Prepared by Merrill Lynch & Co.

International Fixed Income Research

The U.S. Dollar rose to a three-year high versus the Deutschemark this week and all signs point to a continuation of the dollar's gains in the weeks ahead. The dollar's latest gains can be attributed to a number of factors. First, in the past two months the U.S. trade deficit has posted smaller-than-expected shortfalls–$7.8 billion in March and $8.4 billion in April. The better-than-expected U.S. trade performance, which stems in large part from a new surge in U.S. exports, represents a significant improvement over the $10.5 billion monthly average deficit of the prior eight months. Second, recent U.S. economic data suggest that U.S. growth will rebound in the third quarter from the second-quarter lull. The Conference Board's Consumer Confidence Index soared to its highest level in 28 years in the latest month, suggesting that U.S. retail sales should increase after three consecutive months of declining sales. A pickup in growth will raise the odds of a Fed rate hike in the months ahead.

Another factor that has helped lift the dollar higher versus the Deutschemark is deepening concern that the new Euro currency (which is expected to be launched on January 1, 1999) will prove to be a soft currency. Fearing a weaker Euro, investors are shifting funds out of Deutschemarks and moving them into safe- haven currencies such as the dollar, pound, and Swiss Franc. One can gauge the present negative sentiment toward the Deutschemark from the weekly Market Vane Bullish Consensus surveys. According to the latest survey, only 8% of currency traders are presently bullish on the Deutschemark's prospects.

Finally, the dollar may be getting a lift for purely technical reasons as the DM/USD exchange rate has just risen above a critical chart point. The DM/USD exchange rate had been confined to a relatively narrow trading range over the past five months, fluctuating, for the most part, in the 1.66-1.74 range. With the dollar now breaking out to the upside of this trading range, investors are becoming more confident that the dollar's uptrend, which began in April 1995, is still intact.

We believe that the dollar is in the middle of a major long-term uptrend that will carry it toward DM/USD 2.00 by the year 2000. This is a view that we have held for some time now. The reason that the dollar will need to trend higher over time is that at current exchange rates, Germany and the rest of Europe will not be able to meaningfully reduce their record high rates of unemployment. European labor costs presently far exceed those in the U.S. and Japan, which places European companies in a very weak competitive position. A decline in the value of the DM-bloc currencies will be needed to help restore European competitiveness. If exchange rates fail to adjust, European companies may be forced to shift production abroad in order to remain competitive. Since this would have disastrous consequences for European growth and employment, we believe that fundamental forces will carry the day and power the dollar higher versus the Deutschemark over the long run.

It is interesting to note that U.K. labor costs are far below those in continental Europe, notably less than half those in Germany. This places the U.K. in a very favorable competitive position as confirmed in the World Economic Forum's latest Global Competitiveness report. The U.K.'s standing is quite impressive with a strong 7th place ranking (up from 15th place last year), which contrasts quite favorably with the relatively poor rankings of France in 22nd place, Germany in 25th place, and Italy in 39th place. Yet, despite the U.K.'s impressive competitive position, many economists today believe that sterling is significantly “overvalued,” and that a major depreciation in sterling's value lies in the offing.

We strongly disagree with this view. We have been consistently bullish on sterling's prospects versus the Deutschemark and have been recommending an overweight position in sterling in our Strategy Table for some time now. We have no intention of altering this bullish sterling view in the period ahead for several reasons: First, the DM/£ crossrate has been highly positively correlated with the trend in the DM/USD exchange rate over time. If we are correct that the DM/USD exchange rate will trend higher over time, the DM/£ crossrate should rise in tandem; second, on purchasing-power-parity grounds, sterling appears to be fairly valued versus the Deutschemark according to our estimates.

Some economists might quarrel with our PPP estimates. The last time the DM/£ crossrate was this strong back in the late 1980s, the U.K. suffered a major deterioration in its current-account balance, with the shortfall amounting to 4% of GDP over the 1988-90 period. Sterling bears argue that sterling's value needs to fall now to prevent a similar deterioration in the future.

