wmeubank@ocp.kcmo.com
One New York Plaza, New York, New York
(May 5, 1997) CURRENCIES: In a week that witnessed a slew of domestic economic reports, the dollar held in a fairly narrow range. Overall the tone of the currency remained firm, but activity was limited, perhaps reflecting heightened uncertainty about the direction of U.S. monetary and fiscal policy.
Early in the week, the dollar was under pressure as a result of diminishing expectations of further rate hikes by the Federal Reserve. The lower than expected employment cost index and prospects of a budget deal altered expectations about the trajectory of Fed policy. Yet, we doubt that this week's economic data have changed the world for the Fed. Their major concern has been the high level of domestic demand at a time when excess capacity is diminishing. Although we anticipate a slowdown in the economy over the next few months, it is probably only a pause in an otherwise strong expansion. Moreover, with unemployment 4.9%, the Fed would be hard pressed to believe that there is much more room for growth without a further acceleration in wages.
Hence, the major factor supporting the dollar over the past year remains intact. Relatively strong economic growth and high interest rates are still dollar positive. Wide interest rates differentials makes the dollar attractive to hold and expensive to short. Those spreads are still very wide and likely to widen further over the course of the next six to nine months as the U.S. moves into the late stages of the business cycle.
One of the more interesting aspects of this cycle however has been the resilience of trade flows despite huge shifts in foreign exchange rates. U.S. export volumes have continued to run at a fairly healthy pace despite the dollar's rise. Net exports have deteriorated due to the run up in imports, but it would be difficult to argue that competitiveness has been damaged despite the dollar's 50% rise. Moreover, the NAPM export index at 55.7 in April is near its cyclical high. One explanation is simply that the increase in multi-national firms conducting trade within their organizations has grown so sharply over the past decade, currency values are of less impact on decisions. That is, intra-company trade accounts for about 40% of U.S. trade flows now. It looks like changes in exchange rates are having less impact on trade flows than in years past. It is relative growth rates and structural issues that is driving trade, and those are much more difficult to assess and to change than the exchange rate, as evidenced by Japan and Germany's glacial pace of restructuring.
Nonetheless, the political opposition to a stronger dollar is building, both domestically and abroad as a result of the deterioration in net exports. U.S. administration officials have held the line on a strong dollar policy, perhaps simply because it seemed futile to do much else. Moreover, a strong dollar has the beneficial effect of holding down import inflation, slowing economic growth and drawing in foreign capital. Yet, there is concern about the dollar over-shooting its value level and subsequently causing adverse, effects on the economy. Hence, a significantly higher level for the dollar will probably result in at least a modest shift in U.S. policy down the road.
Outside the U.S., the opposition is growing stronger, Bundesbank and Bank of Japan officials continue to warn of possible intervention to support their currencies. For Japan, the motivation is to avoid a resurgence of trade conflict with the U.S. as the Japanese current account surplus begins to grow again. For Germany, it is the worry that further weakness in the Deutschemark is a reflection of the market's outlook for the Euro. Neither country has much concern about inflation and the weakening currencies have boosted exports rather sharply in both countries, providing the basis for modest recoveries. It is going to be a difficult balancing act for the central banks. Holding the dollar at current levels without a shift in the fundamentals is likely to mean an increase in volatility as traders test the central banks' resolve. In the week ahead, the focus of attention will likely shift back to Europe where the French elections and EMU concerns are going to be driving forces in the markets. We continue to look for a lot of volatility as the EMU process moves forward. The near-term key events are the French elections May 25/June 1 and the German estimate of tax revenues which will set the stage for the deficit projection. The political will to push EMU forward is likely to be tested.
Our longer-term forecast for a strengthening in the dollar into mid-summer is still intact. We look for 130-132 dollar/yen and 1.7600-1.7900 Deutschemark in the June-August time period.
