G10 Annual Outlook

CitiFX® Value Added Services & Products
CitiFX® G10 FX Strategy 2011 Outlook

Introduction: Small still better in a world of suspect sovereign debt p.2
Sovereign debt will be a major theme in 2011. Again. However, the focus will likely shift from the
euro zone, where the issues are well known, well debated, and well priced in, to other G4 countries
which have so far been given a relatively easy ride in currency markets despite their poor underlying
fiscal conditions.
Portfolio Update p.3

We stick with our medium-term view that the euro and risk-correlated currencies will outperform. Our
new trades are essentially long Scandis against a mixture of G4. We expect to enter into broader
risk-correlated trades in coming months.
Reserves – China as the tip of the reserves iceberg p.6

China’s reserve accumulation and external surplus receives a disproportionate share of attention.
The bigger issue is the larger set of countries 1) whose aggregate reserves are larger than China’s
and growing just as fast; 2) whose exchange rates have moved just as little as China’s and 4) who
likely are as concerned about the quality of their reserve portfolios and diversification alternatives.
Sovereign strains to impact more than just the EUR p.10

Fiscal conditions in the US, Japan and UK have been largely ignored in currency markets recently.
In contrast those of the euro area are well discussed and well priced in. We highlight the risk that
currency markets lose fiscal patience beyond euro are peripherals.
EUR tail risk to diminish in 2011 p.13

Easing peripheral tensions on the back of sovereign bailouts or ECB measures should help EUR
recover, perhaps not immediately but as 2011 progresses and the consequences of failure become
clear to policymakers.
Risk appetite = capital inflows = commodity currency gains p.17

The biggest surprise in 2011 may be the ease with which AUD, NZD, and CAD overcome recent
resistance and the magnitude of the subsequent gains. Tactically, we believe this argues for
maintaining long exposure, with any AUD and NZD spot dip providing an opportunity to build
medium-term longs.
Beginning the end of JPY appreciation p.20

We expect continued USDJPY strength based on reduced Japanese exporter hedging flows and
increasing unhedged foreign bond purchases by institutional investors.
Structuring: Pro Risk trades for 2011 p.22

The five trades that stand to benefit from a normalization of risk appetites.
Quantitative Investor Solutions: Valuation – The Long Term Perspective p.24

We review mis-valuations from the end of 2009 and subsequent currency moves over 2010. We also
look at the latest mis-valuation signals and their implications for currency direction in 2011.
Market Commentary
CitiFX® Strategy December 3, 2010
Small still better in a world of suspect sovereign debt

Steven Englander
+1 212 723 3211
steven.englander@citi.com
The unifying theme below is that sovereign debt will be a major theme in 2011. However, the focus will
likely shift from the euro zone, where the issues are well known, well debated, and well priced in, to other
G4 countries which have so far been given a relatively easy ride in currency markets despite their poor
underlying fiscal conditions. These fiscal concerns will augment concerns among reserve managers that
remain very long USD relative to global portfolio benchmarks and remain very long USD relative to the
underlying risk and return attached to USD assets. It is unlikely that reserve managers will admire the
profile of risk and return that they see in on other G4 currencies even if some buying is inevitable as they
try to limit their accumulation of USD.
Our first note focuses on the pattern of reserves accumulation and diversification. It argues that there has
been too much focus on China and not enough on the extent to which other major EM reserve managers
have essentially tracked China in their reserves paths. We find that in periods when reserves
diversification intensifies, the major beneficiaries by far tend to be smaller G10 currencies, perhaps
because marginal diversification has more impact on less liquid currencies. We look for them to
outperform.
Our next two notes take a closer look at how G10 currencies will interact with sovereign debt concerns.
Our concern is that the fiscal numbers in the US, Japan, and UK are considerably worse than in smaller
G10 countries. These fiscal issues are no secret but are also not priced into G4 currencies. At this stage
we feel that the risk over 2011 is that the tail risk now priced into the EUR decreases and that tail risk
emerges more concretely in other G10 currencies.
The theme that ‘small is better’ is reiterated in our discussion of commodity currencies. We are less
focused on terms of trade than on the attractiveness of their asset markets. Along with our Strategy and
Economics colleagues, we expect global asset markets to be reasonably supportive and do not anticipate
a major economic disruption. Combined with the G4 sovereign concerns discussed above, this is a formula
for ongoing strength, especially if EM capital controls reduce diversification options.
Our view on JPY is that 2010 price moves reflect catching up of exporters to their hedging needs and
portfolio investors introducing hedges to their USD bond positions. In our view USDJPY probably hit the
bottom this year, although it will take a while for gains to be marked.
The biggest risks:
1. Near-term jumpiness with respect to the EUR and overall risk appetite until euro sovereign concerns
stabilize.
2. US economic rebound sufficient to significantly raise the attractiveness of US fixed income assets.
3. A financial market ‘event’ that returns us back into the post-Lehman world.
4. A much worse than expected inflation/output tradeoff in EM economies.
None of these risks are trivial but it is also clear that policy makers do not want to wander into double-dip
territory. A major sovereign event in Europe would probably unwind risk appetite globally, but this risk is
well known. The possibility of a major upside surprise in the US – 2011 becomes 1983 or 2003 – remains
the major risk in both FX and (probably) FI markets. In EM it is not clear what inflation/growth trade-offs are
and how willing policymakers are to risk a significant slowdown. It is clear that an unexpected EM
slowdown will unwind the commodity producers and capital goods exporters.
In our overlay portfolio (Page 3) we maintain the basic long risk positioning but overall reduce slightly in
line with our concern that markets are not fully past their recent round of risk aversion. The trades that we
introduce in our tactical portfolio (Page 4) reflect the 'small is good' themes above. We also see anomalies
in recent moves in implied volatility (highlighted on Page 21) that can be exploited. Our WERM model
(Page 23) reminds us of valuation concerns but SEK again stands out as attractive,
Market Commentary
2 December 2010
2
Portfolio Update
Portfolio slightly down since our last update Wednesday, 24 November
Risk rebound of recent days has pushed cumulative returns back into positive territory
Trimming risk slightly by cutting long CAD by 10% and long GBP by 5%; cutting USD short
by 10% and CHF short by 5%
Paring back risk exposure

Stabilization in risk appetite over the past two sessions has seen our portfolio move back into positive
territory following sharp losses in previous trade. This rebound not withstanding, we would readily admit
that we initially underestimated the impact of the flare-up in the euro area’s sovereign debt crisis as we
were too optimistic on potential for an early policy solution. As market strains have become less fiscally
driven and motivated more by fears on a banking and liquidity crisis, we likewise underestimated the fallout
on other risky assets. Approaching the end of the year, this leaves our portfolio cumulatively up about
0.7% since inception in the beginning of May.
Since we are cautious that this episode of risk aversion is not over, we choose now to reduce risk
exposure. We reduce our long CAD position by 10% and our GBP position by 5%. We offset these
portfolio shifts by reducing our USD and CHF shorts by 10% and 5% (we are however introducing a long
GBP exposure into our tactical portfolio, albeit with a tight stop.). This leaves exposure for CAD and GBP
at 10% and 5% respectively, and the net USD and CHF shorts at -15% each. This should leave the
portfolio better positioned if risk aversion rises in the closing weeks of trade for 2010.
We stick with our medium-term view that the euro and risk-correlated currencies will outperform. It is not
clear to us that European authorities will implement a systemic back stop quick enough in the weeks
ahead. We are more confident about two-month upside than two-week upside but do not want to severely
cut positions when most of the damage has been done.
A further implication of our cautious view on risk appetite in the near term is that USDJPY may extend its
recent rally. Prevailing wisdom is that JPY should strengthen during periods of risk aversion, but the yen
has actually been positively correlated with risk appetite recently. This evolution in the relationship
between JPY and risk supports the view that positioning is now significantly short USDJPY. This view is
corroborated by our hedge fund positioning indicator which has been rising recently. With hedge funds
buying JPY into the recent rally at relatively unattractive levels, even a modest further spot up move could
see positions flushed out fueling USD appreciation. We view a higher USDJPY as the most
underappreciated risk stemming from the ongoing bout of risk aversion, so we leave our JPY short
unchanged.
Figure 1. G10 FX Portfolio – Current Weightings, Figure 2. G10 FX Portfolio – Cumulative

