than not .

On Chart 43 one can see that traders have been decreasing their short position on Euro strength which something which usually happen near short-

term turning points.

They are net long the yen but have decreased their long position substantially recently (green line bottom panel) (Chart 44).


Currencies: S i


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29Currencies: SentimentChart 46Chart 45 USD/CHF FXCM Customers PositioningGBP/USD FXCM Customers Positioning

Source: FXCMSource: FXCM

. ,

of 2010. When we see a spike like this, this has usually been a good time to exit the GBP.

They are net short the CHF but have been decreasing rapidly their short position (even more with the recent update) (Chart 46). This is supportive

for the USD against the CHF.


Currencies: Li idit


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30Currencies: LiquidityChart 50Chart 49 Dollar Index and Financial Foreign Outstanding CPDollar Index and Financial Foreign Outstanding CP

The structural net short USD position has been at the center of our forex analysis in the past few months as it was in 2008.

Source: Bloomberg, Clue6

Source: Current efforts to enhance global financial supervision ,BIS,

Stephen Cecchetti

The USD line on Chart 49 show the aggregate amount of USD required (net) by Canadian, Dutch, German, Swiss UK and Japanese banks. Thats

usd 1.2 trn. Remember that those obligations could only be met through currency swap arrangements between Central Banks in 2009.

Foreign financial companies have increased their borrowing of USD on the US commercial paper market in the past few months (Chart 50). We


.

31Currencies: Li idit


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31Currencies: LiquidityChart 52Chart 51 Germany Total Net International Investment PositionEUR/USD Basis Swaps

Euro Countries Net International

Investment Position

EUR/USD basis swaps are the cost for an institution to swap EUR for USD (chart 51). In the current situation it costs an Euro owner who wants to borrow USD 40 basis points

per quarter. It is another sign that there is a shortage of USD, notably for European institutions.

Source: BundesBank, Clue6, Macquarie for the Euro-Zone Members Countries Net PositionSource: Bloomberg, Clue6

Anothercentral elements when looking at today's macro landscape is the analysis of the who have and who have not.

Germany has but what does it have. Its net international investment position has moved sharply higher since 1999. Part of the net foreign position improvement is endogenous

capital export resulting from Germany current account surplus among others but there was a very large autonomous capital export stemming from banks (notably Landesbanks). A

significant part (relatively speaking) of Germans banks foreign investments are going to depreciate significantly. Do you remember Landesbank involvement in US sub-primes

through their SIV. They have also invested in shaky sovereign and corporate foreign banks and loaned significant amounts, directly or indirectly, to borrowers who wont be able


to pay back.

Where will the have not find the money they need when risks will be factored again in investors investing decision, we are still looking for an answer

32Currencies: Liquidity


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32Currencies: LiquidityDollar Index and World International

Chart 54Chart 53

Reserve ex Gold MomentumForeign Reserve Currency Allocation

Central Banks relative USD holding has continued to decline (Chart 53) but remember that most or even more is due to the USD relative decline. Anyhow the trend seems to have accelerated in Q4. This is

best seen in China. China has moved from more than 80% USD allocation in 2003 to 52% today . With an acceleration in the past 12 months when it moved from 64% to 52%.

Reserves around the world have been rising much faster than what the improving US current account would suggest. This has only been the case in the past when USD was borrowed short This tends

Source: Clue6Source: Bloomberg, Clue6

to end up with a ig USD rally and some countries going ankrupt.

According to the Chinese State Administration of Foreign Exchange (SAFE) almost usd 40 bio. of the usd 470 bio. increase in foreign reserves was hot money (not a result from the trade and foreign direct

investment balance). Hot money inflows averaged usd 25 bio a year since 2001. The trend is also clear in Brazil, India, Indonesia and many other countries. Why borrow in local currency when one can borrow at

much lower rates in a currency which is doomed to depreciate ad vitam eternam (The USD). There is a big net short position being built in the system and this will ultimately lead to a big, sorry BIG short

squeeze.


e more qu c y reserve r se, t e more as to e so ust to eep t e currency m x sta e, ceter s par us

Lets not forget the fact that foreign holder of US assets are more prone to hedge the currency that US holder of foreign asset . This asymmetry can explain some of the high correlation between the

USD and risky assets when risky assets rise, some more USD have to be sold to hedge the increasing assets This is particularly visible at month end.



