PRUDENTIAL SECURITIES, INC.
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212-776-1000(March 13, 2000) CURRENCIES: THE NEW ECONOMY RACE--The foreign exchange markets have been caught up in the same "new economy" thinking as the rest of the world's markets. In the past few months, the focus has been appreciation of currencies representing "new economies" and weakness in the currencies of "old economies." Hence, Australia's currency has been among the weakest of the majors because trade in basic commodity goods dominates its balance of payments. In contrast, the U.S. Dollar and, increasingly, the Japanese Yen are seen as representing new economies with a heavy emphasis on technological development. Much of the activity is simply a reflection of the trend in asset prices, but with the added e-economy twist.
The week ahead will be a test of this new paradigm in the foreign exchange markets. The U.S. asset markets are likely to be tested by a slew of strong economic reports which will highlight the risk of more Fed tightening. If the dollar is truly a "new economy" currency, then it should hold up well as many believe that the new e-economy is immune to the impact of rising interest rates. Japan's markets will be at risk as well, but for a different reason. The Q4 GDP reports is expected to indicate weakness and could lead to weakness in the currency along with the risk of Bank of Japan intervention. Yet, if Japan's emerging technology sector is any indicator, there is more upside risk to the currency than downside. Europe remains caught in the middle, too far back in the technology revolution to have a strong currency. Yet, despite perceptions to the contrary, Europe's technology sector is alive, well and growing. In fact, in wireless telecommunications, it is quite advanced. Nonetheless, perception is reality in the foreign exchange market, and Europe is perceived to be a laggard.
The focus is really on growth and the potential to grow. As the major industrialized countries of the world face aging populations and growing demands for pensions, growth commands a premium. Faster growth means the ability to fund pension obligations without draconian tax measures which reduce competitiveness. That is why interest rate differentials are not necessarily a good indicator of a currency's likely appreciation. On that growth measure, Japan would seem to come in last with its gray population and sluggish growth, while the U.K. would be ahead of the pack, given its far more balanced pension obligations and growth rate. Yet the yen is strong and the British Pound is firm only against the Euro while languishing against the dollar.
It appears that the market is still struggling to sort out the winners and losers in a rapidly changing global investment environment on the assumption that capital flows will continue to go towards the winner of the technology race. For now, the dollar continues to take more than its fair share of capital inflows. Yet, as the Fed hikes rates, the potential for continued to growth and asset price appreciation would tend to diminish. The U.S., with its old economy current account deficit of 4% of GDP, will have to demonstrate strong asset gains to keep the ever increasing capital inflows needed to finance growth. The tug of war between the old and new paradigms will get more tense as the Fed hikes rates.
In the near term, the dollar is likely to continue to consolidate in a range. Longer term, our bias it to say that the dollar will have a difficult time sustaining gains as growth slows.
THE WEEK AHEAD--In the week ahead, there are several major economic reports due out for the U.S. including crucial inflation and retail sales figures. The numbers are expected to be strong, ratcheting up expectations for Fed tightening. In Japan, the highlight of the week will be the release of the Q4 GDP figures on Monday while in Europe, the European Central Bank meeting is likely to be the focus of attention, but we don't anticipate a rate hike at this juncture. The U.K. employment and earnings data are on tap as well.
BRITISH POUND--Sterling moved sideways against the dollar during the past week but gained modestly on the Euro. Signs of slower economic growth and diminishing expectations of further rate hikes weighed on the currency.
The recent economic data released by the U.K., while still healthy, are beginning to show signs of a slowdown. As a result, the Monetary Policy Committee now appears likely to hold rates steady for the time being. Last week's industrial production figures were weaker than anticipated, showing a second consecutive monthly decline. The rate of growth in manufacturing and industrial output appears to be leveling off, the outgrowth of high real interest rates and a strong currency. In addition, retail sales growth has moderated somewhat as well, suggesting that high real interest rates are beginning to affect the pace of consumer spending.
Our expectation is that the Bank of England Monetary Policy Committee (MPC) will continue to keep policy on hold for the time being to assess the strength or weakness in economic growth. With core inflation undershooting the MPCs target range and nominal rates at 6% the highest in the G7, there is no urgency to hike rates. In fact, the gilt market is signaling slower growth as yields have fallen sharply. Moreover, there appears to be a likelihood of convergence in growth rates between Europe and the U.K. in the year ahead. Longer term, we look for a decline in the British Pound against the Euro but the near-term trend is likely to remain sideways.
EURO--The Euro continued to languish near the lows with no real direction during the past week. The economic news continues to be positive and the likelihood of further interest rate hikes is growing. However, Europe is still seen lagging on the growth curve and therefore the Euro remains soft.
The recent economic data for Europe have pointed to an acceleration in the rate of GDP growth even in the core countries. German unemployment declined sharply for the fifth consecutive month, indicating that the expansion is gaining momentum. Stronger employment growth combined with rising consumer confidence should translate into a rise in domestic demand. Exports were also strong although manufacturing orders fell short of expectations. Overall Euroland growth rose by 0.9% in the fourth quarter to an annual gain of 3.1%. The growth gap with the U.S. is narrowing, a factor which has supported some convergence in yields. Meanwhile, the PPI report indicated another sharp rise of 0.6% in January for a 5% year-over-year gain.
