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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 6, 1997) CURRENCIES: DOLLAR REMAINS VULNERABLE–The dollar continued its downward drift during the past week. However, the dominant trend in the market remains the strength in the Deutschemark relative to the yen. The dollar has simply been caught in the crossfire of these trends. The underpinnings of the dollar's strength are gradually eroding and over the intermediate term, we continue to anticipate an extension of the decline.
The inability of the dollar to move higher during the past week on the back of good economic data, strong asset markets, tensions in the Middle East, and dismal news from Asia is an indication that the underlying dynamic has shifted. It may not be the start of a major bear market. but it appears to confirm that the dollar is headed lower before it can move higher. Underlying the dollar's strength in the past three years has been strong relative growth vis-a-vis the rest of the G7, wide interest rate differentials, worries over European Monetary Union and a favorable policy mix of tight fiscal and monetary policy. These factors, although not completely gone, are waning in importance.
First, the rest of the G7 countries are closing the gap in terms of growth with the U.S. Japan is still the exception, but Europe and Canada are showing steady improvement, which removes some of the appeal of the dollar. Moreover, interest rate differentials versus these countries are shrinking as well. The spread between U.S. two-year yields and German two-year yields has declined sharply in the past few months. Similarly, Canada is beginning to close the yield gap with the U.S. Secondly, the worries over European Monetary Union which drove out capital earlier in the year have given way to EMU euphoria. Now there is even talk of the British, the most skeptical, joining on the first round.
Most important of all, the U.S. policy mix has gotten less favorable. The head of the Federal Reserve is now a “new age” economist who has allowed money supply growth to skyrocket in the face of 4% growth. Meanwhile, Bundesbank officials warn of inflation when unemployment remains near post war record highs. Fiscal policy remains tight which is negative for the currency unless it signals the undoing of excessive deficits, but at this stage that concern has eased. Finally the U.S. commitment to a “strong dollar” policy seems to be waning. U.S. Treasury Secretary Rubin is beating the drums to get Japan back to the bargaining table and showing clear frustration with the lack of progress there. At least for the intermediate term then, the dollar supportive factors which have driven the bull market in the dollar are slipping away.
Market signals for the dollar were also unfavorable last week. Tensions in the Middle East should have boosted the dollar on safe haven buying. Instead it languished against the major currencies. The recent rally in metals prices may be a signal of waning confidence in financial assets as the recent implosion in South East Asian currencies shakes investor confidence. At the end of the day, these signals could prove to be temporary “noise” but they do point to the likelihood that the dollar is going to drift lower near term.
THE WEEK AHEAD–There are several key events coming up next week to move the market. On Sunday evening Federal Reserve Chairman Greenspan delivers a speech in Boston which of course will be closely watched for signals on monetary policy. If he remains in the “new age” camp, signaling lack of concern on inflation, then the dollar is likely to decline. Also on Sunday night, Japan releases trade data for the first twenty days of September. Another large increase will likely increase tensions with the U.S. leading up to talks later in the week. In Europe, the EU finance ministers meeting on Monday and Italy tries to resolve its political/budget crisis later in the week. Rounding out the week, the U.K. Monetary Policy Committee will meet Thursday, and Canada release employment data on Friday.
The one thing that seems quite certain is that the foreign exchange markets will remain volatile. Based on the expected data, the DM/yen trades still look like the best bet. However, we would not be too complacent on short positions in the yen at this stage. For the dollar. the downward drift is likely, to continue.
BRITISH POUND–As usual, the British Pound traded all over the map during the past week. Following the pattern of the past few weeks, a nascent rally was snuffed out by talk of Britain's early entry to European Monetary Union. Markedly, sterling could not sustain a rally on denials about EMU or rising oil prices. Hence, the currency looks vulnerable at current levels.
On the economic front, the data continue to be generally supportive. However, weakness in the Purchasing Managers' survey suggests that the service sector is slowing. The manufacturing sector has seen some weakness due to high interest rates, but this was the first indication of a slowdown in the service sector. The offsetting factors however, were another jump in consumer credit and ongoing strength in money supply. The economic indicators suggest some slowing in the pace of growth as a result of high interest rates, but the ebb and flow of consumer spending has not shown any evidence of signaling a sustained decline. Hence, the risks in the economy still appear to be to the upside rather than towards weakness. Next week's data are not likely to be much more revealing. The Retail Price Index will probably signal a modest decline in inflation which could weigh on the British Pound but industrial production and manufacturing output should post moderate gains. Finally, the CBI trades survey is anyone's guess.
We continue to look at the British Pound as a trading range market. The rumors of early entry to EMU seem overdone simply because there are so many obvious obstacles in the near term. Most importantly the huge economic differences which exist between Britain and continental Europe argue for later entry, if at all. Nonetheless, the rumors are likely to continue and if Britain is to enter EMU it will likely be with the cross against the Deutschemark closer to 2.70 than the current level. Against the dollar, look for a range trade of 1.5800 to 1.6300.
DEUTSCHEMARK–The Deutschemark continued to strengthen during the past week despite the lack of action on the repo rate. Next week's Bundesbank meeting is not likely to result in a change in policy either as the rally in the currency have offset concerns about import price inflation.
The factors supporting the Deutschemark in the short term are the gradually improving economic data, the threat of intervention or rate hike from the central bank and the growing enthusiasm in the market for EMU. Next week's economic data should not be an impediment to further gains. Although we don't look for action from the Bundesbank, the threat is going to remain. The unemployment data should show a modest decline in the rate from 11.4% to 11.3% but with a net increase of about 25,000 in unemployment. As such, the outlook for employment is still soft. On the political front, Kohl's opposition has been weakened by the recent regional elections which should shore up his position. Finally, Waigel has announced a modest repeal of the “solidarity tax” which was imposed to finance unification. Repeal of the tax should filter through to domestic consumption at some stage which is also a net positive longer term.
