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M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
Issue No. 46
Tuesday, September 30, 2003
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++ Viewpoint: Is This the Demise of the American Strong Dollar Policy?
The Bottom Line:
Top-Down: Equity markets are leery of the implication that the US is
backing away from its strong dollar policy.
o While the ministers of the Group of Seven (G-7) struck an
upbeat note on the global economy in saying that the
long-awaited recovery was now "under way," they lobbed a
grenade on the currency and equity markets. In trying to
signal their desire to see China let the yuan appreciate and
for Japan to back off its massive intervention to support the
yen, they also implied that the US is backing away from its
"strong dollar policy."
o The US "strong dollar policy" has been the 500-pound gorilla
of the global economic community. The shocking truth is that
it doesn't really matter whether or not the US has a "strong"
or a "weak" dollar policy. Actually, it is what the market
participants think that matters, and they are selling off the
US dollar regardless of what the US says about its dollar
o The flip side is that because of shifting perceptions
regarding the US "strong dollar policy" and a more upbeat
economic picture in Japan, the Bank of Japan (BOJ) is losing
its battle with the currency markets despite record levels of
intervention. The bottom line is more appreciation in the yen
against the dollar and the euro.
o A significant appreciation of the yen would not be good news
for Japan's budding economic recovery, which, by the way, is
currently being driven by exports. It would also tend to
exacerbate already well-entrenched deflationary pressures.
* Bottom-Up: Historically, a weak dollar-strong yen combination has
usually been good for stocks.
o The increased uncertainty in the forex markets represents an
interim turning point for the rally in global stock markets.
Both the Nasdaq and the S&P 500 have dipped below their 50-day
moving averages and are on the verge of a mid-term
consolidation. In Japan, the froth of the initial run-up is
subsiding, and the Topix is in the process of confirming
support at its 13-week moving average.
o If the recent volatility in the currency markets is a false
alarm (i.e. not the start of a major re-realignment), historical
experience shows that weakness in the US dollar has generally
been good for US stocks. By the same token, a stronger yen has
generally been good for Japanese stocks.
o But a dollar rout and a surge in the yen through 100 yen to
the dollar and perhaps toward historical highs seen in 1995 is
another matter. Given a modest appreciation in the yen, the
smart thing to do historically has been to buy the
export-oriented blue chips as the stronger yen phase is
peaking. This time, however, investors need to be
psychologically prepared for a two-digit yen-dollar rate and a
lot of wailing and gnashing of teeth by the exporters as an
appreciating yen evaporates their corporate profits.
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++ Viewpoint: Is This the Demise of the American Strong Dollar Policy?
Academics will tell you that they (or anyone) do not know exactly what
moves nominal and real exchange rates. What academics, economists and
strategists do not like to admit is that all currency models to date
have failed empirically. Economists cannot find a strong statistical
relationship over time between the "fundamentals" and the exchange
rate that should exist if a particular model were true. Being able to
predict money supply, central bank policies or other supposed
influences doesn't statistically help forecast the exchange rate.
Economists Richard Meese and Kenneth Rogoff in the early 1980s
examined the ability of the fundamentals to predict the level of the
exchange rate for horizons of up to one year. Surprisingly, they found
that a naive strategy of just using today's exchange rate as a
forecast works at least as well as any of the economic or statistical
models. It is not that the naive strategy is particularly good; it's
that the models are even worse. Despite many attempts since the
publication of Meese and Rogoff's results, economists have not
convincingly overturned their findings.
As currency markets nevertheless do respond to the classic laws of
supply and demand, the alternative view is that exchange rates are
determined, at least in the short run, by market sentiment. Under this
view, the level of the exchange rate is the result of a
self-fulfilling prophecy (aka George Soro's theory of reflexivity).
Participants in the foreign exchange market expect a currency to be at
a certain level in the future; and when they act on their expectations
and buy or sell the currency, it gravitates toward the predicted
level, thereby confirming their expectations.
