Second Quarter 2011 GTAA Currencies

Global
Gl b l Tactical
T ti l
A t Allocation
Asset All ti
GTAA
Currencies
Second Quarter
March 23rd , 2011
Damien Cleusix
d i @ l 6
damien@clue6.com
Clue6 Second Quarter 2011

Executive Summary 1
Currencies
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 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.
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 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 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

Executive Summary 2
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,

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.
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
C t l banks
Central b k are busy
b rebalancing
b l i theirth i currency holding
h ldi toward
t d greater
t diversification
di ifi ti (even
( if they
th did nott they
th wouldld have
h t
to
sell some USD to keep the mix stable). We should also remember that a big chunk of emerging markets credit expansion is and
has 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 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 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) ,
th problems
the bl won't't disappear
di and
d will
ill come back
b k later
l t tot hunt
h t them.
th Th system,
The t b th political
both liti l and d financial
fi i l has
h to t be
b
reformed but we will probably need a new crisis.

Executive Summary 3
The Yen overvalued by at least 25%. And the authorities have now started to intervene again (this time jointly) putting an
implicit 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
Kobe earthquake. Yields spreads are diverging negatively with price. This should ultimately leads to a lower Yen.
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.
We would
W ld need
d a break
b k above
b 84 5 for
84.5 f a clear
l change
h i the
in th cyclical
li l trend.
t d Until
U til then,
th our strategy
t t i to
is t sell
ll downside
d id
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. 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

Executive Summary 4
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 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.
The pair
Th i is
i very extended
t d d below
b l itsit 200 and d 50 days
d exponential
ti l moving
i average. This
Thi configuration
fi ti has
h historically
hi t i ll led
l d to
t 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.
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
corrects, ha e a waterfall
aterfall shape.
shape We can not recommend a long position at this juncture
j nct re anymore.
an more The level
le el of
overvaluation and the fragility of the foundation of its strength makes it to risky. We are seller of upside volatility on a move

Executive Summary 5
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.
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 long…We
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.

Currencies: Valuations – Real Rate Spreads 6
EUR-USD
EUR USD 2 Years Real Rate Differential and EUR/USD
Chart 1 EUR/USD Fair Value Model Chart 2 Real Effective Exchange Rate
Source: Clue6 Source: Clue6
Valuations are not very helpful for short-term forecasts but are essentials to put the short, medium and long-term trends into perspective.
The Euro (Chart 1) is now approximately 77-10%

10% overvalued against the USD (the Euro is 20 20-25%
25% overvalued for the PIIGS and only slightly overvalued for
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 few
years.

Chart 3 USD-EUR 2 Years Yield and Swaps Differential Chart 4 USD-EUR 2 Years Yield and Swaps Differential
Nominal 2 years and swaps spreads (Chart 33-4) 4) are also moving in the right direction for the Euro.
Euro But note that despite the “strong
strong vigilance
vigilance” of
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 …

USD-JPY
USD JPY 2 Years Real Rate Differential and USD/JPY
Chart 5 USD/JPY Fair Value Model Chart 6 Real Effective Exchange Rate
The Japanese
p Yen ((Chart 5)) is approximately
pp y 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.

Chart 7 USD-JPY 2 Years Yield and Swaps Differential Chart 8 USD-JPY 2 Years Yield and Swaps Differential
Nominal 2 years and swaps spreads (Chart 77-8)

8) are diverging positively with the most recent low significantly higher than in November 2010 .
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.

USD-GBP
USD GBP 2 Years Real Rate Differential and USD/GBP
Chart 9 GBP/USD Fair Value Model Chart 10 Real Effective Exchange Rate
The British Pound ((Chart 9)) is onlyy slightly

g y overvalued. We expect
p the currencyy to undershoot its fair value byy 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).

Chart 11 GBP-USD 2 Years Yield and Swaps Differential Chart 12 GBP-USD 2 Years Yield and Swaps Differential
Nominal 2 years and swaps spreads (Chart 11

11-12)
12) are diverging negatively with the most recent rally in the Pound not confirmed but the
differentials.
This has historically led to a weaker Pound.