It seems to us, however, that the litmus test to determine whether a currency is overvalued or not is to assess whether the currency's present level leads to a decline in competitiveness and a subsequent deterioration in economic fundamentals. If the U.K.'s economic fundamentals were on a deteriorating trend with severe imbalances in its external and internal sectors, the odds would be that sterling was overvalued and needed to depreciate. But a careful reading of the U.K. data suggests that this is not the case.

On the external-balance front, the U.K. current account has moved into a modest surplus. The U.K. current account has been on an improving trend in the 1990s and has been in surplus in three of the last four quarters. Indeed, the £1.46 billion surplus reported for the first quarter of 1997 was the U.K.'s largest quarterly surplus since the first quarter of 1983.

We've already mentioned some other indications of U.K. competitiveness and external balance: U.K. labor costs are far below those of its major trading partners, and the U.K. ranks relatively high in independent global competitiveness surveys. Indeed, in its latest quarterly report, the Bank of England noted that sterling's recent appreciation so far has had little effect on trade volumes.

On the internal- balance front, the U.K. economy is exceptionally strong, enough so that U.K. short-term interest rates have risen more than 100 basis points in the past year while most other countries have been in an easing mode. The relative strength of the U.K. economy can be gleaned from Exhibit 11 which shows the divergent trends in U.K. and German unemployment rates. Since 1992, the U.K. unemployment rate has fallen from a high of 10.5% to 5.8% today while the German unemployment rate has soared from 6.3% to 11.4% over roughly the same period.

Indeed, if internal- and external-balance criteria are used to assess whether a currency is fairly valued or not, the only major industrial country that is presently not suffering a serious imbalance on either its internal- or external-balance fronts is the U.K. Japan and Germany's structural economic rigidities have led to moribund domestic sectors and high unemployment. And the U.S. is still contending with nagging current-account and trade deficits.

On almost any criteria, we see no evidence of deteriorating U.K. economic fundamentals on either the internal- or on the external- balance fronts. Hence, there is no evidence to support the notion that sterling is an overvalued currency.

The question that remains then is how much room exists for sterling to continue appreciating versus the DM? We can answer that question with a simple stylized diagram of the DM/£ crossrate that highlights the forces that have powered sterling higher since the Fall of 1992 and that will likely continue to power sterling higher in the future. Much of sterling's rise in the past 4½ years can be explained as a correction of its significant undervaluation vis-…- vis the Deutschemark that followed after sterling's sharp fall in September 1992.

Capital inflows also helped push sterling higher as interest-rate differentials clearly favored U.K. bonds over German bonds. Internationally-mobile capital also found its way to the U.K. as sterling gained status as a safe-haven vehicle given market concern that the new Euro might prove to be a soft currency beginning in 1999.

Looking ahead, capital-flow considerations should continue to push sterling higher versus the Deutschemark. Short-term spreads between the U.K. and Germany are presently 375 basis points and will likely widen further in the months ahead.

Sterling should also receive a boost from an apparent increase in sterling's long-run equilibrium level. The U.K. has undergone a major supply-side revolution in the past 10 years that has involved major corporate restructuring, deregulation, privatization, and extensive labor-market reforms. The results of this supply-side revolution are seen in the declining trend in the U.K.'s unemployment rate and the improvement in the U.K.'s current-account position. These supply-side forces have raised sterling's long-run equilibrium level and therefore the DM/£ crossrate should now be expected to gravitate around this new, higher equilibrium level. Summing up, capital-flow and supply-side factors argue for a continuation of sterling's long-term appreciating trend versus the Deutschemark.

Shifting gears from the U.K. to Japan and from currencies to bonds, one has to be impressed by the stellar performance of the Japanese government bond (JGB) market. The JGB market has rallied despite the stronger-than-expected June Tankan report, surging exports, and a rise in the year/year inflation rate to 1.9%. But one has to question just how low JGB yields can fall from their already low levels (real JGB yields out to four years are already negative).