However, the inability to find strong statistical correlations
between fundamentals and exchange rates is not to say that
fundamentals don't matter. Market participants take their
perceptions of fundamentals and the timing and degree of central
bank intervention very seriously when forming exchange-rate
expectations. Thus, to understand current levels of exchange
rates, one needs to know the values of the fundamentals and, more
importantly, how market participants interpret those levels. In
addition, they need to know what market participants perceive the
exchange rate policies of major countries to be. The problem is that
market participants do not use the fundamentals to form expectations
in any consistent way that could be picked up by an economic or
Currency Volatility Derails the Equity Rally
While the ministers of the G-7 struck an upbeat note on the global
economy in saying that the long-awaited recovery was now "under way,"
they lobbed a grenade on the currency and equity markets. The US
dollar fell sharply while the yen surged as the G-7 statement calling
for more "flexibility" in exchange rates caused confusion in world
currency markets and added a new uncertainty to global equity
markets. The statement was perceived as being aimed at Japan and
China in particular. Traders took the G-7 statements to mean that
other G-7 nations were becoming impatient with Japan's aggressive
intervention (a record of over 9 trillion yen so far this year) and
as a signal to China that the Western nations would like to see the
yuan appreciate. The call by the G-7 was seen as a victory for the US,
which heretofore had remained silent while Tokyo massively intervened
massively and at the same time pressured China to revalue the yuan.
Yet what really seems to have spooked market participants about
the G-7 statement was not the implied pressure on the yen and the
yuan to appreciate, but that the statement was evidence of a
demise of the US's "strong dollar policy."
Currency traders reacted immediately. The dollar fell to a near
three-year low against the yen, while the pound and the euro also
strengthened against the US currency. The dollar fell by almost 2
percent against the yen to 111.9 yen, while sterling and the
euro both ended nearly 1 percent higher against the dollar at
$1.648 and $1.148, respectively. A perceived aggressive stance by
the US to have the yuan revalued and to let the yen trend higher
makes financial market participants nervous, as the strategy
could well backfire on the US. For one, the US is dependent on
both Japan and China to fund its $500 billion-plus balance of
payments deficit through the purchase of US government bonds and
other US securities. Secondly, the US and other foreign firms are
the ones doing most of the exporting from China. Thirdly, this
new currency volatility was taken as a negative by the equity
The sharp rise in the yen prompted a 4-percent fall on the Japanese
stock market and at least an interim correction in the rally
seen in the Japanese market since April. Wall Street also felt the
backlash from a weaker dollar, with the Dow Jones index falling by
around 100 points, or 1 percent, in late afternoon trading. The US
equity market has had its worst week since the rally began in
mid-March. The fall on Wall Street also had a knock-on effect in
London as the FTSE100 index closed 28.2 points lower at 4,228.2
points. Conversely, gold, which is denominated in dollars, rose
to a seven-month high on the weaker dollar. Unlike equity
markets, it benefits as a safe haven investment in times of
The media is quoting economists as saying that the yuan is 40 to 50
percent undervalued. US industry and their supporters in Congress are
using such estimates to pressure the Bush administration and Treasury
secretary John Snow to "do something" to save American jobs. As the
reaction to the G-7 statement punched the yen up through what had been
perceived to be "the line in the sand" support level of 115 yen to the
dollar, currency market traders will continue to test the BOJ's
resolve until they discover where the new "line in the sand" is.
US Treasury secretaries since Robert Rubin have given lots of lip
service to what they call the "strong dollar policy." It has
taken on the status of a 500-pound gorilla in the global economic
community. Yet there has never been a clear definition of just
what the US strong dollar policy is, and attempts by those in the
US to achieve clarification from previous treasury secretaries
have come up empty-handed. The closest definition offered by
current Treasury secretary Snow is that it is a policy of "a strong
domestic economy, an inviting investment climate, and competitive
But what's the point of a policy on currency, and how would it be
executed? There was a time when Treasury and central bank
currency policy really mattered. In the 1980s and early 1990s,
central banks could coordinate their currency trading to intervene in
currency markets and really move exchange rates. Twenty years ago, the
combined central bank foreign exchange reserves in the US, UK, Japan,
Germany and Switzerland amounted to about $139 billion against daily
foreign exchange turnover of $39 billion, according to McKinsey
research. In those days central bank reserves were the dominant
repositories of global financial assets.