USD-CHF
USD CHF 2 Years Real Rate Differential and USD/CHF
Chart 13 USD/CHF Fair Value Model Chart 14 Real Effective Exchange Rate
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
position
iti andd buy
b USD.
USD Investors
I t with
ith CHF denominated
d i t d accounts t should
h ld stop
t to
t hedge
h d their
th i USD andd buy
b more. Swiss
S i pensioni funds
f d should
h ld
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
spreads and the Real Effective Exchange Rate is now almost coincident.
coincident A move to a positive US-CHF
US CHF spreads would be the last nail in the CHF
structural upswing coffin.

Chart 15 USD-CHF 2 Years Yield and Swaps Differential Chart 16 USD-CHF 2 Years Yield and Swaps Differential
Nominal 2 years and swaps spreads (Chart 15

15-16)
16) are diverging slightly with the most recent rally in the CHF not confirmed but the differentials.
differentials .
This has historically led to a weaker CHF.

Currencies: Valuations 14
Chart 17 AUD/USD Fair Value Model Chart 18 AUD-USD 2 Years Yield and Swaps Differential
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 is…too much…
N i l yields
Nominal i ld andd swaps are diverging
di i negatively
ti l andd they
th have
h f more than
for th 6 months
th now (Chart
(Ch t 18).
18) Watch
W t h out…
t
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. Don’t 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. “Jusqu’ici tout va bien, jusqu’ici tout va bien, jusqu’ici tout va bien… l’important c’est pas la chute c’est l’atterissage” 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-based
investors this will be one of the trade of the decade.

Chart 19 NZD/USD Fair Value Model Chart 20 NZD-USD 2 Years Yield and Swaps Differential
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.

Chart 21 PPP Deviation vs. PPP GDP per Capita Table 1 Latin America Adjusted Valuations
Source: IMF, Clue6
Source: 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”.
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 amongg them the darlingg of carryy trader the Brazilian Real which is p
probably
y 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. Don’t short the
carry is too large but there will be much better time to harvest it.

Table 2 South-East Asia Adjusted Valuations Table 3 Eastern Europe and Africa Adjusted Valuations
Source: IMF, Clue6 Source: 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 Rupiah was one of our favorite in the past but we would exit positions at current levels as it is now approximately 30% overvalued according 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.

Currencies: Valuations – Sentiment 18
Chart 22-23 ML Fund Managers Survey Valuation Perception Chart 24 ML Fund Managers Survey Valuation Perception
Sentiment USD JPY
Source: ML
EUR
When it comes to valuation, fund managers surveyed by Merrill Lynch have historically been accurate in their opinion.
opinion
Chart 22, 23 and 24 do confirm our valuation analysis.
The USD is undervalued while the Japanese Yen and the Euro are overvalued.

Currencies: Sentiment 19
Dollar Index and Non
Non-Commercials
Commercials Net Future Positions
Chart 25 in Foreign Currencies Chart 26 Dollar Index and Rydex Investors
Source: Bloomberg, Clue6 Source: Rydex, Clue6
Non-Commercials had, a week ago, their biggest historical net USD short position (Chart 25). They have since covered more than 90’000 contracts (almost a third) even if
the USD has continued to decline.
We use this data by looking both at absolute levels, relative 2-3 years levels and divergences between positioning and the USD. What you will usually see at important turning
point is first an extreme in both absolute and relative positioning followed by a reversal in those positions. Then you will see the USD continuing making new highs or lows
without flows confirmation (move down but non-commercials will cut their net short position)… One should get more aggressive on the second spike in net positions (but it will
be not as extreme as the previous one… It usually plays out under a 3-6 months period).
The USD bottomed last year as Rydex traders assets in the weakening Dollar funds surpassed the one in the strengthening fund (Chart 26).
26) This is the case again but we
are not seeing a spike in the weakening dollar fund asset. This is puzzling.

EUR/USD and Non
Non-Commercials
Commercials EUR/USD and 3 Months 25D
Chart 27 Future Net Position Chart 28 Risk Reversal
Source: Bloomberg, Clue6 Source: Bloomberg, Clue6
Similar to the aggregate USD position the non-commercials positioning and price have diverged last week (Chart 27).
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.

USD/JPY and Non
Non-Commercials
Commercials USD/JPY and 3 Months 25D
Non-commercials
Non commercials have a large net long Yen position (Chart 29).
29) We have a nice negative divergence in place.
place
There no short-term risk reversal divergences in place (Chart 30).

