MERRILL LYNCH & CO.

North Tower, 21st Floor, New York, New York

(November 26, 1997) CURRENCIES: Recently, we have been looking for the Dollar Index to trade in a range between 95 and 98. It is presently in the middle of that range. We think that the greater risk of a move out of that range would be to the upside. This would be caused by a spike up in dollar/yen if the situation in Asia, and particularly in Japan worsens, and if the Eurocurrencies led by the yen move down faster than we anticipate.

While the Japanese plan to bailout the banking system may offset the tendency for the yen to rise further, we do look for the Eurocurrencies to decline further. Since the Eurocurrencies as a group have more weight in the Dollar Index than the yen, our intermediate-term outlook remains positive for the dollar, and assuming that dollar/mark once again rises above the 180 level as we think likely, the Dollar Index will eventually rise above our near-term range. Thus, our intermediate-term range for the Dollar Index is 95 to 100.

As indicated above, we think the Japanese recapitalization plan for its banking system will also have the impact of offsetting the tendency for the yen to rise further. Essentially the plan calls for the banks to issue approximately $65 billion in preferred shares with much of those shares being held by the BOJ and the Japanese Postal Savings System. The implication is that in order to raise capital for these shares, both institutions will sell other assets, a good portion of which will be dollar denominated.

While the plan itself is a negative for the dollar, other factors including safety and higher U.S. rates make dollar-denominated assets attractive to Japanese institutions. Thus, there is a continuing near-term risk that the dollar/yen will go through a period similar period to the Spring of 1995, when the market become temporarily somewhat chaotic. Then, the BOJ bought over $20 billion in dollars for several months to counter the rapid fall in the dollar from 100 to 80 yen per dollar in just over three months.

If dollar/yen moves through the 128 level, it is quite possible that the BOJ will sell huge quantities of dollars to help stabilize the situation. But the move through that level could result in a further “panic” move up which could stop anywhere between the 130 and 150 range despite intervention and would probably take place quickly (several weeks or months).

Both Japan and the U.S. have the benefit of having to deal with the 1995 episode and are probably much more willing to coordinate policy to prevent a similar occurrence. Further, an important implication of a further fall in the yen is that it would exacerbate the problems faced by Japan's Asian trading partners and competitors, especially South Korea. It is essential then that dollar/yen remain stable since any stimulative benefit Japan receives from further yen depreciation is offset by the impact on other countries in precarious situations.

One way or another we think the present situation will result in significant dollar sales by the BOJ in the next few months. Our base case is that these sales will keep the yen in a range of approximately 122 to 127 to the dollar for much of the period. Further, if traders and investors get the impression that the policy is working to stabilize dollar/yen, a move back to the 118 to 120 level is a distinct possibility.

While Japanese officials appear, finally, to be dealing with the banking situation, they have not yet indicated how they will stimulate domestic demand. To avoid further competitive devaluation in Asia, and to strengthen the yen meaningfully, such a policy is needed. While making the distribution system more efficient is clearly needed to effect a longer term solution, over the intermediate term, Japan needs an “old fashioned” fiscal jump start. Given that the previous start was negated by the rise in the consumption tax in April of this year, the obvious solution is to reverse the tax increase by enacting a bold and sizeable tax cut. Ultimately, then, we think Japan will be forced to reverse its fiscal policy from restraint to expansion.

If our base case is correct, the nearby yen future will stay between .7800 and .8300 over the near term (2 to 3 weeks), and .7800 to .8500 over the intermediate term (until Japanese officials come up with the appropriate fiscal stimulation plan). Once a credible plan to recharge the economy is enacted, we think the yen will move back to a range between 100 and 120 with a central tendency in the lower part of that range.

The Bank of Canada released its semi-annual report on the economy and monetary policy on November 19th and raised the bank rate 25 basis points on November 25 as the monetary conditions index hit 6. The report maintained the forecast of 4% growth for 1998 and virtually assured the market that policy rates would rise somewhat further as the Canadian economy approached its full potential. However, positive inflation developments in recent years would likely leave rates below their historical levels.

In a follow-up briefing by BOC officials, it was clear that while the Bank believes the Canadian Dollar is undervalued, it has backed away from its “full court press” to jawbone the currency higher. The special circumstances related to the Asian situation, and the recent fall in commodity prices, of which Canada is a relative big exporter, have weakened the value of the Canadian Dollar, and make it counter-productive for the BOC to over-react by raising rates aggressively to push the currency back up in the short run. The risk would be to cut off the healthy economic expansion in Canada, which would ultimately undermine the Canadian Dollar.

Given the new developments we have again revised down our near-term expectation for the Canadian Dollar. Given the recent rise to near 6 in the Monetary Conditions Index, an important factor for policy, it was appropriate for the BOC to raise rates sooner than would otherwise have been the case, and we think they will do so. However, it is important to keep in mind that policy is geared almost entirely to achieving long-term objectives and near-term developments will not deter the BOC from these objectives.

While we do not expect the Canadian Dollar to rise to value as quickly as we previously forecast, we do not expect it to fall much further either. The negative longer-term financial fundamentals which prevailed in the mid 1980's which caused the Canadian to almost collapse are not applicable now. Assuming the BOC raises rates another 25 to 50 basis points over the next 3 to 4 months, we think that the range on the Canadian will be approximately .7050 to .7375, basis the March contract. If the Canadian Dollar does fall below the .7025 level into yearend, we think the move will be very temporary. Further, our fall back “not beyond which” level is .6925. While the BOC has not moved rates up aggressively to support the currency in recent years, we think they would not hesitate to do so if they perceived an overriding need to preserve stability in the currency.

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

David Horner

Consensus National Futures and Financial On Line Index

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