Prepared by Merrill Lynch & Co.

International Fixed Income Research

Each quarter, Merrill Lynch conducts a survey of large institutional fixed-income investors around the globe to assess how their portfolios are structured in terms of currency and duration exposure. The Merrill Lynch Global Investor Survey asks global fixed-income fund managers whether they are heavily overweight, moderately overweight, neutrally weighted, moderately underweight, or heavily underweight in selected currencies and bond markets. Our latest survey (November 1997) marks the 34th time that we have conducted the survey since it was introduced in September 1989.

Quite often, the Merrill Lynch Global Investor Survey results are used as a contrary-opinion indicator. If global fund managers are heavily overweight or underweight a particular currency or bond market, it may be felt that currency values or bond yields could change suddenly if overweight or underweight investors are forced to alter their positions. This is an issue that the markets will have to grapple with in the weeks ahead; our latest survey indicates that global investors are presently heavily overweight both the U.S. Dollar and the U.S. Bond market.

According to our November 1997 survey (a total of 94 global fixed-income managers responded to this quarter's survey), global investors remained heavily overweight the dollar, with the net weighted average allocation amounting to a heavily overweight reading of 66.75 (50.00 is neutral). While this was down from the extraordinary overweight reading of 70.50 in our September 1997 survey, it nevertheless marked the ninth time in the past 10 surveys that investors net weighted average exposure to the dollar has exceeded 60.00.

What we find striking is that, although investors have maintained huge overweight dollar positions during the past 2½ years, the dollar has managed to gain ground on both the yen and Deutschemark. The huge overweight dollar exposures have probably played a role in tempering the dollar's ascent, but have not prevented the dollar from rising over this period.

The survey results show clearly that investors have dramatically cut their exposure to the Japanese Yen. From an already significant underweight exposure reading of 31.00 in September, investors further reduced their net weighted average exposure to 23.00 in November. That is the lowest reading in more than eight years. Investors are actually quite aggressive in terms of their underweight exposure to the yen–only 9% are overweight, 15% are neutrally weighted, while a whopping 76% are underweight.

Concern about the fragility of the Japanese banking system and the need for massive infusions of liquidity by the Bank of Japan is likely to depress the yen for months to come. As we indicated in our last bi-weekly review, we revised our already bearish yen forecast to ¥/U.S.$ 140 in twelve months' time and we believe the risk to that forecast lies on the upside.

Growing concern about the prospects for yen assets are reflected not only in the yen's poor showing in our latest investor survey, but also by the recent sharp rise in the “Japan premium.” Japanese banks looking to borrow short-term funds in the Eurodollar market are now obliged to pay, on average, over 100 basis points more than U.S. or European banks. This risk premium is up from close to zero only five to six weeks ago.

The survey also reveals that investors substantially increased their exposure to the Deutschemark. For much of the past two years, investors had been reducing their exposure to the Deutschemark, from heavily overweight readings in 1995 to significant underweight readings in 1997. But in the past three months, there was a sharp increase in investor allocations to the Deutschemark, from an underweight reading of 41.00 in September 1997 to an overweight reading of 56.25 in November 1997.

There were several reasons for this. First, U.S./German real long-term interest-rate differentials, which had been moving heavily in favor of the U.S. over much of the past two years, suddenly moved in Germany's favor during the late summer and autumn. The DM/U.S.$ exchange rate moves sympathetically with the trend in U.S./German real long-term interest-rate differentials, and the shift in this spread over the last quarter probably encouraged investors to raise their exposure to the Deutschemark. Second, investors probably feared that long-dollar/short-yen positions could be vulnerable if U.S. or Japanese policymakers attempted to talk the dollar down versus the yen. Given such concerns, investors probably felt that a strategy of being long Deutschemarks versus the yen was a safer alternative to being long dollars versus the yen.

But with investors now overweight the Deutschemark, the DM is at risk of weakening again if fundamental forces shift against Germany and investors are forced to unwind a portion of their overweight DM positions. This may in fact be happening. The Deutschemark has started to lose ground to the dollar as U.S./German nominal long-term interest-rate differentials have widened in favor of the U.S. from around 30 to 50 basis points in the past month. This widening is due almost entirely to a dramatic decline in German bond yields.

Looking ahead to 1998, we look for further DM weakness versus the dollar. First, political risk is likely to become a more important factor as German federal elections, slated for September 1998, become a focal point for the market. Second and more importantly, the U.S./German real long-term interest-rate differential could move sharply in favor of the U.S. next year, if the German government announces a one percentage-point rise in the value added tax (VAT) as a substitute for an increase in employer mandatory pension contributions. The rise in the VAT would add roughly 0.6%-0.7% to the German CPI next year, which in turn would reduce the measured real interest rate in Germany. This implies that the real interest-rate differential could move significantly in favor of the U.S. in 1998.

There is even the risk that if German government revenues fall short of target estimates (because of record high German unemployment) then the VAT may have to be hiked yet another percentage point in 1999. This should help to keep the U.S./German real long-term interest-rate differential moving in favor of the U.S. for the next one to two years.

