The currency time bomb
By Gerry van Wyngen
The strengthening euro may have unexpectedly broad ramifications, warns Gerry van Wyngen.
Strange moves in the world's major currencies mask an underlying trend that will change trade and capital flows, and may shake US financial markets. The flow-on could affect Australia.
There is a currency time-bomb.
To understand this danger, go back 12 to 18 months to the imminent launch of the new European currency, the euro. Already the first eurobond issues were being raised. There was excitement about these new securities, regarded by many as an ideal medium for fund raising and investment alike; a superior balance of financial risk.
Japanese trust and life companies, flush with funds, seized on this as a solution to their investment problems and began buying the issues in large quantities.
The wisdom at the time seemed clear. Japan was locked in recession.
Interest rates would remain low and falling (see chart), and the Japanese yen was under pressure. In contrast, Europe was giving birth to a new economic order, and growth would be higher than in Japan, thus underpinning the new currency. A strong central bank, modelled on the German Bundesbank, was an added positive. And interest rates in Europe were much higher than in Japan.
The Japanese institutions bought up big. Probably more than the equivalent of $300 billion of the eurobonds were purchased; possibly as much as $400 billion worth. Because of the obvious wisdom of the investment, most were not initially hedged against adverse currency movements.
But, unexpectedly, the Japanese economy came out of recession. Less of the current account surplus was invested overseas. Foreign capital flowed into the sharemarket. It became clear to the Japanese institutions that perhaps a dreadful mistake had been made.
Not only was the yen strengthening against the major currencies, but the euro against all predictions was weakening.
Many of the institutions went to the derivatives market, and bought cheap option cover. The more limited the cover, of course, the cheaper the cost of the option. Much of the cover began running out as the cross-rate fell to ¾112, that is, ¾112 to the euro. But then it dropped to ¾111, and then to ¾110.
Exacerbating their problems is the so-called 15 per cent rule, an unwritten acknowledgement that loss positions have to be cut or covered once the loss exceeds 15 per cent. Many of the positions were opened when the euro/yen was over ¾135, and are therefore deep in the red.
With the losses increasing rapidly, many of the institutions bought yen against euros, or took out more hedge cover. This further reduced the euro/yen cross-rate, increasing the need for still more cover.
But the Japanese were not the only ones caught. Some of the US hedge funds had bought large positions, and are also unloading or lightening up their exposure.
While this was going on, two dynamic shifts were taking place in the US. First, the current account deficit was blowing out to unprecedented levels (see chart). As recently as two years ago, in the 12 months to September 1997, the deficit was "only" $US135 billion (about $205 billion). It is now running at an annualised rate of approximately $US690 billion.
Indeed and this highlights the second dynamic change inflows no longer exceed the current account deficit. Surveys and anecdotal evidence indicate they are less.
So why is the US dollar not collapsing? In large part, because of the huge long euro exposures still being covered; that is, buying yen and dollars and selling euros.
However, this is a relatively temporary situation. Eventually investors will have covered their long euro positions.
"Trend traders" recently stepped into this arena too, selling the euro, not out of conviction but chart patterns and market behaviour.
Interestingly, that ran into a brick wall when first gold prices rallied, and second, news of Japan's nuclear accident hit the wires.
Markets may act contrarily. The speculators caught short on gold were in many cases the same that were short euros. Many traders took profit on their short euro positions to pay for their gold losses. And the nuclear accident was enough to make some yen enthusiasts doubters.
Chances are we have already seen the low of the euro, against the US dollar certainly. Indications are that long-term demand for euros will soon turn positive.
It is a difficult currency to predict, which is partly why so many experts got caught, because it is not yet a real currency with coins and notes in circulation. You do not need euros to buy bread, or indeed a Mercedes. It is still a synthetic currency.
That said, there are signs of a change from dollar block to euro block investment. European fund managers surveyed in mid-September reported increasing share holdings in their home markets. Buyers of European shares outnumbered sellers by 43 per cent, up 14 points in the month. In contrast, global fund managers were net sellers of US shares, with sellers exceeding buyers by 18 per cent.
There is every reason to expect these changes to continue. Lead indicators such as consumer and business confidence suggest growth in Europe is picking up (see chart).
Forecasts are being upgraded, and the IMF now projects 2.8 per cent growth in 2000, a far cry from the beginning of this year, when many analysts had projections under 2 per cent. In turn, this suggests corporate profit forecasts may be increased, attracting more investment.
At the same time, the US Federal Reserve has made clear that if the US economy does not slow, further interest rate increases are imminent.
Low profit growth and/or higher rates will not excite fund managers.
Concurrently, currency markets are beginning to anticipate these changes. The increasing prospects for the Japanese economy and its superior current account have already caused the yen to strengthen against other currencies. The prospects for the European economy and its current account will cause the euro to follow.
That is the time-bomb.
When the US dollar falls, foreign investors will review further their portfolio investment in the US and, with the equity market there showing less value, the sharemarket will probably be sold down.
There are signs of this beginning to happen, at the periphery, already. In recent days shares have been sold and bonds bought.
It is unlikely the US Fed will intervene to support the dollar. It customarily intervenes in currency markets only when the US dollar is grossly overvalued or undervalued (see chart). Neither is the case at present. If anything, it is overpriced, so Japanese hopes of support are likely to prove fanciful.
Contrary to current pricing, a decline in the US dollar may involve both an initial increase in bond yields and a decrease in share prices, as reduced demand hits both investment groups.
However, bonds would probably recover more, and quicker, and expectations of lower growth make interest rate-denominated securities more attractive.
Watch also for a flow-on into Australian markets: possibly currency, but certainly shares and bonds. While our fundamentals suggest a stronger bounce back, there would be a shock wave first.
In summary, the outcome of the present euro play in the currency markets may have far wider ramifications than superficially apparent.
As the requirement to hedge long eurobond investments is satisfied, the basic trend to sell dollars will become more obvious. Simply, foreign portfolio and direct investment will be less than the current account deficit. There will be an excess of dollars in foreign hands.
There are similarities between now and October 1987, when capital portfolio inflows into the US bond and equity markets suddenly reversed.
Can a substantial flow-on into the US equity market be avoided?
Possibly, if the strengthening of the euro is very gradual. Or if the yen's strength dissipates unexpectedly. But currency markets have a habit of moving quickly, and unpredictably. So don't count on it.
The reality is that foreign portfolio investment into the US markets in recent years has been massive, justified by escalating equity prices and an appreciating US dollar. But now the dollar is turning and US equities look very expensive compared to both US bonds and non-US sharemarkets.
As in the past, investors will probably vote with their feet.
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