The US dollar may be bottoming based on several factors: 1) Valuation measures like the Big Mac Index and OECD measures imply the dollar is undervalued by 30-35% 2) Increases in US oil and gas production from shale could reduce US imports and improve the trade balance by a third 3) A turnaround in US economic confidence and growth could support a rise in the dollar through upward revisions to interest rate expectations

1. Is the US dollar
bottoming?
2nd
June 2011
Laeeth Isharc, Kaleidic Associates

2. VALUATION

3. 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.

4. Where do valuations stand?
(Bloomberg PPP)

5. Where do valuations stand?
(OECD PPP)

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

7. Valuations - summary
Currency 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%

8. ADVOCATUS DIABOLI

9. 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 ?

10. Secular Decline in US Civilization?
Lee Plaza Hotel, Detroit

11. Emerging World Rising -
Shanghai Skyline
Tallest US building was completed in ... 1973. Reflects loss of
ambition, optimism

12. Moral Decline – end of Self-
Restraint?
THEN
NOW

13. 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 on
the average must have lost in moral and intellectual strength and
become more present-oriented.”
- Dr Hans Hermann Hoppe, Democracy: the God that Failed

14. Declining future time orientation
reflected in personal savings rate?

15. Horrible Deficit / GDP Path

16. Declining Trade
Balance/CA ?

17. Declining Participation Rate

18. Picture worse for men
Particularly bad for some minority groups, and for lower-skilled
workers.

19. 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?

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

21. The Americans can always be trusted to do the right thing…
once all other possibilities have been exhausted.
- Winston Churchill (apocryphal)

22. 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.

23. Recent evolution of savings rate

24. Trade Balance Ex Petroleum (bn)

25. US TB ex Petroleum (% GDP $)

26. US TB ex Petroleum (% GDP $)

27. US Trade Balance
Petroleum Products Component

28. Petroleum Balance (volume)

29. US Crude Imports (Value)

30. US Crude Imports (Volume
Proxy)

31. Tight ('Shale') Oil

32. US Natural Gas and Crude Oil Production
Natural gas production at all-time highs. Upturn in US crude
output for first time since 1986.

33. 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

34. 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.

35. 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.

36. Equities (SPX) vs even-weighted dollar index
For now still more driven by risk than interest
rate spreads. Correlations do change over time.

37. 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.

38. 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.

39. Spain – deteriorating retail sales

40. Portugal Retail Sales

41. Greece Looks Shakey

42. Greece 2 Year Price !

43. Scope for revision downwards of rate
expectations (2y Germany)
With US 2y at 50 bps, barely scope for further rally.

44. US rate expectations vs
Europe (2y)
Scope for a reversal?

45. Inflation/Rate expectations/Gasoline – one
trade. Bernanke created inflation in Europe
with QE2?

46. 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).

47. 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.

48. When mainstream media detect a trend, the trend is about to reverse.
– Paul Macrae Montgomery

49. Crude Prominent in News (2011)

50. A little speculative froth?

51. Positioning – Crude Specs

52. 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

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

54. How did it turn out last time? (Crude)

55. XLE/SPY rolling over ?

56. DUG breaking out ?

57. Positioning – Euro, AUD, CAD

58. USA Sentiment

59. Previous occasion with comparably
negative sentiment regarding the USA

60. “America is the great Satan”

61. DXY

62. Is the US dollar bottoming?
Yes.
2nd
June 2011
Laeeth Isharc, Kaleidic Associates