Prepared by Merrill Lynch & Co.

International Fixed Income Research

The Japanese Yen often trades with a great deal of inertia over short- and medium- term periods, then moves suddenly to a new equilibrium level. After it moves to that new equilibrium level, the yen will then tend to consolidate, trading in a sideways manner until it moves suddenly again.

The yen now finds itself locked in a new period of consolidation centered around the ¥/U.S.$120 level. When it breaks out of its present trading range, we believe it will move in the direction of a weaker yen. The ¥/U.S.$ exchange rate has been trending higher for 2½ years now, with the big steps upward occurring in the summer of 1995 and in the winter of 1996- 97, and the time now appears ripe for another big move upward that could carry the ¥/U.S.$ exchange rate to 130 or even higher.

The catalyst for a new round of yen weakness could come from concerns about the recent declining trend in share prices on the Tokyo equity market. The Nikkei 225 index has declined roughly 15% since late July, and there are growing concerns that if it falls below the 17,000 area, which is widely viewed as an important technical support level, share prices could decline a further 10% in the weeks ahead.

What is particularly worrisome is that this decline is occurring at a time when Japanese short- and long-term interest rates are at record low levels, and when the yen is presumably trading at a more competitive level. Indeed, while the weak Deutschemark of the past 2½ years has supported a strong share-price rally on the German equity market, a weaker yen has not been able to lift Japanese share prices.

The poor performance of Japanese share prices and the record low level of Japanese bond yields are clear signs that the marketplace is extremely concerned about the weakening state of the Japanese economy, and rightly so. The Economic Planning Agency's (EPA) leading indicator of the Japanese economy is down sharply, and is pointing to a major slowdown in industrial-production growth in the months ahead.

Assuming Japanese growth weakens, the risk of a further rise in corporate bankruptcies, which are already at record levels, will grow. This risk is now being reflected in a sharp slump in Japanese bank share prices; the market is clearly becoming concerned about the possibility of a further rise in non-performing loans on bank books. Bank share prices have been declining steadily for the past seven years, but they have recently started to fall quite sharply in the past few weeks. Since late September, they have fallen nearly 10%.

It is hard to imagine the yen gaining ground on the dollar in this environment. Declining share prices, record low interest rates, a major slowdown in domestic economic activity, record bankruptcies, concerns about the health of the banking system, and the Bank of Japan's pursuit of an aggressive easy monetary policy should all work to drive the yen lower over time.

Yet there are many who believe that a further decline in share prices may actually prove to be positive for the yen. This view stems from the belief that Japanese investors, in a scramble to rebuild liquidity, may be forced to sell off their foreign holdings and bring the proceeds back to Japan to pay off creditors and rebuild depleted cash positions. This so-called “repatriation argument” is based more on myth than reality. It is highly unlikely that Japanese investors would move to sell assets that are rising in value and reinvest them in markets that are declining in value. The exact opposite is more likely to be the case.

With Japanese growth expected to weaken and the yen expected to slide in value, the question arises whether this could have effects on other markets and currencies. Two areas that could be adversely affected are North and Southeast Asia, which have strong trade ties with Japan. The same goes for the Australian Dollar. Roughly 20% of Australia's exports go to Japan, and another 15% go to the ASEAN countries. Including the 22% of Australia's exports that go to North Asian countries, a rather large 57% of Australia's exports go to all Far East nations.

A slowdown in the Far East would negatively affect Australia's trade balance and domestic economic growth. If this helped push Australian bond yields lower relative to U.S. bond yields, the A$ would likely come under downward pressure.

An interesting way to capitalize on a weaker yen would be to take on a long-C$/short-yen position. There are a number of reasons why the Canadian Dollar may be a better vehicle than the U.S. Dollar to position a short-yen trade. First, on a PPP basis, the C$ is now undervalued versus the U.S.$ by around 20%, more than ever before. Second, the Canadian economy appears poised for sustained strong growth, which should lead to a gradual tightening of monetary conditions by the Bank of Canada. Real GDP growth in Canada languished during the 1990-93 period, then rose briefly in 1994, only then to slow down again in 1995-96. But leading indicators are now rising at a 13-year high pace. We therefore look for Canadian real GDP growth to average close to 3.5% per annum in 1997-98.

Third, Canada actually runs a bilateral trade surplus with Japan. Many investors fear that the U.S. Dollar's upside potential versus the yen may be limited if U.S. policymakers voice concern that a rising ¥/U.S.$ exchange rate could lead to a further widening of the politically sensitive U.S. trade deficit with Japan. Since Canada does not have this problem, the ¥/C$ crossrate should exhibit less inertia to the upside than the ¥/U.S.$ exchange rate.

Actually, the ¥/C$ crossrate has been trending higher for the past 2½ years as the C$ has essentially piggybacked on the appreciating U.S.$. From a low of ¥/C$60 in the spring of 1995, the ¥/C$ crossrate has risen to the 85-90 area. Our expectation is that it will rise further to at least 98 in 1998. On most valuation criteria, the C$ is far superior to the yen. The yen is the most overvalued currency in the industrial world, while the C$ is the most undervalued.