Deviation from Baseline (Labels Denote Chgs) Performance, Pct
30 2.50%
2.00%
20 1.50%
‐10 1.00%
10 ‐5 0.50%
0.00%
0 -0.50%
-1.00%
-10 -1.50%
-2.00%
-20 +5 -2.50%
-3.00%
-30 +10
6-May-10 3-Jun-10 1-Jul-10 29-Jul- 26-Aug- 23-Sep- 21-Oct- 18-Nov-
USD EUR JPY GBP CHF NOK SEK AUD NZD CAD 10 10 10 10 10
Source: Citi, as of 09 Sept 2010 Source: Citi, as of 09 Sept 2010
Market Commentary
2 December 2010
3
Tactical Portfolio update
We expect to be scaling into trades suggested by our themes in coming weeks but not all at once. It
seems unlikely that the complete intersection of our best ideas and the best market opportunities will be
the first week of December. We are introducing three new trades. The first is a short JPY long NOK
position in spot (ref. spot 13.7578). This reflects our analysis of how currencies trade off reserves
diversification. We see considerable upside, considering that the cross was above 16 in March and has
averaged 17.35 the last five years. We allocate 4% of our risk budget, so effectively we have a stop just
below the 2010 low of 12.30.
Our second trade is a 1-year basket option of equally weighted long SEK and NOK and short EUR and
GBP (reference spots of SEK, NOK and GBP vs. EUR are 9.1256, 8.0391 and 0.8474). This reflects our
buying of fiscal rectitude and selling of fiscal pressures. The ATM spot costs 3.30% of notional, and we
allocate 3% of our risk budget. Our last new trade is long GBP, short USD (ref: spot 1.5608) – the UK
ranks second highest on our economic surprise index (next to Sweden) and stands to gain sharply in any
risk-on environment. We have a roughly 2% stop loss at 1.5296 and allocate 2% of our capital to the trade,
which we consider a shorter term trade to capture a bounce in risk appetite.
Market Commentary
2 December 2010
4
Figure 3. Macro Discretionary Tactical Trade Idea Portfolio as of 12pm (New York), 02 December 2010
Percent of FX Trade Instrument Stop-LossCost Present Weekly P&L YTD P&L Notional Weekly P&L YTD P&L Entry Expiry
potential rate(s) Objective Description Strategy % of re-sale % of % of % of % of Date Date
V@R Notional value Notional Notional PotV@R PotV@R
NEW TRADES SECTION
2% EURUSD short spot one-touch lose 18.25% 3.00% -15.25% -15.25% $ 11 -1.67% -1.67% 1-Dec 8-Dec
entry ref: EURUSD put premium .
1.2985 strike 1.2550
3% NOK&SEK long basket option lose 3.30% 3.19% -0.11% -0.11% $ 91 -0.10% -0.10% 1-Dec-10 1-Dec-11
EUR&GBP Scandis equal weighted premium
entry ref: atms
EURNOK 8.04 EURSEK 9.13
EURGBP 0.8474
3% NOKJPY long spot long NOK trailing stop 0.00% 0.00% 0.00% 0.00% $ 100 0.00% 0.00% 2-Dec
entry ref: spot trade loss at
13.76 target 15.50 13.35
3% GBPUSD long spot long GBP trailing stop 0.00% 0.00% 0.00% 0.00% $ 152 0.00% 0.00% 2-Dec
1.56 target 1.62 1.53
PRE-EXISTING TRADES STILL IN PLAY
3% USDJPY long spot Digital USD lose 19.90% 22.00% -0.96% 2.10% $ 15 -0.14% 0.32% 10-Nov 17-Dec-10
entry ref: long vol call: strike at premium
82.58 85.00
1% AUDUSD long spot worst of call lose 0.99% 0.50% -0.27% -0.49% $ 101 -0.49% -0.49% 11-Nov 11-Nov-11
entry 9984 long vol on AUDUSD premium
USDJPY short corr and USDJPY
entry 8250 atm spot both
85% USD holding unused limit NA NA NA 0.00% NA NA 0.00% NA NA NA
TRADES CLOSED IN THE LAST WEEK
10% EURGBP short vol, DNT, triggers lose 36.00% 0.00% -19.95% -36.00% $ 28 -5.54% -10.00% 4-Nov 30-Nov-10
entry ref: range bet 0.9036 premium
0.8722 0.8387
3% GBPUSD long spot long-GBP trailing stop 0.00% -0.91% -0.88% -0.91% $ 331 -2.97% -3.00% 24-Nov 26-Nov-10
1.5786 target 1.62 1.5643
Weekly P&L YTD P&L

TOTALS FOR NEW TRADES AND TRADES STILL IN PLAY -2.41% -1.95%
TOTALS FOR TRADES CLOSED THIS WEEK -8.51% -13.00%
TOTALS FOR PREVIOUSLY CLOSED TRADES 7.20%
GRAND TOTAL -10.92% -7.75%
Source: Citi, as of 02 December 2010
Market Commentary
2 December 2010
5
Reserves – China as the tip of the reserves iceberg

China and the next 15 largest reserve portfolios control USD 6 trillion of
Steven Englander
+1 212 723 3211
reserves, 2/3rds of total global reserves.
steven.englander@citi.com
This USD 6 trillion of reserves move together and the reserve managers
Andrew Cox likely face the same macro forces and share the same incentives.
+1 212 723 3809
andrew.cox@citi.com NOK, SEK, and NZD are the strongest performers in periods of
diversification driven USD selling.
China’s reserve accumulation and external surplus receives a disproportionate share of attention from both
politicians and investors. To be sure, China’s reserve portfolio of USD2.6trn is the largest single country
portfolio (two and a half times the size of Japan, the next largest reserve holder), so this focus is
understandable. Nevertheless, the bigger issue is that there is a much broader set of countries 1) whose
reserves are in aggregate larger than China’s; 2) whose reserves are growing just as fast as China’s; 3)
whose exchange rates have moved just as little as China’s and 4) whose concerns about the quality of
their portfolios are just as profound.
Overall there are USD6trn of reserves that move together: China’s USD2.6trn and the USD3.3trn of the
next 15 largest accumulators (Figures 1 and 2). Our view is that if the reserves move together, the
accumulation is probably driven by the same macro forces and the reserve managers will probably
respond similarly to similar incentives and market conditions. (The next 15 largest EM reserve portfolios
are: Russia, Saudi Arabia, Taiwan, South Korea, Brazil, Hong Kong, India, Singapore, Thailand, Algeria,
Mexico, Malaysia, Libya, Poland and Turkey. When we discuss the 16 largest EM reserve managers we
are including China.)
The next 15 largest reserve asset managers are accumulating reserves at a growth rate of 10-15% per
year. At present, the annual increase in reserves is probably somewhat higher than the annual increase in
GDP, so the ratio of reserves to GDP will go up for some time. We do not think this reserve accumulation
is voluntary, as it is heavily concentrated in periods of USD weakness, when the private sector is off-
loading USD assets and the global reserve mangers reluctantly step in to fill in the gap.
In the medium to long term, we think the trade based on this reluctant reserve buying is to short USD
against more attractive G10 currencies, including but not limited to commodity currencies and EUR. Right
now it seems highly probable that the reserve managers are holding back their selling of USD, as the
private sector buys back their USD shorts, in the anticipation that they will be able to sell USD at more
attractive levels.
Figure 1. China and the next largest 15 reserve Figure 2. ...and portfolios are growing together.
managers control USD 6 trillion in assets….
3,500
Next 15 EM 60%
3,000 50%
China
2,500 40%
China
2,000 30%
G10
1,500 20%
1,000 10%
Next 15 EM
500 0%
ROW
-10%
0
Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul
Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul
04 04 05 05 06 06 07 07 08 08 09 09 10 10
03 03 04 04 05 05 06 06 07 07 08 08 09 09 10 10
Source: Bloomberg, Citi Source:: Bloomberg, Citi
Market Commentary
2 December 2010
6
Our EM Strategy colleagues expect the owners of the USD6trn of reserves to appreciate somewhat more
rapidly against the USD in the medium term but not to show a step jump versus past trends. The next most
likely alternative is status quo --ongoing accumulation of, and diversification out of, USD reserves.
However, even if there is an accelerated rate of appreciation of EM currencies against USD, the initial
reaction will be for reserve accumulation to accelerate and for reserve managers to continue to buy G10, in
an effort to diversify out of USD.
Let us assume that a more accelerated pace means that reserve managers decide against shock therapy,
(we would see shock therapy as a quick double digit move), but decide to phase in currency appreciation
over a period of years. The appreciation will not be quick enough to introduce two way risk into the market
any time soon, but may be large enough to convince investors to keep buying EM assets in the
expectation that further appreciation will be coming.
Until the appreciation has actually progressed some distance towards the equilibrium, the pace of reserves
accumulation may actually increase, and the need to diversify along with it. This will be uncomfortable for
the US, uncomfortable for the reserves managers, and uncomfortable for other G10 currencies that once
again will be the degree of freedom in the equation. For reasons discussed below, we like long NOKJPY
as the best expression of this diversification trade.
Four distinct sets of reserve managers
Reserve managers are divided into four groups – China, the next 15 largest EM reserve portfolios, G10,
and the rest of the world. China and the next 15 largest reserve managers have very similar patterns of
accumulation. China’s reserve portfolio currently contains USD 2.65 trillion, around 30% of global
reserves. Although reserve accumulation has slowed in recent years, assets grew by 16.5% over the last
12 months. The combined reserve portfolios of the next 15 largest reserve managers with USD 3.3 trillion
in assets, is larger than China’s reserve portfolio, growing in a similar manner, and accounts for almost
40% of global reserve assets.
Similar currency inertia
The CNY is subject to considerable official direction. The currencies belonging to other major reserve
managers do not have the same obvious day-to-day determination by officials but they have not moved
any more than the CNY over longer periods of time. This is true whether the exchange rates are nominal,
real, equally weighted, or weighted by reserve size (Figures 3, 4). While there are periods during which
these currencies move more rapidly, there is no dramatic trend move. While it is tempting to use the real
exchange rates (which have moved roughly in line with CNY over most of the last decade), there is some
question as to whether CPI corrections to nominal exchange rates give anything but very rough corrections
for price level moves. If anything we would argue that the currencies of the next 15 largest reserve asset
managers may have moved even less than CNY, but they certainly not moved significantly more.
On a nominal basis, G10 currencies have appreciated by a significant amount against the USD relative to
China and the next largest 15 reserve managers (Figure 5). However, on a real exchange rate basis, the
Figure 3. Relative inertia on a nominal basis… Figure 4. ...and on a real exchange rate basis.
130 135
Next 15 (Reserve Weighted) Next 15 (Reserve Weighted)
125 Next 15 (Equal Weighted) 130

Next 15 (Equal Weights)
CNY
CNY
125
120
120
115
115
110
110
105
105
100
100
95 95
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Source: Ecowin, Citi Source: Ecowin, Citi
Market Commentary
2 December 2010
7
three exchange rates – G10 currencies, China, and the currencies of the next 15 largest reserve managers
– have essentially appreciated by the same amount against the USD over the last 8 years (Figure 6).
Again, the real exchange adjustment, driven by somewhat higher EM inflation rates, provides results that
mitigate somewhat the implications of the nominal analysis.
Figure 5. G10 appreciation on a nominal basis… Figure 6. ...but not on a real exchange rate basis.
140 135
Next 15 EM Next 15 EM
135 CNY CNY
130
G10 G10
130
125
125
120
120
115
115
110
110
105
105
100 100
95 95
Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Source: Ecowin, Citi Source: Ecowin, Citi
Current accounts in the eye of the beholder

