PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(March 24, 1997)

CURRENCIES:

The dollar recovered from an early-week setback to finish slightly stronger. The prospects for higher interest rates in the U.S. and ongoing strength in the economy were the major positive factors, offsetting concerns about European Monetary Union and a widening trade deficit.

The economic news combined with Fed Chairman Greenspan's comments last week confirm the likelihood of a hike in U.S. short-term interest rates. The data suggest that the economy is growing at a strong pace in the first quarter, raising the prospects that the Fed will need to tighten policy to avoid an increase in inflation. Just about every sector of the economy is growing at a strong pace. Housing starts are strong, employment and income growth are strong, consumption is rising and the manufacturing sector is perking up. A strong U.S. economy is both good and bad news for the dollar however. The obvious positive impact is that the Federal Reserve is likely to raise interest rates, making the dollar more attractive to hold. This is particularly true in an environment where most of the G7 countries are experiencing very slow growth and interest rates in Europe and Japan remain very low. The Eurocurrency curves are forecasting further divergence between U.S. and German short-term rates.

On the negative side. strong U.S. growth coupled with an appreciating currency will most likely cause the trade deficit to widen. The January deficit at $12.7 billion was the second highest in more than ten years. Although we don't look for that pace of deterioration to continue, some widening is inevitable in 1997. The stronger the pace of U.S. growth, the stronger the trend in imports. As a huge net importer, the U.S. tends to run higher deficits during periods of strong growth and lower deficits during time periods of slow growth. In fact, the last time the U.S. saw the trade figures in balance was during the 1990-91 recession when consumer goods imports declined sharply.
However, the deficit is not likely to reach the mammoth proportions of the mid-1980s because the dollar is not overvalued as it was then. In addition, the two largest U.S. trading partners, Canada and Mexico, are experiencing much stronger growth than in the past several years and that should result in a recovery in their imports of U.S. goods. In fact, the latest data suggest that just that is happening. Canada's trade surplus with the U.S. declined in the past month due to a jump in imports from the U.S. Mexico's trade surplus with the U.S. has been declining over the past few months as well. As the recovery advances in Mexico, the pace of imports should pick up substantially, with the likelihood that Mexico will return as a net importer of U.S. goods in the next two years. The existence of a trade deficit is not particularly harmful as long as capital inflows are strong. By definition, the balance of payments requires a capital surplus equal to a trade deficit. If the deficit widens, then capital inflows have to increase through higher interest rates and/or a weaker currency. In the case of the U.S., higher rates have helped maintain those inflows without the need for the currency to weaken to clear the market. In the past few years, record amounts of foreign capital have come into the U.S. because interest rates have been very high relative to the rest of the G7 countries and the asset markets have been strong. These conditions should continue at least into the middle of the year and possibly into the third quarter. A sudden cessation of foreign capital inflows seems unlikely at this point. Hence, our forecasts continue to call for the dollar/yen to test 130 and dollar/Deutschemark to trade in the 1.7500 region sometime in the middle of the year.

In the near term, the next few weeks will begin a time period of greater uncertainty for the 07 currencies. In Japan, the quarterly Tankan report is due to be released in early April, which will be the first report in the new format and for several months. The market will be closely watching the central bank's assessment of economic conditions. In addition, Japan will raise the consumption tax as of April first, raising the risk that the economy will slow in the months ahead. Meanwhile, EMU considerations remain the driving force in the European currency markets. Several key events are approaching. The Italian mini-budget is due to be presented, which if in line with expectations and approved, would renew talk of Italy joining EMU on the first round. In Germany, the government will presents its estimates of tax revenues for the year in early May, which is critical to estimating whether Germany will meet the deficit/GDP requirements for EMU. These events are likely to keep volatility high in the European currency markets.

