Prepared by Merrill Lynch & Co.

International Fixed Income Research

Our concern about the weak state of the Japanese economy has led us to revise downward our forecasts for Japanese real growth for 1997 and 1998 and, at the same time, our already-bearish forecast for the yen versus the dollar. We now see the Japanese economy growing a mere 0.7% this year and only 1.3% next year; previously, we expected growth of 1.9% in 1997 and 2.8% in 1998. Except for the short-lived spurt in GDP growth in 1996, the Japanese economy has grown less than 1.0% on average in the past six years.

The marketplace is clearly concerned about both short-term and long-term prospects for Japanese real growth. Long-term JGB yields have fallen below 2%, although current and expected budget deficits loom large. The only possible explanation for the steady decline in long-term interest rates to record low levels, at a time of large public-sector borrowing requirements, is that the marketplace is pricing in significant long-term weakness for the Japanese economy. What is particularly worrisome is that despite record low short- and long- term interest rates, the interest-rate-sensitive sectors of the economy are not responding positively. Normally, one would have expected housing starts and auto sales to have responded favorably to the decline in Japanese interest rates, but Japanese housing starts are instead down a stunning 27.8% on a year/year basis, while auto sales are down 10.5% on a year/year basis.

Normally, low interest rates are also positive for financial-asset prices, but this has not been the case in Japan. Bank share prices on the Tokyo Stock Exchange have been in a bear market trend for seven years. The marketplace is evidently concerned that persistent economic weakness in Japan will translate into a further rise in non-performing loans on bank books.

Policymakers are now clearly concerned about the weak state of the Japanese economy. U.S. Treasury Secretary Rubin revealed, at a press conference following the September 20 G-7 meeting in Hong Kong, that Japanese leaders had expressed concern that measures taken so far to revive the Japanese economy may not work. A tremendous amount of fiscal and monetary stimulus has already been thrown at the Japanese economy in the past six years. While these stimulative measures have not been able to boost the economy, they have at least succeeded in avoiding an outright contraction in real growth over the 1992-1997 period. But with stimulus on the fiscal front now turning to restraint, and with little margin for further easing on the monetary-policy front, there is a real risk that the Japanese economy may not be strong enough to cope unless fiscal restraint is offset by stronger growth in other areas.

That is where the yen comes into the picture. With Japanese domestic demand extremely weak, a pickup in foreign demand is needed to keep real GDP growth in positive territory. But with an expected slowdown in Asian demand likely in the wake of the still-brewing Asian currency crisis, overall foreign demand for Japanese goods is likely to decline, since Asia accounts for 44% of Japan's total exports. To counteract this weakness in Asian demand, the Japanese economy will need to see a pickup in European and Western-Hemisphere demand. To that end, the yen will need to weaken. The problem for U.S. policymakers is that they do not want to underwrite the Japanese economic recovery at the expense of a major widening of the U.S. trade deficit. That is why the G-7 communique' following the Hong Kong summit meeting was carefully worded to indicate that, while the G-7 “agreed that exchange rates should reflect economic fundamentals,” it was important to “avoid excessive depreciation (of the yen) where this could lead to reemergence of large external imbalances.”

Taking into consideration the deteriorating fundamental backdrop in Japan, and the desire on the part G-7 to avoid an excessive depreciation of the yen, we have decided to lift our ¥/U.S.$ exchange-rate forecast from ¥/U.S.$122 in three months and ¥/U.S.$125 in six months to ¥/U.S.$125 in three months and ¥/U.S.$130 in six months. As for our twelve-month outlook, we are presently holding the ¥/U.S.$ exchange rate at ¥/U.S.$130, but we believe that the risks lean heavily in favor of a ¥/U.S.$ exchange rate that lies well above ¥/U.S.$130 in a year's time.