Today they're not. By the early 1990s, foreign exchange turnover was
more than twice the level of reserves, and today central banks'
reserves of $375 billion ($576 billion) are dwarfed by daily foreign
exchange turnover of more than $1.2 trillion. Market power has shifted
from national treasuries and central banks to the private sector. The
reality is that policy makers can smooth daily fluctuations in
currency relativities but don't have the ammunition for longer
battles. Even though the BOJ has spent a cool 9 trillion yen or more
intervening to keep the yen below 115 to the dollar, it has succeeded
only because currency market participants were content to go with this
The shocking truth is that it doesn't really matter whether or not the
US has a "strong" or a "weak" dollar policy. Actually, it is what the
market participants think that matters, and they are selling off the
US dollar regardless of what the US says about its dollar policy.
Indeed, market participants were already interpreting comments by Snow
in May as a change in that policy.
It is almost certainly no coincidence that the US dollar has been
sliding against most of its major counterparts for the past two years.
From the mid-90s until just over two years ago, the dollar
strengthened against other major currencies. This appears to be due to
the flow of capital into the US during the tech boom and the perceived
superior returns on capital available in the US markets at the time.
The US bubble burst in March 2000,and the US dollar has followed. In a
sense, the dollar's decline is explicable and inevitable.
From a purely domestic perspective, accusations that president
George W. Bush is pursuing an economic policy that creates more
jobs in China than in the US have struck a sensitive political chord
in the US that is likely to ring louder as the presidential
campaign gathers momentum. However, US political efforts to help
a US manufacturing sector by focusing on exchange rates is a red
herring. It is likely that the US will not get the same jobs back
that were lost in the recession. During the 1980s, the US put
massive pressure on Japan to strengthen the yen as a means of
reducing the US trade deficit and recovering lost jobs. These
efforts did not restore lost jobs, but Japanese direct investment
in US manufacturing did. When the US came back, it was driven by
the IT boom, which created different jobs, not the old ones that
were lost. However, such economic realities have never seemed to
cloud the thinking of politicians with their eye on elections.
Ostensibly, a weakening US dollar aids the competitiveness of the
US economy and its export earnings potential. It is also mildly
inflationary, and therefore useful to counter deflation. That
isn't, of course, much comfort for the Japanese or Europeans. The
BOJ has been selling yen and buying dollars furiously to try to arrest
or at least slow the dollar's decline and to at least keep the yen's
exchange rate as a neutral factor for the nation's budding economic
recovery. Effectively, via the currency markets, the US is exporting
deflation into economies that are generally far weaker than it.
But as distasteful as this may be to Europe, Japan and the rest of
Asia, the US economy needs to grow if the global economy is to
recover. The Europeans and Japanese can't generate enough growth to
drag the rest of the world with them. The US already has the taps wide
open in terms of both fiscal and monetary policy, yet the economy
remains sluggish and fragile. Thus a more competitive (weaker)
currency may accelerate a recovery. The dollar's rapid fall as a
result of the G7 announcement is basically the continuation of a
longer-term trend. A weaker dollar is crucial for reducing the US
budget and current account deficits, but the danger is that the
decline may turn into a disorderly retreat, and this is why
market participants are allergic to the very smell of the demise of
the strong dollar policy. The fear is that the exchange rate
readjustments will be swift and exaggerated, as they often are.
Thus the charade of the "strong dollar policy."
The International Monetary Fund's managing director Horst Koehler
claimed that foreign exchange markets will calm down after sharp
initial moves in response to the G-7's call for more flexible exchange
rates. Yes, they will, but the secular adjustments could well
Quoting Koehler: "There was an understanding, and I share this view,
that exchange rates can contribute to reducing imbalances in the world
economy, which are most manifest in the high US current account
deficit." But unless a way can be found to collectively work through
the desired exchange-rate adjustment in a way that limits the fallout
of volatile currency movements on other markets, the rallies in the
equity markets are at risk, particularly if market participants
realize that the American "strong dollar policy" emperor has no
Good for Stocks?
The increased uncertainty in the forex markets represents an
interim turning point for the rally in global stock markets. Both
the Nasdaq and the S&P 500 have dipped below their 50-day moving
averages. It is understandable that a sharp appreciation in the
yen and the euro would hurt stock prices because it would squeeze
exporters' corporate earnings, and exports have been the economic
driver so far, at least in Japan.
