FYI | Dec 01 2006
By Chris Shaw
The recent weakness in the US dollar can be easily explained as reflecting a softening US economy, but in Morgan Stanley’s view that would only tell half the story.
The broker suggests it is just as much a euro story, as while the dollar has weakened against a range of currencies the euro has strengthened, particularly against the yen. This, it argues, is a by-product of the European economy being stronger than expected, as growth is now in a range of 2.6-2.8% compared to the potential growth of 2% of the past few years.
The move is not a bad thing in the broker’s view, as it sees it as a reflection of the world economy shifting away from its reliance on the US economy for its growth, indicative of a more balanced global economy.
The broker expects further strength in the euro in the short-term, as it sees little reason for European authorities to attempt to cap the currency at levels of around 1.35 as further strength would not be a threat to the region’s economy.
A level of 1.40 is possible if the currency overshoots its valuation short-term, something the broker sees as possible given the funnelling effect of money moving into the euro and away from the yen as part of the commodity story and the move by central banks to diversify reserves out of the greenback.
Such an outcome would be in excess of what Lehman Brothers expects, the broker targeting 1.34 by the end of the year and 1.36 in coming months as the US dollar catches up with fundamentals as the support it has enjoyed from the business cycle and monetary policy slowly fades.
The broker also points out December is traditionally the worst month for the US dollar against the euro, so there are likely some cyclical factors in play in current movements in the forex market, especially given the European Central Bank is tipped to lift rates again this month.
The broker notes recent strength in the European economy means the gap between policy rates in the US and Europe are closing, especially as the outlook for rates in the US is the Federal Reserve is now on hold.
The views of Morgan Stanley match those of its clients, who expressed similar views at the broker’s half-yearly currency conference. They too regard the economic rebalancing as healthy, particularly as the US economy should achieve a soft landing.
They also agree with the broker’s view the US dollar should not be written off longer-term, as the world’s largest economy is expected to strengthen over the course of next year, which should see the US dollar enjoy renewed attention.
Lehman Brothers agrees, saying there is not enough evidence to suggest the euro’s current strength can continue into next year. Of more relevance in the short-term is what impact the dollar weakness could have on global equities, the broker noting history shows such a move should have little overall impact.
There are likely to be some opportunities for investors though, the broker pointing out European cyclical stocks, which have been strong recently, are likely to underperform in the current forex environment. Also, the Japanese equity market appears to have decoupled the least from the greenback, so weakness in the dollar implies some pressure on the Nikkei Index.