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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(November 10, 1997) CURRENCIES: DOLLAR REMAINS VULNERABLE–The dollar's performance over the past few weeks reflects the U.S. position as a net debtor nation. As equity markets crumbled globally and the Asian economic outlook worsened, the dollar rose against the Asian currencies but fell against the European currencies. This “caught in the middle” stance is not surprising since it is an accurate reflection of the underlying economic forces.
The U.S. direct exposure to problems in Asia is limited by the fact that exports and imports to the region are small compared to U.S. trade with Europe or the Americas. Moreover, U.S. exports in general are a small percentage of GDP and therefore, the impact of declining growth abroad has a limited impact on the U.S. compared to other countries which are more “open.” However, in the currency markets, it is all a matter of relative strength or weakness. As a result, the dollar is relatively more exposed to the problems in Asia than is Europe because U.S. multi-nationals are more invested in the region than European companies. But most importantly, because the U.S. is a net debtor nation with a current account deficit. The net debtor nations depend on inflows of capital from abroad and hence, whenever there is an environment where risk is heightened, the debtor nation currencies fare worse than the net suppliers of capital to the world.
An additional negative for the dollar in the near term is the worsening trend in the asset markets. Although stock markets are declining globally, the dollar's trend has been closely tied to the performance of the stock market over the past few years. The dollar peaked on the same day that the stock market peaked in early August. The close correlation in the past two years suggests that the dollar will continue to follow the equity market trends for the time being.
Finally, trade issues are becoming negative for the dollar. The trade deficit will undoubtedly expand next year as exports to Asia slow and imports pick up. Although the worsening in the deficit may not be as substantial as some fear, it seems highly unlikely that the trade gap will narrow in 1998. Some of the Asian countries, such as Malaysia, have already raised tariffs in an efforts to shrink their current account deficits. The other countries will simply be consuming much less and therefore importing less due to the slowdown in their economies. Japan's trade surplus with the U.S. is already rising and will likely continue to push higher over the next year as the yen slides. Secondly, the inability of Congress to muster enough votes to pass the “fast track” legislation on Friday sends a negative message to the market. The legislation was supposed to allow the administration to negotiate trade deals more quickly and easily and is seen as a symbol of “free trade” on the part of the U.S. Therefore, failure to pass the legislation would suggest that the U.S. commitment to free trade had diminished.
Overall, it is likely that the turmoil in the world's financial markets will continue for a while longer. The dollar will most likely continue to put in a mixed performance, declining against the European currencies, but rising against the yen and other Asian currencies.
BRITISH POUND–Sterling soared to the upper end of the broad trading range last week in response to the Bank of England's surprise rate hike. The central bank boosted the base lending rate by 25 basis points to 7.25% in a move that came as a surprise in terms of its timing if not magnitude.
The economic data justify the Bank of England's rate hike. It is just that the market was of the opinion that the G7 central banks would remain on hold given the turmoil in the world's financial markets. However, domestic considerations were apparently overwhelming for the central bank and the repercussions were fairly limited. The major reason cited for the rate hike was that inflation had not “moderated” enough. The Bank of England is targeting inflation at 2.5% but the recent figures suggest a 3% rate going forward. The precursors of inflation are pointing higher as well. Broad money supply growth is rising at a rate of 11.8%. In addition, narrow money growth, which is correlated with consumer spending, is growing at a healthy 6.4% rate. Given these indicators, it appears that consumer spending in the U.K. will remain strong well into 1998. In addition, concerns about a slowdown in the manufacturing sector appear overdone. Although the industrial sector is lagging the consumer sector, it is not failing. Industrial production and manufacturing output are edging up on a year-over-year basis, despite the tightening in policy this year and the rise in sterling. There is little spare capacity in the U.K. Unemployment has fallen to 5.2% and appears likely to trend even lower. As a result, the central bank clearly feels that there is little room to maneuver on the inflation front.
The debt markets are priced for further modest tightening ahead. We agree that there will probably be one more 25-basis-point hike in rates in the U.K. over the next few months. By the end of the first quarter next year, the impact of the cumulative tightening should begin to show up as slower growth. Meanwhile, sterling is somewhat overvalued by our calculations at current levels. However, we view the risk of sterling becoming more overvalued in the current environment as quite high. Given the attractiveness of Britain's high interest rates, oil reserves and position outside of European Monetary Union, it is difficult to make the case for a decline in the currency near term. As a result, we are currently sidelined. There is resistance in the 1.7000-1.7100 and support at 1.6500- 1.6600.
DEUTSCHEMARK–The Deutschemark rallied against the dollar and the Japanese Yen during the past week, largely because Germany's economy is not closely linked with Asia. Moreover, Germany has a large current account surplus and therefore, any repatriation of capital favors the Deutschemark over the dollar.
The rise in the currency in the past few months is largely unrelated to Germany's economic performance however. Last week's data indicated that the recovery has hit a speed bump with industrial production, manufacturing output and employment all very weak in the past month. Nonetheless, the weakness in the indicators is probably more a reflection of a pause in the recovery rather than the start of a downtrend. The other leading indicators of economic activity, such as the manufacturing and service sector surveys point to an improving trend. The major problem is that the buoyancy in the industrial sector has yet to find its way to the domestic economy and as a result, the pace of economic growth is likely to be, at best, moderate.
