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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(October 13, 1997) CURRENCIES: INTEREST RATES OR ASSET PRICES: WHAT DRIVES THE DOLLAR?–Whenever the dollar shifts direction, it is always difficult to pin point the driving force with great clarity. The reason is simply that the driving force changes. At some times, relative growth rates and interest rate differentials are the clear factors behind the dollar's moves. At other times, it is the performance of the U.S. capital markets which drive the direction.
Recently, the dollar's weakness against the major currencies seems to fit the pattern of an asset-driven decline. Although the U.S. economy remains robust and interest rates have been raised, the weakness in stocks and bonds has been dragging the dollar lower. The underlying issue appears to be that the pace of foreign investment is slowing and given the U.S. dependence on foreign capital due to the current account deficit, the slowdown in capital inflows is weighing on the dollar. The trend is likely to continue. The inflow of foreign capital into the Treasury market has clearly slowed in recent months. These official inflows have been quite strong and have helped to bolster the dollar. Although we don't anticipate a huge decline, the rising trend in rates in Europe and most of the rest of the G7 suggest a slower pace.
Another factor has been the rising trade tension with Japan and lack of official support for the dollar. Last week's auto sector talks, like so many rounds of meetings before, ended with no resolution. Meanwhile, there is pressure on Japan to boost domestic growth through fiscal policy which could prove supportive to the yen. In the midst of all the recent turmoil, supportive words for the dollar have been lacking. Treasury Secretary Rubin has expressed concern about Japan's trade surplus and slow pace of deregulation but has said little about the dollar. It is unlikely he will aggressively “talk the dollar down” as that would be self-defeating for the U.S. Nonetheless, the lack of overt support is a negative.
In the near term then, expected weakness in stocks and bonds along with lack of official support should mean that the dollar will work lower. We don't look for a huge decline or even a very aggressive one as the U.S. economy remains robust and most longer-term fundamental factors are still positive. However, in the changing interest rate environment abroad, the dollar can correct further to the downside.
THE WEEK AHEAD–In the week ahead, the markets will begin a holiday-shortened week focusing on the Japanese trade surplus figures and then quickly turn to a slew of U.S. economic reports. In addition, Fed Chairman Greenspan will speak to Congress again on October 14th, an appearance which could mean another decline in stocks and bonds should he reiterate his concerns about overvaluation In these markets. In Europe, there will be an EU finance ministers meeting and the ongoing political drama in Italy to drive the markets. These factors suggest a rather choppy week ahead.
We, look for the dollar to test the 1.7000-1.7300 range against the Deutschemark and the 117-118 level against the yen over the intermediate term.
BRITISH POUND–The British Pound edged slightly higher against the dollar but weakened against the Deutschemark last week. The Bank of England's decision to leave rates unchanged at last week's meeting was a minor negative. Overall, this remains a trading range currency.
The economic data for the U.K. remain strong enough to suggest that interest rates will rise further before year-end. Last week's manufacturing data were soft, indicating a modest decline in both manufacturing output and industrial production in August. However, much of the decline was due to the warm weather which reduced utility output and usage. Hence, the indications are that this sector is still growing at a moderate pace. The consumer sector is where the strength in the economy continues to show up. Last week's Confederation of British Industries (CBI) survey indicated a very robust outlook for consumer spending in the months ahead. Based on the jump in the index for retailers, spending should grow at a 6% annualized rate in the fourth quarter.
The inflation outlook points to the likelihood of another 25- to 50-basis-point hike in rates in the next few months. The Retail Price Index (RPI) rose modestly last month, bringing the overall rate up to 3.6% and the core rate to 2.7%. Given the central bank is targeting a core rate under 2.5%, these figures signal the likelihood of another rate hike given the strength in domestic demand. Hence, the British Pound should be well supported by the prospect of higher rates going into year- end.
However, the upside is limited by the likelihood that Britain will move towards joining the European Monetary Union longer term. The Labour government appears pre-disposed towards joining EMU and as a result, they will likely try to keep sterling from rising much against the core European currencies. Although we don't look for Britain to join in 1999, they will probably target the 2.60-2.70 Deutschemark region.
In the week ahead, the PPI data are likely to indicate modest inflation at the wholesale level while the Unemployment report is expected to show another large drop in unemployment. With a tightening labor market and rising wages, there is likely to be upward pressure on the currency. We continue to favor trading the December British Pound in a 1.5900 to 1.6300 range.
DEUTSCHEMARK–The Bundesbank decision to hike short-term interest rates 30 basis points was only a surprise in terms of timing. The central bank had been warning of bias towards tightening for quite some time, but the move coming a day after another dismal Unemployment report was a surprise. Nonetheless, the move should underpin the Deutschemark against the other major currencies.
Although Bundesbank officials have gone out of their way to assure the markets that the recent rate hike was not necessarily the first in a series, it would be difficult to see anything else. The move was most likely motivated by several factors, not the least of which is convergence for European Monetary Union. The central bank is clearly aiming to bring core European yields up towards the periphery as a means of setting the stage for a more sustainable monetary policy at the start of 1999. As a result, we would anticipate another 20-30 basis point rate hike before year-end.
