FYI | May 22 2006
By Greg Peel
It is not central banks that have caused earlier weakness in the US dollar, note Morgan Stanley currency specialist Stephen Jen and economist Charles St-Arnaud. It is more a fear that they will. The reality is that "real" money investors – insurance companies, mutual funds and pension funds – have been diversifying out of the US dollar, and they represent a much larger holding.
Both experts calculate funds under management in these big three areas add up to seven times that held in US reserves by Asian central banks. Tracking any diversification of these investments is more significant, and more visible, than central bank flows.
Morgan Stanley notes US investment in foreign equities increased from 11.1% in 2003 to 13.9% in 2005. If this trend is assumed for all real money under management then the economists calculate US$1.1 trillion has left the US in that time – the same amount that has flowed in from Asia. Thus they believe a fear a massive central bank diversification, be it from Asian or Middle Eastern central banks, is misplaced.
Stephen Jen and economist Luca Bindelli still expect the US dollar will correct (fall) this year for cyclical reasons. The beneficiary of the correction will not be the euro, which has been receiving all the attention of late, but Asian currencies, particularly the yen. The experts believe the euro has overshot, and that the Euroland economy will struggle to absorb the rise.
In the second half of 2005, Japanese investors began to take investment risks again, Morgan Stanley notes, after a decade of doldrums. The slow pace of the Bank of Japan in its reassessment of monetary policy has pushed the US dollar higher against the yen on the interest rate gap. However, as the BoJ begins to normalise rates, the situation will reverse and the yen will appreciate, such that the USD/JPY will head down towards what Morgan Stanley believes to be a fair value of 100. The economists forecast 106 by the end of the year.
Morgan Stanley believes the Japanese Ministry of Finance will not intervene, but let the market do its thing. However, the US dollar will not fall far if the Fed continues to pass over the current account deficit situation and raise rates further on inflation fears.
The currency markets are in a real state of flux at the moment, without a clear trend emerging. While most agree the US dollar should fall, there is consensus that the euro is overdone, and there is baited anticipation of the Fed’s next move. Every little scrap of inflation data will be potentially explosive.
The currency expert team at DBS acknowledges this and while anticipating FX markets may be in for some consolidation after the recent strong movements of the US dollar, the team also reiterates the view the greenback should see some further losses further down the track.