wmeubank@ocp.kcmo.com
COMMODITY INSIGHT
152 Ennis Lake Road, Ennis, Montana
(September 22, 1997) CURRENCIES: The only two currencies I am involved with at this time from the long side of the market are the British Pound and the Canadian Dollar. The Brit ended the week at nearly a 1-month high while the Canuck bounced a bit at midweek, but generally remained sluggish.
Unfortunately, I was stopped out of my long position in the Brit on Tuesday, with small profits and then was forced to watch the market rally impressively. The Brit only needs to close over the 1.665 level to look especially strong. It ended the week at 1.6058.
For the next five days, buy (1) December British Pound at 1.5860 or lower with a 1.5500 intra-day stop. The Brit and the Canuck should rise sharply into the end of the year. Both are a buy on any hard break. But boy are they sloppy!
Jerry F. Welch
PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(September 22, 1997) CURRENCIES: G7 WILL COME AND GO–The foreign exchange market performed about as expected over the course of the past week with the yen weakening against all of the other currencies and the dollar remaining range bound against the European currencies. Although there was some anxiety about the G-7 meeting over the weekend, these broad trends remained intact. Assuming nothing too surprising emerges from the G-7 meeting, we look for more of the same in the week ahead.
The dollar's recent decline against the Deutschemark and other European currencies continues to beg the question of whether it is a correction in the longer-term uptrend or a reversal. Clearly with the European economies on the mend and the Bundesbank poised to raise rates, the case for a trend reversal exists.
However, even with an improving growth outlook and the prospect of higher rates, it would be difficult to construct a case for a substantial move lower in the dollar simply because nearly all of the growth seen in Europe and Asia of late is export-related and, therefore, dependent on cheap currencies. Moreover, the relative growth rates and interest rate differentials even with a rate hike in Europe would still be wide enough to make the dollar appear well supported fundamentally. Finally, portfolios are no longer overweight dollars as they were a few months ago, rendering it less vulnerable.
However, going forward, we doubt that the dollar will gain much against the European currencies as the markets will continue to anticipate tighter monetary policy in Germany and eventually, the rest of Europe. Moreover, the U.S. trade deficit is wide enough to be a limiting factor for the dollar in the absence of other negatives. Last weeks' release of the U.S. July merchandise trade data indicated a sharp month-to-month increase in the deficit. There is a strong seasonal tendency for the deficit to widen in the third quarter and this could weigh on the dollar as well. Longer-term, however, the dollar's downside should be quite limited. With the entire North American region growing at a rapid pace, the bias in interest rates will be to the upside. In addition, Europe is still witnessing steady capital outflows as EMU approaches, a trend which could intensify as January 1, 1999 approaches. Finally, the issue of competitiveness favors the dollar over Europe. Even with a widening of the deficit and a strong dollar, U.S. exports are fully 13% above year-ago levels. That is why there is a good chance that the dollar will remain in a secular bull market for one to two more years.
THE WEEK AHEAD–In the week ahead, the market is going to initially look to the results of the G7 meeting for some indication of direction. We anticipate that the yen will remain independently weak against the other major currencies while the dollar will remain range bound against the European currencies. In dollar/DM, a broad range of 1.7400 to 1.8000 is likely for the time being. The threat of higher interest rates in Germany is likely to remain just a threat for the time being and that should mean the Deutschemark's upside is limited. The British Pound should be independently firm as strong economic data suggest the potential the likelihood of higher rates. The yen still appears poised to test the old lows in the 125-130 region.
BRITISH POUND–RATE HIKES SHOULD LIFT THE CURRENCY–Sterling recovered from the recent setback on strong economic data and renewed talk of higher rates. Given that leading indicators continue to point to a robust economy with rising inflation, sterling should continue to appreciate.
Despite four rate hikes this year, the highest nominal interest rates in the G-7 and rising inflation, sterling has tumbled to the low end of the year's broad trading range in recent weeks. The setback was largely the result of concern that sterling's strength earlier in the year would slow the pace of exports and the manufacturing sector. Some evidence of a slowdown was seen, but it was the expectation of slower growth and a peak in rates which were the driving factors. In recent weeks, however, it has become apparent that the economy is still growing at a healthy pace, with rising inflation and the likelihood of higher rates. As a result, a resumption of the uptrend appears likely.
Last week's data underscored the strength in domestic demand. Retail sales put in a stronger-than-expected performance, gaining 0.4% for the month. On a year-over-year basis, growth in real consumer spending is up more than 5% and rising rapidly. Broad money supply growth is still expanding at a healthy 11.6% pace, suggesting ample liquidity to drive consumption. In addition, employment growth has been quite robust with the unemployment rate falling to its lowest level of the 1990s in the past month. Finally, labor costs continue to edge higher, suggesting the potential for demand-pull inflation. Given the recent numbers, we would anticipate that the Bank of England will need to raise rates another 50 basis points before year-end even though the yield curve is slightly inverted. Tight monetary policy should be supportive for the currency.