In the near term then, the Deutschemark appears poised to test the upper limits of its recent rally. Although the long-term outlook is not all that favorable since Germany is still a difficult place to invest and do business, the intermediate-term outlook is positive. Hence, we look for a test of the 1.7200-1.7300 dollar/DM level and want to stay with long positions in the December contract.
SWISS FRANC–The Swiss Franc also posted a healthy rally during the past week, reaching a five-week high against the dollar. The economic data continue to point to a modest recovery in place which is positive. However, given the central bank's bias towards easy money, gains are likely to be limited.
The Swiss economic data indicate some hints of better growth. Building permit applications rose 7.1% on a year- over-year basis in September and second-quarter industrial production jumped nearly 10%. However, these figures are coming off of a very low base, so the gains overstate the condition of the economy. Nonetheless, a gradually improving trend is apparent. However, inflation fell to a 33-month low in September, standing at only 0.4%. Moreover, even with growth approaching its best level in seven years, GDP is only likely to advance 1.7% this year. Hence, monetary policy is likely to remain accommodative which should limit the upside potential in the Swiss Franc.
In the near term, we anticipate that the Swiss Franc will follow the Deutschemark higher against the dollar and yen. However, we look for a downtrend versus the mark. Stay with long positions in the December contract.
JAPANESE YEN–The Japanese Yen drifted lower during the past week, but failed to take out its recent lows. Dismal economic news and record low interest rates weighed on the currency, but worries over the trade dispute with the U.S. provided support.
On the economic front, it is hard to imagine the news getting any worse. The quarterly Tankan survey indicated both large and small businesses are pessimistic about their prospects. Moreover, both manufacturers and non-manufacturers are gloomy. It had been anticipated that sentiment would weaken, but the decline was more than anticipated with the index for major manufacturers' declining from +7 to +3 and the index for non-manufacturers falling steeply from —7 to —15. Perhaps most interesting, large manufacturers who are believed to be somewhat shielded from weak domestic demand by strong export growth showed a decline as well. In addition, household spending continues to fall and housing starts plummeted by over 17%. Rounding out the week was the unemployment report showing the rate unchanged at 3.4% with the ratio of job offers to seekers holding at 0.74%.
If it is hard to imagine the numbers getting worse, maybe that is just the reason to think that they won't. Taking a contrarian point of view, it is not surprising that the economic numbers for the quarter ending in September were poor. After all, taxes were raised and government spending scaled back in the spring. Tightening fiscal policy in the midst of a very sluggish economy is not exactly high on the list of recommended moves by Keynesians or monetarists. Nonetheless, the impact of the tax hike is probably most pronounced in the months just after the hike is in place. So going forward, the economy will probably adjust. Beyond that, Japan's politicians will probably get into the act sooner or later. Although there is an incredible ability in Japan to withstand self-inflicted economic woes, at the end of the day politicians are politicians. They want the economy to run well so they can get votes.
It would not be surprising between now and year-end to see Prime Minister Hashimoto tell the bureaucrats to sit down while he introduces another fiscal stimulus package. A cut in consumer and corporate taxes along with some renewed spending programs could boost confidence and activity as well as the standing of politicians in the polls. Moreover, such moves if they included at least token deregulation of the consumer sector, would keep the U.S. and European critics at bay. The question is when or if such a scenario will play out.
In the meantime, the market is more likely to focus on the weak economic data which should pull the yen lower. Trade friction will likely mean however, that the downside is limited at least temporarily.
We are still looking for a decline in the yen to the 125-130 region by year-end, but we are concerned that this is a universally held expectation. As a result, the market is vulnerable to any news which suggests a stronger than expected Japanese economy and/or a heating up of trade problems.
CANADIAN DOLLAR–FINALLY, HIGHER RATES–The Bank of Canada finally fulfilled market expectations by raising short-term interest rates 25 basis points during the past week. It was the second rate hike of the cycle and had been widely anticipated. Nonetheless, the move gave a boost to the Canadian Dollar.
As we have noted for months, the Canadian economy is quite robust. Last week's GDP report indicated that growth in August rose by 0.8%, well above expectations and signaling a very healthy third-quarter rate. In fact, the rate of growth in Canada looks likely to come very close to the second quarter's blistering 4.9% pace. In addition, nearly every sector of the economy is booming. Housing, manufacturing, durable goods, services and retail sales are all strong. If the Canadian economy continues to grow at a 4% pace, then the output gap would be closed by late 1998. As a result, last week's hike of 25 basis points was probably just the second in a series of gradual tightening moves that will be seen over the next year. Bank of Canada Governor Thiessen pledged to keep inflation low through preemptive policy but allowed as how there was room to do so gradually. Right now, the Monetary Conditions Index does not signal the need for tighter policy due largely to the rise in the Canadian Dollar.
The only negative on the horizon is the widening current account deficit. Although by U.S. standards, the deficit is minor it is starting to widen in spite of the strong export sector. However, we doubt this will be much of an issue over the next six months. Moreover the obvious response on the part of the central bank would be to damp domestic demand with higher rates. Hence, we are inclined to not let it be too worrisome.
Next week's string of economic reports should be supportive to the Canadian Dollar. The big report will be unemployment on Friday which we expected to show another robust gain in jobs of about 40,000 with the rate falling below 9%. A gradual decline in unemployment is likely over the next year. Other data due next week include building permits and housing starts as well as motor vehicle sales. Healthy numbers are anticipated since consumer demand has been robust. In all, the outlook for the Canadian Dollar remains favorable, We have two long positions established against short positions in the December 98 futures. We are looking to add long positions in the currency next week.
Kathy Jones
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