GLOBAL FX STRATEGY
Prepared by Deutsche Bank AG
Foreign Exchange Research Department
Overview
(May 19, 2000) Since the beginning of 1999, the world's best performing currencies (currency change plus interest income) have been the Canadian Dollar, U.S. Dollar, and yen. The Canadian Dollar's superior performance owes largely to the fact that it started 1999 from a heavily oversold position versus the U.S. Dollar. The modest gains posted by the Canadian Dollar versus the U.S. Dollar from this oversold level since January 1999 have been sufficient to place the Canadian currency at the top of the global total return performance derby.
The yen comes in third place behind the Canadian Dollar and U.S. Dollar even though the yen actually gained ground on both currencies over the January 1999-May 2000 period. The reason for the yen's third place showing is that Japanese short-term interest rates averaged 500-600 basis points less than the U.S. short-term interest rates over much of this period. The yen's strength was not sufficient to make up for the negative carry incurred in holding onto a long yen/short dollar position. The continental European currencies have fared the worst in the total return performance derby in the past 16-17 months, with the Euro being the world's worst performing major currency.
Looking out over the next six to twelve months, we believe that the total return ranking of the world's major currencies will look very different from the performance ranking of the last 16-17 months. Based on our projected total returns for the world's major currencies, we believe that the European currencies will be among the better performing currencies, followed by the commodity-based currencies (Canadian Dollar, Australian Dollar, and New Zealand Dollar), with the U.S. Dollar and yen bringing up the rear.
There are several reasons why we believe the yen will be the world's worst performing currency in the next 6-12 months. To begin with, the yen is substantially overvalued on a PPP basis versus all the major currencies.
Second, the yen has exhibited a tendency to move sympathetically with the trend in the ratio of Japan's monetary base to the U.S. monetary base and this ratio has recently started moving in favor of a stronger dollar. U.S. monetary base growth has started to slow, in response to the Federal Reserve's recent tightening moves, while Japanese monetary base growth has recently picked up. To the extent that the Fed continues to press on the monetary brakes, this trend should continue to be a negative for the yen.
Another reason to be negative on the yen is the trend in the U.S./Japan real short-term interest-rate differential. The yen/U.S. Dollar exchange rate has exhibited a tendency to move sympathetically with the trend in the U.S./Japan real short-term yield spread. That spread looks set to move in favor of a stronger U.S. Dollar given the likelihood of a widening in U.S./Japan nominal short-term yield spreads as well as the prospect of an end to the deflationary price trend in Japan.
Other variables that closely track the trend in the yen/U.S. Dollar exchange rate are also turning yen negative. These include the trend in bank share prices, the trend in the OECD's leading indicator of the Japanese economy, and Japan's basic balance of payments. The basic balance is defined as the current-account balance plus net long-term capital flows. Japan's current-account surplus is now declining on a trend basis and Japan's long-term capital account posted its first net outflow (¥244 billion) in five months in March.
The trend in Japan's fiscal stance also bears close watching. Japan's fiscal stance has played a key role in influencing the path of Japanese GDP growth in recent years. The net stimulus of 1995-1996 played a major role in boosting GDP growth with roughly a one-year lag while the fiscal contraction of 1997 contributed to the Japanese economic downturn in 1998, again with roughly a one-year lag. The fiscal stimulus efforts of 1998-1999 helped boost GDP growth in 1999-2000, again with a one-year lag between stimulus and GDP growth. But with the Japanese fiscal stance now set to turn neutral this year and likely to turn contractionary in 2001, the prospects for Japanese GDP growth are not likely to be very bright in 2001-2002. If the market place looks ahead to the possibility of slower Japanese GDP growth in 2001-2002, the yen will likely lose ground to the dollar.
Finally, the importance of negative carry on long yen positions should not be ignored. As discussed above, even though the yen gained ground on the dollar over the 1999-2000 period, long yen positions have underperformed long U.S. Dollar positions because of the existence of significant negative carry.