We remain longer-term skeptical about European Monetary Union proceeding on schedule. The choice facing Europe's finance ministers now is between fudging the data to allow EMU to go forward on time or delaying EMU. By fudging the data, there is a risk that the Euro will be a weak currency and that the agreement will eventually fall apart, causing economic damage throughout Europe. Delaying EMU runs the risk of losing the political momentum as federal elections approach in Germany and France in 1998. It is not an easy choice, but the more likely is for delay since the major countries do not appear willing to accept a large number of countries in the initial round nor do they seem willing to risk a weak currency.

Next week, the U.S. FOMC meeting on Tuesday will be the highlight early in the week but with a rate hike already widely discounted, we would not expect a major reaction in the markets. Meanwhile, there are several reports due out from Germany on the manufacturing sector and Japan is due to release its leading diffusion index.

BRITISH POUND

"Sterling posted a recovery from the recent lows to close the week above the 1.6000 level. The recent volatility in the currency reflects the mixed fundamental picture. On the positive side, economic growth is strengthening and interest rates appear poised to rise. However, these supportive factors are offset by uncertainty over fiscal and monetary policy after the May 1st elections Despite the recent volatility we expect sterling to rally from current levels as the positive factors outweigh the negatives. The spate of economic data released last week painted a very strong picture of the U.K. economy. The softening in consumption seen in the past few months appears to have been temporary pointing to stronger GDP growth in the months ahead. Retail sales rose 0.5% in February to stand 4.4% above year-ago levels. Household goods purchases were quite strong, indicating that the ripple effect of a rising property market is finding its way through the economy. Moreover, unemployment fell sharply to 6.2% from 6.5% the previous month and reflects a steep decline over the past two years. In addition, the drop in the number of people unemployed totaled more than 68,000 while unfilled positions increased. The employment figures raised inflation concerns in Britain because average earnings jumped to a 5% annualized rate from 4.75% in December. The figures imply that the demand side of the economy should continue to run at a strong rate.

Based on the economic figures, we expect the Bank of England to raise interest rates soon after the May 1 election. However, there is nothing outside of politics to indicate that a rate hike cannot be made sooner, but given that the Bank of England is not a fully independent institution, we doubt the likelihood of a rate hike near term. Nonetheless, as long as the economy continues to grow at a healthy rate with rising wages, the pressure will build for a hike in short-term rates to cool off the pace of growth. As a result, the British Pound should remain well-supported versus the dollar and the continental European currencies. Interest rates are already high in real terms and a further rate hike will make the British Pound attractive to hold.

The caveat to a stronger currency longer term is the uncertainty about what direction policy will take under the Labour party. At this point, a Labour victory appears to be a foregone conclusion. The market is fairly sanguine about the change in government for the first time in eighteen years because the Labour party's policies appear to be quite similar to the Conservative party's right now. Nonetheless, there will be pressure on the new government to raise wages in the government sector and to provide more general social benefits. How these pressures are addressed will be a major factor in the markets going forward. If taxes are raised to finance these expenditures, then sterling will suffer. Currencies typically do poorly in countries where taxes are rising because of the contractional impact on consumption. Finally, there is the question of monetary policy. Countries with loose monetary policy combined with tightening fiscal policies usually see their currencies decline. That is what the market will be watching for in the UK in the second half of 1997.
For the near term, we look for the British Pound to rally to the upper end of the broad trading range near the 1.6200 level. Longer term, we are mostly positive but will have to see what direction fiscal and monetary policies take after the election.

DEUTSCHEMARK AND SWISS FRANC

"It was a wide-swinging week in the Deutschemark and Swiss Franc which was the currencies finish with diverging trends. The Deutschemark held onto most of its gains, while the Swiss Franc retreated at the end of the week. The cross finished at the .8640 level.