In the week ahead, the economic reports will include Euroland CPI, industrial production, as well as German retail sales. The figures are expected to show another inflation gain and strong industrial activity. German retail sales figures will most likely remain sluggish. We look for a rate hike by the ECB in late March. At that point, they will have seen the M3 money growth figures and CPI figures. Given the central bank's worries about the currency there is a strong likelihood that there will be another rate hike in the next few weeks. The Euribor curve has already discounted further rate hikes with 25 basis points discounted by month-end, but further tightening could be anticipated if the pace of economic growth continues strong. As the growth rate between Euroland and the U.S. begins to narrow, the Euro is likely to rally. However, at this juncture, the trend remains weak.
SWISS FRANC--The Swiss Franc moved sideways throughout most of the past week despite strong economic data. The overall soft tone to the European currencies continued to weigh on the Swiss Franc.
The most recent data from Switzerland confirmed that the cyclical upturn in growth is intact. GDP growth expanded at a 3.7% annualized rate in the fourth quarter of last year, the fastest pace in nearly three years. Moreover, growth was broad based with gains in exports and domestic demand. The case for a sustained expansion is strong. Consumer confidence is at an eleven-year high, pointing to strong domestic demand. Corporate profits have risen sharply portending more investment spending and the weakness in the currency should continue to fuel export growth. Meanwhile, inflation pressures have picked up somewhat. The current rate of 1.7% is still moderate, but well above the 0.1% rate seen a year ago. As a consequence, the Swiss National Bank appears likely to continue tightening policy over the next few months. The combination of strong growth and tighter monetary policy should provide support for the Swiss Franc long term. In the near term however, it is likely to range trade near current levels.
CANADIAN DOLLAR--The Canadian Dollar spent most of the past week in a range, as strong economic data continue to be offset with low inflation readings. The major negative factor for the market is uncertainty as to whether the Bank of Canada will hike rates later in the month along with the U.S.
Last week's economic data for Canada were uniformly strong. Housing starts posted a sharp 11.9% gain during the past month indicating a strong quarterly rising in housing activity. However, building permits declined which may signal some slowdown in the months ahead. Capacity utilization rose to 86.8%, the highest level since 1995. Moreover, capacity use has been expanding for five consecutive quarters, an indication of strong demand. The employment figures also pointed to ongoing strength. The unemployment rate held at a 26-year low of 6.8% in February despite a surge in the size of the labor force while the number employed rose by 35,000. With job growth strong and consumer confidence high, the pace of domestic demand looks likely to remain strong.
There is considerable uncertainty as to whether the Bank of Canada will hike rates later in the month if the U.S. Federal reserve does. The Monetary Conditions Index (MCI) does not indicate a need for tighter policy and inflation continues quite low at 2.3% overall and 1.4% excluding food and energy. Nonetheless, we anticipate a rate hike by the Bank of Canada later in the month to match the expected 25 basis point hike in rates by the Fed. The strong pace of domestic demand is enough of an excuse to hike rates even if inflation is low. Moreover, the Bank of Canada has raised rates without an indication from the MCI in the past six months, largely because of the potential for capital outflows to weaken the currency. We look for the Canadian Dollar to resume its uptrend longer term.
JAPANESE YEN--The Japanese Yen continued to advance despite intervention from the Bank of Japan during the past week. The rally in the currency reflects several factors including improving economic indicators, seasonal repatriation of capital and the ongoing supply/demand forces in favor of a stronger yen.
Last week's economic data from Japan tended to surprise on the upside. Leading indicators posted a gain to the highest level in over five years. The index is designed to signal the pace of growth six months into the future. In addition, the current account surplus surged in January on strong exports. Finally, machinery orders were surprisingly strong in January posting a year-over-year gain of 20%. These data all point to the likelihood that the economy will gain ground in 2000 after a drop in growth late last year. In the week ahead, the focus will be on the Q4 GDP release on Monday which is expected to show a contraction for the quarter. However, if the decline is modest, the impact on the market is likely to be limited.
For the intermediate term, the market is likely to remain range bound reflecting the mixed fundamental picture. Weak domestic demand and ongoing deflationary pressures are being offset by signs of improving cyclical growth. Meanwhile, the seasonal repatriation of capital for fiscal year-end is putting upward pressure on the yen while the Bank of Japan's intervention is an offsetting factor. Longer term, our view remains the same: the supply of yen is not adequate to meet the demand and until it does, the yen is much more likely to move higher than lower. Demand for yen is an outgrowth of the high savings rate and large current account surplus. These savings have to be recycled in the global markets if the yen is to stay even or decline. However, Japanese investors have less incentive to invest abroad when their stock market is rising. Hence, the yen moves up more easily than down. Moreover, Bank of Japan policy remains somewhat tight as money supply growth is actually decelerating in spite of the zero interest rate policy. We continue to see room for gains in the yen towards the 104-105 region near term.
Kathy Jones and Lisa Conte
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