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Foreign Capital FlowsUpside Pressure on Domestic

Currency

Central Bank Intervenes (Buyforeign currencies, international reserves

increase)

Central Bank sterilizes the increase

in domestic li uidit resultin from

Domestic Authorities start

to impose capital controls.(When they feel they can not control the

foreign flows anymore.)

(assets rise before the money

reaches the Central Bank coffers)

its forex intervention (It sells short-termpaper to reabsorb the domestic currencies it had to

sell to by foreign ones)

Inflation starts to be a

concern

Domestic Actors start to believe that theirThe domestic economy

booms.

Source: Clue6

Understanding the Emerging Markets Liquidity Loop is essential to put what is currently happening in perspective and to understand what it will ultimately lead to.

currencies UP. (They borrow in foreign currencies. Credit outsideof the domestic Central Bank control is created.)

Central Bank Tighten (Rise domestic short-term rates, increase banks reserve requirements,)

Facing large foreign capital flows, domestic Central Banks intervene to limit the gain of their currency. By buying foreign currencies they are, ceteris paribus, expanding their monetary base which, if

unsterilized, usually leads to faster economic nominal growth.

It is important to note that the foreign money buy domestic assets or is borrowed by local actors before it reaches the central bank. The Central Bank/local authorities have thus to tighten/impose

capital controls when they estimate that the domestic economy is overheating. This initially leads to more rapid inflows (as foreigners try to buy before they can not anymore) and foreign currency

denominated borrowing by local actors (as the interest spread with between domestic and foreign currencies increase).


It makes sterilizing more costly and central banks start to do less sterilizing but more monetary tightening (short-term rate rise, bank required reserve increase,...). The later is also a consequence of

rising inflation which also leads central bank to accept a more rapid increase in their currencies which can further increase capital inflows and domestic foreign currency borrowing. Finally the circle

is broken and...



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Central Bank tightening aggressivelyand domestic authorities capital

controls increased

Inflation starts to be a

concern

The domestic

economy slows

significantly

Foreign Capital

Outflows

Domestic Assets

Foreign currencies

rise (usually the

USD is THE

Source: Clue6

ec ne winner)

Domestic Actors struggleto repay/roll-over their

foreign currencies debt(short squeeze)

... what took years to build unravel in a matter of days/weeks. Inflows turn to outflows, domestic actors have to pay back or can not roll-over their foreign currency borrowing. . .

The problems are compounded this time as the liquidity created by the developed markets central banks is flowing more or less directly toward emerging markets and

commodities making the process particularly powerful.

While capital will flow to emerging market on a long-term basis, on a cyclical basis we are closer to the end of the current wave than the beginning (as C. Gave uses to say, it will

be like the sea after ou have detonated a lar e bomb below the surface first ou will see small dead fishes emer in onl after ou will see the dead whales so be on the look out


, ,

for struggling small fishes like Vietnam to be ready for the big ones). Dont be the marginal provider of liquidity. Step up and do it when nobody else want (well when nobodyhas done it for some time).



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35Currencies: LiquidityFX Intervention Vs. Non-FDIFX Intervention in the Past 12

Chart 46Chart 55.

Capital Inflows

Months (as a % of GDP)

Source: UBSSource: UBS

On Chart 55 and 46 one can see the level of FX interventions and the non-foreign direct investments capital inflows.




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36Currencies: LiquidityChart 58Chart 57 Yen and MOF InterventionsMonetary Base Growth and Sterilization

Source: MOF, Clue6Source: UBS

On Chart 57 one can see the influence of the Net Foreign (NFA) and Net Domestic Assets (NDA) contribution to the base money growth.

.

On Chart 58 one can see that the BOJ recent interventions. The most recent ntervention should work as it was coordinated with other Central

Banks. The last coordinated intervention in 2000 saw the Euro appreciate in the following days then retesting its lows before embarking into a multi-

years ascension which say the currency almost double against the USD.


If the intervention is unsterilized and the BOJ embarks into a new round of quantitative easing, the depreciation of the Yen could be verysignificant, wit a move above 125 in the next18-24 months a distinct possibility.