In the Deutschemark, EMU issues continue to be the major longer term factor driving the market. When doubts are raised about EMU going forward on schedule, the Deutschemark spikes higher against the high yield currencies in Europe in anticipation that capital will seek the stronger currency if EMU unravels. Conversely, when the prospects for EMU seem bright, the Deutschemark slumps on the expectation that Germany will move full force to boost economic growth in the short run in order to meet the criteria. Cheapening the currency and keeping monetary policy loose are the quickest ways to boost economic growth. As indicated in the overview section, we don't see this issue resolving itself very soon. In fact, in the lead up to May when the government will estimate tax revenues and therefore the budget deficit, expectations will be heightened. Eventually we expect Germany to call for postponement of EMU, but that may not happen until 1998.

Meanwhile, the economic data continue to point to a very gradual recovery in Germany with exports leading the way as a result of the softness in the Deutschemark. Last week's figures point to slow growth with very low inflation. Retail sales were unchanged on a year over year basis in February, while new car registrations fell 2.7%. The IFO business confidence index rose a very modest 0.3% to 93.6 in the past month, but the pace has slowed enough to suggest that industrial production may be slowing in the months ahead. M3 growth cooled to a 9.1% pace in February compared to over 11% in January. Although money supply growth is still above the Bundesbank's target range, it is beginning to slow. The PPI figures were soft as well at a 0.6% year over year increase. The sum of the data suggest that growth in Germany is likely to remain sluggish for the next few quarters, allowing monetary policy to remain on hold.

Our longer-term bias in the Deutschemark is still negative, but we are being cautious due to EMU concerns. Nonetheless, the pace of economic growth remains constrained by the structural changes taking place in industry. Therefore, even though exports are picking up, the overall pace of the expansion is likely to remain slow. Meanwhile, because labor costs remain so high, the only way industry can remain competitive is by reducing the nominal cost through a lower currency. Unless there is some change to the structure of Germany's recovery and a major alteration in the pace of regulatory and labor market change, we anticipate that the Deutschemark can slide longer term. We would be sellers on rallies to the .6000 region basis the June contract, but due to EMU considerations, we would keep stops relatively tight.

The Swiss Franc lost ground late in the week after an initial rally on flight-to-safety buying by those concerned about EMU. Whenever there are EMU concerns, the Swiss Franc rallies due to Switzerland's safe haven status within Europe. Switzerland has opted out of EMU through referendum years ago, which means that the Swiss Franc has value as a European currency outside the system. Yet, the fundamental indicators continue to point to further weakness in the Swiss Franc longer term, despite its safe haven status.

On the economic front, the indicators for Switzerland are still weak. Despite years of virtually no growth in output and a severe decline in the service sector, the economy is still languishing. The overvaluation of the Swiss Franc in the past few years has wreaked havoc on several key industries, both on the manufacturing side and in the service sector. Tourism is running at half the pace of the 1980s due to high costs and the strength in the Swiss Franc. Industry cannot compete with an overvalued currency when so many other European currencies have lost value in the past several years. The official forecast for growth in 1997 is 1% and it is conceded that growth in 1998 will probably not exceed 2%. The Swiss National Bank is trying to maintain a very loose monetary policy in order to soften the currency and return the economy to a more competitive status. Inflation is simply not a concern. In fact, deflation is a greater concern for the central bank. Producer prices are falling at a 1.2% pace on a year over year basis. Last week, the President of the Swiss National Bank indicated that monetary policy would remain expansionary for the foreseeable future although he believes current policy will result in a stronger economy down the road. Nothing in the comments appeared to reverse the policy of trying to devalue the currency to boost competitiveness.

Moreover, they have voiced concerns that a rise in the Swiss Franc due to EMU concerns might have to be countered through easier monetary policy.

Given that the central bank appears to want to see a further erosion in the currency to support the economy, we continue to favor the short side of the Swiss Franc.

JAPANESE YEN

"The Japanese Yen remained range-bound during the past week between about 122 and 123. The lack of activity reflects the market's uncertainty about the pace of Japan's recovery and the growing unease in trade relations with the U.S.

