wmeubank@ocp.kcmo.com
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(November 17, 1997) CURRENCIES: VOLATILITY IS THE ONLY CERTAINTY–The dollar rallied against the major currencies during the past week, but the territory reclaimed in the rally has been minor basis the Dollar Index. Given the magnitude and range of uncertainty in the world's markets, the dollar's performance as a safe haven remains mediocre at best. It has rallied sharply against the yen, but so has every other major G7 currency. It has only regained about three pfennigs against the Deutschemark and has barely moved against the Swiss Franc, which is still considered the world's safe haven. Against the backdrop of uncertainty over Iraq, Korea, Japan, Brazil and whatever country is next on the agenda for problems, the dollar's underperformance stands out.
At the heart of the dollar's lackluster trend in the past few months is the fact that the U.S. is a net debtor nation, needing to tap the global capital markets for funds. Attracting capital inflows has been easy in the past few years as U.S. interest rates were relatively higher, the economy was strong and well balanced and there were few attractive alternatives. However, in recent months, the problems in Asia and other emerging markets suggest that those inflows could begin to abate. Although the impact on the U.S. of Asia's problems is still unclear, one thing that is obvious is that the U.S. trade deficit with Asia is destined to widen. With sharp devaluations in much of Asia and slower growth abroad relative to the U.S., an expansion in the current account deficit from the $160-billion level to as high as $190 billion is possible. Another outcome will likely be somewhat slower growth, although the magnitude of a slowdown is quite uncertain. At this juncture, only a minor decline in growth is likely, but with Brazil looking likely to experience a slowdown, the impact on the U.S. is potentially greater than it was a few weeks ago. Latin America accounts for a significant share of U.S. exports and a growing share of exports. As a result, a slowdown in Brazil and/or Argentina would impact the U.S.
Europe remains the most removed from the world's problems for the time being. However, several Eastern European countries have economic conditions similar to Asia: large current account deficits, currencies pegged to the dollar or the Deutschemark and a poor mix of economic policies. Moreover, the indications coming from Europe are that policy makers are leaning towards lower rather than higher interest rates for the initial launch of the Euro. It appears that the reliance on exports for growth continues to drive policy and as a result, the Euro is increasingly likely to be “soft” when it makes its appearance. So longer term, the potential upside for the European currencies appears limited as well.
Rounding out this trip around the globe, the commodity-based economies are nowhere to look for strength. Both the Canadian and Australian Dollars have fallen in recent months as a result of the problems in Asia. Australia is clearly vulnerable to the inevitable downturn in Asia because over 40% of the country's exports go to the region. Canada's link is more indirect. About 20% of Canada's exports go to Asia, which is a considerable chunk. However, Canada is also vulnerable simply because its exports are typically basic materials and any downturn in overall global growth will diminish demand for these goods.
So, where does one go in a world with heightened risk and falling asset markets? For the time being, Europe still appears to be the least vulnerable, but the long-term prospects are not that good. Switzerland will probably continue to be a safe haven, despite the protests of the Swiss National Bank. The U.K. should also continue to have a strong currency due to high real interest rates, oil reserves and its absence from European Monetary Union. As long as the tone of the market is risk-averse. then the dominant theme will be repatriation of capital. That theme works against the net debtor nations and in favor of the net creditors.
What would change the outlook? Perhaps the most significant single event would be a meaningful financial reform package out of Japan. If Japan could put together a plan to rescue its economy from what looks like another downturn, then the outlook for Asia and the markets in general would change. The upcoming November 18th release of the LDP's third phase of their financial plan will be closely watched. To date, they have disappointed the markets, but perhaps the level of risk has reached a point where they will finally come up with something.
BRITISH POUND–Sterling soared to its highest level for the year last week, driven by strong fundamentals. The economy remains robust, interest rates are high in nominal and real terms and Britain enjoys something of a safe haven status. These factors should remain supportive for the near term, but the longer- term outlook remains in question.
Britain's economic data continue to point to a strong expansion driven by consumer spending. Despite five rate hikes in the past few months, consumers continue to spend at a hefty pace, reflecting strong employment and income growth. Last week's employment data point to more of the same. Unemployment is at 5.2% and is running at half the rate of continental Europe. Wages are rising at a rate of over 4% and credit is expanding rapidly. The manufacturing sector, although worried about the strong currency, has yet to experience a significant downturn. In addition, retail prices are rising and core RPI is above the government's target rate.
The market is currently pricing in another 25- to 50-basis-point hike in short- term rates in Britain over the near term, which is clearly supportive to the currency. Another quarter-point rate hike would bring base rates to 7.5% and would seem, at least on the surface, to be enough to slow the economy. However, considering the rapid pace of growth in money supply and credit expansion, it does not appear that rates are restraining growth. Moreover, compared to previous cycles, real interest rates at 4.5% are not as high as real rates at the peak of the past two cycles, when they averaged well over 6%. Finally, the magnitude of increase in interest rates in this cycle has been far less than in other cycles. Although this is true for all the major G7 countries and reflects the relatively low rate of inflation, it may be that the U.K. economy can adjust to a higher level of nominal rates fairly easily. Next week's money supply data are expected to show yet another strong increase.