There is a 712 basis-point spread between one-year Euro-dollar rates at 7.4% and one-year Euro-yen rates at a mere 0.28%. With the yen currently trading near ¥/US$ 109, and given that interest-rate cushion, the dollar would have to fall below the ¥/US$ 102 level before it would underperform the yen on a 12-month investment horizon. And since the economic fundamentals are leaning toward a weaker yen, we believe that the dollar's outperformance versus the yen could be sizeable in the next 6-12 months given the prospect of both dollar appreciation and positive carry on long U.S. Dollar positions.
Figure 1
Expectations Of U.S. & Euroland Growth In 2000 And The U.S. Dollar/Euro
Exchange Rate
(Consensus Economics Survey GDP Forecasts)
While the dollar is likely to do well versus the yen, we do not look for the dollar to fare as well against the other major currencies in the industrial world. The dollar has been trending higher against most major currencies in the past year as continued upward revisions in market expectations of U.S. economic growth prospects (see Figure 1) and U.S. short-term interest rates (see Figure 2) have given rise to a steady increase in the demand for dollars. However, we are concerned that the past year's extended dollar rally may now be a bit overdone.
Figure 2
Changing U.S. Interest-Rate Expectations And The U.S. Dollar/Euro Exchange
Rate
(Dec. 2000 Three-Month Euro-$ Futures Contract)
There are several reasons why we believe that the dollar appears overbought and therefore ripe for a downward move, principally against the continental European and commodity-based currencies. First, the dollar's rise has taken the U.S. currency into deeply overvalued territory against the Euro, Danish Krone, Swedish Krona, Norwegian Krone, Australian Dollar, New Zealand Dollar, and Canadian Dollar.
Second, bullish sentiment toward the dollar presently appears excessive. The latest surveys of market sentiment indicate that over 82% of polled analysts are presently bullish on the dollar, the highest such reading since August 1998. While high sentiment readings toward the dollar do not necessarily imply that a dollar decline is imminent, it does hoist a warning flag that the dollar could be vulnerable if sentiment suddenly shifts against the U.S. Dollar.
What could serve as a catalyst for a shift in sentiment against the dollar? As we saw in Figures 1 and 2, the dollar's rise in recent months has been driven in large part by significant upward revisions in market expectations regarding the U.S. economic and interest-rate outlook. Since strong U.S. economic activity spearheaded the dollar's advance in the past year, it will take signs of a moderation in U.S. growth to spearhead its decline.
Given the strong association between the U.S. economic outlook and the dollar's fortunes, if new developments were to come to surface that forced investors to lower their assessment of the U.S. economic and interest-rate outlook, sentiment toward the dollar could shift in an unfavorable direction. That, in turn, could lead to considerable downward pressure on the dollar, particularly against those currencies that it gained substantial ground on in the past year, such as the Euro.
Indeed, we believe that fundamental forces that could precipitate a reversal in dollar sentiment in the coming months are beginning to shift. A variety of economic and financial indicators in the U.S. are now warning of a moderation in U.S. growth in the next 6-12 months.
The trend in the OECD's leading indicator of the U.S. economy has lost considerable upside momentum in recent months and is now pointing to more moderate growth ahead. The U.S. yield curve slope (as measured by the spread between 10-year Treasury bond yields and three-month T-bill rates) has flattened considerably in recent months, portending a moderation in U.S. growth later this year and into 2001. Real M2 growth, traditionally a good leading indicator of U.S. economic growth, has slowed significantly in recent months. Nominal M2 growth has moderated while the CPI headline inflation rate has risen suggesting that U.S. GDP growth will moderate in the months ahead.
This same message is also being conveyed in the slowdown in the year-over-year percent change in the Wilshire 5000 stock-market index as well as in the trend in the NAPM Composite index of business sentiment. Finally, credit spreads have traditionally been good leading indicators of U.S. growth prospects with wider spreads often anticipating future slowdowns in U.S. growth. Swap spreads, Baa corporate/Aaa corporate bond yield spreads, and Baa corporate/Treasury bond yield spreads have all widened significantly in recent weeks, hinting at a possible moderation in U.S. growth in the coming months.