This next group of fifteen have broadly similar current account moves to that of China (Figure 7). Their
surpluses move in parallel with China’s but on a somewhat lower path. This similarity can only be taken a
certain distance because most of the increase comes from the oil producers in the group. If we take out
these producers, there is not much trend on the current account side.
If a country is accumulating reserves while running a significant current account surplus, the presumption
is that the exchange rate is undervalued. If a country is in current account balance, accumulates reserves
and has limited exchange rate appreciation, then intervention may be viewed as offsetting capital inflows.
Sweden has had a current account surplus for some time. For much of this period it was depreciating
because of capital outflows. Over the last year, SEK has had a strong appreciation path, presumably
because outflows have slowed or reversed. Our point is that there is no presumption that countries with
current account surpluses, like Sweden, will appreciate, or that countries with current account deficits, like
Australia, will depreciate.
The fact that non-commodity exporters have modest current account surpluses and rapidly rising reserves
suggests that their authorities are mitigating the impact of capital inflows, either to prevent currency
appreciation or because they believe the inflows will have some other deleterious asset market impact.
The cost of preventing appreciation
Over the past eight years, the 16 largest EM reserve managers have together accumulated USD 4.9 trillion
in reserves. On a monthly basis, this is approximately the equivalent of USD 50 billion per month, of which
USD30 bn is probably USD, and the rest other currencies. The most generous interpretation is that this
has led to G10 currencies to appreciate by about 10% more against the USD than has CNY and about
20% more than the next 15 currencies. G10 currencies tend to appreciate against reserve manager
currencies when reserve accumulation is most rapid (Figure 8), suggesting that USD pressure on EM does
tend to be diverted into G10, on a relatively high frequency basis.
However, it can also be argued that the sterilization was imperfect and may have contributed to higher
inflation among the reserve managers – the interventions may have achieved nominal stability but had a
more modest net impact on real exchange rates.
Market Commentary
2 December 2010
8
Figure 7. Current Account surpluses moving in Figure 8. Pace of monthly reserve accumulation
parallel prevents EM appreciation relative to G10 currencies
200
1.16
180
1.14
160
1.12 140
U S D B illio n s
1.10 120
100
1.08
80
1.06
60
1.04
40
1.02 20
1.00 0
Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul- Jan- Jul-
03 03 04 04 05 05 06 06 07 07 08 08 09 09 10 10
Monthly Reserve Accumulation (RHS) G10/Next 15 (LHS)
Source: Ecowin, Citi Source:: Bloomberg, Citi
What’s the trade?

In periods when reserves are accumulating rapidly and appear to reflect diversification efforts, the
strongest performers among G10 currencies are NOK, SEK, and NZD. We measure this by defining a
diversification driven selling episode as a period when the USD has dropped and our reserves
accumulators have increased reserves (adjusted for valuation effects) over the prior two months. Buying
NOK, SEK or NZD over the subsequent two months leads both to high absolute returns and very high
returns relative to the a ‘sell-always’ strategy. Interestingly, periods of yen appreciation are concentrated in
periods of relatively modest reserves growth probably because JPY is not a big target of reserve managers
and JPY appreciation is concentrated primarily in periods of risk aversion, when USD selling is not a
priority. We therefore propose going long NOKJPY on the view that reserves diversification will be a big
theme next year.
Figure 9. Selling USDSEK according to trading rule Figure 10. Buying NZDUSD according to trading rule
outperforms always selling USDSEK outperforms always buying NZDUSD
45 60
40
Sell USDSEK according to trading rule 50 Buy NZDUSD according to trading rule
35
Sell USDSEK Always Buy NZDUSD Always
40
30
25 30
Returns (%)
Returns (%)
20
20
15
10 10
5
0
0
-10
-5
-10 -20
2003 2004 2005 2006 2007 2008 2009 2010 2003 2004 2005 2006 2007 2008 2009 2010
Market Commentary
2 December 2010
9
Sovereign strains to impact more than just the EUR

Greg Anderson The 4 major reserve currencies all have shaky fiscal footing
+1 212 723 1240
greg.anderson@citi.com The other G10 currencies have much better sovereign situations
One of the open questions for 2011 is whether the UK, Japan or even the
US could experience a sovereign ‘attack’ like EUR has endured this year
If sovereign strains become an FX theme for the other G10 currencies
(besides EUR), look for the commodity currencies to outperform
This year will go down as a year driven by three primary themes: sovereign strains, monetary policy
differences and the speed-of-recovery differential between the reserve currency countries and the rest of
the world. Two of those themes (growth differentials and monetary policy differences) are normal FX
drivers and would be put near the top of the list of drivers for each of the last 20 years, not just 2010.
Having sovereign credit issues rate so highly among the drivers of major currencies is something that
hasn’t occurred for decades. Given the debts and deficits of the past three years, it may well remain a key
theme in 2011 and potentially for many years to come.
The 2010 focus of sovereign angst was all on Europe, but there is potential for the focus to broaden.
Within the G10 currencies, the countries can be grouped roughly in two groups: (1) small and fiscally fit, (2)
large and fiscally challenged. It is interesting to note that the four reserve currencies {USD, EUR, GPB,
JPY} all have extensive fiscal fitness problems while the rest do not. One of the open questions for 2011 is
whether ratings agencies will downgrade US, Japanese or ‘core’ euro area debt. A related open question
is whether central bank reserve managers will accelerate a shift out of the big 4 currencies in to the fiscally
fit group, even without ratings downgrades.
When evaluating the fiscal fitness of sovereign countries, the most commonly evaluated indicators are the
current fiscal balance and the existing debt level. Figures 1 and 2 look at the G10 currencies (except the
euro area) on both those fronts. In both pictures, Norway is an outlier, with the government running a large
fiscal surplus and holding a net creditor position. Sweden’s central government has also evolved in to a
net creditor position over the past five years, while Australia and New Zealand have essentially zero net
government debt. All four countries are running modest fiscal deficits in 2010, but have structural deficits
small enough to prevent a rise in their debt ratios. Canada (29%) and Switzerland (39%) have higher
Debt-to-GDP ratios, but their ratios have declined in the past five years and are small when compared to
those of the US, UK and Japan.
Figure 1. Net Debt-to-GDP ratios in 2004 and 2009 for Figure 2. Estimated 2010 fiscal balance as a
G10 currencies (except euro area) percentage of GDP
15.0%
150%
2004 2009
125%
100% 10.0%
75%
50% 5.0%
25%
0% 0.0%
-25%
-50%
-5.0%
-75%
-100%
-10.0%
-125%
-150%
Australia Canada Japan New Norway Sweden Switzerland UK USA -15.0%
Zealand Australia Canada Japan New Norway Sweden Switzerland UK USA
Zealand
Source: IMF Source: OECD
Market Commentary
2 December 2010
10
According to IMF data and definitions, the UK’s net debt-to-GDP ratio widened from 36% in 2004 to 61% in
2009. The OECD estimates that the UK will finish 2010 with a fiscal deficit of 8.2% of GDP, so the net
debt ratio is likely to deteriorate to around 65%. In absolute level terms, 65% is not terribly alarming, but
the trend was bad enough that S&P gave the UK’s AAA sovereign rating a negative outlook (see Figure 3).
Japan similarly has a negative outlook to its AA rating after also running an estimated 8.2% fiscal deficit in
2010. Given Japan’s estimated net debt-to-GDP ratio of 112% at the end of 2009 and its weak nominal
GDP growth, the ratio should end 2010 just shy of 120%, which is by far the worst of the G10 and only
slightly behind Greece’s net debt ratio.
Figure 3. S&P sovereign ratings and outlook for those ratings for G10 currencies
Local Currency Local Currency Local Currency Foreign Currency Foreign Currency Foreign Currency Transfer Risk
Long-Term Rating Outlook Short-Term Rating Long-Term Rating Outlook Short-Term Rating Rating
Australia AAA Stable A-1+ AAA Stable A-1+ AAA
Canada AAA Stable A-1+ AAA Stable A-1+ AAA
Germany AAA Stable A-1+ AAA Stable A-1+ AAA
Japan AA Negative A-1+ AA Negative A-1+ AAA
New Zealand AAA Stable A-1+ AA+ Stable A-1+ AAA
Norway AAA Stable A-1+ AAA Stable A-1+ AAA
Sweden AAA Stable A-1+ AAA Stable A-1+ AAA
Switzerland AAA Stable A-1+ AAA Stable A-1+ AAA
UK AAA Negative A-1+ AAA Negative A-1+ AAA
USA AAA Stable A-1+ AAA Stable A-1+ AAA
Source: Standard & Poor’s
The US has yet to face a ratings downgrade (or even a negative outlook warning) from any of the big 3
ratings agencies, although a Chinese ratings agency downgraded it in October. Given its deficit of the past
three years, including an estimated deficit of 10.7% in 2010, it is not hard to see why the Chinese rating
agency downgraded the US. To its credit, the US has a history of being able to rein in deficits and reduce
its debt burden, having done so impressively after WWII and to a lesser extent in the late 1990s through
2001. Over the last five years, however, the deficit has widened dramatically. The net deficit-to-GDP ratio
(using the IMF’s definition and data) widened from 42% in 2004 to 59% in 2009 and will likely end 2010
around 65%. Using the US government’s own data and definitions for gross debt, the widening is even
more dramatic, going from 63% in 2005 to 94% at the end of the US’s fiscal year in October 2010. All the
G10 countries face fiscal challenges from a retiring baby boom generation, but the US’s case seems
particularly worrisome because of the lack of political agreement on how to address the problem and the
apparent lack of willingness to make necessary compromises. Two different plans (Bipartisan Policy
Center or Rivlin/Domenici and president’s commission or Simpson/Bowles) have been released in the past
month, but both have been roundly criticized as unacceptable by both major political parties, with
Republicans resisting net tax increases and Democrats resisting cuts to social spending. Achieving
consensus and compromise ahead of the 2012 presidential election appears extremely unlikely at present.
In this article, we have admittedly ignored various subtle nuances to debt-to-GDP and fiscal-balance-to-
GDP ratios. Moreover, they are not the only indicators used to evaluate sovereign creditworthiness. For
example, an argument that is frequently made in support of Japan is that its debt problem is not as severe
as the statistics make it seem because of low interest rates and its large domestic savings pool. Similarly,
the argument is often made that the US’s debt is not as problematic as the numbers make it appear
because the majority of its debt is in domestic currency and most of the goods the US imports are priced in
US dollars. Both arguments have merit, as shown in Figures 4 and 5, but are often overstated.
Figure 4 shows that low interest rates do in fact keep the sovereign interest burden of Japan’s debt below
the interest burdens of the United Kingdom or the United States. However, Japan still ranks third on the
sovereign-interest-burden list and its burden is steadily increasing. It was only 1.03% of GDP in 2004, but
rose to 1.17% for 2009, even though interest rates were broadly lower in 2009. By contrast, the US’s
sovereign interest burden shrank from 1.90% in 2004 to 1.70% in 2009 due to the decline in US interest
rates during that period.
Market Commentary
2 December 2010
11
Figure 4. Central government net interest cost Figure 5. Net external debt (government + business +
(revenue) as a share of GDP household) in number of months worth of exports
2.50% 200
2004 2009
2.00% 180
1.50% 160
1.00% 140
0.50% 120
0.00% 100
-0.50% 80
-1.00% 60
-1.50% 40
-2.00% 20
-2.50% 0
Australia Canada Japan Norway Sweden UK USA Australia Canada Japan Norway Sweden Switzerland UK USA
Source: IMF Source: CIA World Factbook
Figure 5 shows the net external debt of the G10 currency host countries (except the euro area), as
reported in the CIA World Factbook. Net external debt includes private business and household debt, so it
is not exclusively a measure of sovereign indebtedness. Rather, it measures how much is owed to foreign
counterparts, with the implication being that high foreign indebtedness is riskier than high domestic
indebtedness because a depreciation of the domestic currency can cause the external debt burden to
spiral out of control. External debt is normally scaled by nominal GDP or by exports, since export
proceeds would presumably be the source of funds for repaying external debt in the event of a crisis.
Scaling by GDP shows the US with an ‘average’ external debt burden, but scaling by exports leaves the
US with the second highest external debt in the G10.
Trading conclusions
Although the euro was the focus of FX traders during the two periods in 2010 when the sovereign risk
theme drove markets, it is not the only currency with deep underlying fiscal sustainability issues. In the
case of the euro area, we have seen market pressures progress from credit to credit in what appears to be
a rotating ‘speculative attack’. That term is probably a misnomer because most of the spread widening is
probably more about risk management than speculation, but we will continue with the term ‘attack’
because of its descriptiveness. If the rotation of ‘attack’ continues, it is logical to think that credits outside
the euro area will also face pressure at some point. Within the G10, the logical next targets are clearly
GBP, JPY and USD. Only the order is debatable. Based on observations from Europe’s crises this year,
it’s likely that the country that appears to be doing the least to address its fiscal situation will be the first to
experience an ‘attack’, although the sheer size of the US might shield it from going first.
Another lesson from watching the sovereign strains that have pushed around EUR in 2010 is that it is very
difficult to predict either the trigger or timing of an ‘attack’ on a sovereign credit. However, it does seem
possible to catch the associated currency move in the early stages by paying careful attention to sovereign
pressures. We don’t advocate indiscriminate selling of USD, JPY or GBP right now, but we do believe
market participants should develop an itchy trigger finger and make it a habit to regularly check sovereign
CDS prices for those three (Bloomberg codes: US – CUSA1U5, UK - CUKT1U5, Japan – CJGB1U5).
If/when sovereign strains begin to pressure USD, GBP and JPY, the logical basket of counterpart
currencies are those with smaller debt burdens, most particularly AUD, CAD, NOK, NZD and SEK. Of
course this particular group of currencies (save SEK) is typically identified as the commodities basket and
the commodities currencies are arguably already quite strong relative to GBP and USD on the back of high
commodity prices. However, it is important to note that the excellent fiscal position of these countries does
not stem solely from the rise in commodity prices over the past decade; fiscal management has also been
much more prudent than in the G4. With that in mind, in the event that sovereign strains truly become a
driving factor for all the G10 currencies and not just EUR, the so-called commodity currencies could likely
appreciate much more than commodity prices alone might suggest.
For those with the flexibility to do so, one way to trade the sovereign story immediately would be to go long
the commodity currencies (plus SEK) against commodities. For those constrained to trading currencies,
going long the Scandinavian currencies against GBP and EUR is another. We show one such trade idea,
a European basket collar, in our Top Trades for 2011 section.
Market Commentary
2 December 2010
12
EUR tail risk to diminish in 2011