The upshot is that sterling can continue to move higher, probably exceeding levels of last year. Moreover, considering that the British Pound enjoys at least a partial safe haven status since it is outside European Monetary Union and Britain has large oil reserves, there is still upside potential. The biggest risk is that officials will try to talk the currency down for competitive reasons. Threatening to join EMU is usually the biggest threat. However, the underlying fundamentals remain strong. We look for good support at the 1.6700-1.6800 level and would be buyers on setbacks.
DEUTSCHEMARK–The Deutschemark edged lower during the past week, as expectations for further interest rate hikes diminished. The economic figures continue to point to weak domestic demand while EMU-related issues suggest limited rate hikes going forward.
German economic data continue to point to a total reliance on exports to boost growth. Domestic demand is largely absent due to high unemployment and lack of income growth. Retail sales have been falling for well over a year in real terms and show no signs of improvement. However, the manufacturing sector continues to benefit from strong export demand due to the impact of the Deutschemark's decline over than past two years. At this juncture however, the currency has returned to the mid-point of its broad trading range, so the incremental improvement in exports is likely to slow.
More important that the economic data however, is the market expectation about the Euro. Comments from Bundesbank President Tietmeyer last week suggested that he does not favor significantly higher interest rates ahead of convergence. Since the parities for the currencies will be set in the spring of 1998, there is very little time for interest rates to reach convergence. If the Bundesbank does not favor higher rates, then the prospects for the Euro to be a weak currency are raised. As a result, the Deutschemark may be reaching the upper end of its trading range. For now, we continue to favor long positions, but we are ready to take profits in the near term.
SWISS FRANC–The Swiss Franc pulled back from its recent highs last week, but remains well bid as a safe haven currency. Although the Swiss National Bank continues to fight the rise in the currency by injecting liquidity into the money markets, demand for Swiss Francs is driven not by interest rates but by uncertainty about the Euro.
The Swiss economy continues to show signs of gradual recovery. Consumer confidence reached a two-year high in October and retail sales have finally begun to edge higher on a consistent basis. However, there are signs that the recovery is slowing. The construction sector remains weak and corporate bankruptcies are still rising. The Swiss National Bank has remained adamant about preventing a sharp rise in the currency against the Deutschemark. They continue to push money market rates lower to discourage capital inflows. With inflation at near nonexistent levels, there is not much risk to this approach. In fact, we would anticipate that rates will remain on hold well into 1998. Nonetheless, the Swiss Franc is still seen as a safe haven currency by most Europeans, so it will be a difficult process for the central bank to hold the currency down in an uncertain economic environment.
We continue to favor long Dm/short Sf spreads at current levels with very close stops.
JAPANESE YEN–The Japanese Yen fell to near the year's lows against the U.S. Dollar during the past week before rebounding late on Friday. The currency was depressed by a falling stock market, fears of bank failures, the competitive pressures from other Asian currency devaluations and disappointment over the government's proposals to boost economic growth.
The outlook for the Japanese economy remains very poor. It appears that Japan is falling back into recession, wiping out the modest gains seen in the past year and threatening the stability of the global financial markets. The tax hike April 1st was a key negative for the economy as it squashed any hint of domestic demand. Meanwhile, exports have been the only buoyant sector of the economy, but the Asian currency devaluations have diminished expectations for growth in that sector. Obviously, letting the currency slide lower is one way to offset the downward pressure on the economy but that is a politically unacceptable solution because it would bring protests from the U.S. and other major trading partners. In fact, the rhetoric has picked up in recent weeks as the yen has worked lower.
The obvious solution is the one that continues to be rejected by the Liberal Democratic Party (LDP). What Japan needs now is a dose of supply-side economics. Cutting taxes to boost domestic demand and de-regulating the domestic economy to allow cheaper priced imports into the market would do more to revive economic growth than any of the tinkering around the edges done to date. The problem is that such an approach would cause the budget deficit to widen even further, which is unpopular with Japanese voters. The deficit is already over 5% of GDP and rising and with Japan's population aging rapidly, there is a risk to a further expansion to the deficit. Nonetheless, there are few other options left. Monetary policy can't be eased much more. Rates are already at post war record lows and in real terms, interest rates are negative. Presumably borrowing should be booming, but the fact is that the banks can't lend because they don't have the capital. They are held down by nonperforming loans capitalized with highly leveraged positions in the equity market. As the Nikkei has gradually worked lower, that capital base has come under pressure.
For now, the yen appears likely to work lower. However, if the LDP were to come up with some sort of bailout package for the banking system, then the yen could rebound quite sharply. It is oversold and sentiment is quite negative. We covered short positions on Friday and will sidelined for the time being.
CANADIAN DOLLAR–The Canadian Dollar continued to decline last week, reflecting the low level of interest rates and the Bank of Canada's reluctance to tighten monetary policy. The economic data of late suggest that the economy continues to run at a healthy rate, if somewhat slower than earlier in the year. Housing activity remains very strong, but job growth has slowed a bit and vehicle sales have declined. Nonetheless, the pace of activity still points to GDP growth over 4%, which remains among the highest in the OECD.
The key to the Canadian Dollar's weakness is the Bank of Canada's slow approach to tightening monetary policy. The monetary conditions index fell to —5.76 in the past week and now stands about 25 basis points below where it was the last time the Bank of Canada tightened. Although there is still some slack in the economy, clearly at a 4% growth rate, the slack is being taken up fairly quickly. However, the BOC has yet to raise rates and so the currency is working lower. We are currently sidelined in the Canadian Dollar but if current conditions persist, then it will probably edge lower from here.
Kathy Jones
|
|
Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com