Chart 31 TFX Net Retail JPY/USD Margin Position Chart 32 TFX Total Retail Yen Net Short Margin Position
Source: TFE, Clue6 Source: TFE, Clue6
A lot has been said about “Japanese Housewives” in the past few years. So let’s see what they are up to.
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.

GBP/USD and Non
Non-Commercials
Commercials GBP/USD and 3 Months 25D
Non-commercials
N i l have
h a GBP nett long
l position
iti (Chart
(Ch 33).
33) Note
N that
h there
h i a clear
is l di
divergence as non-commercials
i l are liquidating
li id i their
h i long
l
position on strength.
There is no divergence on the risk reversal (Chart 34).

USD/CHF and Non
Non-Commercials
Commercials USD/CHF and 3 Months 25D
Non-commercials
Non commercials are very long the CHF (Chart 35).
35)
There are no short-term divergence on the risk reversal but note that it is currently higher that in September (Chart 36).

USD/CAD and Non
Non-Commercials
Commercials USD/CAD and 3 Months 25D
N
Non-commercials
i l have
h th i biggest
their bi t nett long
l position
iti on the
th CAD ever (Chart
(Ch 37).
37)
There are some identifiable divergences on the risk reversal (Chart 38).

AUD/USD and Non
Non-Commercials
Commercials AUD/USD and 3 Months 25D
Non-commercials
Non commercials have a big (too big) net long AUD position (Chart 39).
39)
There is a large medium-term risk reversal divergence (Chart 40). This is bearish for the AUD.

NZD/USD and Non
Non-Commercials
Commercials NZD/USD and 3 Months 25D
Non-commercials
Non commercials are net short the NZD (Chart 41).
41)
There are no risk reversal divergences (Chart 42).

Chart 43 EUR/USD FXCM Customers Positioning Chart 44 USD/JPY FXCM Customers Positioning
Source: FXCM Source: 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).

Chart 45 GBP/USD FXCM Customers Positioning Chart 46 USD/CHF FXCM Customers Positioning
Source: FXCM Source: FXCM
They are undecided on the GBP (Chart 45). 45) Note that looking at daily data,
data they moved to their largest net short GBP position since the beginning
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: Liquidity 30
Chart 49 Dollar Index and Financial Foreign Outstanding CP Chart 50 Dollar Index and Financial Foreign Outstanding CP
Source: “Current efforts to enhance global financial supervision “,BIS,

Stephen Cecchetti Source: Bloomberg, Clue6
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.
The USD line on Chart 49 show the aggregate amount of USD required (net) by Canadian, Dutch, German, Swiss UK and Japanese banks. That’s
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
are not far from the 2008 and 2010 highs which preceded USD short covering rallies.
rallies

Chart 51 EUR/USD Basis Swaps Chart 52 Germany Total Net International Investment Position
Euro Countries Net International

Investment Position
Source: Bloomberg, Clue6 Source: BundesBank, Clue6, Macquarie for the Euro-Zone Members Countries Net 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.
Another central 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 won’t 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…

Dollar Index and World International
Chart 53 Foreign Reserve Currency Allocation Chart 54 Reserve ex Gold Momentum
Source: Bloomberg, Clue6 Source: Clue6
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
to end up with a big USD rally and some countries going bankrupt.
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.
Th more quickly
The i kl reserve rise,
i theh more USD has
h to be
b sold
ld just
j to keep
k the
h currency mix
i stable,
bl ceteris
i paribus…
ib
Let’s 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.

Upside Pressure on Domestic
Foreign Capital Flows Currency
Central Bank Intervenes (Buy

foreign currencies, international reserves
Domestic Authorities start increase)
to impose capital controls.
(When they feel they can not control the
foreign flows anymore.)
Central Bank sterilizes the increase
Domestic Assets Rise q
in domestic liquidityy resultingg from
(assets rise before the money its forex intervention (It sells short-term
reaches the Central Bank coffers) paper to reabsorb the domestic currencies it had to
sell to by foreign ones)
Inflation starts to be a
concern
The domestic economy

booms. Domestic Actors start to believe that their
Centrall Bankk Tighten
i h (Rise domestic short- currencies has only one way to go against foreign
term rates, increase banks reserve requirements,…) currencies… UP. (They borrow in foreign currencies. Credit outside
of the domestic Central Bank control is created.)
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.
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...