Next week's trade figures will likely indicate some further deterioration in the trade balance, but overall only a modest deficit is expected. Hence, we continue to look for the British Pound to work higher against the dollar in the next few weeks. A test of the upper end of the broad trading range at 1.6300-1.6400 seems likely. Stay with previously recommended long positions and add on dips below 1.6000 basis the December contract. We also favor short March 98 short sterling at current levels.
DEUTSCHEMARK–BUNDESBANK WILL RIDE THE RANGE–The Deutschemark range traded throughout the past week, ending about unchanged. Uncertainty about when the Bundesbank will begin to raise rates has prevented the Deutschemark from building on the gains seen since early August.
The German central bank's decision to leave rates on hold last week does not remove the uncertainty. The weekly repo settings on Tuesdays will now be closely watched for a policy shift. However, we would not be surprised if it turns out to be quite a wait. Although the economic figures continue to point to an improving economy, the inflation figures suggest that any price pressures are the result of the weak currency. Since the Deutsche mark has rallied off its lows, there is not likely to be much urgency t o raise rates going forward.
As for the economy, the numbers are getting consistently better. The IFO Business Confidence Index rose to 98.9 in August after a sharp rise in July. The figures suggest that the industrial sector is experiencing strong growth and expectations of rising future orders would suggest the possibility that the domestic economy will finally revive. In fact, new car registrations did post a strong 6.6% gain in August hinting at a possible upturn in consumer spending. However, to date, the domestic economy has remained moribund despite the steady rise in export-led manufacturing output. With unemployment still stuck near record levels, income growth weak and confidence low, it may be several more months before the consumer surfaces.
Yet, the market and the Bundesbank are focusing on the potential for a rate hike. The catalyst has been the rising trend in wholesale inflation due to a jump in import prices. Clearly, the weak Deutsche mark has been the key factor behind the upturn hi prices. However, inflation is not being generated domestically and, hence, shouldn't be a major concern to the central bank now that the currency has rebounded. Consumer prices are still low despite the rising trend in wholesale prices.
Next week's slew of data releases will likely indicate more of the same. Import prices are expected to post a 0.5% gain while overall CPI could decline by about 0.1%. The trade figures are expected to show some deterioration versus last month with a slight widening in the current account deficit which could weigh on the currency. The ICON consumer sentiment index should post some improvement while industrial production estimates are likely to be strong. A mixed picture on the data and an uncertain outlook for monetary policy suggest that the Deutschemark will remain in a trading range for the time being. We look for the dollar/DM to hold in the 1.7400 region on the downside and 1.8000 on the upside.
SWISS FRANC–SWISS NATIONAL BANK SLOWS RALLY–The Swiss Franc was also a range bound currency. The economic data continue to point to stronger growth, but the Swiss National Bank's apparent willingness to continue to provide liquidity to the banking system suggests an easy monetary policy.
The most surprising news released last week was the second quarter jump in GDP. The Swiss economy grew at a 1.9% rate in the second quarter, the large increase seen since late 1994 and one of the best of the 1990s. The growth was paced by a 9.3% jump in exports but consumer spending was stronger than anticipated at a 1.6% pace. The report was riot uniformly strong however, as capital investment declined 5.3% and construction shrank by nearly 6%. Nonetheless these figures, combined with the uptrend in consumer confidence and retail sales suggest that the worst of the 1990s recession is over in Switzerland and export-led growth is beginning to spread to the domestic sector.
However, Swiss National Bank President Meyer has indicated that the recovery is not yet strong enough to warrant a rate hike. Switzerland has seen thirteen rate cuts in the past our years and at 1% has the lowest rates in Europe. Rate hikes are inevitable, but the central bankers apparently believe that there is still ample slack in the economy to accommodate stronger growth without risking inflation. Moreover, since exports are leading the recovery, a premature rate hike might send the Swiss Franc higher and choke off the recovery. Finally, Meyer may be concerned about a potential inflow of foreign capital over the next year as European Monetary Union approaches. He has indicated in the past that appreciation of the Swiss Franc against the Deutschemark because of EMU would be a concern.
Overall, given the accommodative monetary policy and the likelihood that the recovery will be fairly patchy near term, we look for the Swiss Franc to remain range bound near term as well. Our bias however is to see a correction in the short run as it has probably seen the upper end of its trading range for now.
