EUR/USD hit 1.17 Morgan Stanley Fair Value 1.06 ........ BUT
Correcting an Out-of-Balance Dollar Correction (Morgan Stanley)
Friday, May 16, 2003
morganstanley.com The structural dollar correction that began in July 2001 has been going well in terms of magnitude and speed, but has been problematic in terms of symmetry, or the lack of it.
Going forward, we see downward pressures simultaneously impinging on the USD index and EUR/JPY. With the weak USD having reached our targets, we update the profile for the remainder of the year. We have revised our EUR/USD forecasts to 1.17 by end-2003, with an intra-period peak of 1.21 in 3Q. Investors have reluctantly chased EUR/USD higher over the course of this rally. We believe this process of a ratcheting move higher in EUR/USD is not yet complete. For USD/JPY, we see the present ‘line in the sand’ of 115 eventually broken, and see USD/JPY ending the year at 113. Our previous forecasts for year-end -- made on February 13 -- were 1.12 for EUR/USD and 117 for USD/JPY. For 2004, we expect EUR/USD to average 1.14 and for USD/JPY to average 109.
Three surprises since our last forecast change
Since our last forecast round, there have been three surprises for us. First, the post-war relief rally in global equities has not been as convincing as we had expected. In particular, the tepid recovery in business sentiment underpins the lingering market concern about capex. While consumer sentiment has recovered sharply as expected, we expected to see the business sector also responding positively to the lifting of the fog of war and the decline in oil prices. The lack of an improvement in business sentiment cast doubt on a bullish outlook on capex in 2H. Second, Chairman Greenspan and, later, the FOMC surprised us with their public statements about their fear of the US falling into deflation. With so much stimulus already in the pipeline and the seemingly palpable eagerness in the market to buy equities in the aftermath of an early end of the war, it was most surprising to us for the Fed to signal downside risks to prices. The third surprise to us was the continuing tolerance of European officials in accepting what is, in our view, an overshoot in EUR/USD above its fair value. Juxtaposing these three surprises, we now believe that, though the USD index is still not likely to undershoot, EUR/USD could overshoot its fair value as downward pressures on the USD should continue to be deflected from Asia as Japan continues its defence of 115 in USD/JPY. This out-of-balance adjustment in the USD will not be corrected until USD/JPY is allowed to break convincingly below 115, in our view.
The structural USD correction so far
We continue to believe that the structural USD correction should be seen from the perspectives of magnitude, symmetry, and speed. In terms of magnitude, this USD adjustment is roughly 60% through we believe, i.e., since the beginning of 2002, we’ve seen the USD index decline by 15%, out of the correction of around 25% that we believe is needed by end-2004. On speed, the 15% correction has taken place within a 16-month period. This adjustment in the USD has been extraordinarily orderly, given the size of the underlying current account (C/A) imbalance. This is a view we continue to hold, that the USD correction will be significant in size, but gradual in pace. And, because of the gradual nature of the correction, the USD index is not likely to undershoot. Having said this, bilateral USD exchange rates vis-à-vis some currencies could over- or undershoot. In fact, the USD correction seems very much out-of-balance between Europe and Asia. During the past 12 months, EUR/USD has moved twice as much as the major USD index, while USD/JPY has moved by a little more than half as much as the major USD index. Given that the US runs the bulk of its C/A deficit against Asia, this lopsided adjustment in the USD is not sustainable, we believe, if the whole point about a currency adjustment is to contain the yawning C/A deficit. The USD is still overvalued, we believe, and should correct further. But the asymmetry in its adjustment is becoming a serious problem in the currency markets.