Valentin Marinov Euro area break-up is undesirable and unlikely. This tail risk should
+44 20 7986 1861 remain a drag on EUR as sovereign bailouts extend into 2011. The
valentin.marinov@citi.com
bailouts will remove the risk of immediate sovereign default and could
mute the impact of the break-up risk going forward.
We expect EUR to emerge a stronger currency from the current
sovereign debt crisis supported by closer euro zone integration.
Political intransigence may call for greater participation by the ECB.
Unconventional monetary policy measures will be seen as reluctant and
temporary, however, providing cyclical support for EURUSD.
For most of 2010 the fundamental story behind EUR, when investors were actually looking at it, was all
about sovereign credit risk. The escalation of the peripheral funding crisis in the summer and, most
recently, at the start of November were both associated with pronounced EUR weakness across the board.
Lingering tensions in the euro area periphery are likely to trigger bouts of EUR weakness in 2011 as well.
At the same time, periods of easing peripheral tensions on the back of sovereign bailouts or ECB
measures to ease peripheral tensions should help EUR recover. During such periods, investors will turn to
negatives associated with other majors like the Fed’s quantitative easing (in the case of USD) and the
impact of fiscal austerity on the UK economy (in the case of GBP).
Euro area break-up - undesirable and unlikely

Euro area break-up is undesirable and unlikely at this stage. A break-up will result in difficulties for both
euro area peripheral and core member states which are likely to outweigh any positives associated with it.
We do not subscribe to this view but it is worth going thought the arguments for it.
Under the most popular break-up scenario Greece, Ireland, Portugal and Spain will use their national
currencies and implement less restrictive monetary policy than the ECB as a way to economic recovery.
The argument is not without its merits. Such a US-style recovery for Greece, Spain and Portugal may be
preferable given the greater role that private consumption plays there (Figure 1). Weaker national
currencies combined with a temporary bout of high inflation would achieve both international
competitiveness and a sustainable recovery in domestic demand as real debt is wiped out.
Figure 1. The weakest peripherals also the ones with Figure 2. The weakest peripherals among the least
greater reliance on private consumption productive euro area members
2y yield spread to Germany (log scale)
2y yield spread to Germany (log scale)
7 7.00 Greece
6 Ireland Portugal Greece 6.00 Portugal Ireland
Italy Spain Spain Italy
5 5.00
Belgium Belgium
4 4.00
Austria Austria
3 France 3.00 France
2 Finland 2.00 Finland
1 Netherlands 1.00 Netherlands

