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PRUDENTIAL SECURITIES, INC.
One New York Plaza, New York, New York
(August 18, 1997) CURRENCIES: THE DOLLAR CORRECTION CONTINUES傍he dollar attempted to rally mid-week but fell back to new lows by Friday. A number of factors have combined to send the dollar lower. Threats of higher German interest rates, worries about Japan's rising trade surplus, and weakness in U.S. asset markets have all played a part in the decline. Longer term, we continue to view the setback in the dollar as a correction in the longer-term bull market, but for the near term, further losses cannot be ruled out.
The catalyst for the dollar decline appears to be the German central bank's threat to raise interest rates. The Bundesbank recently set the repo for only one week and continues to hint that rates may have to rise to defend the currency. This is not surprising given that since the Louvre accord, Germany has tolerated a 1.50-1.80 range for dollar/Deutschemark and the Deutschemark has fallen through the 1.8000 level. However, raising rates at this juncture, when the German economy is still experiencing very weak domestic demand and record high unemployment, would be counterproductive. Moreover, it disrupts the rest of the G-7 and the European Monetary Union as well.
The currency market is the mechanism through which the G7 economies are re-balancing. Since the late 1980's, the G7 business cycles have been out of sync. Europe has been weighed down by the impact of German unification and later, by the drive to reduce deficits to meet the Maastricht requirements for EMU. Moreover, Europe is in the throes of restructuring to try to achieve greater competitiveness. Japan has been weighed down by the lingering impact of the land and stock market deflation of the early 1990's. The sharp declines in the Deutschemark and yen have lifted export growth in those countries, providing a prop in otherwise weak economic conditions. Although we do expect growth to pick up in Europe and Japan in the months ahead, a rise in interest rates could derail those nascent economic recoveries.
Another component of the recent volatility has been the pick up turmoil in the Asian currency markets. The devaluation of various Southeast Asian currencies such as the Thai Baht, the Malaysian Ringitt and the Indonesian Rupiah have limited Japan's ability to nudge the yen higher. Since Japan is a major creditor to and exporter to the region, a sharp rise in the yen against these currencies will likely curtail exports and cause even more businesses to relocate out of Japan to lower cost production centers in Asia. Hence, the yen's upside potential has been temporarily capped by these forces.
For the U.S., the rise in the dollar has been welcome as it has held down import price inflation and thereby kept interest rates lower than they otherwise might have been in a strong expansion. Although some market share has been lost by exporters, the trade-off has been worthwhile from a macro economic point of view. That is why there has been so little reaction on the U.S. side to the dollar's advance and so little tolerance of the complaints from the U.S. auto industry.
Going forward, if the Germans do raise rates, it will probably boost the Deutschemark for a while. However, because the rate hike would come at a time when the German recovery is still tentative and EMU, concerns are still dominant in Europe, it is quite possible that such a move could backfire. Investors, who are already pulling out of Germany, could step up their disinvestment on worries about the recovery and much hoped-for restructuring.
Overall, we continue to believe that the dollar, British Pound and Canadian Dollar are still the more attractive currencies over the next few months. Until there is strong evidence of rebounding economic growth abroad, corrections should prove to be limited. We would look for the dollar to find support in the 114-115 yen region and in the 1.7800-1.8000 Deutschemark region.
BRITISH POUND亡terling fell sharply early in the week on indications that the Bank of England may be finished raising interest rates for the time being, However, it recovered lost ground later in the week as the market reassessed the longer-term outlook. Typical of sterling, the price action was extremely choppy.
The economic indicators for the U.K. continue to point to a healthy economy and moderate inflationary pressures. The unemployment rate fell to 5.5% from 5.7% in the past month with a sharp 50,000 drop in the number of jobless. Moreover, wages are edging higher at a 4.25% rate, indicating some tightness in the labor markets. In addition, the pace of overall inflation is edging up as is the underlying rate. These trends led the Bank of England to raise interest rates aggressively over the past four months, pulling the base rate up to 7%, from 6% during that time. In their latest report however, they indicated the growth is likely to slow as result of tighter monetary policy and the rise in sterling. As a result, the central bank has gone so far as to say that policy has now reached the appropriate level, implying no further need for tightening. Those comments sent the British Pound reeling.
Later in the week however, sterling rebounded sharply. There wasn't any particular piece of news, but perhaps it was simply a reflection of the fact that the British Pound had gotten quite oversold and undervalued. After all, the economy is still quite strong and even if interest rates do not rise further, they are still twice as high as German interest rates and 150 basis points above U.S. rates. Moreover, Britain continues to enjoy a healthy recovery and a record level of foreign direct investment. Finally, by staying mostly sidelined with respect to EMU, the British Pound continues to function as a safe haven currency.
In the week ahead, the economic data should continue to reinforce the strong growth scenario. Retail sales are likely to post another strong gain for July, keeping the growth rate in excess of 5% on a year-over-year basis. Money supply growth is also likely to remain robust. Our estimate is for a growth rate of 11.8% and for M4 lending to rise by 6.5 billion. Finally Q2 GDP will likely be revised to a 3.4% growth rate and the CBI trends survey should remain strong. Overall, given the low level from which sterling has rallied, we would anticipate further gains next week. We recommended long positions from the 1.5750 level and anticipate a rebound to at least 1.6200-1.6300 near term. Longer term a rally to the 1.6600- 1.68000 remains a possibility.
DEUTSCHEMARK傍he Deutschemark rebounded from recent lows on the ongoing threat of higher interest rates from the Bundesbank. Although a rate hike is inconsistent with the underlying fundamentals, it cannot be ruled out. The major question is what the impact would be on the currency.