Many analysts and market participants may find it difficult to believe that the yen could weaken versus the dollar on a sustained basis at a time when both the Japanese trade surplus and U.S. trade deficit may be widening. The reason for this skepticism is that conventional wisdom holds that exchange rates are driven largely by external-balance considerations. This was essentially correct in the 1970s and 1980s, when most industrial countries did not suffer serious internal imbalances. But in the 1990s, that is no longer the case. Serious internal imbalances in both Europe and Japan lie behind the weakening trend in the European currencies and the yen during the past 2½ years. How else can one explain the fact that the European currencies have been on a weakening trend versus the dollar since the spring of 1995, at a time when the EU current account swung from a deficit into a sizable surplus, and that the yen has been on a weakening trend at a time when the Japanese current-account balance has significantly improved?

Japan's large current-account surplus is causing a shift in the external-balance schedule to EB1, which would normally be positive for the yen's external value.

But Japan's weak domestic demand is causing a downward shift in the internal-balance schedule to IB1, now intersecting the external balance schedule at point B1, and causing a drop in the yen's external value to q1.

This is not to say that external- balance considerations are not an important determinant of exchange rates. Our assertion is that internal-balance considerations are now dominating external-balance considerations in determining the dollar's longer-term path. One can visualize the internal- and external- balance forces at work in driving the yen's long-term path by looking at the chart above. This simple textbook diagram shows that the yen's equilibrium value is determined when the requirements for internal and external balance are simultaneously satisfied. As shown, larger current-account surpluses in Japan shift the External Balance (EB) schedule up and to the right, and would push the value of the yen higher. On the internal-balance front, sustained weakness in domestic demand shifts the Internal Balance (IB) schedule downward, which is negative for the yen. If the downward shift in the IB schedule exceed the upward shift of the EB schedule–which we believe is the case today–the yen weakens on a steady and sustained basis.

The chart is just as applicable to the Deutschemark as it is to the yen. Structural rigidities in the German labor market, coupled with overly tight monetary policies in the first half of the 1990s (which pushed the Deutschemark deep into overvalued territory on a purchasing power parity basis) have led to extreme weakness in German domestic demand since 1992. Record high unemployment rates, record bankruptcies, and persistent weak growth in domestic manufacturing orders have worked to push the German Internal Balance (IB) schedule down relative to the German External Balance (EB) schedule in the past 2½ years. The net result has been a steady decline in the Deutschemark's value versus the dollar over this period.

Some concern has been expressed recently that the German and European Internal Balance schedules may no longer be declining, since signs of stronger European growth are now becoming more evident. While it is true that European growth has picked up, and that leading indicators point to further gains in the months ahead, there is still some question whether the cyclical recovery presently underway will prove to have strong or weak legs. Europe has been unable to sustain an economic recovery in the 1990s. The trends in industrial production and leading economic indicators fell steadily over the 1989-1993 period, then rose sharply in 1994, but contracted again in 1995-96. In 1997, European leading indicators are once again climbing at roughly the same pace as during the 1994 recovery, but the question remains whether the 1997 recovery will prove to be as short-lived as the 1994 recovery, or whether it will be sustained into 1998 and beyond.

The 1994 recovery ended largely because the rise in German foreign orders in 1993-94 stagnated in 1995. Foreign demand for German goods stalled in 1995 because the Deutschemark soared in 1994-1995 to levels that made German industry uncompetitive. The Deutschemark rose mainly because the Bundesbank was pursuing too tight a monetary policy during that period. If Germany and Europe want to sustain their recoveries into 1998 and beyond, then European monetary policies need to stay more accommodative this time.

Unfortunately, there is now a growing risk that German monetary policy may turn less accommodative. The marketplace is now pricing in a significant tightening in Bundesbank policy in the months ahead and this, in turn, has helped lift the Deutschemark's value higher in recent weeks. At the moment, we believe that the Deutschemark's recent gains versus the dollar are merely a technically-driven partial retracement of the dollar's substantial gains versus the Deutschemark during the past 2½ years. Indeed, the dollar was ripe for a technical correction, since investors were heavily overweight the dollar, according to our latest Global Investor Survey. But we suspect that a sizable portion of those overweight dollar positions have now been pared back. The latest weekly Market Vane survey of investor sentiment finds 55% of the investor base bullish on the Deutschemark, while 51% are bullish on the dollar. Two weeks ago, 76% of the investor base were bullish on the dollar while only 30% were bullish on the Deutschemark.