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37Currencies: LiquidityChart 60Chart 59 JP Morgan Real Broad EUROJP Morgan Real Broad USD

Plaza Accord

Louvre

Accord

Joint

intervention

ECB

intervention

Source: JP Morgan, Clue6Source: JP Morgan, Clue6

Past joint interventions have been rather successful even if the Louvre Accord was only able to slow the USD downside momentum (Chart 59-60).

Cynics could say that they work when the goal is to weaken the USD and not that well when the reverse is true but we would rather say that the

USD was not that undervalued when the Louvre Accord was signed and the US not very committed.




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38Currencies: LiquidityChart 62Chart 61 NZD and RBNZ InterventionsAUD and RBA Interventions

The Reserve Bank of Australia has continued to intervene in the market (Chart 61) but it has yet to step ups in a meaningful way (but it is moreactive every time the AUD move above parity). It might hope that the rise in the AUD tighten the domestic monetary condition. It knows that the

Source: RBNZ, Clue6Source: RBA, Clue6

country is the home of the biggest housing bubble in the world with an overly exposed banking system. It can not risk to pop it. Rising rates too

quickly might cause that risk. Furthermore it is a way to protect the domestic economy (limiting the resource sector boom to get out of control from

rising commodity prices which are pushing its term of trade up.

The Reserve Bank of New-Zealand is in a similar position even if we would not be surprised that it sold some NZD on the aftermath of the


Christchurch earthquake (Chart 62).



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Cu e c es: Liquidity

The US uantitative easin has been blamed for the USD decline. While correlation is not causation the mi ht be somethin to it.

Source: BOJ, Federal Reserve, Clue6

Looking at the relative growth of the Fed and BOJ balance sheet, one can see that if the BOJ start to ease quantitatively on its own, the Yen might

loose some ground.




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q y

The 1995 Yen strength was not related to the Kobe earthquake (or at least not as closely as many analysts have recently argued). As one can seeon the above charts, there were no real repatriation (defined as Japanese entities (government, companies, households,...) sell foreign assets to cover

Source: Goldman Sachs

domestic needs). The earthquake losses are mainly domestically insured. Repatriation in Japan has usually been seen when there were global

financial tensions, not domestic one. We would not be surprised if some large Japanese institutions took advantage of the JPY rapid appreciation to

buy some for foreign bonds.

When talking about repatriation, one has also to keep in mind that US corporations are hoarding large amount of cash (past profits) outside of


the US. While a large part is probably held in USD, a new Homeland Investment Act to let corporation repatriate offshore income with a highly

discounted tax rate would probably be a catalyst for a strong USD rebound. The first version at the end of 2004 lead to a 14% rise in the USD.

41Currencies: Trade


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USD/JPY and Ja anese MerchandiseDollar Index and Ex ort to GDP RatioChart 64Chart 63

Trade Balance NSA

4 Quarters Rate of Change

The export to GDP ratio momentum has turned positive again (Chart 63). This is structurally bullish for the USD (and this time it is not as 18


months ago due to a decline in nominal GDP).

Japan merchandise trade balance has been improving markedly since the 2009 lows but remains much lower than in the past (Chart 64). It

has even started to roll over again which is JPY-negative.


42Currencies: Trade


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Source: Nomura

e s curren y more an e ow e apanese expor ers rea even ra e w c ncrease e po ca pressure o pus e en

lower.


43Currencies: Intermarket


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Chart 66Chart 65 Dollar Index and ISM MomentumDollar Index and Crude OIl

The USD and oil price have had a negative 0.7 correlation in the past 25 years (Chart 65).


This is true that the USD tends to decline when crude oil rise but this is only true up to a point. When oil gets so expansive that global growth

falters, this become USD positive.

The USD tends to perform well when the ISM manufacturing index has a negative momentum , especially when the ISM is below 50 (Chart


66).

44Currencies: Seasonality


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Chart 68Chart 67 USD/JPY TR Seasonality (since 1989)EUR/USD TR Seasonality (since 1989)


T ere are no rea seasona e ges n t e mont s to come C art 67-68 . T e USD as ten e to e re at ve y wee unt m -Septem er ut t was

supposed to be strong in the past 3 months




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Chart 70Chart 69 USD/CHF TR Seasonality (since 1989)GBP/USD TR Seasonality (since 1989)


T e Poun as stor ca y een strong t e Apr -Ju y per o C art 69 .

