A.G. EDWARDS & SONS, INC.
One North Jefferson, St. Louis, Missouri
314-955-3050
(March 23, 2000) CURRENCIES: The economics profession has nearly abandoned theories that determine valuation of foreign exchange rates. This is mostly due to their overall poor performance. There are a number of reasons for the inability to predict rates. First, foreign exchange rates have "floated" less than 30 years, giving less history to analyze. Second, governments have tended to try and manipulate their exchange rates as a matter of policy, which lowers the explanatory power of economic variables. Third, most of the theory assumed trade flows would be the most important factors in predicting rates. The theory did not anticipate the size of capital flows between nations. Thus, the investing climate and government policy has become more important to determining exchange rates compared to trade issues.
Since the late 1980's, there has been a trend for exchange rates to follow relative growth rates. In general, the stronger economy tends to have a stronger exchange rate. This is a major change from the 1973-85 period, when relative inflation performance seemed to have a bigger impact on exchange rates. For the yen/U.S. Dollar relationship, an important variable is manufacturing employment, with an 18-month lag.
This chart shows the yen against U.S. manufacturing employment. Since 1985, the correlation has moved sharply negative, suggesting that falling manufacturing employment eventually brings a stronger yen. We think the reason for this relationship is that manufacturers face competition from imports. As manufacturing weakens, U.S. policy makers, from either party, try to aid this sector by allowing the dollar to weaken. Since Japanese manufacturing firms are major competitors for U.S. firms, the target currency tends to be the yen.
This chart shows a regression model based on manufacturing employment with an 18-month lag. The model's forecast calls for a stronger yen in 2000, with a peak in early 2001. However, the yen is trading above the forecast by more than one standard error, shown as the "top" line. Essentially, the yen has gotten ahead of itself. With the yen above fair value, the model suggests the yen is overvalued, and should decline toward the 9000 level.
We are short June yen from 9515, and would add on a rally to 9600, risking to 9720 with an objective of 9000.
Bill O'Grady