Central Bank tightening aggressively

Inflation starts to be a
and domestic authorities capital
concern
controls increased
The domestic
economy slows
significantly
Foreign Capital
Outflows
Foreign currencies
rise (usually the
Domestic Assets USD is THE
Decline winner)
Domestic Actors struggle
to repay/roll-over their
foreign currencies debt
Source: Clue6 (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
(their short position is you prefer) the domestic currency and assets collapse
collapse. A vicious cycle starts.
starts The USD is the currency you wan t to own.
own
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 you have detonated a large bomb below the surface, first you will see small dead fishes emerging, only after you will see the dead whales so be on the look out
for struggling small fishes… like Vietnam to be ready for the big ones). Don’t be the marginal provider of liquidity. Step up and do it when nobody else want (well when nobody
has done it for some time…).

FX Intervention in the Past 12 FX Intervention Vs. Non
Non-FDI
FDI
Chart 55 Months (as a % of GDP) Chart 46 Capital Inflows
Source: UBS Source: UBS
Let’ss look at the current figures…

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

Chart 57 Monetary Base Growth and Sterilization Chart 58 Yen and MOF Interventions
Source: UBS Source: MOF, Clue6
On Chart 57 one can see the influence of the Net Foreign (NFA) and Net Domestic Assets (NDA) contribution to the base money growth.
Even developed Central Banks have/are actively intervening.

intervening
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 very
significant, wit a move above 125 in the next18-24 months a distinct possibility.
Chart 59 JP Morgan Real Broad USD Chart 60 JP Morgan Real Broad EURO
Plaza Accord
Louvre
Accord
Joint ECB
intervention intervention
Source: JP Morgan, Clue6 Source: JP Morgan, Clue6
Past joint
j i interventions
i i h
have b
been rather
h successful
f l even if the
h Louvre Accord
A d was only
l able
bl to slow
l the
h USD
S downside
d id momentum (Chart
(Ch 59-60).
9 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.

Chart 61 AUD and RBA Interventions Chart 62 NZD and RBNZ Interventions
Source: RBA, Clue6 Source: RBNZ, Clue6
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 more
active everyy time the AUD move above pparity).
y) It might
g hopep that the rise in the AUD tighten
g the domestic monetaryy condition. It knows that the
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).

Source: BOJ, Federal Reserve, Clue6
The US q
quantitative easingg has been blamed for the USD decline. While correlation is not causation,, theyy might
g be somethingg to it.
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.

Source: Goldman Sachs
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 see
on the above charts, there were no real repatriation
p ((defined as Japanese
p entities (g
(government, companies,
p households,...)) sell foreign
g assets to cover
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.

Currencies: Trade 41
Dollar Index and Export to GDP Ratio USD/JPY and Japanese Merchandise
Chart 63 4 Quarters Rate of Change Chart 64 Trade Balance NSA
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.

Currencies: Trade 42
Source: Nomura
The USD/JPY is currently more than 10% below the Japanese exporters’ breakeven rate which
hich increase the political pressure
press re to push
p sh the Yen
lower.

Currencies: Intermarket 43
Chart 65 Dollar Index and Crude OIl Chart 66 Dollar Index and ISM Momentum
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).

Currencies: Seasonality 44
Chart 67 EUR/USD TR Seasonality (since 1989) Chart 68 USD/JPY TR Seasonality (since 1989)
There are no reall seasonall edges

Th d i the
in h months
h to come (Chart
(Ch 67-68).
67 68) The
Th USD has
h tended
d d to be
b relatively
l i l weekk until
il mid-September
id S b but
b it
i was
supposed to be strong in the past 3 months…

Chart 69 GBP/USD TR Seasonality (since 1989) Chart 70 USD/CHF TR Seasonality (since 1989)
Th Pound
The P d has
h historically
hi i ll been
b strong the
h April-July
A il J l period
i d (Chart
(Ch 69).
69)
The USD/CHF has usually been week into mid-September (Chart 70).