0 Germ any 0.00 Germ any
45% 50% 55% 60% 65% 70% 75% 35% 55% 75% 95% 115%
Private consumption (% of GDP) Labor productivity relative to Germany
Source: Bloomberg, Citi, IMF Source:: Bloomberg, Citi, OECD
Market Commentary
2 December 2010
13
This looks attractive when contrasted with the recipe for growth which both the IMF and the core euro zone
government seem to be envisaging for the periphery. The recovery under this scenario will involve
excruciating real wage declines to boost competitiveness which will have to come at the cost of
deteriorating domestic demand (assuming current fiscal austerity plans remain in place). The introduction
of the EUR in 1999 was associated with pronounced losses in Greece, Portugal and Spain. Together with
Italy the three countries form the group of the least productive euro area member states (Figure 2). Real
wages may have to drop significantly to bring these countries’ productivity to the level of other euro zone
countries. As a result, the price of the adjustment could be potential further economic stagnation and/or
contraction as well as deflation.
There are two important economic risks to this scenario. First, the currency risk associated with the exit of
the euro area could be enormous. This could lead to escalating funding costs way before the economic
recovery has started. This in turn could fuel further currency depreciation which is likely to increase the
price of any (EUR-denominated) debt repayments even more.
The peripheral funding costs have been on a downtrend for most of the 1990s as economic convergence
and the prospect of euro adoption drove lower funding costs. As shown in Figure 3, the funding costs for
some peripherals have already picked up to reach levels last seen well before the euro introduction in
1999. However, this need not suggest that that there is fairly limited upside for peripheral funding costs in
the event of a euro area break-up. The period of the convergence was also a period in which the EU
currencies were locked into the ERM with their volatility confined to a very tight range of 2.5% above and
below a central parity. Upon leaving the euro are, the peripherals are not going to join a version of ERM of
sorts. Most likely, they would want complete currency flexibility vis-à-vis their trading partners in the EU. As
a result the amount of currency risks added on the top of peripherals already soaring funding costs could
be substantial.
Second, boosting domestic demand by inflating its way out of the economic slump may not be credible
enough for bond vigilantes and rating agencies alike. The restructuring of economies like Greece, Portugal
and Spain to rely more on exports and less on domestic consumption could take time and may not be
always credible. When Greece, Portugal and Spain joined the euro area, their funding costs declined
because they could ‘borrow’ credibility from the fiscal prudence of euro zone’s largest economy –
Germany. The stability and growth pact also seemed a (credible) mechanism to guarantee fiscal prudence.
The end result of a euro area exit for the peripheral member states could thus be excessive weakness (to
improve competitiveness and help rebalance the economy) and funding costs getting out of control
crippling their fragile economic recovery.
Figure 3. Funding costs for some peripheral euro area countries returned to pre-EUR levels
14
13 EUR introduced
12
11
10
9
8
7
6
5
4
3
Jan-93 Mar-95 May-97 Jul-99 Sep-01 Nov-03 Jan-06 Mar-08 May-10
Greece Ireland Portugal Spain Italy
Source: Citi, Bloomberg
Market Commentary
2 December 2010
14
A break-up of the euro zone is likely to have huge damaging consequences for the health of the euro zone
banking sector as a whole. In Figure 4 below, we show the high degree of interlinkages in the euro zone
banking sector. Euro area banks account for about 60% of the total exposure to the troubled euro area
peripherals. Exit from the euro area is going to affect the quality of the bank assets in Portugal, Spain and
Greece and hurt bank performance for extended period of time. Last but not least, the impact on euro zone
core member states like Germany through their export exposure to peripherals could be significant (Figure
5).
Figure 4. Bank exposure to peripherals concentrated Figure 5. The bulk of German exports still going to the
in the euro area EU/ the euro area
100% 70% 90.00
65%
80.00
80% 60%
70.00
55%
60%
50% 60.00
40% 45%
50.00
40%
20% 40.00
35%
30% 30.00
0% 1999-10 2001-12 2004-02 2006-04 2008-06 2010-08
Greece Ireland Portugal Spain
EU exports
Euro area exorts
Germany Spain France Italy Other EA UK ROW Total exports (rhs, EUR bn, 12m MA)
Source: BIS, Citi, as of March 2010 Source:: Deutsche Bundesbank, Citi, as of Sept 2010
Sovereign bailouts could help ease the negative impact of break-up risk on EUR
The euro area bailouts have so far replaced a certain bad outcome - sovereign default of Greece and
Ireland - with an uncertain and potentially positive outcome of fiscal and economic restructuring.
Importantly, on both occasions, the risk of sovereign default was seen as augmenting the risk of the
respective country leaving the euro and thus precipitating the euro area disintegration. The sovereign
bailouts could extend into 2011 with Portugal and Spain likely to remain under market pressure to request
financial help from the EU and the IMF. Any future bailouts should provide a temporary alternative to
sovereign default. Provided that they also bring down contagion in the euro zone periphery this should
mute the impact of the break-up tail risk on EUR going forward.
Admittedly, the ability of the sovereign bailouts to reduce contagion in the euro area is not given. For one,
longer-term solvency risks could linger even after the rescue package has been implemented. The impact
of sovereign risks need not be that pronounced, however, since a sovereign bailout sends a credible signal
about authorities’ commitment to tackle any underlying solvency issues as well. Recent evidence also
seems to suggest that investors tended to focus more on the near-term liquidity risks with contagion easing
once these are addressed.
Secondly, concerns about the success of the bailouts could grow and contagion could remain elevated if
real wage adjustment and fiscal austerity as part of the rescue packages lead to worse than expected
deterioration in euro area economic performance in 2011. The loss of credibility should materialize only
slowly, however, with evidence about their economic impact in the periphery to be offset by economic
resilience elsewhere in the euro area as global recovery continues.
Last but not least, the credibility of the bailouts hinges upon their ability to deal with potential escalation of
liquidity problems elsewhere in the euro area. The Irish bailout has used up about EUR 67 bn of the funds
available under the EFSF (about EUR 350 bn – less than the total of EUR 440 bn due to the 120%
collateral requirement) and the available IMF funding vehicle and the EFSM (totaling EUR 310 bn). Bailing
out Portugal and Spain could push the existing liquidity backstop facilities to their limit. EUR investors are
already questioning whether the remaining funds will be sufficient to bail out Portugal and Spain given the
uncertainty about their growth outlook and banking sector performance going forward. Unless the level of
commitment by the euro area core countries and/or the IMF is increased in coming months, the ECB may
Market Commentary
2 December 2010
15
be called upon to move in size on the peripheral markets. The ECB has been particularly concerned about
the impact of peripheral bond purchases on its inflation fighting credentials and the quality of its balance
sheet. Yet, we think that the ECB will act if needed to stabilize the peripheral bond markets.
The ability of the ECB to credibly distance itself from the bailouts in the periphery will determine the degree
of cyclical support EUR will receive in 2011. In Figures 6 and 7 we plot EURUSD against its key drivers
over the 2010 – peripheral risks (proxied by the 2y yield spread between Spain and Germany) and the
cyclical attractiveness of the cross (proxied by 2y yield spread between Germany and the US). EUR has
shown remarkable resilience during the latest bout of peripheral tensions. Indeed, while the Spain-
Germany spread reached new highs EURUSD was still trading above its summer lows. This is reflecting
the fact that the Germany-US spread trades well above its lows from the summer.
The ECB bond purchases so far amount to EUR 67 bn or less than 3% of the public debt for Ireland,
Greece, Spain and Portugal. This compares with USD 1.2 tn in US treasury purchases or about 17% of the
US coupon bearing debt under the current quantitative easing program by the Fed. Even if the ECB were
to participate more aggressively in peripheral bond purchases it is likely to do only very reluctantly and in
exchange of greater burden sharing by the core euro area member states. This will be different from the
pre-emptive unconventional monetary policy implemented by the Fed, the BoE and the BoJ to combat
economic slowdown. As a result, we think that the ECB will still be perceived as the most hawkish of the
major Central Banks going forward. This should continue to provide EUR with cyclical support for now.
EUR to emerge a stronger currency from the sovereign crisis

We think that EUR should remain supported in coming months with bouts of intensifying peripheral
pressures weighing only temporarily on the currency. While the tail risk of euro-area break up should
remain a drag on EUR series of sovereign bailouts could mitigate its impact on the currency. ECB’s
temporary and reluctant participation in peripheral bailouts should further provide EUR with cyclical support
against USD, GBP and JPY.
The current institutional set-up in the euro zone is partly to blame for the elevated EUR volatility of late. We
think, however, that the recent events could promote closer integration. A decisive move towards quasi
budgetary confederation using euro-area bonds may still seem fairly unlikely for now. However, we think
that calls for closer union will become more vocal in 2011 especially as the ECB remains a reluctant buyer
of peripheral bonds. EUR should eventually emerge a stronger currency from the sovereign debt crisis
supported by intensifying integration and stronger euro area institutions going forward.
Figure 6. EURUSD still trading well above levels Figure 7. EURUSD supported by still wide 2y
implied by 2y Spain-Germany yield spread Germany-US 2y rate differential
0.00 1.42
0.70 1.42
0.50 1.38
1.38
1.00 1.34
0.35 1.34
1.50 1.3
1.30
2.00 1.26
0.00 1.26
2.50 1.22
1.22
3.00 1.18
-0.35 1.18
1-May 31-May 30-Jun 30-Jul 29-Aug 28-Sep 28-Oct 27-Nov
1-May 31-May 30-Jun 30-Jul 29-Aug 28-Sep 28-Oct 27-Nov
Spain-German 2y yield spread (inv.) EURUSD (rhs) Germany-US 2y yield spread EURUSD (rhs)
Market Commentary
2 December 2010
16
Risk appetite = K inflows = commodity currency gains

Todd Elmer Commodity currency upside remains…
65-6328-2932
yodd.elmer@citi.com …driven by risk appetite and capital inflows.
PPP based overvaluation not a risk, except in global crisis.
Commodity currency strength may yet surprise
AUD, NZD and CAD have all struggled to maintain gains approaching round numbers recently. AUD and
CAD have been unable to stay above 1.00, while NZD has yet to push through 0.80. These currencies are
overvalued by some (mainly PPP based) measures and this price action has driven some speculation that
valuation is now acting as a more important constraint and that gains may be harder to come by moving
forward.
Commodity currencies have already come a long ways. They have been the strongest performing major
currencies since the recovery began in March 2009. Even with the recent spot pullback, AUD and NZD are
up over 50% vs. the USD, while CAD has gained nearly 27% (see Figure 1). The latest leg of the risk rally
from June ’10 has seen about a 19% appreciation by AUD, 15% by NZD and more than 7% from CAD.
The biggest surprise in 2011 may be the ease with which they surpass these round numbers and the
magnitude of subsequent gains. Although, we would not argue that these currencies will match the
performance of the past two years in the coming two years. Tactically, we believe this argues for
maintaining long exposure, with the AUD and NZD spot dip approaching the end of this year providing an
opportunity to build medium-term longs.
The best alternatives to USD
The perception that the commodity currencies are overvalued often comes down to the view that this
appreciation appears to be outpacing actual movements in the commodity terms of trade. AUD has now
moved beyond its peaks from before the onset of the crisis, while NZD and CAD are trading only
moderately shy of their highs. By comparison, Citi’s (real-time) terms of trade indices for AUD, NZD and
CAD all stand well beneath their peaks from 2008 (see Figure 2). If currency appreciation is outpacing
underlying moves in commodity prices, it stands to reason that the potential boost from increases in
exports could prove more moderate than expected.
Figure 1. Pct Chg vs. USD Figure 2. Citi Commodity Terms of Trade (Weekly)
60 60 AUD
Since Mar '09 NZD
Since Jun '10 50 CAD
50
40
30
40
20
30
10
0
20
-10
10 -20
12/31/99 12/31/01 12/31/03 12/31/05 12/31/07 12/31/09
0
AUD NZD SEK CAD CHF NOK JPY GBP EUR
Sources: Bloomberg Sources: Bloomberg
Market Commentary
2 December 2010
17
However, this line of thinking greatly overemphasizes the impact from trade flows and underemphasizes
that from capital flows. Note that the correlation between moves in commodity currencies and commodity-
bloc exports looks weak relative to that between the currencies and global asset prices (see Figures 3 and
4). In particular, exports from the commodity producers did not rebound until late 2009, when currency
appreciation was already well underway.
This demonstrates that during periods of rising risk appetite and gaining asset prices, the commodity
currencies tend to benefit from inflows. The fact that AUD, CAD and NZD have appreciated by more than
other ‘risky’ currencies suggests that they are in fact the most attractive alternative to USD.
We doubt that the factors which contribute to this attractiveness are going to change in the quarters ahead.
First, very easy monetary policy in the G3 and tight links to quick growing emerging markets remain in
place. Second, they benefit from relatively robust domestic conditions. Third, interest rates are high relative
to their peers and they should rise further.
Indeed, investors are likely underestimating the scope for potential interest rate rises in Australia and
Canada (this may be less true in NZ). The expansive liquidity afforded by easy monetary policy among the
G3 is feeding overheating in domestic asset markets in these smaller economies, which is likely to demand
a policy response even if policymakers are somewhat uncomfortable with positive fallout on the exchange
rate. Policymakers simply cannot target all three variables at once (domestic asset markets, interest rates
and the exchange rates) and may be forced to accept some degree of currency appreciation.
There appears to be particular upside for Canadian interest rate expectations. Proximity to the US and
disappointment from Canadian economic indicators previously contributed to lag from Canadian yields, but
they have begun to turn higher over the past two weeks. Partly this reflects improvement in Canadian data
th
flow, with our Economic Surprise Index (ESI) for Canada rising sharply. Since hitting a low on October 8 ,
the Canadian ESI has jumped more than 55 pts, making it the second strongest performing country over
this period behind NZ. With markets only pricing in slightly more than 50 bps of tightening in the year
ahead there should be further breathing room rises upon an extension of this trend.
This likely presents opportunities in relative value space. While broad swings in risk appetite and asset
prices appear to play a more important role in driving the commodity currencies vs. the USD (as opposed
to idiosyncratic factors), moves on the crosses have been well correlated with those from interest rate
spreads. Following the sustained uptrend in AUDCAD, the recent turn in interest rate spreads looks to
have marked a peak (see Figure 5). We suspect there is further room for CAD catch-up with AUD
appreciation in the months ahead, although a broad USD decline will probably generate upward pressure.
Figure 3. USD vs CAD, AUD and NZD and Canadian, Figure 4. USD vs CAD, AUD and NZD and SPX, YoY
Australian and NZ Exports, YoY Pct Chg Pct Chg
USD vs CAD, AUD and NZD (LHS)
50 -40
40 Canadian, Australian and NZ -30

