PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
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(March 27, 2000) CURRENCIES: DOLLAR DOLDRUMS OVER--Just when it looked like the foreign exchange markets would go into the summer doldrums early, the market came back to life. The catalyst for the pick up in volatility was a surprise rate hike by the Swiss National Bank. It shook the market out of its stupor and may be the start of a change in trend. The dollar, which has been locked in a trading range near the recent highs for the past several months, may finally be ready for a change in direction.
It has been our view for quite some time that the next major move in the dollar will be lower. The combination of a record current account deficit and improving economic conditions abroad, sets the stage for a shift in capital flows away from U.S. assets to other markets. The issue is one of timing. In past cycles, it has been common for the dollar to remain under or over valued for extended periods of time. A change in the direction of the dollar requires a change in the fundamentals or policy or both. This time around, it appears that the catalyst for a shift in the dollar will be a change in external conditions rather than internal conditions. While the U.S. economy continues to appear strong and interest rates are rising, it is the shift in economic conditions outside the U.S. that will most likely drive a re-valuation of the dollar.
Figure 1
10-Year Yield Spread: U.S. Less Eurozone (percent)
Source--Haver Analytics
The biggest change taking place in the global economy is a narrowing of growth and interest rate differentials between the U.S. and the rest of the world. After two years in which the Americas accounted for the nearly one-third of all economic growth globally, the rebound in Asia and upward momentum in Europe are changing the cycle. Hence, the relative attractiveness of U.S. asset markets is likely to diminish over time. In fact, the narrowing of interest rate differentials with Europe over the past few weeks should provide the basis for a firmer Euro versus the dollar. (Figure 1) Meanwhile in Asia, the signs of recovery in Japan are growing and a shift away from the "zero interest rate" policy to a tighter monetary policy seems to be on the horizon.
Domestically, the issue for the dollar remains one of funding the growing current account deficit. At 4.2% of GDP and rising, the deficit requires the importation of over $1 billion in capital on a daily basis just to stay even. At some point, importing the capital will likely become increasingly difficult without some concession from the currency or interest rates. In addition, global liquidity is beginning to decline as a result of tighter monetary policies in the G-7 countries. As Figure 2 illustrates, the dollar's cycle tends to move in tandem with the global liquidity cycle because the dollar is the world's reserve currency. If we are right that liquidity is beginning to decline after the surge of the past two years, then the dollar is likely to decline over time as well. We are staying with the forecast of a gradual decline in the dollar over the course of the next year.
Figure 2
Global Liquidity Index* And U.S. Dollar Index
*--OECD M1 Money Supply less Nominal GDP
Source--Haver Analytics, Prudential-Bache Securities (HK).
THE WEEK AHEAD--The week ahead promises to be eventful as well. It starts off with the OPEC meeting amid high hopes that there will be an explicit agreement to raise production significantly. In Japan, the data calendar includes several major reports including industrial production and retail sales figures, both of which are expected to show gains. In addition, there may be further indications of a shift away from the zero interest rate policy of the Bank of Japan. In Europe, the data include M3 money supply growth and an ECB meeting in Madrid. Generally constructive data are anticipated, but it may take more than good economic news to boost the Euro through resistance. For the U.S., the economic data will be on the minor side and quarter-end could curtail some activity as the week goes by.
BRITISH POUND--Sterling fell sharply early in the week only to post a strong reversal on Thursday. There was no singular reason for the sharp turn around. It simply looked oversold at its lowest levels. The British Pound, after showing strength for much of the past year against its major European counterparts has begun to slip. It may be the start of a weaker trend in the currency vis a vis the Euro, but the fundamental indicators have not yet fallen into place to confirm a change in trend.
The recent economic data for the U.K. have been mixed, but the overall pace of growth appears to be slowing. The manufacturing sector continues to be negatively affected by the strength in sterling, particularly against the European currencies. Consumer spending, while still healthy, appears to be decelerating somewhat in response to higher real interest rates. The budget, released last week, showed a generally cautious approach to policy. It contained modest increases in spending and cuts in taxes in recognition of the steep drop in the government debt. In fact, the debt to GDP ratio is projected to fall to 33% in the next few years, an astounding change in the past decade. The level of change in fiscal policy does not appear to be enough to impact overall growth and monetary policy. The loosening in fiscal policy will amount to about 0.5% of GDP in the current year and half that in the following year. After the past few years of tightening policy, these are politically popular moves but not economically all that outstanding.