JAPANESE YEN–NO END IN SIGHT–The Japanese Yen fell to a five-month low against the dollar during the past week as the reality of weak growth and low interest rates offset concerns about trade friction with the U.S. Assuming no surprises out of the G-7, the yen looks poised to move lower.
There wasn't much optimism in Japan over the past week. Japan's Economic Planning Agency (EPA) in its monthly report, was the most downbeat in years. The impact of the April 1 tax hike is depressing domestic demand and the economy as a whole. It was an incredible miscalculation in a series of miscalculations since 1989 when the bubble economy burst. Meanwhile, the EPA even noted that industrial activity is “sluggish” while inventories rise. Finally, the outlook for employment was described as “severe.” These are strong words for the bureaucrats to use and indicate the depth of despair in the government about the economy.
Meanwhile, of course, the market continues to focus from time to time on Japan's rising trade surplus on the expectation that there will someday be a replay of 1994/1995 when the market forced the yen higher in an effort to reduce the surplus. However, in the currency markets, elephants rarely “stampede over the same ground” as the popular saying goes. In fact, once an economy has fallen into a liquidity trap as severe as Japan's. It usually takes many years of pump priming, loose monetary policy and a weak currency to stimulate growth. Chances for a huge rebound in the yen any time soon are fairly limited no matter how large the trade surplus.
That is the dilemma facing the U.S. at the upcoming G-7 meeting. The U.S. can complain about the lack of domestic demand and the high level of regulation within the Japanese economy, but not much can be done about it. Sending the yen higher would only tip Japan back into recession, causing the pace of imports to slow even more and in turn push the trade gap higher. Monetary policy is already about as loose as it can get and with a huge budget deficit, the potential for a big increase in fiscal spending is low. Japan can offer it recent deregulatory moves as a step in the right direction, but at the end of the day it is an exported recovery and will likely remain one for the foreseeable future. That means interest rates will remain low, capital outflows will stay strong and the yen will stay weak until recovery is on the horizon.
Meanwhile in the week ahead, the yen could have a short-covering rally from the current oversold levels, but upside potential will likely be limited. The diffusion index is likely to point to a slight improvement, but hold below the 50 boom/bust line. Later in the week, CPI should be unchanged. The approach of the end of the fiscal half-year in Japan could mean that capital outflows will slow as well. However, the bigger picture suggests a move to new lows in the yen over the next few months. We favor holding previously recommended short positions and add to those positions on minor rallies. We look for the 125-130 region to be reached by year-end.
CANADIAN DOLLAR–STILL WAITING FOR THE CENTRAL BANK–The Canadian Dollar continued to hold in a narrow range near the recent lows. The economic data remain quite robust, but the market is waiting for a sign that the Bank of Canada is prepared to move rates higher and until that happens, the currency is likely to languish.
Last week's economic data confirmed that the third quarter is getting off to a very strong start and growth may even exceed the 4.9% pace of the second quarter. Retail sales rose a robust 1.3% in July, offsetting a 0.4% decline in June. Much of the increase was concentrated in auto sales as pent up demand continues to fuel sales of consumer durable goods. Retail sales in the second quarter rose at a 6.3% annualized rate and it is possible that the third quarter could even exceed that pace. The economy has clearly moved into a demand-driven expansion phase after several years of export-led growth.
The trade figures for Canada were somewhat disappointing in August. The surplus came in at C$1.7 billion which was down from the previous month's level of C$2.3 billion and somewhat below expectations. It appears that imports are beginning to trend higher as domestic demand expands. Imports were up 5.2% on the month but 16.4% year over year. Exports remain healthy with a 2.8% month to month gain and a 5.5% year over year rate.
In spite of strong growth however, inflation remains quiet in Canada. August CPI rose 0.2% while the core rate edged up only 0.1%. Year over year, Canadian inflation is running at a 1.8% rate overall and at 1.6% for the core rate. It is for this reason and the existence of a relatively large output gap that the Bank of Canada has kept rates on hold since the June rate hike. With an output gap estimated at 2% and unemployment still hovering near 9%, the central bank appears inclined to let the economy run on the expectation that inflation will not pick up until the excess capacity is reduced. Meanwhile of course, the lack of a rate hike in the face of very strong data has pushed the Canadian Dollar lower. As yet, the Monetary Conditions Index does not signal the need for a tightening but if the currency slips much more, another rate hike can be expected.
For now, we are on the sidelines in the Canadian Dollar. The longer-term prospects are favorable and the currency is quite undervalued. However, until the rate gap with the U.S. contracts from the current level of 200 basis points, the negative cost of carry on the trade makes holding the currency unattractive. For now, we prefer selling rallies in short term debt instruments in anticipation of a series of rate hikes later in the year and into early 1998, but we are sidelined in the currency.
Kathy Jones
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