Chart 71 AUD/USD TR Seasonality (since 1989) Chart 72 Asia/USD TR Seasonality (since 1999)
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
EUR/USD
Th Euro
The E i att the
is th top
t off its
it 3 months
th old
ld rising
i i channel
h l att the
th same time
ti as it is
i pushing
hi toward
t d an important
i t t resistance
it area (red
( d area on the
th graphh andd down
d trend
t d line
li
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 a
rise above 1.5 when the ECB started to intervene when it was hovering near 0.85 almost 10 years ago.
USD/JPY
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.
We would totally hedge the Japanese equity holding of “gaijin” investors.

investors

GBP/USD
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.

USD/CHF
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 usuallyy fight

g trends,, we would take a short pposition 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.

AUD/USD
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.

Currencies: Conclusion 52
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 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.
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 increasingly
g y supportive
pp for the USD. Speculators
p had their biggest
gg USD net short pposition ever a week ago
g 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
p byy their current account balance and the net foreign
g direct investments. Hot moneyy is flowingg to emerging
g g 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.

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 Central banks are busy rebalancing their currency
holding toward greater diversification (even if they did not they would have to sell some USD to keep the mix stable). We should also remember that a
big chunk of emerging markets credit expansion is and has 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
g the Euro will make before it move below our trigger
gg zone ((so not 1.4248 but higher
g or lower depending
p g where the current intradayy 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
ppolitical decisions might
g be taken in the near future ((but it seems theyy won't as is usual)) , the pproblems won't disappear
pp and will come back later to hunt
them. The system, both political and financial has to be reformed but we will probably need a new crisis.
The Yen overvalued by at least 25%. And the authorities have now started to intervene again (this time jointly) putting an implicit 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
g to repatriation,
p it is a myth.
y There are no data confirmingg it after the Kobe earthquake.
q Yields spreads
p are diverging
g g negatively
g y with pprice.
This should ultimately leads to a lower Yen.
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.
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. 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 short-term
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 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 runningg out of options
p ((we would not be surprised
p to see capital
p controls be introduced on further strength.
g Theyy 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
p have a huge
g net CHF longg p
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.

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.
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
g p Dollar. The more then Yen decline the less attractive the Won pproposition
p will become so we are no longer
g recommendingg
the South Korean currency for those who have to be long…We 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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Global

Clue6 Second Quarter 2011

Clue6 Second Quarter 2011

The Euro is 7-10% overvalued,

Clue6 Second Quarter 2011

Clue6 Second Quarter 2011

Speculators have a huge net CHF long position.

Clue6 Second Quarter 2011

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

The Euro (Chart 1) is now approximately 77-10%

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

Nominal 2 years and swaps spreads (Chart 77-8)

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

The British Pound ((Chart 9)) is onlyy slightly

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

Nominal 2 years and swaps spreads (Chart 11

This has historically led to a weaker Pound.

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

Nominal 2 years and swaps spreads (Chart 15

This has historically led to a weaker CHF.

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

Clue6 Second Quarter 2011

Source: Clue6 Source: Clue6

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

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

Clue6 Second Quarter 2011

Source: IMF, Clue6

Clue6 Second Quarter 2011

Source: IMF, Clue6 Source: IMF, Clue6

Clue6 Second Quarter 2011

Sentiment USD JPY

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

Clue6 Second Quarter 2011

Source: Bloomberg, Clue6 Source: Rydex, Clue6

Clue6 Second Quarter 2011

Source: Bloomberg, Clue6 Source: Bloomberg, Clue6

Clue6 Second Quarter 2011

Source: Bloomberg, Clue6 Source: Bloomberg, Clue6

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

Clue6 Second Quarter 2011

Source: TFE, Clue6 Source: TFE, Clue6

Clue6 Second Quarter 2011

Source: Bloomberg, Clue6 Source: Bloomberg, Clue6

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

Clue6 Second Quarter 2011

Source: Bloomberg, Clue6 Source: Bloomberg, Clue6

Clue6 Second Quarter 2011

Source: Bloomberg, Clue6 Source: Bloomberg, Clue6

Clue6 Second Quarter 2011

Source: Bloomberg, Clue6 Source: Bloomberg, Clue6

Clue6 Second Quarter 2011