There are also economic justifications for the move. Growth remains sluggish, but the outlook is considerably improved from just six months ago. Most of the growth has been led by the export sector and domestic demand remains quite weak. This is likely to be the case for several more months. With unemployment still holding near record levels, consumer spending will likely remain soft. However, the central bank has made it clear that they view the employment problem in Germany and Europe as a whole as a structural issue which cannot be addressed through monetary policy. In addition, the recent spike up in import prices due to the drop in the Deutschemark was clearly an issue for the central bank.
The Deutschemark may pull back a bit next week. Much depends on the outcome of the political crisis in Italy which lifted the Deutschemark as a safe haven and on unwinding of convergence trades. In addition, the economic data will likely indicate ongoing weakness in retail sales and a modest decline in the wholesale price index to a 3.2% annualized rate. The IFO business sentiment index is expected to remain at relatively strong levels however, signifying an improving economy six months forward. A reading close to last month's 99.1 is likely. Finally the M3 money supply data should indicate a modest decline to a 5.5% growth rate, down from 5.8% last month. The mixed economic news and extent of the recent rally suggests that the market could pull back a bit. However, the trend has changed, and we continue to favor the long side of the Deutschemark against the dollar, the yen and the Swiss Franc.
SWISS FRANC–The Swiss Franc fell sharply against the Deutschemark and remained steady against the dollar during the past week. Unlike the German central bank, the Swiss National Bank held back on hiking rates, sending the Swiss Franc lower.
The major feature to the market last week was the lack of action by the central bank. After the Bundesbank rate hike announcement, most of the other continental European central banks also lifted rates. However, Switzerland held back. Swiss National Bank President Meyer has repeatedly indicated that he would raise rates when there were clear signs of recovery. Although those signs are visible, the decision to leave policy unchanged was probably meant to assure a decline in the Swiss Franc relative to the Deutschemark for competitive reasons. Switzerland's discount rate stands at only 1% which represents a nineteen-year low. Given a rising trend in industrial production, a nascent recovery in consumer spending and a drop in unemployment, there is enough data available to justify a rate hike. We would anticipate that one will be made within the next few weeks.
Hence, we see little downside potential In the Swiss Franc against the dollar, although it is likely to slip further against the Deutschemark. We favor long positions in December futures from current levels.
JAPANESE YEN–The Japanese Yen rallied last week, breaking through the 120 level. The move came in spite of very pessimistic economic data.
The Economic Planning Agency (EPA) confirmed the widely-held dismal view of the economy. They indicated that the official outlook for the economy had worsened in response to the negative impact of the consumption tax increase on spending. However, the yen declined very little in response to the report because of comments from Mr. Sakikabara. at the Ministry of Finance who indicated that those who buy Japanese bonds at these low yields would eventually “get hurt.” It appears that the Ministry of Finance is trying to talk up the economy. Ultimately the direction of JGBs from current levels will be determined by the government's moves to boost economic growth. On October 20th, the new proposals will be submitted for boosting the economy. Right now, despite a call from the LDP to cut income taxes, it looks like the government is leaning towards a cut in corporate taxes combined with speeding up already planned deregulation. In addition, they are probably going to try to boost liquidity in the property sector. Although these are all good moves longer term, they aren't likely to do much for the economy in the near term and hence, the yen is vulnerable to another decline.
However, there is the potential for a surprise. With LDP officials pushing Hashimoto and the economy sinking, there is the chance that there will be more meaningful moves to boost consumption. Clearly this would come as a surprise to the market. An additional factor which could work in favor of the yen is the renewed emphasis on trade tensions with the U.S. Given that Japan is due to report another large jump in the current account surplus next week, these tensions should remain at the forefront of the market. We are currently holding long positions in the yen anticipating a near-term rebound from current levels.
CANADIAN DOLLAR–The Canadian Dollar pulled back from its recent highs on worries about higher U.S. interest rates and disappointing employment statistics.
The data released last week were mixed, but in general consistent with a strong economy. Housing data were somewhat weaker than anticipated with both building permits and starts declining modestly in the month. It looks like there was a pause in this sector during the July- August time period. However, even with some decline, activity is still running nearly 10% above year-ago levels. Meanwhile, vehicle sales were up 2.8% in August after a 3.8% gain in July. Sales are running more than 20% ahead of a year ago so far this year. In addition, the help wanted index increased to 126 in September making the twelfth gain In thirteen months. The index is at the highest level since early 1991. However, the Employment report fell short of expectations indicating only a 16,000 gain in employment with the rate remaining at 9%. The underlying figures in the report were stronger than the headline numbers however. What jumps out the most is the huge gain in full-time employment of 72,000 versus a drop in part-time employment of 54,000. The figures suggest that workers are moving into more secure full time jobs which is a very healthy sign. Overall, a GDP growth rate of 4.5% to 5.0% remains in place.
Next week's data should confirm the strong growth outlook. Existing home sales are expected to rise while manufacturer's new orders should also be strong. Wholesale trade should be firm as well. On Wednesday, Finance Minister Martin delivers his mid-year fiscal and economic update. He will most likely indicate that the budget will be balanced in the 1998-99 fiscal year and that, the economy is growing at a rate stronger than anticipated.
Bank of Canada Governor Thiessen, speaking mid-week confirmed that policy would continue to be gradually tightened through a combination of higher short-term rates and a firmer currency. His hope is that pre- emptive rate hikes at this stage will keep long-term rates from rising too rapidly. Thus we continue to believe that the best approach to this market is to hold long positions in the currency with corresponding short positions In the December B.A.s.
Kathy Jones
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