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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(September 29, 1997) CURRENCIES: DOLLAR DOLDRUMS–The dollar continued its steady decline during the past week, falling to a ten-week low against the Deutschemark. However, the dollar put in a more steady performance against the yen and other major currencies. In all, the recent shifts in the markets continue to point to increased volatility with the potential for further dollar weakness over the intermediate term.
Domestically, the economic news for the U.S. continues to be quite favorable. Last week's economic data simply highlighted the ongoing strength in the economy, particularly the manufacturing sector which is enjoying its most sustained expansion in decades. Factory orders were strong, housing demand is up and hiring continues at a pace which is testing the limits of the labor market. The strength in manufacturing suggests that the U.S. remains competitive even with the dollar having appreciated sharply over the past two years. These factors are all supportive and when taken in combination with healthy consumer spending, suggest that there is still the risk of a hike in rates in the U.S. later this year.
Then why has the dollar fallen in the past two months? The first and most obvious reason is that the situation abroad has begun to change. Europe's moribund economy has begun to show enough life to signal the end of the extremely accommodative monetary policy of the past few years. Although Europe is far from a robust expansion, the worst does appear to be over. Strong exports, driven by currency depreciation coupled with very easy monetary policy for several years are finally producing healthier year-over-year growth rates. Moreover, the G-7 finance ministers have gotten into the act. Germany's officials have successfully talked the Deutschemark higher through threats of higher rates and emphasis on the potential inflationary pressure stemming from rising import prices. Japan's finance officials have so far, defended the yen from further depreciation by raising the threat of intervention. More importantly, the U.S. has been fairly quiet on the issue. No objection has been made to the dollar's slide although it has not been officially encouraged either. All this suggests a shift to a more “benign neglect” attitude towards the dollar at current levels.
In addition, there is perhaps a more economic explanation for the dollar's recent weakness. The U.S. now appears to be running a far more accommodative monetary policy than over the past few years at a time when monetary policy is shifting towards a bit more tightness in Europe. U.S. money growth has been rising over the past two years, but it has accelerated sharply in just the past six months. In contrast, money growth has slowed in Germany, suggesting a less accommodative policy. In addition, the yield spread between U.S. and German intermediate-term rates has narrowed substantially in the past six months. Typically the dollar/mark relationship tracks this spread although in the past year that was not the case. Perhaps concerns about EMU or simply the depth of Europe's recession overwhelmed the relationship. Now it may be that the relationship is getting re-established which would mean that the dollar/mark parity should be closer to 1.7000 than 1.8000.
In Asia, however, the situation is much different. Not only does Asia have to deal with the recent series of economic and political disasters, but the region now has an ecological disaster on its hands. In some ways, the smokey haze hanging over Asia seems almost to be a physical manifestation of the region's economic problems. The burning of the forests in Indonesia and the impact on the rest of the region suggest even further downward pressure on the economies of Southeast Asia and heightened political tensions. As a result, it seems unlikely that Japan's economy will muster much strength in the near term, keeping the yen in a downward drift against the other currencies.
Elsewhere, sterling continues to provide the foreign exchange market with a lot to talk about, rallying early in the week only to plunge on Friday in response to speculation that Britain will try to enter EMU. The Canadian and Australian Dollars posted moderate recoveries last week although the outlook for these currencies continues to diverge despite the similarity of their economies.
Given the mixed fundamental story for the currencies, we would continue to anticipate a further downward correction in the dollar over the intermediate term, particularly against the European currencies. Given that portfolios are probably still overweight dollars, the risk of further liquidation will remain a negative for the dollar and dollar-denominated assets. However, the downside for the dollar is most likely limited over time by the macro economic picture. If the currencies of Europe rise too quickly, the driving force behind the nascent recovery will be snuffed out, leaving little to boost growth. Moreover, too strong a rise in the Deutschemark will be a negative for EMU in general leading up to the setting of the parities in May 1998. We anticipate that the dollar/mark will trade in the 1.7300 to 1.7800 region while the dollar/yen will likely remain confined to the 118-123 range.
THE WEEK AHEAD–The week ahead will see a slew of economic reports out of the U.S. along with the FOMC meeting. However, early in the week the focus will be on the Bundesbank's repo setting Tuesday. Rumors of a hike in the repo rate of 10-15 basis points are circulating, so the market is going to be closely attuned to developments in German monetary policy. In the U.K., Blair addresses the Labour Conference early in the week and given the speculation about entry into EMU, his comments are going to be market-movers. Finally, Japan weighs in with the quarterly Tankan survey, which should only confirm the dismal state of the economy.
We expect the U.S. economic data to remain strong, which should provide some support for the dollar. However, no one expects a rate hike by the Fed so the focus will remain elsewhere. The Deutschemark appears likely to benefit at the expense of the dollar and the yen.