There is conflicting data. For instance, leading indicators are pointing to a new slowdown in Japan. For example, the Economic Planning Agency's leading diffusion index fell to just 5.6% in April, the lowest such reading since the Fall of 1992. And the OECD's leading indicator of the Japanese economy fell in April to its lowest year/year reading since the Fall of 1993. But these indicators probably are being distorted by the effect of the April consumption tax. On the other hand, while the June Tankan report revealed an improvement in large manufacturers expectations, the report also revealed that non-manufacturers and small firms remained pessimistic about their business prospects.

Because the data are conflicting and/or distorted, it is hard to get a clear reading on how strong or weak the Japanese economy truly is. Whatever the case, it would be hard to recommend an aggressive overweight position in JGBs at this time with yields so low in both nominal and real terms. Our strategy would be not to chase this recent rally. Instead, we would favor a more defensive position toward JGBs at this time.

Finally, we would like to discuss some opportunities that are available in the dollar-bloc bond markets. Given the recent easing moves by the Reserve Banks of Australia and of New Zealand, coupled with the recent tightening move by the Bank of Canada, the relative thrust of monetary policies is clearly shifting in the dollar-bloc area. With inflation falling to 1% or possibly less in both Australia and New Zealand this year, there is ample scope for further rate cuts in both markets in the period ahead. Given the risk of a further hike in Canadian short-term interest rates, we believe that investors should position themselves for a considerable narrowing of Australia/Canada and New Zealand/Canada yield spreads in the weeks ahead.

~Michael R. Rosenberg

The FOMC will have two more months of employment and retail sales data before its August 19 meeting, and three full months of additional data by the September 30 meeting. By then the FOMC should have enough information to assess if the rebound from the second quarter sluggishness is sufficient to justify such a further rate raise.

Our expectation of a Fed tightening by the end of the summer relies upon economic growth returning to near or above potential in June and the months beyond after the spring slowdown. With the release of the first full-scale set of data for June in the coming weeks, we will be able to see if that is actually happening. Available June data suggest that it is:

–The LJR Redbook data show a rebound in department store sales in June, suggesting that the spring lull may have been due to unusual weather.

–The drop in mortgage rates may be giving a lift to housing. The Mortgage Bankers Association's index of applications for new purchases averaged 208 for the first three weeks of June, up from 193 for May.

–The Conference Board's consumer confidence index rose to its highest level in the past 28 years. Perceptions about the strength in the job market also improved to new highs.

However, the evidence on the labor market is mixed. Jobless claims jumped during the last week of May and sustained those high levels for two weeks before falling back down last week. The Conference Board's Help Wanted Index dropped six points in May, although an official at the organization said that the drop may be an aberration. The employment report is a much more reliable indicator of the job market, and we expect a fairly strong report.

While the economy seems well underpinned, the decline in inflation in the first half of the year puts the real Fed funds rate at more than 300 basis points, a level that is normally considered restrictive. If the forces propelling the economy begin to dissipate before inflation heats up, the economy will eventually slow on its own. That suggests that no more than one or at most two Fed tightenings may be needed.

~Martin Mauro

Though we admit to having missed the market's move in the second quarter, we have not altered our opinion about the general direction of interest rates, about the need for the Fed to further tighten monetary policy, or about the U.S. financial market's dependency on foreign capital flows. We are reluctant to believe that the market has enough fundamental support or that the economy will weaken enough to allow interest rates to reach this year's previous lows. We expect rising interest rates to be accompanied by additional flattening of the coupon curve for the rest of the year. We view the forward curve as being too optimistic with respect to the Fed and to the level and direction of short- term interest rates. The only change we are currently recommending to our asset allocation model is to begin a gradual reduction in mortgages, from 38% to 33% (relative to the market index weight of 28%). This will probably be the first of several actions that will result in underweighting this sector by the end of this quarter.

Thomas J. Sowanick

(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)

~July 2, 1997 Merrill Lynch & Co.

International Fixed Income Research
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World Financial Center,
New York, New York

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