On balance then, the economy appears to be decelerating somewhat as a result of tightening monetary policy, a fact which could weigh on the currency. However, the slowing in growth has been moderate at best and with high real rates and an inverted yield curve, the currency is not likely to give up much ground in the near term.
In the week ahead, the releases will include current account figures for Q4 1999, consumer confidence and credit along with house prices. The numbers will have a bearing on the outlook for monetary policy. In fact, the focus will most likely start to shift to the April 6th Bank of England Monetary Policy Committee (MPC) meeting. Since the MPC have spent a considerable amount of time focusing on the strength of the British Pound (on a trade-weighted basis) and its impact on manufacturing, it is an open question as to whether rates will be moved at the meeting. We put the odds at about 50% because of the MPCs concern about asset price and wage inflation.
For the near term, we look for the British Pound to rebound further from the recent setback. However, it is at best a trading range market against the European currencies and is possibly beginning a longer-term decline. We are currently sidelined however in this market ahead of the outcome of the next Bank of England meeting.
EURO--The Euro moved sideways to higher during the past week, reflecting the growing belief that the growth and interest rate cycle may be moving into a new, stronger phase. In addition, the Swiss National Bank's sharp rate hike as "raised the bar" on policy within Europe, a factor which may mean higher rates than anticipated.
The cyclical economic backdrop for the European economies remains positive. Last week's German IFO survey showed the index rising to the highest level since 1994, a clear indicator of stronger growth in the EU over the next six to twelve months. The figures were an offset to the EUR-11 industrial production figures which showed a modest slowing in the past month. The trend in the industrial sector however, remains strong, boosted by the rebound in global economic growth and the weakness in the currency. Domestic demand indicators have also shown improvement in recent months, even in the core countries where the trend has been most sluggish. Although the tightening in monetary policy has raised concerns about growth it is worth keeping in mind that fiscal policy has become considerably less of a drag on growth in the past year than it has for the past decade. The run up to the introduction of the Euro and the impact of German unification meant that fiscal policy was very tight in Europe for most of the past decade. Now the trend is towards more neutral to less restrictive policy, which should accommodate stronger growth.
In the week ahead, there are several key events for the market to watch. The M3 money supply data will clearly be on the forefront. It weakened somewhat in January to a three-month average growth rate of 5.7%. A slight decline is anticipated for February. France will release several indicators including business confidence, unemployment and industrial production. All are expected to show strong readings. The European Central Bank meeting, which will be held in Madrid, will clearly be the focus of attention. We are anticipating steady policy at this meeting, but the risk has increased as a result of the rate hike in Switzerland. One of the ECB's major concerns will be the Euro, which has added to inflation pressures by pushing up import prices. Germany's recent import price figures clearly show the combined impact of higher oil prices and a weak currency. If the OPEC meeting doesn't result in lower energy prices, then the risk of tighter policy in Europe will rise.
For the Euro, the recent trends in the economic data and in policy suggest that there is room for a further rebound. The ECB is clearly confident enough of the trend in growth to tighten policy and will probably err on the side of more aggressive rate hikes than not. The result should be a moderate improvement from current levels. However, we would prefer to wait for a push above resistance in the .9850 region before initiating new long positions.
SWISS FRANC--The Swiss National Bank (SNB) surprised the markets last week with a massive 75 basis point hike in short-term interest rates. The magnitude of the rate hike was the surprise as most had anticipated that they would simply match the recent 25 basis point moves in Europe and the U.S. As a result of the move, the Swiss Franc rallied sharply, gaining on most of the major currencies.
Recent strong economic data and worries about inflation were the forces behind the aggressive rate hike by the SNB. GDP growth is projected to rise to the 2.5% to 3.0% region in 2000, the strongest pace in ten years. Unemployment has fallen to 2.2%, consumer spending is on an upward path and capital investment is improving. Exports have benefited from the rebound in global economic growth, particularly in Asia. On a year-over-year basis, exports have been rising at more than a 20% pace in recent months. Inflation at 1.7% is still tame, but at the highest level since 1995. It appears that the SNB was aiming to ward off possible inflation pressures stemming from stronger growth and a weak currency by hiking rates 75 basis points, rather than taking a more incremental approach. The strategy has succeeded. The Swiss Franc rallied 1.6% against the dollar and 0.5% against the Euro.