BRITISH POUND--After holding steady all week, sterling dropped sharply in the wake of the Labour party's landslide victory in the elections. Although a Labour victory had been widely anticipated for months, the knee-jerk reaction was to sell the British Pound immediately after the results were out, Subsequently, the currency rebounded, ending the week about where it had started.
Despite all of the short-term volatility, the market is still range-bound, reflecting the, uncertain longer-term outlook. For the U.K., the change in government after eighteen years of Tory rule is momentous. Clearly the major issues revolve around monetary policy, fiscal policy and Britain's relationship with Europe. The first question will be answered fairly quickly. There is a monetary policy meeting scheduled next week and a rate hike has been anticipated. If the Treasury keeps the Bank of England at bay with a hike in rates, then confidence in policy will erode quickly. However, the converse is also true. A swift move to hike short-term rates would reinforce confidence in the new government.
Fiscal policy questions will clearly be in the market as well. It seems quite likely that there will be some kind of tax hike in the U.K., given Blair's comments about spreading the wealth from those who have benefitted from the advance in the financial markets to those who have not. But at this juncture, only a modest utility tax appears likely. Given the rise in the fiscal deficit, some sort of tightening in fiscal policy appears likely and that may slow the economy longer term.
Finally, there is the question of Britain's relationship with the rest of Europe. Given Blair's overwhelming majority and the force of his own personal campaign on the election, it would seem likely that whatever direction the Labour party wants to take Britain on the EMU issue, it will succeed. Yet, despite talk of a closer relationship with Europe, Blair has not articulated just what the specific terms of that relationship should be.
In the near term, the focus is likely to be on the monetary policy meeting next week. We would anticipate a modest rate hike and therefore some firming in the currency. Longer term however, the economy is growing at a moderate pace and inflation pressures are not alarming. Hence, the scope for a sharp rally on one rate hike is small. We are sidelined. Our bias is to say that the British Pound is going to remain a wide ranging, trading market for the time being.
DEUTSCHEMARK AND SWISS FRANC--The Deutschemark edged lower during the week as the economic data still point to a sluggish economy with little likelihood of higher interest rates in the foreseeable future. However, threats of intervention from the Bundesbank and uncertainty about EMU prospects are supportive factors.
There was little economic data released for Germany last week, but the week ahead should be more interesting since it includes the release of industrial production, manufacturing orders and the ever-popular unemployment figures. We look for a continuation of moderate economic data. Industrial production will most likely rise a modest 0.2% bringing the year-over-year rate to 4.5%.
Manufacturing orders should also rise at about a 4.5% year-over- year rate, which is an improvement over the past few months. Those figures are consistent with an improving export sector which has benefitted from the weak Deutschemark. However, it should be emphasized that even with relatively strong figures, the overall trend in manufacturing is still rather dismal. The dominant trend continues to be one of manufacturing jobs shifting abroad, to Eastern Europe or Asia due to the wide discrepancies in labor costs.
As for the unemployment report, a modest improvement is likely. The overall rate is likely to hold at 11.4% but unemployment should fall by 20,000 to 30,000 due to an improving construction sector. The figures will probably give the government an opportunity to declare victory over unemployment, but the reality is that even if the peak is in, the process of boosting job growth will be a slow one.
Longer term, the key issues for the Deutschemark going into the summer will revolve around Europe's commitment to EMU. There is no doubt about Kohl's political commitment, but the government's forecast of tax revenues is approaching and that will set the stage for estimating the deficit/GDP ratio for EMU. It is likely to come in at about 3.2%, just above the cut-off for the Maastricht accord, thereby raising the issue of who will qualify and/or who will be "in" and who will be "out." Moreover, the government is also pursuing an aggressive strategy of tax reform which has to date, been stymied by the opposition. These reforms are critical to boosting growth and addressing the structural impediments to growth in the economy. In all, prospects for EMU going forward combined with a sluggish economy suggest that the Deutschemark could remain under pressure. However, any doubts about EMU raised by internal issues or the French elections could send the Deutschemark sharply higher.We currently favor short positions in the currency, but we would keep stops close.