There will be very little economic data released for Germany next week. However, there are a number of speeches on the schedule which will highlight concerns about EMU and the split within the central bank about policy. Specifically, there appears to be disagreement as to what interest rate will be appropriate for convergence. The “hawks” at the Bundesbank have indicated a level above 4% which is where the market is pricing in convergence. However, the “doves” are indicating little reason to expect much in the way of higher rates. This discussion will drive interest rate expectations in Germany.
Meanwhile, the focus is likely to remain on the equity markets and the potential for “flight to safety.” As a result, we continue to look for the Deutschemark to move higher against the other major currencies. Germany's recovery is not likely to be particularly impaired by problems in Asia or Latin America and the trend in interest rates is clearly higher. Moreover, with a large current account surplus, Germany is not in need of foreign capital and therefore, less at risk than other major G7 countries. Hence, we continue to favor long Deutschemark positions and DM/yen spreads.
SWISS FRANC–The Swiss Franc rallied sharply along with the Deutschemark on flight to safety buying in the midst of the recent financial market turmoil. The Swiss National Bank continues to try to limit the rise in the currency on fears that it will cause the economy to weaken, but to date, they have had only marginal success.
The driving force behind the Swiss Franc's advance has been safe haven buying. The economy is showing solid signs of recovery, but not enough to prompt higher interest rates or a rise in the currency. Retail sales jumped 1.7% in September and want ad spending rose a sharp 9.7%. In addition, unemployment has edged to a twelve-month low of 4.8% in October, indicating that the domestic economy is gradually recovering from the six-year slump.
The driving force behind the rise in the Swiss Franc is its traditional role as a safe haven currency amidst turmoil in the world's markets. We would anticipate that the Swiss National Bank will continue to try to fight the trend. Directorate member Gehrig reiterated the bank's policies last week. He indicated no need for a rate hike near term and pointed to the Deutschemark/Swiss Franc cross rate as a reason why an easier policy stance is appropriate. He went on to say that the Swiss National Bank would continue to provide liquidity to the system in order to push the Swiss Franc lower.
Look for the Swiss Franc to continue to rally against the dollar in the near term due to ongoing weakness in world equity markets. However, we would anticipate that the Swiss National Bank will continue to try to push the currency lower against the Deutschemark.
JAPANESE YEN–The yen fell to a new low during the past week as the reality of the country's financial sector problems finally became apparent. Fears of bank failures in Japan and in other Asian countries imply that there is little else the Bank of Japan can do but let the currency slide.
Japan's bank woes have been well known for years. The amazing thing has been how long the day of reckoning has taken to arrive. A second-tier bank is apparently folding but there is talk that one of the major four banks is going to have its debt rating downgraded which in turn could cause the bank to fold. Moreover, there are concerns about Korea's banks and the Korean Won is vulnerable to devaluation. Meanwhile, the Ministry of Finance is pessimistic on the economy but refuses to loosen fiscal policy to stimulate domestic demand. Since monetary policy is already about as loose as it can possibly be, something has to give.
In this environment, the only thing left to “give” is the exchange rate. The dollar/yen rate has been politically sensitive for more than a decade and to that end, officials on both sides have tried to keep it range-bound so that trade conflicts could be avoided. However, there is only so much that can be done without addressing the underlying issues. Japan has dragged the process of deregulation and restructuring out over the course of the past eight years and there is really no end in sight. Moreover, the whole push for reform appears to have died in the past year with the election of Prime Minister Hashimoto who represents the anti-reform faction of the Liberal Democratic Party. Although a hefty dose of supply-side economics is clearly needed, the consensus for such policies has yet to be formed. Perhaps the current economic crisis will cause faster response, but it seems unlikely.
The real risk in Japan's financial system is that banks will be forced to liquidate cross-holdings of shares which in turn will send the Nikkei sharply lower, causing the country to spiral down into another deflationary downdraft similar to the early 1990's. Hence, U.S. and Japanese officials are likely to step back and let the yen fall even though it will undoubtedly result in another sharp rise in the trade surplus with the U.S. We continue to look for a test of lower levels in the yen. We are short the December contract looking for a test of 130 longer term.
CANADIAN DOLLAR–The Canadian Dollar continued to decline last week in response to the ongoing turmoil in the world's markets. The selling pressure was compounded on Friday when the employment report came in weaker than anticipated.
Canada's economic data continue to show a healthy economy. Fourth quarter consumption appears to be off to a strong start with a jump in auto sales of 8.6% and a rise in building permits of 27% on a year-over-year basis. Moreover, the help wanted index jumped to 128, the highest level since late 1990. The index is a good leading indicator of employment growth going forward. The unemployment report was disappointing however, indicating that the rate rose to 9.1% from 9.0% with new jobs declining by 11,000. It appears to be a pause in the expansion rather than the start of a slowdown, as all other indicators remain strong.
Nonetheless, the Canadian Dollar continues to fall in response to the Bank of Canada's monetary policy stance. The central bank has yet to tighten policy despite a sharp deterioration in the Monetary Conditions Index. It is probably the case that with low inflation and still high unemployment compounded by turmoil in the financial markets, they are simply reluctant to add to problems.
Nonetheless, the currency is likely to continue under pressure as long as there remains a wide rate gap with the U.S. With base lending rates in Canada at 3.5%, there is still at 2% negative cost of carry on long Canadian Dollar positions which makes it difficult to hold. Hence, we don't look for a recovery until the rate spread narrows, despite the good fundamentals for the currency.
Kathy Jones
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