US economic recovery and the USD
Our US economists Dick Berner and David Greenlaw continue to expect the US economy to recover in 2H, powered by a surge in capex. The pent-up demand for replacement capex in the IT sector has attracted a great deal of investor attention, particularly from equity investors. However, there remains considerable uncertainty on the economic outlook, and the bond and stock markets are behaving as if the two markets are not in full agreement on the outlook on the economy. Equity investors may be leveraging off the bottoming and the incipient recovery in nominal GDP, while bond investors seem still of the view that growth will remain tepid and therefore insufficient to halt the widening in the output gap for some time. The simultaneous rally in both equities and bonds is not likely to continue indefinitely. In any case, unless US growth somehow accelerates above the potential growth rate or the US experiences another outright contraction in growth, we believe the USD is likely to continue to weaken, in index terms.
Japan likely will not voluntarily back away from 115
The Japanese economy remains in dire straits. The parlous state of the financial sector is only gradually being restructured. We need not go into too much detail on the state of the Japanese economy, but only note that, now that the BoJ is more pragmatic and less dogmatic with respect to the policies it is willing to consider, it is very difficult for us to imagine that the MoF will back away quickly from defending 115 -- something they have been very successful at doing for a while now. But spirited intervention at around 115 could effectively repel capital away from Japan and Asia, and channel the downward pressures on the USD through EUR/USD, making the EUR even more overvalued. In other words, there is an important causal relationship between the overshoot in EUR/USD and Japan’s competitive devaluation policy, in our view. If we are wrong and the MoF does withdraw from the market, USD/JPY will be exposed to a sharp decline below 1.10, in our view.
Europe’s dilemma
The EUR has moved into overvalued territory, we have argued. The median fair value of EUR/USD is 1.06 and for EUR/JPY it is 117, based on our calculations. Though the EUR is overvalued, it is capable of, and indeed likely to, overshoot by a significant margin, for the following reasons. First, the USD is still overvalued. Even though it is now undervalued against the EUR, ongoing intervention by Japan could push EUR/USD deeper into overvalued territory, as we argued above. Second, there appears to be a disparity in the ‘threshold of tolerance’ of Euroland exporters and policy makers. Based on their statements in recent days, the policy makers seem to believe that the disinflationary impact of a stronger EUR should support domestic consumption to offset much of the negative impact of a strong EUR on exports. Public enemy number one, as far as the European policy makers are concerned, is still inflation, not an overshot EUR. Third, the ECB may have a particular fair valuation model in operation, we suspect. In our fair valuation exercise, only two out of the 12 models we computed suggested that the EUR was not overvalued. These two models were the ‘RID’ -- the real interest differentials -- models. The average fair value of these two models is 1.18. In light of how ‘calm’ the ECB has appeared regarding EUR/USD, it is possible that their valuation model is of the RID type. If that is the case, in the ECB’s mind, the EUR has just reverted to its fair value, after being undervalued for most of the last three years.
The distinction between the second and the third points above should be underscored, as the second point is about the finance ministries’ tolerance for a high EUR, while the third point is about the ECB’s tolerance. In the ECB law, it has not been made clear whether the ECB has the legal mandate to intervene in the currency markets, while it is clear that the finance ministries, collectively, unambiguously have the legal mandate to do so. Nevertheless, the ECB was the intervening agent in October 2000 to support EUR/USD. Gauging and tracking the relative tolerance for an overshoot in EUR/USD by these two different institutions will be important, in our view.
More on our forecasts: a USD move vs. EUR/JPY move
Another point we would like to stress about our forecasts is this tension between the downward pressure on the USD and the fact that EUR/JPY is out-of-balance from the goods market perspective. In the event that the correction in USD/JPY turns out to be more violent than we expect, i.e., USD/JPY plunging to 1.10 or below this year, it is likely that EUR/JPY could fall so much that the ascent in EUR/USD could be stalled. The same point applies to the other JPY-crosses such as AUD/JPY and GBP/JPY.
Bottom line
We look for EUR/USD to peak at 1.21 in 3Q, and end the year at 1.17. Japan should mount a spirited defence of 115 for several months. But we believe 115 will be broken by 4Q. We have a year-end target of 113 for USD/JPY. We see continued downside risk to the USD index and new downside pressure mounting on EUR/JPY. |
