FYI | May 10 2006
By Chris Shaw (Tokyo)
In recent trading sessions the pace of the devaluation of the US dollar against the yen has increased as the greenback has slipped from above 113 yen to around 111 yen, with most in the market suggesting further falls are likely.
The central reason given for the weakness is the US has all but come to the end of its series of interest rate increases, while interest rates in Japan and Europe appear to be headed higher.
This leads Morgan Stanley economist Steven Roach to suggest the US dollar is entering the second phase of its decline, the first of which ran until 2004. He notes the actions and comments of the G7 and the International Monetary Fund (IMF) are supportive of further declines in the currency, as such a move would help address the imbalances in the global economy stemming from the trade surpluses in Asia in particular and the growing trade deficit in the US.
Roach is not so sure such an outcome will occur though, as he estimates a rebalancing of 20-30% in relative currency values would be necessary to bring the US trade deficit down to more sustainable levels of GDP. Revaluations of such an amount are unlikely to occur, as in his view policymakers in countries where the currency strengthens would likely intervene to limit the extent of any revaluation.
The other factor is the likelihood the central banks in Asian and other developing economies will adjust their reserve management practices going forward, shifting out of low-yielding US dollar denominated assets into higher yielding investments. Factoring in such a shift, Roach suggests any fall in the greenback may be limited to another 10-15%, not enough to address adequately the issue of global imbalances.
Another issue in Roach’s view is even allowing for a significant depreciation in the US currency, there is no guarantee it would improve the US trade position given both what he terms the "hollowing out" of US manufacturing in recent years and the incredible boom in consumption. Roach suggests the only cure will come from a correction in the housing market, as the wealth impact of such a shakeout would likely result in falls in personal consumption.
So where to now for the greenback? Trading guru Dennis Gartman suggests the currency has executed a classic "head and shoulders" pattern (we’re talking technical analysis), so further weakness is likely. He advises selling into strength rather than buying weakness.
In contrast, NikkoCitigroup has taken an opposite position, suggesting the uptrend in US interest rates is likely to continue (so the outcome of tonight’s Federal Reserve meeting is worth watching), with rates possibly moving as high as 5.7% in coming months. (It is worth noting that Credit Suisse forecasts US interest rates may run up as high as 6% in 2007).
While NikkoCitigroup agrees market sentiment suggests a yen to US dollar rate of about 110 yen is likely in the short-term, the broker’s view is the exchange rate will bottom somewhere around that level before the US dollar again rallies.
It suggests the interest rate differential, which would still be substantial if the US were to end its cycle of higher interest rates and the Bank of Japan (BOJ) lifted rates in coming months, will continue to support the US dollar in the longer-term as money will continue to be attracted to the yields available in the US.
The broker is not talking just a small appreciation, suggesting a medium-term target of 125-126 yen on the way to a longer-term level of as much as 140-150 yen. In its view, any weakness leading into June would represent a buying opportunity, a position very much at odds with current market consensus.