CitiFX Strategy

FX Focus: EURUSD why so strong

Valentin Marinov
+44 207 986 1861 valentin.marinov@citi.com

February 24, 2011

The beginning of 2011 saw a perfect storm of improved global risk appetite, sovereign spread narrowing, EUR-positive widening of rate differentials, position unwinding and sovereign buying Looking ahead we doubt that these forces will continue to be a positive for the EUR Positions are beginning to point in the long EUR direction and we doubt that sovereign debt or global risk will be as EUR-positive as in recent weeks

Steven Englander
+1 212 723 3211 Steven.englander@citi.com

The euro has rallied so far this year and has kept its gains despite market (and our) skepticism that sovereign debt issues have been resolved. The 2011 rally is driven by incentives for reserves diversification, rate differentials moving in the euros favor, rebuilding of long EUR positions and improving global risk appetite. We find that the EUR is reasonably priced given the above factors. However, it is less clear that these factors will continue to evolve in a euro-positive direction. In particular, investors appear to be buying the EUR on the back of increasingly optimistic comments from the ECB about the state of the euro zone economy. But incoming data largely reflect November-January conditions and probably not the conditions that would exist if there was a major oil shock. We think that FX investors may begin to reconsider their optimism. The EUR is sensitive to a global oil shock because such a shock will likely lead to a reduction in risk appetite, a cutting of positions with respect to risk-correlated assets and slower growth. The major economic risks if these shocks intensify are for capital goods exporters, oil importers, and non-oil commodity exporters and their currencies. The EUR is sensitive to the first two. More broadly, slower growth and risk aversion would make investors price sovereign debt more negatively, and if that is the direction in which global asset markets are moving, it seems unlikely that the EUR rally would continue.

EUR model captures impact of positioning and sovereign buying

Given the forces at play, we try and decompose the drivers of the EUR and assess their impact. We have the advantage in that we have developed positioning indicators and indicators of reserve manager stress that we can introduce into our statistical analysis along with rate spreads and overall indicators of risk appetite (Figure 1). All data are in monthly first difference form except for the EUR which is in monthly percent change form. The first three variables are pretty standard - the EUR-US 2yr rate spread, the Spain-Germany 2-yr rate spread (as a measure of sovereign pressure) and the VIX (as an indicator of global risk appetite).
Figure 1. Regression results
EURUSD m/m % change, VIX and Interest Rates m/m difference. Observations 58 Degrees of freedom 52 R2 0.63 F 18.52 Standard error of regression 2.30 Coefficients Intercept -2.40 EUR-US 2yr spread 5.23 Spain-Germany 2yr spread -1.73 VIX -0.29 Reserves dummy (1mth lag) 3.19 CitiFX PAIN EUR long dummy (2mth lag) -1.96

Figure 2. EURUSD and PAIN EUR positioning indicator

100 80 60 40 20 0 -20 -40 -60 -80 1-Jun 9-Jul 16-Aug 23-Sep 31-Oct Citi PAIN for EUR 8-Dec 1.18 15-Jan 22-Feb 1.23 1.38 1.33 1.28 1.43

t -2.04 3.52 -1.95 -4.81 2.56 -2.51

EURUSD (rhs)

