Corporate Finance : Foreign Exchange

There has been an impor-tant, if not yet seismic, shift in foreign exchange market psychology in favor of the US dollar, ana-lysts say.

“The market appears more confident in a US recovery,” says Marc Chan-dler, chief currency strate-gist at HSBC Bank USA in New York.

This is reflected in the steeper US yield curve, as a result of a sudden drop in bond prices, and a sus-picion that the Federal Reserve is through cutting interest rates, he says.

“Look at the market’s contrasting reaction in early July to the US and German employment reports,” Chandler says. The US report disap-pointed, yet the dollar remained firm.And while the German unemploy-ment rate ticked down, the euro found no reprieve from the selling pressure that has knocked it down since mid-June.

“Over the next quarter, we expect to see the dol-lar firm modestly across the board as evidence of a US recovery begins to mount,” says Adrian Schmidt, London-based currency strategist at Royal Bank of Scotland.

“However, some of this recovery has already been anticipated in the finan-cial markets with the gain in equity markets seen so far this year, so the dollar’s strength should not be expected to be too dra-matic,” he says.

Growth prospects in the eurozone continue to look dismal for the remainder of this year, so although the euro might benefit in a more risk-averse environment, in a recovering world it looks more likely to weaken, according to Schmidt.

David Mozina, head of Group-of-10 foreign exchange strategy at Bank of America in New York, says,“The market’s focus has seemingly turned from the struc-tural decline of the US dollar to the more cycli-cal aspects of growth differentials and superior US economic perfor-mance.”

However, the structural factors behind the gaping US current account deficit, and immediate funding requirements, are not about to go away, Mozina says.This will prevent a long-lasting rally in the dollar, although the US econ-omy is likely to outper-form Europe, he adds.

As global bond yields continue to back up and as the US dollar firms, it appears that investors are unwinding some of the recent gains in emerging-market currencies, says Clyde Wardle, currency strategist at HSBC Bank USA, who focuses on emerging markets.

“The risk now appears to be that this trend will continue,”Wardle says. “This year’s strong perfor-mances in emerging-mar-ket currencies have been mirrored by large interna-tional investment inflows into local bond markets.”

Certain countries look more vulnerable than oth-ers,Wardle says.“We still like Russia, where infla-tion is still too high for the central bank’s com-fort. It cannot afford to allow the huge excess liq-uidity in the system to continue,” he notes.

bank will need to slow down its intervention efforts and allow the ruble to strengthen to 29 to the US dollar by the end of 2003, he says.

The Indonesian rupiah has been the strongest performing currency against the dollar this year,Wardle says.“While we do not anticipate fur-ther large local currency gains, the attractive yields on Indonesian bonds mean we like holding positions in the rupiah,” he says.

EUROPE Is the Euro Weak, or Is the Dollar Strong?

The euro fell below $1.13 in early July, leaving ana-lysts to wonder if the cur-rency’s rout was based on optimism about the US economy or disappoint-ment with German eco-nomic data.

“We think it has more to do with comparisons between asset classes than with comparisons between countries,” says Anne Mills, director of currency research at Brown Brothers Harriman in New York.

“What’s bad for bonds, at present, is also bad for the euro,” she says.“And the move, obviously, is being amplified by profit taking and by technical positioning.”

While the upward cor-rection in the dollar may have further to go, Mills says, it will eventually cre-ate a real trading opportu-nity with a chance to buy the euro at very appeal-ing levels.

Rather than dollar strength, the third quarter could provide more evi-dence of euro weakness, according to Adrian Schmidt of Royal Bank of Scotland.

“We expect the euro to move down toward $1.10 in the third quarter, but we would not expect a decline much beyond that,” Schmidt says. “Longer-term reserve man-agers are likely to be buy-ers at the lower levels.”

As long as the evidence of global recovery contin-ues, the Swiss franc also looks likely to stay weak, since economic growth in Switzerland is even weaker than in the euro-zone, and yields are lower, Schmidt says.

The yen also suffers from lack of yield attrac-tion, he adds, but the Japanese currency will tend to strengthen against a weak euro if there is any evidence of recovery in Japan.

ASIA Japanese Recovery Could Boost Yen

Recent signs of life in the Japanese economy could be for real, analysts say. If they are right, this could complicate the Bank of Japan’s efforts to keep the yen from rising.

A powerful rally in the Nikkei stock index and a sudden plunge in Japan-ese government bonds in early July showed that at least some investors are convinced something is stirring in Japan’s long-dormant economy.

Increases in Japanese machinery orders suggest that capital spending is outpacing expectations, says Anne Mills of Brown Brothers Harriman.“This reinforces our view that the Japanese economy really is picking up a bit of steam,” she says.

Core machinery orders are a good leading indica-tor for Japanese business spending, Mills says. She notes that a survey released by the Ministry of Economy,Trade and Industry shows that large and mid-size firms plan to boost spending by 6.7% this year—the first gain in three years.

Meanwhile, foreign investors continue to put money into Japanese shares. Portfolio inflows are increasing the need for the central bank to intervene to restrain the yen.At the same time, ana-lysts say, pressure is build-ing on Japan to let the yen appreciate in order to reflect improving eco-nomic figures.

“It is entirely possible, and some would say likely, that Japan grows faster than the eurozone this year,” says Marc Chan-dler of HSBC Bank USA.

The yen might now be ready to play a role in the next round of dollar weakness, says Michael Rosenberg, global head of foreign exchange research at Deutsche Bank in New York.

“Our concern about the deteriorating trend in the US current-account deficit now supersedes our con-cern about Japan’s funda-mental problems,” he says.

A key factor that is likely to support the yen going forward is an expected improvement in Japan’s current-account balance, Rosenberg says.

Japan’s current-account surplus as a percentage of gross domestic product has been averaging between 2% and 3% since 1997, he says, but it could rise to as high as 4% of GDP in 2004.

A wider US deficit has to be matched by a wider surplus elsewhere in the world, and Japan will likely see its surplus grow along with the US deficit.

The main issue for for-eign exchange market par-ticipants, Rosenberg says, is whether a strong rebound in US growth in the coming year will be bullish or bearish for the dollar. Stronger growth will widen the US deficit to 6% or 6.5% of GDP in 2004 from its current record 5.1%, he says, which will weaken the dollar.

—Gordon Platt