Our November 1997 survey also sheds light on how investors are positioned in other currencies. For example, in the case of the Canadian Dollar, investors appear to be tiring of holding onto long C$ positions. Investors' allocation to the C$ has been dropping steadily this year, from an overweight net exposure reading of 60.25 in February to an underweight reading of 47.75 in November. While we cannot yet say whether this represents an aggressive underweight C$ position, if it did, then the time would be ripe to go long the C$. (Of the 34 surveys that we have conducted since September 1989, in only eight instances have investors been more underweight the C$ than they are now.) The C$ looks extraordinarily cheap on a PPP basis, and with investors' allocation to the C$ at its lowest level in roughly two years, the C$ should begin to attract more buyers.

The same may be true for the Australian and New Zealand currencies. Caught up in the currency maelstrom in Asia, both the A$ and NZ$ have lost considerable ground in the past two months. As a result, global investors' allocation to the currencies down under have fallen sharply from an already significant underweight net exposure reading of 44.00 in September to just 34.50 in November. This is the lowest reading for investors' exposure to the A$ and NZ$ in six years, and the third lowest reading since our survey began. With investors now heavily underweight the A$ and with the A$ now more undervalued versus the U.S.$ than at any time in the past 10 years, the A$ may soon look more attractive to international investors.

Turning to the British Pound, the survey reveals that investors remain substantially overweight sterling. In fact, investors' net weighted average exposure to sterling has equaled or exceeded 50.00 for eight consecutive quarters. At its current reading of 56.25, it is at its third highest reading since our survey began.

There are a lot of reasons to like sterling, particularly versus the Deutschemark, given the strong U.K. economy, a relatively low unemployment rate, a broadly balanced current account, and comfortably wide U.K./Germany yield spreads. The big question is whether sterling is overbought at current levels, and whether it is becoming overvalued. Sterling is now a bit overvalued versus the Deutschemark, and with investors overweight as well, the pound may be vulnerable in the period ahead. Our expectation is that the downside risks to sterling should be limited, given the U.K.'s still-solid fundamentals.

Turning our attention to how investors are positioned in terms of portfolio duration, our November 1997 survey reveals that global fund managers substantially increased their duration exposure in the U.S. Treasury market from a roughly neutral reading of 49.75 in September to a heavily overweight reading of 61.25 in November. The 61.25 reading in November is the second-highest reading that we have recorded since our survey began, and is just a shade under the all-time high set seven years ago.

The Asian currency crisis is evidently having a profound impact on investors' positioning. Despite the fact that U.S. economic data has been strong of late, investors fear that U.S. growth may slow next year in response to the likely slowdown in the Asian, Latin American, and East European emerging markets. Indeed, despite the fact that U.S. wage gains have recently accelerated to a 4.2% per annum pace, market expectations of where U.S. inflation is heading have actually moved lower.

The key question is whether global investors are presently too heavily overweight in terms of their allocation to U.S. Treasuries. While it is true that investors appear to be a bit aggressive in terms of their exposure to U.S. Treasuries, these are unusual times, and market conditions probably warrant such a position. What is particularly interesting is that so many pundits are worried about the possibility of Japanese capital repatriation, which would negatively affect the U.S. Treasury market, at a time when global investors are flocking into U.S. Treasuries at a near-record pace.

The November 1997 survey also shows that investors substantially increased their duration exposure in the German bond market. This may help explain why German bond yields have recently rallied so strongly. Investors' allocation to German Bonds rose from a modest underweight exposure reading of 47.25 in September to a substantial overweight exposure reading of 58.25 in November.

The survey also revealed that investors' exposure to the U.K. Gilt market rose from 57.25 in September to 59.25 in November. This represents the highest allocation to U.K. Gilts in four years, and the second-highest reading since our survey began. Hence, for the U.S., Germany, and the U.K., investors appear to be significantly overweight in terms of their duration exposure.

Where investors are light in terms of their duration exposure is in the JGB and Canadian bond markets. Investors' exposure to JGBs dropped from 33.75 in September to 29.00 in November. As Exhibits 11 and 12 show, investors have been heavily underweight JGBs for three consecutive years. Since JGBs have rallied over much of this period, global investors as a group have significantly underperformed the JGB market.

Regarding Canada, investors have been cutting back their exposure steadily to Canadian Bonds for the past year. From an overweight reading of 61.00 in November 1996, investors' allocation to Canadian bonds has declined steadily, and now stands at a significant underweight reading of 42.75 in November 1997. This is the lowest allocation to Canadian bonds in four years. Investors, therefore, have moved not only out of the C$, but out of Canadian bonds as well.

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

December 3, 1997 Michael R. Rosenberg

Merrill Lynch & Co.

International Fixed Income Research

North Tower, 21st Floor

World Financial Center, New York, New York

Consensus National Futures and Financial On Line Index

Added to the WWW 12-05-97
Last updated on 12-05-97

Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com

wmeubank@ocp.kcmo.com