Assuming U.S. GDP growth slows and the U.S./European growth differential narrows, the Euro would stand to benefit, especially since the Euro now appears to be heavily oversold and undervalued.
Figure 3
Medium-Term Cycles In The Deutschemark/U.S. Dollar Exchange Rate
(Peaks & Troughs--1987-2000)
The Euro clearly appears ripe for a rebound. Based on our medium-term cycle work, the current cycle of dollar strength versus the old Deutschemark is both longer in duration and larger in magnitude than the median length and magnitude of previous Deutschemark/U.S. Dollar exchange-rate cycles (see Figure 3). Assuming that a new medium-term cycle of dollar weakness sets in, we would look for a minimum objective of DM/US$ 1.95, which would represent a 25 pfennig decline in the exchange rate from the DM/US$ 2.20-2.21 high set on May 4th. A decline in the dollar to DM/US$ 1.95 would be consistent with a rebound in the Euro's value to US$/e 1.00-1.01.
Figure 4
U.S. Dollar/Euro Exchange Rate
At this juncture, we would view such a rally in the Euro as a mid-course correction in what still appears to be a long-term downtrend in the Euro's value (see Figure 4). We are not at all convinced that a Euro rebound over the next six months would represent the beginning of a new secular uptrend in the Euro's value. While it is true that the dollar is significantly overvalued on a PPP basis versus the Euro and that the U.S. suffers from an uncomfortably wide current-account deficit, the overall thrust of U.S. fiscal and monetary policies should remain generally dollar supportive in 2000-2001.
Michael R. Rosenberg
U.S. Dollar
This week, the Fed raised both the Fed funds and discount rate by 50 basis points to 6.50% and 6.00%, respectively. The Fed also attached a statement to the rate hike warning of upside inflation risks. Based on the continued strength in the U.S. economy, surely more tightening will be necessary. The key question for investors is how much higher do rates have to go in order to slow economic growth to a sustainable pace?
A nominal GDP/Fed funds rule provides us with a rough answer. By definition, nominal GDP is comprised of real GDP growth plus the rate of inflation. If we assume that potential real GDP growth is 4% and the Fed is targeting inflation of 2%, then the equilibrium (or sustainable) rate of nominal GDP growth is 6%. Unfortunately, nominal GDP growth has been accelerating over the last year, reaching 6.8% in the first quarter, which is indicative of excessive economic growth. And it appears that this fast trend has continued in the current quarter, evidenced by big gains in April employment and industrial-production growth, and a new low in the unemployment rate.
According to the GDP/Fed funds rule, in order for monetary policy to be considered restrictive, the level of the Fed funds rate has to rise above the growth rate in nominal GDP. Since the early 1980s, whenever nominal GDP growth exceeded the Fed funds rate, nominal GDP growth either accelerated or stayed strong, with the converse being true during periods of slow economic growth.
The reasons for this are simple. The Fed funds rate can be thought of as the borrowing rate for the economy. Thus when the economy is growing faster than the cost of borrowing, monetary policy can be considered accommodative of strong economic activity, as is the case right now. It is only when the cost of borrowing exceeds the growth rate in the economy that monetary policy can be considered restrictive and we can expect the economy to slow.
U.S. Bond Market Trends
For example, during the Fed's last meaningful tightening cycle between 1994-1995, it was not until the Fed funds rate surpassed nominal GDP growth in Q1 1995 that nominal GDP growth declined sharply, inflation pressures dissipated, and the Fed stopped tightening. Unhappily for fixed-income investors, the current trend in nominal GDP growth of close to 7% is likely to be maintained for the foreseeable future. That implies that the Fed funds rate has to go to at least that level if not higher in order to brake economic activity. Expect a 7% Fed funds rate sometime this year, with the risk that it is a bit higher.
Joseph A. LaVorgna
May 19, 2000 Deutsche Bank AG Foreign Exchange Research Department 31 West 52nd Street, New York, New York 212-469-2761