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Currencies

·  As the Fed tightens and the U.S. yield curve flattens, the U.S. dollar should gain traction.

·  It should perform well against the euro, which is in a near-term bearish trend.

·  It also will have traction against the yen, because the Yuan was not revalued, and the yen carry trade may become more popular.

Big Picture Looks Better for Dollar

Courtesy of realmoney.com

5/9/2005

Developments over the past few days have helped clarify what had been a murky macroeconomic picture. This, in turn, resolves some of the questions that have dogged the U.S. dollar, the euro, the Yuan and the yen.

Clear Numbers

The much stronger-than-expected U.S. jobs data will go a long way toward easing fears of a protracted slowdown in the world's largest economy. Not only was the April job creation well above consensus forecasts, but the February and March figures were revised higher by a total of 93,000.

Coupled with the April rise of nonfarm payrolls of 274,000, job growth this year virtually has matched the first four months of last year: 868,000 in January to April 2004 vs. 864,000 in January to April 2005.

A back-of-the-envelope calculation for growth is aggregate hours worked multiplied by productivity. The April jobs report showed the largest jump in aggregate hours worked in years, 0.9%. Hourly earnings rose by 0.3%, a bit more than expected.

The combination of more people working longer hours and earning more money bodes well for the economic data due out in the coming weeks. It also indicates that the second quarter started off on solid footing. But in aggregate, first-quarter GDP growth of 3.1% was nothing to sneeze at either. Recall that U.S. growth between 1991 and 2001 averaged 3.3%.

The market is likely to see evidence of this in April retail sales data on May 12. Already we have been given an inkling of what the report will contain. Auto sales were stronger than expected, even if not for GM (GM:NYSE - commentary - research) and Ford (F:NYSE - commentary - research). And chain store sales were largely in line with expectations, with a few upside surprises. This is expected to translate into a 0.6% rise in headline retail sales in April, according to Bloomberg consensus, double the March increase. Excluding auto sales, the same consensus calls for a 0.5% increase in retail sales, up from the sullen 0.1% increase posted in March.

 

This is evidence that the so-called soft patch, which even sparked some talk about stagflation, was short-lived. Further, it means that the Federal Reserve should be expected to continue to remove the monetary accommodation that continues to exist. We should be prepared for a 4.00%-4.25% fed funds rate at the end of 2005.

Dollar Improvement

In the strategic argument I have made on these pages, as the Federal Reserve tightens policy and the U.S. yield curve flattens, the U.S. dollar is likely to find more and better traction. But now it also is becoming clear that it is not just that U.S. rates will continue to rise, but that the weak economic performance in Europe, the U.K. and Australia are likely to mean that monetary policy is unlikely to be tightened as soon as the market previously expected. This, too, should lend the greenback support.

The next main target for the euro is near the lows of the year, set in the middle of the first quarter near $1.2732. The five-day moving average moved below the 20-day moving average in late April. This is consistent with a near-term bear trend. The momentum indicators also have turned down. Thus, the technical conditions and fundamental considerations both favor the euro's downside. It will take a move above the $1.2950 to $1.3000 area to undermine this bearish view of the euro.

I suspect the dollar also can do well against the yen because another part of the macro picture appears clearer: China. There had been widespread expectations that China would change its currency regime during the Labor Day holidays in early May. The speculation appeared to help underpin the yen, ostensibly on the idea that an appreciation of the Yuan would be good for the Japanese economy; Japanese exports to China would have become more attractive.

 

Chinese Yuan

As you know, China did not announce a change in its currency regime. I suspect this was for good reason. Yes, I acknowledge the Yuan is undervalued, but according to various economic measures, currencies of developing countries tend to be undervalued.

My argument against a small widening of the Yuan’s band now is based on two considerations. First, such a widening would not resolve anything for the currency. Second, it could be counterproductive.

Say that China was to announce a widening of the band in which the Yuan trades from 0.3% to, say, 5%. It is reasonable to expect the Yuan to move immediately to the strong side of the band. Chinese officials then would have to defend that new band by intervention, which means accumulating reserves, probably U.S. dollars and Treasuries.

Moreover, given that the Asian Development Bank estimates that skilled manufacturing wages in China are about 4% of the U.S. level, a small appreciation of the Yuan probably wouldn't change trade or investment flows. In turn, this suggests that a small widening of the band, which apparently would make the currency regime somewhat more flexible, would not be enough to blunt the protectionist sentiment that seems to be on the rise in the U.S. and Europe.

Not only would no good come from a small widening of the band, but there would be the potential to do harm. For example, it could embolden speculators to look for another move, thus intensifying the pressure on Chinese officials. In addition, a move now by Chinese officials would look like capitulation to international pressure without a quid pro quo, which could undermine their negotiating position in the future.

There are two events on the near-term horizon to be aware of. First, on May 9, mid-level U.S. and Chinese Treasury officials will meet. While the outcome could be the subject of speculation, the truth is that these are regular meetings and would not be the forum for any announcement on the currency. Second, on May 18, China is scheduled to allow eight more currencies to be traded in addition to the current four (dollars, euros, Hong Kong dollars and yen). This, too, should not be seen as a signal of change in the Yuan, though it is consistent with Chinese efforts to lay the groundwork for a more flexible currency regime.

 

Big Picture for the Yen

Many other factors influence the yen's value in the foreign exchange market besides China. With U.S. rates poised to increase, the yen once again may appear to be an attractive financing currency. Thus, there may be renewed interest in yen-carry trades, in which the yen is shorted and the proceeds are used to buy a higher-yielding asset.

The dollar appears to have built a good base near the 104-yen level. As Japanese investors returned from their Golden Week holidays, there was talk in the market of good institutional demand for U.S. dollars. Near-term potential extends toward the 106.00-50 area.

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