The USD/CHF has usually been week into mid-September (Chart 70).




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Chart 72Chart 71 Asia/USD TR Seasonality (since 1999)AUD/USD TR Seasonality (since 1989)


The AUD has historically been strong in April and June with a hick up in May (Chart 71).

The same is true for the NZD (Chart 72).


Currencies: Graphs 47


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T e Euro s at t e top o ts 3 mont s o r s ng c anne at t e same t me as t s pus ng towar an mportant res stance area re area on t e grap an own tren ne

from the 2008 peak. It is also far away its 200 and 50 days moving average which has historically led to at least a consolidation.

We would exit long positions at least until we get an upside break. We would sell 1.5-3% OTM calls with 1-3 months maturity and would start to build an outright short

position on a move below 1.39 and increase it if it moves below 1.375. We would use an initial stop at the high the Euro will make before it move below our trigger zone

(so not 1.4248 but higher or lower depending where the current intraday rebounds stop).


Longer-term we maintain that the Euro could fall below 1. We think that it will bottom near 0.7 if it survives. Crazy? We met the same skepticism when we forecasted arise above 1.5 when the ECB started to intervene when it was hovering near 0.85 almost 10 years ago.



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We would need a break above 84.5 for a clear change in the cyclical trend. Until then, our strategy is to sell downside volatility (USD/JPY puts

with strike from 80.5 and below and 1 to 3 months to expiry). We would get outright long (the USD/JPY) on a move above 84.5 with a stop at the

rising 65 days exponential moving average or on a new move below 80.5. Our first target would be a move to 93.5-94 and then 100.


e wou o a y e ge e apanese equ y o ng o ga n nves ors.



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Diamond Top

The British Pound is in the middle of its up channel entering an important resistance zone.

We might contemplate taking a short position on a move below 1.60.


We are seller of upside volatility on a move above 1.65. We would sell 1.675-1.69 1-3 months to expiry calls.



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Head & Shoulders

Head & Shoulders

Target

The large head & shoulders top identified last year has reached it 0.93-0.95 target early in 2011. The pair is very extended below its 200 and 50

days exponential moving average. This configuration has historically led to a return to the mean. The technical structure remains favorable to the

CHF with no identifiable trend change.

While we do not usuall fi ht trends we would take a short osition at the current 0.8980-0.9015 level. If we can move above 0.935 and then


0.975, the move could extend to last years high.



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The AUD might be in the process of forming a complex top. It looks distributive to us. Remember that when the AUD corrects, it tends to do have a waterfall

shape.

We can not recommend a long position at this juncture anymore. The level of overvaluation and the fragility of the foundation of its strength makes it to risky.

We are seller of upside volatility on a move above 1.02 and would even take a tiny outright short position to profit from the probable RBA selling.


We would have to wait for some technical deterioration before we are willing to fight against the carry with more commitment but a close below the recent 0.985

lows would be a move in the right direction. Stay tuned.

52Currencies: Conclusion


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The USD is becoming increasingly undervalued against most currencies. It is at a 40 years low on a real broad trade-weighted basis. Its

economy is much more dynamic and has started to rebalance earlier than other developed economies. Companies have been cutting costs aggressivelyand are much more competitive in the international markets.

The big problem remains that the Fed is suppressing real government bond yields through quantitative easing. Ceteris paribus, the USD will have

to be more undervalued on a PPP basis to be in equilibrium. Indeed, the deficit of interests payment foreigners are receiving has to be

compensated by a lower price I.e. lower USD (this is another reason why emerging markets with negative real yields have very undervalued

currencies on a PPP basis). At current levels we think the compensation is large enough.

The declining USD is pushing other Central Banks/Treasuries to become increasingly aggressive buyer of USD to weaken their own currencies .

They then have to recycle their newly acquired USD and in so doing are exerting a downward pressure on real rates in the US and thus weakening the

USD. This can not last forever. This will end by a radical redesign of our current monetary system and the sooner the better. The winner Gold.

Sentiment is increasin l su ortive for the USD. S eculators had their bi est USD net short osition ever a week a o and have covered a third

despite continued USD weakness (a positive divergence. Assets in the the Rydex Weakening Dollar have surpassed assets in the Rydex Strengthening

Dollar fund but have yet to spike briefly higher as they usually do when the USD decline exhausts itself.