The key issue for both the Deutschemark and the sustainability of the German/European recovery is whether the marketplace is presently pricing in too much Bundesbank tightening. If so, and if the Bundesbank surprises by being more accommodative, the Deutschemark should resume weakening. Perhaps our best barometer of the future trend in German/European growth and the Deutschemark will be the behavior of the DAX index. The DAX index, until recently, had soared in the past 2½ years, as a weaker Deutschemark had improved the competitiveness and profitability of German industry. Unfortunately, the DAX index has weakened in recent weeks, as a stronger Deutschemark has aroused concerns that German competitiveness and profitability may be eroded if the Deutschemark's gains are sustained. If the German equity market views the Deutschemark's recent rise as merely a temporary phenomenon, the DAX index should hold its ground. Otherwise, the DAX index will weaken, and the 1997 German/European recovery will eventually wither, just as in 1994.

In the end, we believe that the Bundesbank will not move to as tight a monetary policy as the market is presently pricing in, since German policymakers will seek to balance the present foreign-demand-driven cyclical recovery presently underway in Germany against the still-weak pace of German domestic demand. If we are right, the dollar should get back on track and resume rising versus the Deutschemark.

What we find particularly interesting is that despite evidence of stronger economic activity in Germany and across Europe, long-term bond yields continue to drift lower. In fact, bond yields in Italy and Spain have fallen to new cyclical lows, while German bond yields have fallen to levels that nearly match their cyclical lows. This is not just a European phenomenon. Despite signs of strong Canadian growth, Canadian bond yields have fallen to new cyclical lows, while U.S. bond yields are approaching the lows of the past 18 months.

In fact, bond yields are falling everywhere–in economies with weak growth as well as in those with strong growth. Indeed, bond yields have fallen in markets where short-term interest rates have fallen and in markets where they have risen. Short-term interest rates have risen in the U.K., Ireland, Canada, the U.S., the Netherlands, Finland and Norway, yet long-term bond yields in all those markets have drifted lower this year. Even in Germany, where the market has recently priced in a significant tightening in Bundesbank policy, long-term bond yields have still fallen.

What lies behind this favorable trend in global bond markets is a still relatively benign outlook for global inflation. While it is true that real growth has picked up in Europe and North America, this is being counterbalanced by relatively weak growth in Japan, Southeast Asia and Australia. Overall global growth has therefore been relatively modest, and this has helped to foster a fairly benign global inflation environment.

One of the interesting by-products of the trend toward lower bond yields has been a fairly dramatic convergence of global interest rates at the long end of the maturity spectrum. Excluding Japan and Switzerland (where yield levels are inordinately low), the yield spread between the highest and lowest-yielding bond markets in the world has narrowed from 507 basis points in September 1995 to just 145 basis points in September 1997. This suggests that yield convergence is not just an EMU phenomenon, but a global phenomenon.

The chart shows that short-term interest rates have not exhibited the same degree of convergence as long-term interest rates have. That is likely to change in the next year, as the 1999 EMU start date approaches, since all participating EMU members should see their money-market yields converge. Interestingly, the forward markets are also pricing in considerable yield convergence at the front end for the U.S. versus the ECU, Canada, Australia, and New Zealand over the next one to three years.

If the forward markets are correct, interest rates at the front and back ends of the world's fixed-income markets will all converge, making individual markets indistinguishable from one another in terms of yield. This is likely to have a profound impact on the global fixed-income business. If interest rates become more tightly linked, it will significantly alter the way investors view their long-term diversification opportunities in the global fixed- income markets. It will also affect the way investors view short- term trading opportunities. Hence, one should expect global yield convergence to affect not only the traditional investment manager but the hedge-fund manager as well.

Overall, global yield convergence will probably accelerate investors' interest in taking on greater credit risk in individual markets to enhance yield, as well as increase investors' appetite for emerging-market debt. With yields at the front and back ends more tightly linked, currency considerations will probably take on greater importance in assessing relative value.

Michael R. Rosenberg

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

September 25, 1997Merrill Lynch & Co

International Fixed Income Research

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Consensus National Futures and Financial On Line Index

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