Exports, Avg YoY Chg (RHS,
Reversed)
30 -20
20 -10
Percent
Percent
10 0
0 10
-10 20
-20 30
-30 40
2005:01:00 2006:04:00 2007:07:00 2008:10:00 2010:01:00
Sources: Ecowin Sources: Ecowin
Market Commentary
2 December 2010
18
Positioning unlikely to alter trend
Of course, these positive factors are widely recognized and have contributed to a build-up of long
positioning among investors. IMM data still shows a significant long position in the commodity currencies
among speculators despite some recent position paring (see Figure 6). Since speculators shifted to an
overall net short USD position in July, longs in the commodity currencies have accounted for, on average,
about 50% of total positions. This vastly outweighs the commodity currencies share of global capital
markets and turnover in foreign exchange. This likely means that there is risk for temporary pullbacks as
positions are flushed out upon bouts of risk aversion.
Still, we doubt that this is would mark a change in the trend. Note that according to the IMM data there
have been three flush-outs over the past year that have seen more than a 50% correction in positioning.
However, in each of these instances more than half the correction was reversed in less than a month (on
average three weeks). While it is not clear that this pattern of relatively quick reversals will repeat itself in
the future, it does show that the flush-outs themselves are not strong deterrents to investors rebuilding
positions during periods of rising risk appetite. Intuitively, this makes sense since periodic bouts of risk
aversion have done little to alter positive fundamentals for the commodity currencies.
Similarly the correlation between moves in the commodity currencies and those from global asset prices
has remained consistently strong. The fact that there has been little deterioration in this relationship
suggests that positioning is not as of yet contributing to reduced sensitivity during periods of rising risk
appetite.
Furthermore, a component of commodity currency buying appears to be more ‘structural’ and could be less
dependent on short-term price action than is the case with hedge fund flows. Inward cross-border M&A
activity in Canada and Australia looks to be picking up following a fallow period in the immediate aftermath
of the crisis and the commodity currencies appear to be key beneficiaries of the trend towards
diversification of official reserves portfolios. Indeed, according to the IMF’s latest COFER data, reserves
managers are increasingly favoring ‘other currencies’ (probably accounted for to a large degree by AUD,
CAD and SEK). In Q2, reserves managers bought about USD21bn in other currencies. While this is below
USD and EUR accumulation, other currencies only represent about 4% of reserve holdings, so their
roughly 20% share of incremental buying is significant. Given more limited liquidity, even a small amount of
diversification can have a large impact.
Figure 5. AUDCAD vs. 2yr Spread Figure 6. CAD, AUD and NZD – IMM Net Speculative
Longs, Contracts
200000
150000
100000
50000
-50000
Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10
Sources: Ecowin Sources: Ecowin
Market Commentary
2 December 2010
19
Beginning the end of JPY appreciation

Osamu Takashima
+81-3-6270-9127 Exporters will hedge at a normal pace, thereby discouraging further
osamu.takashima@citi.com speculative buying of JPY
Issei Suzuki Given the decline of USDJPY to near historical lows, we expect long-term
+81-3-6270-9114 investors will begin reducing hedges and making new foreign bond
issei.suzuki@citi.com purchases unhedged
Four reasons to believe it is the beginning of the end of JPY appreciation:
1. Exporter flows suggest that USDJPY will continue to climb for the rest of the fiscal year ending
in March 2011.
We believe that over the last 6 months, one of the primary drivers of the USDJPY decline was the massive
amount of USD hedging by Japanese exporters. As USDJPY marched lower, exporters left sell orders
above the market, but constant selling pressure from speculators left the hedge orders unfilled.
Speculators became aware of the unfilled sell orders, so they sold further and a vicious circle was formed.
This circle pushed USDJPY close to its historical low just below 80.
We believe that exporters sold most of their USD exposure when USDJPY rebounded to levels around 82
and that exporters are now mostly finished hedging for the remainder of the fiscal year. They are no
longer underhedged and thus will not begin to sell USD again until February when they decide on internal
budget rates for fiscal year 2011.
Additionally, we believe that exporters have already lowered their internal rates to the 80 to 85 range,
which we believe is a very conservative view for the fiscal year. Further, we expect that manufacturers will
reduce production levels in Japan after the JPY’s massive appreciation. And unlike this year, we expect
exporters will maintain more of a programmed approach to hedging, which should help prevent another
vicious circle from being created by their orders and USD selling flows.
2. Institutional investors may take increased FX risk in bond portfolios

Most Japanese institutional investors, such as life insurance funds, regularly purchase US Treasuries.
When the interest differential is small because US rates are low, they hedge their FX risk with short-dated
forwards. At the beginning of a US rate hike cycle, USD selling hedges will not increase significantly in
cost, at least not to the level at which investors will be particularly concerned. Such should be the case in
2011. However, when US rates (and USD hedging costs) increase, US bond investments with FX hedges
will be less attractive to Japanese investors. In addition to choosing not to hedge the FX risk of new bond
purchases, we expect that investors will unwind hedges on existing US bond investments. The unwinding
of hedges causes a large amount of USD buying, which would firmly cement a bottom in USDJPY.
We expect that institutional investors, especially life insurance funds, may reconsider their US bond
investment strategies. Now that USDJPY has declined to near historical lows, foreign bond investments
without FX hedges may be very attractive, particularly if the FOMC signals earlier rate hikes than markets
expect.
Market Commentary
2 December 2010
20
3. Limited downside risk from FOMC rate hikes
From a historical perspective, the FOMC rate hike decisions are very influential on USDJPY. Admittedly,
in the past there has typically an 8 month lag between the first FOMC rate hike and the bottom in USDJPY
(Figure 1). The reason for the decline in USDJPY at the beginning of the FOMC rate hike cycle is the fact
that more than 80% of portfolio investment flows into the US are bond investment flows. At the beginning
of the rate hike cycle, bond investors may be concerned about increasing US rates and inclined to reduce
exposure to US Treasuries. This would result in downward pressure on the USD. Given the low absolute
level of US short term interest rates, speculators will not be eager to buy USD to enter JPY carry trades,
and offset the outflows from bond investors. However, in this case, it appears the cycle has been brought
forward for a couple of reasons. First is the extraordinary amount of FX hedging that Japanese
institutional investors undertook. Even if they reduce US bond holdings in 2011 due to rising bond yields,
Japanese institutional investors won’t be net sellers of USDJPY because they will be buying back hedges.
Second, even though we don’t expect the FOMC to hike rates in 2011, we do expect signaling to begin.
The Fed will begin to reduce USD liquidity, which will push speculators away from seeking funding in USD
and back toward funding in JPY.
4. Valuation model suggest 80 will be the bottom

