Is the US dollar bottoming?

2nd June 2011

Laeeth Isharc, Kaleidic Associates

VALUATION

VALUATION

Economist Big Mac Index implies US dollar undervalued by around 35%.

Perhaps it's biased by relative factor availability.

But the US dollar is undervalued by c. 30% on the OECD measure.

Where do valuations stand? (Bloomberg PPP)

Where do valuations stand?(OECD PPP)

Where do valuations stand? (Notorious ‘Big Mac’ Index)

Valuations - summaryCurrency Ref OECD Bberg Big Mac Average

CHF .8774 42.28 29.08 101.78 57.71

NOK 5.5475 39.25 17.21 119.48 58.65

AUD 1.0660 38.30 34.97 20.93 31.40

SEK 6.3083 29.51 1.13 107.89 46.17

JPY 81.70 26.38 11.27 5.50 14.38

CAD .9742 20.19 19.30 17.79 19.09

EUR 1.4161 11.60 21.07 31.52 21.39

AVERAGE 29.64 19.14 57.84 35.54

US dollar undervalued by c. 35% ? Even if the Big Mac index is biased by relative factor availability, this is close to just the OECD valuation measure of c. 30%

ADVOCATUS DIABOLI

Despite undervaluation versus developed world, many compelling reasons to be short the dollar?

• Chronic current account deficit• Unmanageable debt load (public and private) vs GDP• Japanese experience suggests deleveraging will require monetary policy

support for years to come to support GDP growth. QE 3, 4, 5 ?• Very polarized political scene, disturbing lack of social cohesion suggests

taking tough decisions will be hard. Majority of households do not pay income tax! Political swing away from policy elite towards a more populist direction (‘Tea Party’ ascendancy). Republicans playing chicken with Democrats over the budget – risk of threatening US credibility and prestige in bond market. Black swan possibility of a technical default?

• Secular decline in US civilization accompanied by a genuine ascendancy of the emerging world. Declining moral qualities (restraint, willingness to sacrifice for the future), loss of optimism. Is the American Dream dead? Wages in emerging world still cheap in USD terms vs those of US workers.

• Stagnant real wages since 1970s; declining overall participation rate since 2000 – very much worse for men, particularly those from minority groups (that are in the sample statistically less skilled).

• Iraq, Afghanistan, Libya. Wherever next ?

Secular Decline in US Civilization?

Lee Plaza Hotel, Detroit

Emerging World Rising - Shanghai Skyline

Tallest US building was completed in ... 1973. Reflects loss of ambition, optimism

Moral Decline – end of Self-Restraint?

THEN NOW

Future Time Orientation?

''The lower-class individual lives moment to moment...Impulse governs his behavior either because he cannot discipline himself to sacrifice a present for a future satisfaction or because he has no sense of the future. He is therefore radically improvident.''

- Edward C Banfield, The Unheavenly City

Why did interest rates rise in the twentieth century?

“The social time preference schedule must have shifted upward. That is, the character of the population must have changed. People onthe average must have lost in moral and intellectual strength and become more present-oriented.”

- Dr Hans Hermann Hoppe, Democracy: the God that Failed

Declining future time orientation reflected in personal savings rate?

Horrible Deficit / GDP Path

Declining Trade Balance/CA ?

Declining Participation Rate

Picture worse for men

Particularly bad for some minority groups, and for lower-skilled workers.

One more word about giving instruction as to what the world ought to be. Philosophy in any case always comes on the scene too late to give it... When philosophy paints its gloomy picture then a form of life has grown old. It cannot be rejuvenated by the gloomy picture, but only understood. Only when the dusk starts to fall does the owl of Minerva spread its wings and fly.

—G.W.F. Hegel, Preface to Philosophy of Right (1820)

In other words, all this has already happened.

But what of the future?

“The Americans can always be trusted to do the right thing”- Winston Churchill

The Americans can always be trusted to do the right thing… once all other possibilities have been exhausted.

- Winston Churchill (apocryphal)

Reality Check!• Is the current account situation really so bad? We ought to examine the

detail.

• Bears on the US want to have it both ways – to believe that prospective US growth will be weak due to dampened animal spirits, and that the current account will continue to worsen leading to further dollar weakness.

• But dampened animal spirits ought to lead to rising/high savings rate and a stabilizing/improving current account. Not likely to be associated with large portfolio outflows on the capital account either.

• Danger of extrapolating recent experience indefinitely out into the future. Every natural phenomenon has an ebb and flow. Possible we might see a stabilization or turnaround in participation rate, government spending/fiscal deficit and national self-confidence.