For the US, however, at least between the 1970s and the 1990s, stocks
have gone up 60 percent of the time when the dollar showed noticeable
weakness, ostensibly because corporate profits are boosted. Given
quarter-on-quarter declines of between 4 to 6 percent on 10 occasions
between 1977 and 1998, the S&P 500 declined only four times and
underperformed total returns on bonds only four times. Given a median
quarter-on-quarter decline in the US dollar of 4.7 percent, the S&P
500 appreciated 5.6 percent versus a median appreciation of 1.7
percent for treasuries.
A strong yen has also been a mixed blessing for the Japanese market.
In the instances where the yen appreciated against the dollar by more
than 5 percent over a quarter since 1989, the Topix has declined four
times and was essentially flat in another. However, for foreign
investors buying Japan from their home currencies, there are four
possibilities. Either they: a) gain on both the Topix and the yen; b)
lose on both the Topix and the yen; c) gain on the Topix and lose on
the yen; or d) lose on the Topix but gain on the yen. In terms of
currency-adjusted returns for foreign investors, total returns have
been negative in only three cases where the yen has appreciated by
more than 5 percent over a quarter since 1989. Consequently, a
stronger yen during the quarter has also been historically positive
for particularly foreign returns in Japanese stocks.
Excess Liquidity Still Sloshing around
Consequently, it is likely that the knee-jerk reaction to the
negative surprise of a sharp move in currencies is mainly
profit-taking from the good rally seen in both the US and Japanese
stocks since March-April and does not represent a major change in
market direction, nor in major sector leadership. The continued
strength in gold stocks may be taken by some as a negative sign for
the equity market recovery, but gold is not the only precious
metal/nonferrous metal that is rising. Indeed, the best-performing
stocks in the Dow Jones US mining index are copper stocks, and rallies
in copper stocks have traditionally been more associated with economic
recoveries than weak dollars and the "store of value in uncertain
times" that usually supports a rally in gold stocks. Indeed, the fact
that economically sensitive commodities, gold and the equities markets
have been rallying together is more a statement about the degree of
excess liquidity sloshing around in global financial markets as the
US, Europe and Japan attempt to reflate their economies.
The US rally has been supported over the past three months by the
mining and nonferrous metals sectors on expectations of economic
recovery, which has also supported stock prices in the technology,
computers and semiconductors space. Conversely, Japan's market has
been supported by small cap stocks, financials and real estate, which
are not typically economically sensitive sectors.
However, these sectors are among those more closely associated
with the dark side of the Heisei Malaise and financial system
fragility. Conversely, the automobiles, auto parts, electronic and
precision instrument sectors are always the most adversely affected by
negative surprises in the form of "unexpected" appreciations in the
yen. But while a yen-dollar average below 115 yen was not budgeted in
the initial fiscal 2003 forecasts for the major export-oriented
companies, the peak of any strong-yen phase will be a good contrarian
opportunity to buy the bluest among Japan's globally-oriented blue
chips, including Toyota, Honda and Canon, but also stocks such as
Kubota and Matsushita, which are showing up favorably in the US sector
Allow for the Risk of a Move Below 100 Yen to the Dollar
While the contrarian move would be to go for Japan's blue-chip
exporters on any yen appreciation move, investors must be
prepared for the possibility that the yen cracks the 100-yen
barrier and perhaps even challenges highs hit in 1995. Despite lip
service for a "strong dollar policy," a weaker dollar is now more
politically convenient in the US, as it is seen by some to be the
additional stimulus needed to get the US economic recovery on firmer
footing and a way to boost US exports and "save" US jobs. For US
politicians looking toward elections, the real economic implications
of such a policy are secondary.
Thus, while the BOJ has pumped upwards of 10 trillion yen into the
support of the currency markets to cap the yen's appreciation, all of
that could come for naught if market participants really believe the
US has abandoned its strong dollar policy. If market participants
really believe the US has indeed abandoned the strong dollar policy,
the yen could well appreciate beyond the 100 level and even attempt a
challenge of the previous historical high of 79 yen to the dollar set
in April 1995. A move of this degree could well derail Japan's budding
cyclical recovery and exacerbate the deflationary pressures that
already exist in Japan's economy. Needless to mention, it would also
lead to a more substantial sell-off of the export-oriented blue chips
until investors get a handle on how far the upside of this yen
appreciation move will be.
-- Darrel Whitten
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