We look for continued strength in the Swiss Franc in the near term. Having raised rates aggressively, the SNB has sent the signal that currency weakness is a concern and shown confidence in the economy's sustainable growth rate. We are holding long positions looking for a more extended rally towards the 1.6000 level over the near term.
CANADIAN DOLLAR--The Canadian Dollar bounced off of its recent lows during the past week. Ongoing strong economic data coupled with confidence that the Bank of Canada will keep pace with the U.S. Fed in policy moves, helped to boost the currency.
The Bank of Canada's decision to match the recent Fed rate hike reflects their concern that the economy's strong momentum will test capacity constraints sooner rather than later. Unlike the U.S., Canada still has an output gap, although it is modest and is closing quickly. Meanwhile, the pace of growth remains quite strong. Retail sales were flat in January but remain more than 6.5% above year-ago levels. Exports are very strong, reflecting robust demand from the U.S. as well as the recovering Asian nations. Capital investment is likely to slow a bit after Y2K related surge late last year. The inflation picture remains pretty tame meanwhile. However, the Bank of Canada continues to target the 1% to 3% range which opens the door to further tightening in the near term.
Foreign investment in Canada continues to strengthen, also providing support for the currency. There was a net inflow to the equity market of C$4.7 billion in January, reflecting the strength in the market. Money market funds also attracted funds, but the bond market saw modest net outflows. However, given the turnaround in the Canadian bond market, it would not be surprising to see inflows resume. From a longer-term perspective, the changes taking place in policy are very positive for the currency. Fiscal policy is beginning to loosen after years of contraction. Now that the budget surpluses are assured for several more years, taxes can be reduced to a level which is more competitive with other G-7 countries. Meanwhile, monetary policy is tightening. This policy mix is quite bullish and represents a big reversal from the trend of the past ten years.
Overall, we continue to believe the Canadian Dollar is modestly undervalued at current levels. There is a strong seasonal tendency for the currency to rally from late March into early May, a factor which may help account for the recent turn around. We are holding long positions looking for a test of the 70-cent region near term.
JAPANESE YEN--The Japanese Yen spent most of the week caught in a trading range against the dollar, but it fell back against the European currencies. While the news was limited, we continue to believe that the outlook for the yen remains generally positive.
On the economic front, the recent data have been mixed and somewhat confusing. Leading indicators continue to show strength. The recent figures were revised higher, and signal improving economic conditions over the course of the year. In addition, vehicle production has rebounded and the trade surplus is beginning to rise again, after a year of decline. Moreover, capital investment is rising strongly. However, the signals on domestic demand remain mixed. Part of the problem is that the data series are not particularly reliable when it comes to the sector and various indicators tend to point in opposite directions. Nonetheless, there are signs of life in domestic demand. Last week's release of department store sales showed a 2% gain for the past month, a significant improvement over the recent trend. It may be that when the retail sales figures are released next week, there will be an increase for the first time in three years.
Perhaps even more significant than the data, there appears to be a change in monetary policy taking place in Japan. In a speech last week, Bank of Japan Governor Hayami indicated that he was not concerned about deflation as it was mostly the result of technological advancement. The trend in service sector deflation is abating, although it has yet to entirely disappear. He also indicated that the economy was in a "sustainable recovery." He appears to be signaling an end to the zero interest rate policy. In addition, it appears that the Ministry of Finance, which has been at odds with the Bank of Japan over policy, is beginning to shift its view as well. After months (or years) of calling for easier monetary policy, they appear to be coming around to the view that the economic expansion is sustainable and that policy does not have to be eased further. A close adviser to Prime Minister Obuchi indicated last week that the zero interest rate policy may need to end soon.
There is a political motivation behind this change in stance by the government. Low interest rates have been unpopular with pensioners and there will be over $1 trillion in postal savings bonds maturing in the next year. These bonds were invested ten years ago at interest rates in the vicinity of 6%. Now the postal savings system is offering less than 0.5%. The government is eager to retain some of those savings. Hence, they may acquiesce to higher rates.
The picture for the yen remains positive. A tighter monetary policy stance coupled with improving economic growth should mean ongoing strength in the stock market, continued capital inflows and a firmer yen. We are holding long positions.
Kathy Jones and Lisa Conte