BRITISH POUND–Just when it seemed safe to re-enter the long side of the British Pound on strong economic data and the likelihood of higher rates, the story about Britain entering the EMU re-surfaces. Sterling, which was hovering near an eight-week high against the dollar and was edging higher against the mark, plunged to the bottom of its recent trading range.
The story of Britain joining European Monetary Union in the first round has surfaced twice in the past two weeks. The story in the Financial Times suggests that skeptical government officials have been won over by the argument that Britain may be missing out on access to the European market by remaining out of EMU. Of course, this is clearly not a new argument, but the fact that the reports are coming from the FT and have surfaced a few times lends credibility to the idea that perhaps the story is a trial balloon. Among the population, there is not inclination to join EMU and of course the Tories have practically torn themselves apart on the issue. However, among the bankers and business leaders, there is worry and perhaps they are working to persuade government officials of the benefits of EMU membership.
However, it hardly seems reasonable to assume that Britain will really enter EMU on January 1 1999. There are three very compelling reasons why skepticism is warranted. First, a referendum has been promised on the issue. Convincing the British public to join EMU would involve a concerted, time-consuming and expensive public campaign. Just getting such a campaign put together in time to make the parity setting in early 1998 would be a task. Secondly, Britain does not meet the currency requirements for EMU. The Maastricht accord stipulates that member countries must have maintained their currencies within the ERM for two years prior to entry. Britain dropped out of the ERM in 1992 and has not re-entered. Now, perhaps it is possible that the EU countries would agree to suspend this part of the agreement, but it would have to be addressed.
Third and perhaps most compelling is the economic argument against Britain joining EMU on the first round. Britain is at a very different stage of the business cycle than continental Europe. Growth is strong, inflation is creeping higher, unemployment has fallen sharply and the Bank of England has raised rates four times this year. In contrast, continental Europe's recovery is just getting under way. Unemployment is at record levels, consumer spending is still contracting and monetary policy remains generally lax. Britain's base rate is 7% while Germany's is 3%. How could the European Central Bank set policy for these two countries? What would be the appropriate base lending rate? It is going to be difficult enough to set one policy for Germany and the Netherlands, let alone Britain. It would seem quite disadvantageous for all concerned for Britain to enter EMU in the first round.
Nonetheless, the rumors have driven the market and pushed sterling back towards its lows. Moreover, even if the upcoming economic data are strong and it looks like the Bank of England is going to raise rates, it may be difficult to sustain rallies in sterling. We continue to believe the fundamentals are good. The economy is growing at a healthy pace, nominal and real interest rates are high and Britain's economy continues to be among the most competitive in the industrialized world. Even with the rise in sterling earlier this year, exports are growing at a healthy clip. Next week's data calendar features money supply figures which should confirm strength in consumer spending. In addition, Blair will address the Labour Party Conference and the subject of EMU will be what the market waits to hear about. All in all, the fundamentals are good. We would continue to trade this in a range however, buying near the 1.5900 level and selling near 1.6300.
DEUTSCHEMARK–Expectations of higher interest rates in Germany continued to drive the Deutschemark higher against the other major currencies during the past week. The gain pushed the currency to new highs for the move against the dollar, the yen and the British Pound. The Deutschemark also strengthened against the other ERM currencies.
The driving force behind the rate hike expectations is the evidence of an uptrend in import prices. Last week's data which indicated a 0.9% month to month increase in import prices helped to raise the likelihood of a near-term hike in rates by the Bundesbank. Import prices are now rising at a 5.4% clip which is well above the central bank's comfort level and clearly an out-growth of the currency's weakness over the past few years. However, it is worth pointing out that the increase in import prices did not find its way into the CPI figures for August, which indicated a modest 0.2% increase to a 1.8% rate. As a result, it is still questionable just how much inflation is being generated by rising import prices. Moreover, now that the Deutschemark has rallied 7% against the dollar since August 1, the threat of even higher import prices should diminish.
Nonetheless, there is still a strong chance that the Bundesbank will begin to raise interest rates sooner rather than later. They would certainly be glad to see the mark closer to the 1.7000 level than it is now. In addition, they want a strong currency going into European Monetary Union, so that there will be less pressure on the new European Central Bank to raise rates at the outset. Next week's economic data may not provide the compelling evidence needed to justify a rate hike however. Industrial production and manufacturing orders are likely to have declined in the past month. Consumer sentiment is expected to rise slightly but with no evidence of an increase in spending, the impact should be limited.
The market is going to be watching the repo setting on Tuesday. There has been considerable talk of a 10-15 basis point rate rise at that time. If it does materialize, the Deutschemark is likely to test the 1.7300-1.7400 region against the dollar. If they leave rates unchanged, then a setback is likely within an overall trading range environment. From a longer-term perspective, we see this as a range bound currency with upside in the 1.7000-1.7300 region and downside at 1.8000 to 1.8200.
SWISS FRANC–The Swiss Franc rallied against the dollar during the past week, following the lead of the Deutschemark. However, it gave up ground against the mark as the Swiss National Bank is not expected to follow a German rate hike in the near term.