In addition, Canada has made tremendous strides in reducing its budget deficit in the past five years. In contrast, Japan's budget deficit has nearly doubled in size over the same period. Furthermore, Canadian fixed-income assets presently enjoy a hefty yield pickup over comparable Japanese assets along the entire maturity spectrum. Finally, while Canada's leading indicators point to stronger growth in the months ahead, Japan's leading indicators suggest just the opposite.

Canadian bonds have been star performers this year–Canadian bonds in local currency terms have significantly outperformed their U.S. counterparts–given that the C$ is the world's second-strongest currency (right behind the U.S.$). In fact, the Canadian bond market has posted the highest total return among all the world's major bond markets in U.S.-Dollar terms since the beginning of the year. Looking ahead, Canadian bonds should stay ahead of the rest of the pack, but this time most of the relative outperformance should come from the currency side rather than the bond side.

We are bullish on the C$ now that the Canadian economy is in the midst of its strongest growth surge since the late 1980's. Canadian GDP growth in the second quarter was 4.9% at an annualized rate, and the prospects for the third quarter are looking even better. Growth is currently well-balanced, unlike the export-dominated growth of the early 1990's. Real domestic demand has risen by over 5% at an annualized rate for three consecutive quarters, with business investment growing at a year/year rate of more than 20%. The interest-rate-sensitive sectors of the Canadian economy–new car sales, department-store sales, housing starts, and building permits–all posted year/year growth rates in excess of 20% in the third quarter. The manufacturing sector also started the third quarter strongly; in July, new orders rose by 7.2%, shipments were up by 3.8%, and inventories fell by 0.8%. This is clearly a sign that supply is having trouble keeping up with demand.

The Bank of Canada has promoted robust growth by maintaining relatively low interest rates over the past year. These low interest rates have been possible because Canadian inflation has stayed lower than inflation in the U.S. for eight years in a row, and because Canada has implemented an impressive fiscal consolidation program in the past few years. But the BoC has made it very clear in recent statements that it will be shifting monetary policy from an accommodative stance to at least a neutral stance over the coming months. It has already raised rates twice (by 25 basis points each time) in the past four months. Since the last tightening, BoC Governor Thiesen has said that the market can expect a combination of a stronger C$ and higher short-term rates in the months ahead, and that “exporters should prepare themselves for a stronger C$.”

How high Canadian interest rates will go largely depends on how strong the C$ gets. We envision short-term interest rates being raised by 75 basis points, regardless of any rise in U.S. short-term rates in the coming year. This should result in a significant narrowing of the short-term interest-rate differential between the U.S. and Canada, which should, over time, push the C$/U.S.$ exchange rate from the current 1.38 level down to the mid- 1.30's over the next three months, and to the low 1.30's over the next year.

Finally, we would like to offer some thoughts on the outlook for the Deutschemark. The Bundesbank's hike of its repo rate from 3.00% to 3.30% is being viewed largely as a pre-emptive strike to prevent inflationary pressures from building in the future. Since the move was conducted in a joint action by several European central banks, it is also being widely viewed as a demonstration of the European central banks' commitment to a hard Euro. The rate hike has clearly altered market expectations of the future path of German short-term interest rates. Previously, the market was expecting German short-term rates to rise toward 4.5% by the end of 1998, from 3.6% today; it now expects them to rise toward 5.0% by early 1999. This past summer, the market was looking for 1998 year-end German short rates to rise to only 4.0%.

This change in expectations has affected the entire German yield curve. Indeed, in the past few months, nominal and real yield spreads between the U.S. and Germany have narrowed significantly as German yields have either risen more or declined less than their U.S. counterparts. Such movements have clearly affected the DM/U.S.$ exchange rate in recent weeks. Historically, the 10-year U.S./German government bond real yield spread has been highly correlated with the trend in the DM/U.S.$ exchange rate. With U.S./German real yield spreads narrowing significantly in the past two to three months, it should come as no surprise that the dollar has lost ground to the Deutschemark.

The question that international investors are trying to wrestle with at the moment is whether the dollar may be vulnerable to further downside risk in the weeks ahead. In our view, the marketplace is pricing in too much tightening in German monetary policy out to the end of 1998. While it is true that German growth has picked up and that short- term interest rates will need to rise, we seriously question whether they will need to rise as much as the market currently expects. Bundesbank policy members must still take into account a record-high unemployment rate of 11.7%, sustained weakness in German retail sales, weak growth in German capital spending, surging overseas direct investment by German firms, and a large negative output gap for all of Europe.

Assuming that German short-term rates rise by less than the market expects, we would argue that the dollar's downside risk from present levels should be limited. On balance, we expect the DM/U.S.$ exchange rate to be broadly stable at around the 1.75 level between now and the end of the year. Looking ahead to 1998, we see the dollar's appreciating trend getting back on track. Next year, the major problem facing the Deutschemark will be political risk as the September 27, 1998 federal elections in Germany draw nearer. Germany's high and rising unemployment rate, as well as general public concern about the stability of the new Euro currency, could become important issues and affect the outcome of the next election.

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

October 23, 1997Michael R. Rosenberg and Karim M. Basta

Merrill Lynch & Co.

International Fixed Income Research

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