From a valuation perspective, our best purchasing power parity model has the bottom in USDJPY at
around 80. Our model uses a shadow exchange rate derived from the average of Producer Price Index
(PPI) and export price index. As shown in Figure 2, the shadow exchange rate from our model has
marked the bottom of USDJPY over the past 10 years. With US and Japanese inflation rates moving
closer to convergence, the downward crawl of our shadow exchange rate should flatten. We believe that
the 80 level will prove to be the bottom at this time being. As for year 2011, we believe that USD will be in
the appreciation cycle and the upper limit could be around the level of 90. Once USDJPY bottoms, it often
climbs 10 big figures.
Conclusion
The market has been discounting the probability of a double-dip recession for the US but this risk is
diminishing. We expect that USDJPY will continue to rise as US interest rates continue to increase and
speculators exit long JPY positions. We believe that USDJPY may rebound to as high as about 90
between now and the 2nd quarter of 2011. After Q2, we do not expect USDJPY to decline again and
believe that USDJPY will continue along a gradual upward trajectory.
Figure 1. US Monetary Policy and USD/JPY Figure 2. USDJPY PPI Valuation Model
12 170
US monetary policy and USD/JPY
375
160 USD/JPY Purchasing Power Parity
350 (Apr.1973 base)
10 Average time lag is 8 months
150 325
300
140
8 275
130 250
USDJPY
225
FF%
USD/JPY
6 9 months 120
200
110
4 months 175
4
100 150 CPI Base 135
8 months
125 PPI Base 105
90
2 100
14 months 80 75 Mid-line 80
7 months
50 Export Price
0 70
Base 55
Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 25
Source : Bloomberg[01(03)] FF USD/JPY [Rhs] Jan-71 Jan-76 Jan-81 Jan-86 Jan-91 Jan-96 Jan-01 Jan-06
Souece : BLS, BOJ, IMF[01(01)] USD/JPY ①CPI ②PPI ③Export Price MidLine of ②③
Source: BLS, BoJ, IMF, Citi Source: Bloomberg; Citi
Market Commentary
2 December 2010
21
FX Structuring – 2011 Pro Risk Trades

Mark Balascak Current risk aversion environment has created vol opportunities in
1-212-723-1113 relative value and term structure
mark.balascak@citi.com
Trades below are well positioned to benefit from risk normalization and
Joe Hedberg declining volatility
1-212-723-1456
joseph.hedberg@citi.com Expect appreciation of commodity currencies and JPY to return as a
funding source
Trade Idea 1
Short AUDJPY 6-month implied vol in 1-year’s time FVA at 20.00%
o Current 6-month implied is 17.5%
o The FVA takes advantage of the steep vol curve which is currently at a 4.5 vol difference between 1-
month and 1-year.
o Realized vol has been below 15% for the past three months which is causing pressure on the front end
of the vol curve while a good deal of risk premium remains in the longer end creating the steep curve.
o In a pro risk environment this should weigh on vols going forward
o Even if the current vol term structure remains static this trade will look attractive however over time the
current or even lower realized vol levels should eventually weigh on implieds
o Leading up to 2007, while the market was very pro risk, 6-month AUDJPY implieds were below 10%,
implieds may not reach that level over the next year but it gives an idea where implieds have been
when markets were positive and carry trades were popular
Trade Idea 2
Long a 1-year "Worst Of" atm spot AUD call USD put vs. USD call JPY put
Price: 0.89% of USD notional (level on spots of .9680 and 84.20)
o "Worst Of" gives excellent leverage compared to the vanillas which cost 4.02% for AUDUSD and
4.78% for the USJPY
o The structure is short/long the USD which creates a significant correlation benefit resulting in the large
discount
o Currently the implied correlation is positive, 25% in 1-month and 15% in the 1-year, however longer
term, the mean of the realized is closer to -17% since 2006.
o The trade is essentially bullish AUDJPY through the USD legs, the AUDJPY vanilla option would cost
4.45%
Trade Idea 3
Long a 1-year EURCHF 1.2450/1.4425 DNT at 25%, spot ref 1.3125
o 1-year EURCHF implieds are at the 99%ile relative to the past four years
o Range is short vol and pro risk environment should see these vols decline
o Lower barrier is below the year’s low in spot
o This trade could also be done as a relative value trade vs. USDCHF as this relationship is at the
100%ile. The spread is at -1.75 vols on the mids while the four year mean is -5.6 vols
o Other variations are short a vol/var swap however the range may appeal as an asset side trade.
Market Commentary
2 December 2010
22
Trade Idea 4
Long a 1-year USDJPY 85.00/92.00 USD call spread with 96.00 KI on liability, net cost 2.73% on 84.20
spot ref.
o Fits the overall bullish USDJPY perspective
o The short 92.00 call knocks in at 96.00 which is above the year’s high
o Only costs slightly more than the vanilla spread yet gives possible additional appreciation of nearly four
yen if barrier is not touched
o Cheap way to play USD appreciation
o Risk reversal is very low for USD downside which gives a relatively high vol for the short topside strike
Trade Idea 5
Short 1Y USDNOK delta-neutral straddle at 16.00% vol, Long 1Y USDCAD delta-neutral straddle at
12.25% vol
o This trade takes in 3.75 vols.
o The vol spread is at the 96%ile versus the past four years.
o Only observations higher than the current spread were briefly during the crisis of 2008 (See graph
below)
o Previous spikes in this spread mean reverted rapidly
o Spread traded flat last May
o While taking in the large spread between two USD/Commodity pairs, the short pair vol is one of the
highest quality sovereign credits in the world (10% budget surplus).
o In addition to this spread being at extremes, the USDCAD vol is relatively cheap (27%ile over the
previous year) and USDNOK vol is relatively expensive (90%ile over the previous year)
USDNOK Vol 1Y - USDCAD Vol 1Y spread
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
-1.00
-2.00
-3.00
11/30/2006
2/28/2007
5/30/2007
8/30/2007
11/30/2007
2/29/2008
5/30/2008
8/30/2008
11/30/2008
2/28/2009
5/30/2009
8/30/2009
11/30/2009
2/28/2010
5/30/2010
8/30/2010
11/30/2010
Source: CitiFX
Market Commentary
2 December 2010
23
Valuation – the Long Term Perspective

Pierre-Alexandre Noual, PhD Convergence trades based on WERM fair values remained
+1 212 723 3508 successful in 2010, although with more volatility and less direction
pierrealexandre.noual@citi.com than in 2009. G10 currencies began the year with smaller mis-
Kristjan Kasikov valuations gaps compared to 2009, providing less potential for
+44 20 7986 3032 convergence trades.
kristjan.kasikov@citi.com
The USD, which used to be overvalued vs. most other G10
currencies, now trades closer to fair value. Some currencies have
become overvalued vs. the USD, most significantly the NZD and to a
slightly lesser extent, the AUD. Despite having closed some of the
valuation gaps, GBP and SEK remain undervalued vs. the USD.
The World Exchange Rate Model (WERM) is Citi’s fair value model for currencies. It explains fluctuations
in real exchange rates based on the relative prices of non-tradable and tradable goods, net foreign assets
and commodity terms of trade. The results of the model are updated quarterly. The most recent update
was published in the FX&LM Strategy Weekly of September 09, 2010.
The output of the WERM provides a long-term anchor for exchange rates. The fair values from the model
do not dictate where currencies should trade, but provide guidance on which levels of exchange rates are
consistent with fundamentals. In practice, currencies may deviate strongly from fair values, based on
various short-term factors that are not captured by the model.
While deviations from fair value can persist for an average cycle of around 5 years, large valuation gaps
can provide useful information on future currency direction. For instance, recent research at CitiFX has
shown that relative mis-valuations beyond 10% are a useful trading signal (see June 2010 QIS In-Focus,
“A Hybrid Trading Model Using Fair Value Convergence and Carry Trade Strategies”).
In this article we review mis-valuations from the end of 2009 and subsequent currency moves over 2010.
We also look at the latest mis-valuation signals and their implications for currency direction in 2011.
Figure 1 tracks mis-valuations of exchange rates vs. USD from the time of our previous update, published
in January (CitiFX Global Strategy 2010 Outlook). At the end of 2009, the SEK, GBP, AUD, CAD and NOK
were the most mis-valued, all of them trading at a 12% to 18% discount vs the USD. Over 2010, all these
currencies appreciated vs. the USD, thereby reducing or even reversing the mis-valuation gap. In fact, the
mis-valuation in AUDUSD is now roughly as large as it was one year ago, but with the opposite sign. While
less overvalued than the NZD, the AUD is now deemed expensive according to WERM.
Figure 1. Mis-valuations in G10 FX vs. USD since 2009 Figure 2. Spot moves in 2010 vs mis-valuation at the
(2010 Q2 column compares spot on 1-Dec-10 to latest end of 2009 – all 45 G10 crosses
fair values, which are based on data up to 2010 Q2)
25% 20%
20% Spot Change over 2010
15%
15%
10% 10%
5% y = -0.0997x - 0.015
5%
0% R2 = 0.0146
-5% 0%
-10%
-5%
-15%
-20% -10%
EUR JPY GBP CHF NOK SEK AUD NZD CAD -15%
-20%
Misvaluation, 2009 Q3 update (published Dec. 2009)
-25%
2009q3 2009q4 2010q1 2010q2
-20% -10% 0% 10% 20% 30%
Source: Citi, Sample: 31-Dec-09 – 01-Dec-10 Source: Citi, Sample: 31-Dec-09 – 01-Dec-10
Market Commentary
2 December 2010
24
Figure 1 also shows that other major currencies EUR, JPY, and CHF have traded relatively close to fair
value. Despite the large moves we have seen in EURUSD and USDJPY, these pairs were never further
than 5% from our WERM estimates on any recent quarter-end.
While 2009 saw strong performance of fair value trades, convergence moves in 2010 were smaller and
less consistent. We find that 26 of 45 individual G10 crosses traded in the opposite direction to their end-
2009 mis-valuation in 2010, closing on average 10% of the original valuation gap (see Figure 2). This
compares to 30 crosses moving in the direction of fair value over the course of 2009.
Figure 3. Mis-valuations of individual currency pairs as of 1-Dec-10
Bilateral Misvaluations among G10 currency pairs