The Swiss Franc was lower on the week as well, reflecting ongoing softness in the economy. The CPI figures confirmed very low inflation at 0.5% and the Swiss National Bank appears intent on allowing the currency to continue to move lower.
Given the long running recessionary conditions and low inflation, the Swiss Franc should continue to have further downside potential longer term. Even the EMU safe-haven play seems to be waning somewhat in the current environment. We continue to favor the short side.
JAPANESE YEN--The Japanese Yen fell to a new five-year low against the dollar before rebounding slightly on threats of intervention from the Bank of Japan. The economic data continue to point to a soft economy with very low inflation, so the prospects for rates remain benign and that implies a weaker currency going into the next six months.
The recent economic data appear to confirm expectations that the hike in the consumption tax is leading to a slowdown in the pace of spending. Housing starts have fallen sharply, new vehicle sales were down over 12% in the past month and retail trade is weak. Now that the consumption tax has gone into effect, consumers appear to have pulled back on spending, particularly on big-ticket items. Moreover, the construction industry is feeling the impact of the decline in spending on public works.
Nonetheless, Japanese officials continue to threaten to prevent the yen from declining further. Their concerns seem to center on the impact a falling yen has had on domestic investment and the potential for further trade tension with the U.S. Nonetheless, Japan is not yet at a point in the business cycle or in the restructuring of bad debt at the banks where rates can be hiked. Given the huge negative cost of carry on yen positions, the upside potential even with intervention is likely to be quite limited. We continue to favor the short side, although with potential intervention, it is likely to be a more difficult trade than it has been for some time. Our next target is the 130 level.
CANADIAN DOLLAR--The Canadian Dollar rebounded from its recent slump to finish stronger. It was the first sharp upturn in the currency on a weekly basis since February. Strong economic data and declining expectations of higher U.S. interest rates helped boost the Canadian Dollar.
Canada is at the spot in the economic cycle where growth can remain robust without threatening inflation because there is ample excess capacity. As a result despite a robust pace of growth, the Bank of Canada has kept short-term rates very low and appears unlikely to raise for several months. The wide interest rate differentials vis a vis the U.S. has been a major factor in the Canadian Dollar's weakness over the past several months. We continue to believe it will be a limiting factor as we anticipate further rate hikes by the U.S. Federal Reserve while Canada's rates may only edge higher down the road.
Nonetheless, there are several longer-term positives for the Canadian Dollar which bias us towards wanting to buy setbacks. First off, the economic data are improving rapidly which means that the rate cycle is likely to shift towards tightening later in the year. GDP growth in the past few months has been quite strong and we expect an overall growth rate this year of about 4%, the highest in the OECD. Exports remain very strong, new record levels, the result of strong demand from the U.S. and a very competitive Canadian economy. The deficit reduction plan in place has been highly successful and will likely result in a balanced budget in the next few years. As a result, Canada has gone from the second highest deficit/GDP ratio in the G7 to the second lowest in just four years. Moreover, with a large current account surplus and a declining deficit, Canada doesn't need foreign capital inflows. In the near term, the focus will likely be on the upcoming elections June 2. Chretien's party appears comfortably ahead in the polls and given the improving trend in most economic indicators, the party should overcome the opposition, it would help if next week's Unemployment report indicated another decline in the rate, perhaps closer to the 90% level so that the "feel good" factor would contribute, but overall there is a general sense of well being resulting from the improvements in the economy. The Quebec issue remains a political thorn but even here, the separatists appear to have lost some support.
We believe the Canadian Dollar is the most undervalued currency among the major industrialized countries. Over the long term, barring any major policy changes, we expect it to move sharply higher. Near term, it could be constrained by the wide interest rate differentials with the U.S., but we are looking to buy setbacks in anticipation of a rally in the second half of the year.
Kathy Jones
Added to the WWW 05-09-97
Last updated on 05-09-97
Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com