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MERRILL LYNCH & CO.
World Financial Center, New York, New York
(October 16, 1997) CURRENCIES: U.S. MAY REDUCE PRESSURE ON JAPAN–We think the U.S. and Japan may be reaching a consensus in which the U.S. will reduce its near-term pressure on the Japanese to keep their trade surplus from rising in exchange for a relaxation of fiscal policy and a speed up in reforms that will ultimately stimulate domestic demand and, at the same time, make it easier for foreign companies to compete in Japanese markets.
The Japanese economy is currently in a slump which has, for the most part, resulted from what we regard as an ill-timed rise in the consumption tax last April 1. Second quarter GDP slumped at an annual rate of 11.2%, and while the worst part of the slide might have ended, the outlook is not that rosy. The recent quarterly Tankan report (somewhat akin to the monthly NAPM), indicated the Japanese industry, both manufacturing and non- manufacturing, continues to suffer from the domestic demand slowdown, and that, looking ahead, industry leaders did not foresee a rebound before year-end. Indeed, the only growth area in Japan at present has been exports.
JAPAN'S TRADE SURPLUS WITH THE U.S. COULD WIDEN FURTHER–Given the higher growth rate in the U.S. relative to Japan, it is highly likely that the Japanese trade surplus with the U.S. will rise further. Further, recent currency depreciation in key Asian countries that compete with Japan (e.g., Thailand, Malaysia and Indonesia), and the slowdown in the economies of these countries will both offer stiffer competition for Japan in world markets as well as decease the growth in Japan's exports to these countries. Unless the Japanese somehow stimulate domestic demand, the economic prospects will stay gloomy.
By encouraging the Japanese to loosen up on fiscal policy and deregulate faster, the U.S. hopes to both stimulate Japanese domestic demand and to provide for a rise in U.S. exports to Japan over time. Meanwhile, however, it is important for the U.S. not to cut into the only source of growth that is currently working for Japan. Meanwhile, as long as the U.S. is producing at near full capacity, the rise in our trade deficit is less worrisome than if the U.S. were to have excess capacity. Over the long run, however, the rise in the U.S. indebtedness due to the widening current account and trade deficit could be a more onerous problem for the U.S.
The other advantage for the U.S. in allowing for a temporary increase in the Japanese surplus with the U.S. is that it will help keep down prices. In particular, U.S. auto companies have just announced an increase in production at a time when demand may not support that increase. It appears, then, that U.S. companies are prepared to compete fiercely with imports in the next few quarters, and this will probably lead to price cuts.
As far as dollar yen is concerned, the near-term solution to Japan's problems should be relatively supportive of the yen and, indeed, dollar/yen briefly moved back under the 120 level soon after the policy agreement was rumored. The factors which benefit the yen are the potential for an even larger trade surplus and the fact that a relaxation of fiscal policy puts less downside pressure on Japanese interest rates. Meanwhile, however, U.S. fixed income assets remain highly attractive to Japanese investors as U.S. rates remain near 400 basis points above comparable Japanese rates throughout the yield curve. Still, capital flows still favor the dollar and the policy- related response will only temper, not reverse the near-term dollar-bullish positive.
For some time now, we have maintained, albeit cautiously, that a top might be in for dollar/yen (it traded between 1.27 and 128 in late April). Its recent inability to move back above 125 despite woefully weak economic data in Japan, and its recent move back below the 120 level reinforce our opinion, but the primary risk remains a “blowout” on the downside for the yen (to above dollar/yen 127). Specifically, our 2- to 3-week range is .8200 to .8500, and our intermediate-term (3 to 4 month) range is .8000 to .9000.
Our range for other currencies is as follows: Near term we look for the mark to move into the bottom half of our .5625 to .5825 range. Over the next several months, we remain negative on the mark and look for it to test the .5325 to .5475 area. The Swiss will likely move with the mark. Our 3- to 4- month range is .6600 to .7050. We continue to be bullish on the Canadian, but a weaker-than-expected Employment report released on October 10 will likely keep it in a range near present levels for the time being. Our 2- to 3-week range is .7225 to .7325. Finally, we expect the pound to continue in its recent range. Our 2- to 3- week range is 1.5750 to 1.6300.
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
David Horner
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