Term currency
USD EUR JPY GBP CHF SEK NOK AUD NZD CAD
USD 4% -4% 11% -4% 8% 6% -15% -21% 2%
EUR -4% -8% 7% -8% 4% 2% -19% -25% -2%
JPY 4% 8% 15% 0% 12% 10% -11% -17% 5%
Base currency
GBP -11% -7% -15% -15% -3% -5% -26% -32% -9%
CHF 4% 8% 0% 15% 12% 10% -11% -17% 6%
SEK -8% -4% -12% 3% -12% -2% -23% -28% -6%
NOK -6% -2% -10% 5% -10% 2% -21% -27% -4%
AUD 15% 19% 11% 26% 11% 23% 21% -6% 17%
NZD 21% 25% 17% 32% 17% 28% 27% 6% 22%
CAD -2% 2% -5% 9% -6% 6% 4% -17% -22%
Bilateral Misvaluations among G10 currency pairs, relative to realized volatility (annualized since Jan-2010)
Term currency
USD EUR JPY GBP CHF SEK NOK AUD NZD CAD
USD 0.32 -0.36 1.11 -0.39 0.53 0.42 -1.00 -1.42 0.14
EUR -0.32 -0.49 0.77 -0.90 0.50 0.25 -1.51 -2.04 -0.19
JPY 0.36 0.49 0.99 -0.02 0.60 0.52 -0.54 -0.86 0.29
Base currency
GBP -1.11 -0.77 -0.99 -1.46 -0.29 -0.48 -2.01 -2.60 -0.84
CHF 0.39 0.90 0.02 1.46 1.03 0.90 -0.77 -1.23 0.45
SEK -0.53 -0.50 -0.60 0.29 -1.03 -0.28 -2.15 -2.50 -0.56
NOK -0.42 -0.25 -0.52 0.48 -0.90 0.28 -2.21 -2.62 -0.42
AUD 1.00 1.51 0.54 2.01 0.77 2.15 2.21 -0.73 1.95
NZD 1.42 2.04 0.86 2.60 1.23 2.50 2.62 0.73 2.15
CAD -0.14 0.19 -0.29 0.84 -0.45 0.56 0.42 -1.95 -2.15
Source: Citi, Sample: 1 December 2010
Figure 3 shows that with the exception of GBP, SEK, AUD and NZD crosses, most G10 currency pairs
trade close to fair value. The main points of interest for long-term investors and hedgers are:
• Irrespective of their base currency, investors should consider hedging exposures to AUD and NZD.
The current over-valuation of these currencies exceeds one-year realised volatility in most crosses.
• Conversely, New Zealand and Australian investors should consider reducing hedge ratios. The NZD
is overvalued by more than 20% vs. all other G10 currencies except CHF (17%) and AUD. The AUD
also trades at double-digit premium in against most other currencies.
• Exposures to assets denominated in GBP or SEK can be left unhedged as these currencies remain
somewhat cheap, especially for investors with USD, JPY and CHF bases. UK and Swedish investors
should consider hedging their overseas exposures.
• There is no strong reason for Euro-Zone investors to depart from their hedge benchmarks as the
EUR is not far from fair value, particularly in EURUSD, which trades close to equilibrium. Japanese
investors also have little incentive to modify their hedge ratios as the WERM suggests that the strong
Yen is fairly valued.
• Canadian investors should consider putting on hedges against other commodity currencies except
the NOK.
• Swiss investors should consider leaving GBP and EUR exposures unhedged.
Market Commentary
2 December 2010
25
Global FX & Local Markets Strategy
G10
Steven Englander Head of G10 Strategy 1-212-723-3211 steven.englander@citi.com
Greg Anderson G10 Strategy 1-212-723-1240 gregory1.anderson@citi.com
Todd Elmer G10 Strategy 65-6328-2932 todd.elmer@citi.com
Valentin Marinov G10 Strategy 44-7986-1861 valentin.marinov@citi.com
Osamu Takashima G10 Strategy 81-3-6270-9127 osamu.takashima@citi.com
Andrew Cox G10 Strategy 1-212-723-3809 andrew.cox@citi.com
Suzuki Issei G10 Strategy 81-3-6270-9114 issei.suzuki@citi.com
CEEMEA
Wike Groenenberg Head of CEEMEA Strategy 44-20-7986-3287 wike.groenenberg@citi.com
Luis Costa CEEMEA Strategy 44-20-7986-9757 luis.costa@citi.com
Leon Myburgh Sub-Sahara Strategy 27-11-944-1830 leon.myburgh@citi.com
Coura Fall Sub-Sahara Analyst 27-11-944-1889 coura.fall@citi.com
Latin America
Dirk Willer Head of LATAM Strategy 1-212-723-1016 dirk.willer@citi.com
Ram Bala Chandran LATAM Analyst 1-212-723-3081 ram.balachandran@citi.com
Kenneth Lam LATAM Analyst 1-212-723-3619 kenneth1.lam@citi.com
Asia
Patrick Perretgreen Head of Asia Strategy 65-6328—2931 patrick.perretgreen@citi.com
Albert Shaulun Leung Asia Strategy 852-2501-2398 albert.shaulun.leung@citi.com
Subodh Kumar Asia Analyst 852-2501-2360 subodh2.kumar@citi.com
CitiFX® Value Added Services & Products – Group Heads
Global Head of Value Added Services & Products

Arnold Miyamoto New York 1-212-723-1380 arnold.miyamoto@citi.com
Corporate Solutions Group

Stephane Knauf London 44-20-7986-9486 stephane.knauf@citi.com
FX Technicals
Tom Fitzpatrick New York 1-212-723-1344 thomas.fitzpatrick@citi.com
Policy Strategy
Tom Glaessner New York 1-212-816-9896 thomas.glaessner@citi.com
Quantitative Investor Solutions

Jessica James London 44-20-7986-1592 jessica.james@citi.com
Structuring Group
Stephane Knauf New York 1-212-723-1274 stephane.knauf@citi.com
Value Added Products

Philip Brass London 44-20-7986-1614 philip.brass@citi.com
Nicolas Thomet Zurich 41-58-750-7646 nicolas.thomet@citi.com
Market Commentary
2 December 2010
26
Disclaimer
This communication is issued by a member of the sales and trading department of Citigroup Global Markets Inc. or one of its affiliates (collectively, “Citi”). Sales and trading
department personnel are not research analysts, and the information in this communication (“Communication”) is not intended to constitute “research” as that term is defined by
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Market Commentary
2 December 2010
27

G10 Annual Outlook

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CitiFX® Value Added Services & Products

CitiFX® G10 FX Strategy 2011 Outlook

 Portfolio Update p.3

 Reserves – China as the tip of the reserves iceberg p.6

 Sovereign strains to impact more than just the EUR p.10

 EUR tail risk to diminish in 2011 p.13

 Risk appetite = capital inflows = commodity currency gains p.17

 Beginning the end of JPY appreciation p.20

 Structuring: Pro Risk trades for 2011 p.22

 Quantitative Investor Solutions: Valuation – The Long Term Perspective p.24

Small still better in a world of suspect sovereign debt

Paring back risk exposure

Figure 1. G10 FX Portfolio – Current Weightings, Figure 2. G10 FX Portfolio – Cumulative

Source: Citi, as of 09 Sept 2010 Source: Citi, as of 09 Sept 2010

PRE-EXISTING TRADES STILL IN PLAY

85% USD holding unused limit NA NA NA 0.00% NA NA 0.00% NA NA NA

TRADES CLOSED IN THE LAST WEEK

Weekly P&L YTD P&L

TOTALS FOR TRADES CLOSED THIS WEEK -8.51% -13.00%

TOTALS FOR PREVIOUSLY CLOSED TRADES 7.20%

GRAND TOTAL -10.92% -7.75%

Source: Citi, as of 02 December 2010

Reserves – China as the tip of the reserves iceberg

Source: Bloomberg, Citi Source:: Bloomberg, Citi

125 Next 15 (Equal Weighted) 130

Source: Ecowin, Citi Source: Ecowin, Citi

Source: Ecowin, Citi Source: Ecowin, Citi

Current accounts in the eye of the beholder

Monthly Reserve Accumulation (RHS) G10/Next 15 (LHS)

Source: Ecowin, Citi Source:: Bloomberg, Citi

What’s the trade?

Source: Bloomberg, Citi Source:: Bloomberg, Citi

Sovereign strains to impact more than just the EUR

Source: IMF Source: OECD

Source: Standard & Poor’s

Source: IMF Source: CIA World Factbook

EUR tail risk to diminish in 2011

Euro area break-up - undesirable and unlikely

2 Finland 2.00 Finland

1 Netherlands 1.00 Netherlands

Source: Bloomberg, Citi, IMF Source:: Bloomberg, Citi, OECD

Greece Ireland Portugal Spain Italy

Source: Citi, Bloomberg

100% 70% 90.00

EUR to emerge a stronger currency from the sovereign crisis

Source: Bloomberg, Citi Source:: Bloomberg, Citi

Risk appetite = K inflows = commodity currency gains

Sources: Bloomberg Sources: Bloomberg

40 Canadian, Australian and NZ -30

Sources: Ecowin Sources: Ecowin

Sources: Ecowin Sources: Ecowin

Beginning the end of JPY appreciation

Four reasons to believe it is the beginning of the end of JPY appreciation:

2. Institutional investors may take increased FX risk in bond portfolios

4. Valuation model suggest 80 will be the bottom

Source: BLS, BoJ, IMF, Citi Source: Bloomberg; Citi

FX Structuring – 2011 Pro Risk Trades

USDNOK Vol 1Y - USDCAD Vol 1Y spread

Valuation – the Long Term Perspective

Figure 3. Mis-valuations of individual currency pairs as of 1-Dec-10

Bilateral Misvaluations among G10 currency pairs

CitiFX® Value Added Services & Products – Group Heads

Global Head of Value Added Services & Products

Portfolio Update p.3

Reserves – China as the tip of the reserves iceberg p.6

Sovereign strains to impact more than just the EUR p.10

EUR tail risk to diminish in 2011 p.13

Risk appetite = capital inflows = commodity currency gains p.17

Beginning the end of JPY appreciation p.20

Structuring: Pro Risk trades for 2011 p.22

Quantitative Investor Solutions: Valuation – The Long Term Perspective p.24