The latest Japanese economic data point to a fairly healthy pace of growth in the past few months. Industrial production has risen sharply and machinery orders are rising as well. The industrial sector is clearly benefiting from the yen's decline over the past two years, particularly the auto makers. GDP growth will undoubtedly benefit from this upturn in manufacturing activity. Longer term, however, it is not clear how strong the pace will be through the rest of the year. Given the rise in the consumption tax on April 1 and planned reductions in government spending, there is a good case to be made that second-quarter growth will slow substantially from the pace of the past few months. Moreover, domestic demand has yet to revive in this recovery. Department store sales have fallen for the past three consecutive months, reflecting the low level of confidence in the recovery. Finally money supply growth has been gradually slowing since last fall, apparently due to declining demand for credit. Hence, there is the possibility that Japan's recovery will falter or at least lose some of its footing in the months ahead. The Bank of Japan appears to have little choice but to keep monetary policy accommodative for several more months in order to assess the sustainability of the recovery.
Longer term, we expect that the regulatory changes taking place in Japan will be the key to the expansion longer term. However, those changes will open up the economy to more imports and shift production offshore. Currently, Japan only produces about 10% of its goods offshore as compared to Germany at 15% and the U.S. at nearly 20%. As the Japanese economy matures and becomes more open, the globalization process will likely mean a permanent reduction in the trade surplus and a lower threshold for the yen.

In the near term, the push-pull affair in the dollar/yen will likely continue. The recent trade figures showing Japan's surplus turning higher and the U.S. deficit widening (albeit not with Japan) will keep the political heat on to avoid a sharp decline in the yen near term. Moreover, the upcoming Tankan report will keep the market on edge. Nonetheless, our longer term view remains that the changes taking place slowly in Japan will eventually mean another move down in the yen with a test of the 130 level likely by mid-year.

CANADIAN DOLLAR

"The Canadian Dollar slumped last week despite a raft of strong economic reports. The market continues to focus on the wide interest rate differential between the U.S. and Canada, which in turn has kept the Canadian Dollar under pressure. Ironically, it has been several years since the Canadian economy has looked as healthy as it currently does. The expansion appears to be on solid footing with strengthening indicators in both the manufacturing and consumer sectors. On the manufacturing side, shipments posted a strong 2.2% rise in the past month while inventories declined. As a result, the inventory/sales ratio is now at its lowest level of the expansion. Moreover, unfilled orders rose 3.0% in January and now stand at the highest level in over a year, suggesting that manufacturers will have plenty of work in the months ahead. New orders are also at a multi-year high. Much of the gain has been spurred by strong export demand. Canada's trade surplus, although down from its peak level, is still a source of strength for the manufacturing sector.

Perhaps the biggest change in the past six months however has been seen in the consumer sector. After a prolonged period of sluggishness, consumer spending is finally responding to the steep decline in interest rates and upturn in economic growth over the past two years. Retail sales rose a solid 1.4% in January and are up 5.6% over a year ago. Consumer spending accounts for about 60% of GDP and the gains of the past six months have been impressive. Housing starts rose 9.6% in February after a solid 7.8% increase in January. Starts are now at the highest level since mid 1994. Permits have turned sharply higher suggesting a continuation of the strength in housing. Employment has lagged the rest of the recovery somewhat, but private sector employment is beginning to offset the declines in public sector employment over the past few years as the government cut spending.
The market assumes that the Bank of Canada won't match a Fed rate hike in the near term and as a result, the Canadian Dollar has been declining. However, given the momentum in the economy there is a good chance that the Bank of Canada could lift rates modestly in the months ahead. Hence, the pessimism in the Canadian Dollar seems overdone at current levels. Moreover, we continue to like the long-term prospects for the currency because of the huge transition which has taken place in the economy and in particular in government finances. We are currently sidelined in the Canadian Dollar but we are waiting for a place to re-enter the long side. Kathy Jones

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