Sources: Citi

Sources: Bloomberg, Citi

Market Commentary

CitiFX Strategy

February 24, 2011

The reserves dummy is a measure of diversification pressures on reserve managers. It has a value of 1 if reserves accumulation in any given month is positive, after adjusting for the impact of currency valuation effects. It is lagged one month. The CitiFX PAIN EUR dummy has a value of 1, if our positioning indicator for the EUR is above its critical threshold. It is also lagged one month. The coefficient sizes are interesting. A 100 bps move in EURUSD 2yr spreads is estimated to lead to a 5% EURUSD move. A 100bp moves in sovereign risk spreads between Spain and German leads to a 1.7% EUR depreciation and a move of 10 in the VIX pushes EURUSD down by 2.9%. Given the correlation between sovereign risk spreads and the VIX, the joint effect is larger if sovereign spread widening leads to a higher VIX or vice versa. When reserve managers are increasing reserves, the odds are that the USD sells off in the next month. This we link to diversification pressures. The impact of such pressures is about 3.2% when the pressures are present, while the market being long EUR is associated with a 2% EURUSD drop the next month. To get a sense of magnitudes, the 50bps move in two year spreads would have contributed about +2.5% to the EUR since the end of 2010, the narrowing of Spain-Germany spreads about +1.4%, offset by the run-up in the VIX which would have subtracted 1.5% based on our regression. Positioning would have been a EUR negative in December but would not have had an impact in 2011, since CitiFX Pain has been below the threshold on the monthly close basis used in the regression. We do not have IMF data on global reserves beyond November but there are indications that reserves accumulation may have picked up so presumably there would be an additional impact from these reserves.

EURUSD positioning is no longer short

Many market participants started 2011 holding EUR-shorts. The leg higher in EURUSD on the back of hawkish Trichet comments in the second half of January took some by surprise. The recent path of our daily CitiFX PAIN positioning indicator seems to corroborate this conclusion (Figure 2). PAIN measures the correlation between hedge fund performance and EURUSD returns. The indicator picked up at the start of January as EURUSD weakened but then weakened noticeably later on as the leg higher in EUR seemed to be hurting hedge fund performance. According to PAIN, hedge fund positioning caught up only gradually with the move higher in EURUSD (PAIN started growing again in February as shown in Figure 2). IMM data further suggest that a broader group of FX market investors were caught wrong footed when the EUR started rallying in mid January. Consistent with the PAIN indicator, the IMM data also suggests that there has been a gradual build up in EUR longs which intensified in February (Figure 3).
Figure 3. EURUSD and EUR positioning (IMM data)
60000 1.41 40000 1.38 20000 1.35 0 1.32 -20000 1.29 -40000 1.26 -60000 1.23 -80000 1.2 -100000 -120000 1.17 Jun-10 Jul-10 Aug-10 Oct-10 Nov-10 Dec-10 Feb-11 IMM net EUR positions (rhs) EURUSD

Figure 4. EURUSD and EURCHF

104 102 100 98 96 94 92 90 1-Nov

16-Nov

1-Dec

16-Dec

31-Dec

15-Jan

30-Jan

14-Feb

EURUSD (Nov 2011 = 100)

EURCHF (Nov 2011 = 100)

Sources: Bloomberg, COTR, Citi

Sources: Bloomberg, Citi

Peripheral risk remains

EUR downside risks are still dominated by the situation in the euro area periphery. We have seen and heard European politicians talk about finding a comprehensive solution to the problems of the fiscally weak euro area member states. However, Portuguese funding costs continue to hover close to record highs highlighting the likelihood of Portuguese bailout in coming weeks. While we have seen some correction in SpainGermany yield spreads, these remain very elevated historically and suggest that some risk remains.

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CitiFX Strategy

February 24, 2011

The bailout problem could come to the fore much sooner if the Irish opposition parties stay true to their pledges and demand a re-negotiation of the Irish bailout following a likely victory in tomorrows election. Importantly, such demands could be met with firm opposition by countries like Germany where the ruling coalition is desperately trying to improve its standing with an electorate which is turning increasingly hostile to growing German participation in the peripheral rescue effort.