Despite the fact that Germany's economy is growing very slowly, that domestic demand is virtually nonexistent and that unemployment is at a post World War II record, the Bundesbank is concerned enough about the Deutschemark's decline to consider raising interest rates. The reasons are very clear, even if they aren't particularly compelling. The drop in the Deutschemark through the 1.8000 level has violated the wide band that has existed since the Louvre accord. In addition, import prices are rising at a 5% rate, which could lift the overall inflation fate down the road. Finally, it is clear that the currency's decline reflects poorly on investor expectations for EMU and to that extent, the Bundesbank would prefer to see EMU start on a strong note rather than a weak one.
However, even if rates are raised, it does not guarantee a stronger currency. Germany's economic problems are not currency or interest rate related. The problems are structural and have largely to do with the rigidity in the labor markets and the high levels of taxation and regulation, There are changes taking place, but the pace has been slow. The weak Deutschemark has helped smooth the way by boosting exports. Nonetheless, a rise in interest rates is not likely to help lift domestic demand, prevent businesses from moving production offshore or stop domestic investors from worrying about EMU. Hence, a rate hike could backfire and then the central bank would be hard pressed to come up with a credible scheme to lift the currency.
In the week ahead, the focus will once again be on the weekly repo setting on Tuesday. Beyond that, there are several key economic reports due to be released including M3 money supply figures, manufacturing orders and industrial production revisions well as import prices. Previous corrections have pulled the Deutschemark as much as eight pfennigs higher which would translate into a target of about 1.8000 against the dollar. We continue to favor the short side longer term, but in the near term we would wait for the repo decision before going back in on the short side. Our longer-term target is still the 1.9300-1.9500 region.
SWISS FRANC傍he Swiss Franc rallied against the dollar during the past week, but fell modestly against the Deutschemark. Although the Swiss economy is showing signs of improvement, it is unlikely that the Swiss National Bank would follow the Bundesbank's lead on a rate hike and hence, the Swiss Franc looks likely to edge lower on the cross.
Last week's economic data for Switzerland were actually slightly encouraging. Newspaper advertising rose in July, reaching the highest level since 1994. The rise in this indicator reflects the gradual increase in the leading indicator over the past six months. In addition, the purchasing managers' index has edged higher along with building permits and employment. Yet, the economy is far from reaching the point where it warrants higher rates or a stronger currency. Inflation is virtually zero and growth is still flat. The Swiss National Bank has made it abundantly clear that keeping the Swiss Franc weak is a part of the strategy to boost economic activity. With the discount rate at 1%, the central bank continues to focus on trying to boost exports and domestic demand.
As long as the Swiss economy remains moribund and the central bank accommodative, we continue to favor the short side. For now, we are looking to sell rallies back to the 1.4800- 1.5000 cash level or 6750-6850 in the September futures. We also favor long Deutschemark/short Swiss Franc spreads from current levels looking for .8350-.8400 longer term.
JAPANESE YEN傍he yen rallied spent another week in a choppy trading range before ending on a weak note. Weak economic data combined with the ongoing turmoil in the Asian currency markets weighed on the currency.
Japan's economy has yet to show signs of a rebound in domestic demand. Department store sales fell more than 5% in July compared to a year ago. Industrial production has fallen sharply as well and corporate bankruptcies continue to rise. As a result, bond yields are now at an all-time low of 2.065%. Meanwhile, as mentioned, the yen has also been weighed down by the turmoil in the Asian currency markets. One by one, the Southeast Asian currencies are being devalued and there is even a threat to the Northern Asian currencies. In that light, there is no room for the Bank of Japan to raise interest rates due to Japan's position as the largest exporter to and creditor to the region. Moreover, the yen's rapid advance against those currencies this year will provide even more incentive for Japanese manufacturers' to move production offshore to lower cost centers.
In the week ahead, Japan is due to release trade figures for July which will probably indicate another sharp jump in the surplus. As a result, the early part of the week will probably witness a rally in the yen back towards the 115 region. However, longer term it now appears likely that the Bank of Japan will have to keep policy steady until early 1998 and that the outflow of capital from Japan will continue. Hence, we are revising our outlook for the dollar/yen. The dollar is likely to rally back through the 120 level and possibly test the 125 region before year- end as there is little scope for the Bank of Japan to support the currency on setbacks.
CANADIAN DOLLAR傍he Canadian Dollar rallied modestly off its recent lows during the past week as prospects for tighter monetary policy were supportive. The economic data for Canada continue to be quite strong, but the wide interest rate differential with the U.S. has been a limiting factor. Longer term, however, we look for the gap to gradually close and the Canadian Dollar to move higher.
Canada's economic indicators continue to be quite robust. Housing starts rose 2.7% in July to an annualized rate of 144,000 which is 14.3% above year-ago levels. With mortgage rates declining and employment growth rising, the outlook for housing continues to be quite healthy. In addition, leading indicators for July rose 0.8% marking the 22nd consecutive monthly increase. The leading index is a good proxy for the direction of GDP growth and its recent sharp advance suggests stronger growth ahead.
The Bank of Canada's quarterly review of the economy indicated an upbeat assessment of the outlook. The central bank is looking for the economy to grow at a 3.5% to 4.0% rate, which would imply the need for tighter monetary policy and/or a stronger currency. Although the output gap is estimated at about 2.25%, that will close within a few quarters if the economy continues to grow at a rapid rate. Since the Bank of Canada's job is to set monetary policy with an eye to the future, it seems only logical that they would be leaning towards tighter policy in the months ahead to prevent inflation from picking up in 1998.
In the near term, the Canadian Dollar could continue to languish at current levels but as monetary policy tightens later in the third quarter and through year-end the Canadian Dollar should rally. We would use dips below .7200 to be buyers.
Kathy Jones
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