Although Switzerland's economy is experiencing a more solid recovery than Germany's, it is likely that the Swiss National Bank will take a more cautious approach to tightening monetary policy. The Swiss economy has recently posted its strongest growth rate since 1990 and prospects are for a pick up in momentum into 1998. The leading indicators are trending higher, exports have picked up and tourism has recovered from a substantial decline in the past few years. However, the pace of growth is far from robust and it appears that the central bank is inclined to let the currency stay soft for a while longer to ensure the recovery becomes entrenched. Money supply growth has slowed in the past few months to a 4.2% annualized rate, which is above the top end of the target range, but still slower than earlier in the spring. Moreover, with annualized inflation at only 0.5% and significant excess capacity, there is not likely to be a significant upturn in price pressure for at least a year.
Finally, the Swiss National Bank wants to be sure that the Swiss Franc does not gain sharply on the other European currencies in the run up to European Monetary Union. Safe haven inflows of capital could cause the Swiss Franc to strengthen at the expense of competitiveness. Hence, it is likely that the Swiss Franc will continue to lag the Deutschemark. However, given the ongoing correction in the dollar, there is probably some further upside potential to the Swiss Franc over the near term.
JAPANESE YEN–MR. YEN STRIKES AGAIN–The Japanese Yen staged a recovery early in the week on comments from the Ministry of Finances' “Mr. Yen.” He indicated that the market was not taking the G7 communique seriously and should note that they do not want to see excessive weakness in the currency. The market jumped higher in response to the comment but drifted back towards the lows later in the week.
The problem with trying to “talk the yen higher” is that the fundamentals are still so poor. Japan's economy has slipped back into the doldrums after a modest recovery late last year. The April 1 consumption tax hike cut into consumer spending just when the recovery was starting to show signs of gaining momentum. The most recent data have been anything but encouraging. Department store sales are falling, output is weak and now with the problems in Southeast Asia, exports look likely to soften. Adding insult to injury, the CPI jumped last month as medical care costs surged. Medical care costs rose as a function of the government pushing costs onto the consumer in an effort to reduce the soaring budget deficit.
Given that there is little the government can do with fiscal or monetary policy to boost the economy in the near term, it is likely that the yen is going to remain in the doldrums. Next week's release of the quarterly Tankan survey is expected to show on-going weakness in the consumer sector and a slowdown in manufacturing. The Bank of Japan cannot afford to raise interest rates in the current environment, so the outflow of capital from Japan is likely to continue. JGB yields fell to a record low 1.88% last week, bringing real ten-year yields into negative territory. The only impediment to a weaker yen is the prospect of rising political tension with the U.S. over trade. But even that is not likely to be a strong enough factor to prevent the yen slipping to new lows at some point before year end. We continue to favor selling rallies towards the 118 level in anticipation of a test of new lows longer term.
CANADIAN DOLLAR–STILL WAITING FOR THE CENTRAL BANK–The Canadian Dollar posted a healthy rally during the past week, but pulled back from its highs on Friday. The market continues to gain on the expectation that monetary policy will be tightened in response to strong growth. However, to date, the Bank of Canada has proven reluctant to take further steps and that is the limiting factor for the currency.
Canada's economic data continues to point to robust growth, but without significant inflation pressure. Although GDP growth in the third quarter is likely to match the second quarter's unbelievable 4.9% pace, inflation has remained subdued. The department store sales data released last week point to robust consumer demand. Moreover, all of the ingredients of further gains are in place. Income and employment growth have risen strongly in the past year. Pent up demand for durable goods and housing has been evident. Manufacturing is growing rapidly as the strength of the U.S. economy continues to feed exports. The output gap is gradually closing. Nonetheless, the Bank of Canada has yet to move rates up after the 25-basis-point move to the 3.50% level a few months ago.
Bank of Canada Governor Thiessen and Deputy Governor Kennedy have both laid the groundwork for a rate hike. They have indicated recently that the output gap is closing and that the central bank will have to be forward looking. They've discussed the Monetary Conditions Index (MCI) and the need to monetary both the exchange rate and interest rates. However, until there is some catalyst for a rate hike, the Canadian Dollar is likely to flounder. The next chance will be the GDP report September 30th. If the figures show another huge rise in output, it is possible the central bank could tighten policy. Of course, if the U.S. decided to raise rates, it is quite likely Canada would follow due to the potential negative impact on the currency and in turn, the MCI. However, if the GDP figures and the Fed do not provide the reason, then attention will turn to the Employment report October 10th.
Our view is that the Canadian Dollar will eventually rally in response to tighter monetary policy. However, in the near term the currency could continue to range trade. We favor long positions in the December Canadian Dollar futures with corresponding short positions in Canadian BAs. If the currency falls then BAs should fall in anticipation of a rate hike. If the currency rallies, the BAs could rally on ideas that rates remain on hold. However, a substantial move up in the currency could be caused by higher rates, which would make the position work on both sides.
Kathy Jones
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