There is a big global short USD position which is growing by the day as the increase in foreign central bank reserves can not be completely

explained by their current account balance and the net foreign direct investments . Hot money is flowing to emerging markets and we are on the

look out for canaries

A new Homeland Investment Act could be voted in the month to come which could offer some support for the USD as it did at the end of 2004,

while oil price rising further might reach a level where its historical highly negative correlation with the USD turns positive as it does when oil price

rise enough to break the back of the macro up cycle.

The Euro is 7-10% overvalued, after its recent rebound (more like 20-25% overvalued if you are leaving in Spain and much more if you are Greek).

Yields spreads remain favorable and in synch (which is even more important) but the spread momentum has been faltering in the past 2 weeks despite

M. Trichet "strong vigilance".


Sentiment is not supportive with Speculators having accumulated a large net long position and a short-term positive risk reversal divergence.


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rising 65 days exponential moving average or on a new move below 80.5. Our first target would be a move to 93.5-94 and then 100. We would totally

hedge the Japanese equity holding of gaijin investors.

The British Pound is now sli htl overvalued and deserve to trade at a bi er discount ith lower real short-term ields than in the US. Man

accidents are just waiting to happen with notably the residential real estate market. Authorities will use, among others, a depreciation of the Pound to

support the British economy. Yields spreads are not confirming the recent Pound appreciation.

Speculators are net long but they have sold some on strength which is a bearish divergence. The risk reversal is still in synch with the cross.

The British Pound is in the middle of its up channel entering an important resistance zone. We might contemplate taking a short position on a move

below 1.60. We are seller of upside volatility on a move above 1.65. We would sell 1.675-1.69 1-3 months to expiry calls.

The CHF is more than 50% overvalued. The SNB has its hands partly tied having been to early to the party. It has already intervened massively

and is runnin out of o tions we would not be sur rised to see ca ital controls be introduced on further stren th. The could take the form of a tax on

foreign money entering the country or negative yields on CHF denominated deposit owned by foreign entity). Walls of money are still heading to

Switzerland from European banks while many holders CHF-denominated mortgage in Eastern Europe are slowly but surely getting squeezed. As for

the JPY the yields spreads have not confirmed the recent CHF strength.

Speculators have a huge net CHF long position.

The pair is very extended below its 200 and 50 days exponential moving average. This configuration has historically led to a return to the mean.

The technical structure remains favorable to the CHF with no identifiable trend change. While we do not usually fight trends, we would take a short

position at the current 0.8980-0.9015 level. If we can move above 0.935 and then 0.975, the move could extend to last years high.

Commodities currencies are overvalued The AUD is probably more than 35% above fair value while the NZD is 15-20% overvalued. The CAD

is more than 10% overvalued. They have profited from the "Chinese inventory build-up, Emerging Markets boom, institutional love affair and

more recently QE2 related commodity rally. We think that the latter rally is very long on its tooth so

Speculators have a large AUD long position while there is a negative divergence building in the risk reversal.




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The AUD might be in the process of forming a complex top. It looks distributive to us. Remember that when the AUD corrects, it tends to do have a

waterfall shape. We can not recommend a long position at this juncture anymore. The level of overvaluation and the fragility of the foundation of itsstrength makes it to risky. We are seller of upside volatility on a move above 1.02 and would even take a tiny outright short position to profit from the

robable RBA sellin . We would have to wait for some technical deterioration before we are willin to fi ht a ainst the carr with more commitment

but a close below the recent 0.985 lows would be a move in the right direction.

On emerging currencies, we prefer to stay on the sidelines for now as valuation are not attractive and authorities seems to have decided,

especially in Latin America, that their currency will not be allowed to strengthen. If we had to we would maintain a long position on the Taiwan

Dollar and the Sin a ore Dollar. The more then Yen decline the less attractive the Won ro osition will become so we are no lon er recommendinthe South Korean currency for those who have to be longWe would not short, however, as the carry is too high for most of them. There will come a

time were we will short emerging market currencies opportunistically, as we last did in 2008 but not yet.


Second Quarter 2011 GTAA Currencies

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Transcript of Second Quarter 2011 GTAA Currencies