Recent evolution of savings rate

Trade Balance Ex Petroleum (bn)

US TB ex Petroleum (% GDP $)

US TB ex Petroleum (% GDP $)

US Trade BalancePetroleum Products Component

Petroleum Balance (volume)

US Crude Imports (Value)

US Crude Imports (Volume Proxy)

Tight ('Shale') Oil

US Natural Gas and Crude Oil Production

Natural gas production at all-time highs. Upturn in US crude output for first time since 1986.

Collapse in Natural Gas Prices following Shale Gas coming on line

Combination of rising supply (shale gas), limited storage availability and still-depressed US electricity demand vs peak

US Shale Output (Liquids k b/d)

2010 Output 2015 Output Increment

Bakken Shale 350 850 500

Eagle Ford 130 530 400

Permian 1100 1400 300

Niobrara 160 410 250

Andarko Baisin 5 255 250

Monterey 75 275 200

Others 100 100

TOTAL 1,820 3820 2000

Per a US consultant, US liquids output could add 700k b/d in Gulf of Mexico, 200k b/d in biofuels, 100k b/d oil from natural gas formations, 400k b/d natural gas liquids. So they estimate a total increase in US liquids output of 3.3mm b/d by 2015.

How significant is 3.3mm b/d increase in US production?

• Net Imports– 1973 6.1 mm b/d– 1980 6.4 mm b/d– 1990 7.1 mm b/d– 2000 10.5 mm b/d– 2010 9.5 mm b/d

• So very simplistically, would reduce net import requirement by 1/3.

• Gross trade balance 48.2bn; ex petr 16.9 bn.

• Presuming no change in price and everything else held the same, this would reduce total trade balance to 27.3 bn.

• Supposing crude price fell 40% it would put total trade balance at 23bn – levels of 1999 in current USD, and even better as share of GDP. In 1999 DXY was 100, 32% richer than current levels.

Equities (SPX) vs even-weighted dollar index

For now still more driven by risk than interest rate spreads. Correlations do change over time.

EUR vs US/Germany 2y Spread

EUR/USD clearly influenced by interest rate differentials. Rally in Euro since last year was associated with sell-off in Schatz and inflation fears.

Outlook for EUR/USD

• Depends on risk appetite overall

• Scope for pricing out rate hikes as periphery continues to deteriorate, particularly if inflation concerns recede.

• Greece cannot possibly pay back its government debt.

• Nascent shift to radical right means that time is running out for EU integrationists. Bailouts politically unpopular, and EU fiscal union seems very far away.

Spain – deteriorating retail sales

Portugal Retail Sales

Greece Looks Shakey

Greece 2 Year Price !

Scope for revision downwards of rate expectations (2y Germany)

With US 2y at 50 bps, barely scope for further rally.

US rate expectations vs Europe (2y)

Scope for a reversal?

Inflation/Rate expectations/Gasoline – one trade. Bernanke created inflation in Europe

with QE2?

US Consumer Confidence Still Weak!

Despite improving labour market and a strong equity rally US consumer confidence remains remarkably weak. Historically this has been a good contrarian indicator (buy stocks when confidence hits depressed levels).

Vicious Cycle turns Virtuous?

• Why is Consumer Confidence weak? Perhaps because of elevated gasoline (and other commodity) prices. This has been a focus of much popular discontent towards the Fed.

• Most bullish phase for commodities is abundant liquidity and relative weak growth. Ie crude is high because dollar is weak and because the effective Fed Funds rate is low.

• The effective Fed Funds rate is low in part because consumer (and business) confidence is weak.

• Headline and core inflation both currently low. Tightening in rental market (vacancy rate was 12%; now 9.5%, 2012 5%) implies pickup in the large OER and tenant’s rent component of CPI. Core inflation 1.8% by year end 2011 according to DB.

• QE2 ends shortly. A pickup in hiring and spending would be associated with upward revisions to interest rate expectations, which would tend to support the dollar and weaken gas prices – which would tend to lead to improving consumer confidence.

When mainstream media detect a trend, the trend is about to reverse.

– Paul Macrae Montgomery

Crude Prominent in News (2011)

A little speculative froth?

Positioning – Crude Specs

Positioning – NYMEX Crude

Extremely long positioning by Funds. DSI sentiment index reached 97% in February suggesting we are in the zone timewise for a reversal in duration and magnitude

Last time crude prominent in News(May/Jun 2008)

How did it turn out last time? (Crude)

XLE/SPY rolling over ?

DUG breaking out ?

Positioning – Euro, AUD, CAD

USA Sentiment

Previous occasion with comparablynegative sentiment regarding the USA

“America is the great Satan”

DXY

Is the US dollar bottoming?

Yes.

2nd June 2011

Laeeth Isharc, Kaleidic Associates