Sovereign USD-selling can explain some of the EURUSD resilience

Fully quantifying the extent to which the EURUSD resilience recently has been due to USD-selling by reserves managers is difficult. Anecdotal evidence, as well as indications that the so called currency wars practices and rhetoric of late, seems to corroborate the view that global reserve managers were indeed active buyers of EURUSD recently. There were indications at the start of the year that Asian investors will purchase peripheral assets or participate in the bond auctions of the EFSF. While the indicated amounts were rather small overall, we think they sent a credible signal about the intentions of global currency managers in their (apparently) continuing efforts to diversify away from USD. This interpretation seemed to persevere even as price action in the peripheral debt markets was turning less supportive of that view in February. One way to gauge the extent to which USD-selling added to EUR-resilience is to compare the relative performance of EURUSD and EURCHF over the last few months (Figure 4). The level of EURCHF is a well known proxy for the magnitude of perceived risks in the euro area periphery. At the same time, USDrecycling seems to be less of a driver for CHF. As shown in Figure 4, EURUSD clearly outperformed EURCHF. This was particularly true over the last few weeks when we saw a renewed widening of the peripheral spreads to Germany (see also Figure 5). The key risk associated with the feed back loop between USD-recycling and EURUSD is that USD selling could come to a sudden stop against the background of sharp deterioration in market risk sentiment. Foreign safe-haven demand tended to pick up during bouts of risk aversion like the two sovereign bailouts in the euro zone in 2010 (Figure 6). This was supportive for USD (see also the EURUSD path in Figure 2).
Figure 5. Peripheral spreads to Germany (Feb 2010 = 100
170 160 150 140 130 120 110 100 90 80 1-Nov

Figure 6. Net foreign buying of US securities

16-Nov

1-Dec Spain

16-Dec

31-Dec

15-Jan Italy

30-Jan Ireland

14-Feb

Portugal

Sources: BoE, Citi

Sources: Reuters, Ecowin

EUR pluses and minuses

The big EUR pluses are the chronic global overhang of USD among reserve managers, the perception of a bias towards easing in US monetary policy, the lack of credibility of fiscal policy, and the perception that US policy is oriented to dollar weakness. Admittedly, these are hefty USD negatives and we expect them to dominate in the long term.

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February 24, 2011

In the shorter term, we think investors are overestimating the EURs resilience in the face of global supply shocks. Even in their absence, we still see significant risk that sovereign issues return to the front burner as significant differences become increasingly difficult to paper over. In the past, sovereign pressures have been correlated with German-US spreads moving in the USDs favor as well, as investors piled into German government bonds. Notwithstanding the price action, we still find it hard to sweep away sovereign issues, especially if private sector positions continue to creep up. Under a benign global outcome, we continue to see better currencies to buy than the EUR, and under a not-so-benign outcome, we expect that the run-up in risk aversion will be a significant EUR negative. At these prices we are not buyers.

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CitiFX Strategy

February 24, 2011

Global FX & Local Markets Strategy

G10
Steven Englander Greg Anderson Todd Elmer Valentin Marinov Osamu Takashima Andrew Cox Suzuki Issei Head of G10 Strategy G10 Strategy G10 Strategy G10 Strategy G10 Strategy G10 Strategy G10 Strategy 1-212-723-3211 1-212-723-1240 65-6328-2932 44-7986-1861 81-3-6270-9127 1-212-723-3809 81-3-6270-9114 steven.englander@citi.com gregory1.anderson@citi.com todd.elmer@citi.com valentin.marinov@citi.com osamu.takashima@citi.com andrew.cox@citi.com issei.suzuki@citi.com

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Wike Groenenberg Luis Costa Leon Myburgh Coura Fall Head of CEEMEA Strategy CEEMEA Strategy Sub-Sahara Strategy Sub-Sahara Analyst 44-20-7986-3287 44-20-7986-9757 27-11-944-1830 27-11-944-1889 wike.groenenberg@citi.com luis.costa@citi.com leon.myburgh@citi.com coura.fall@citi.com

Latin America
Dirk Willer Ram Bala Chandran Kenneth Lam Head of LATAM Strategy LATAM Strategy LATAM Analyst 1-212-723-1016 1-212-723-3081 1-212-723-3619 dirk.willer@citi.com ram.balachandran@citi.com kenneth1.lam@citi.com

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Patrick Perretgreen Albert Shaulun Leung Subodh Kumar Head of Asia Strategy Asia Strategy Asia Analyst 65-63282931 852-2501-2398 852-2501-2360 patrick.perretgreen@citi.com albert.shaulun.leung@citi.com subodh2.kumar@citi.com

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