A bearish dollar forecast from Morgan Stanley
Currencies: Restating Our Bear Case for the Dollar
Joachim Fels & Stephen L. Jen (London)
Short-term calls marked to market ...
In our monthly forecast session among the currency strategy and currency economics teams earlier this week, there was an unanimous feeling
that our end-September 2000 targets for EUR/USD (1.10) and USD/JPY (95) needed to be marked-to-market in light of recent and prospective
economic and asset market developments. The soft-landing scenario for the US economy appears to prevail for now, and the consensus among
our equity strategists is that the US market will do OK over the next few months as long as inflation remains benign. Against this backdrop, it
is reasonable to tone down our bearishness on the US dollar. Our currency strategists, who are responsible for the three-month forecasts, have
thus reset the target for EUR/USD by end-September to parity, and to 100 for USD/JPY. For the details of the near-term story, please see FX
Pulse, July 13, 2000.
... but secular story still intact
Our medium-term view remains, however, that the important psychological barriers of 1.00 and 100 for EUR/USD and USD/JPY will be
broken decisively later this year. Note that we have reduced our year-end 2000 target for EUR/USD from 1.15 to 1.10 to reflect the lower
near-term forecast profile. Yet, our adjusted forecast is still way above the consensus and the forward rates, and we expect even higher levels in
2001. Meanwhile, our forecast for USD/JPY stays at 90 for year-end 2000. We are acutely aware that these are big calls. In the following, we
restate our reasons for being bearish on the dollar and bullish on both the euro and the yen.
Dollar to weaken
The essence of our bearish call on the dollar is that, with its economy slowing, the US will find it increasingly difficult to attract the huge
capital flows needed to finance the current account (C/A) gap. Though concerns about the size of the US C/A gap are not new, we believe that
there will be important changes in the global economy that will make the C/A deficit a problem for the US dollar. Let’s think through the
various arguments carefully.
High US productivity growth matters. One argument justifying a strong dollar makes the point that the large C/A deficit is
the result of a large capital account (K/A) surplus, which, in turn, is justified by the higher productivity growth the US commands
over the rest of the world. It should thus not be surprising that the country with the highest productivity growth rate deserves to
borrow from countries that cannot offer competitive returns on capital. In other words, it is the massive inflows of capital to the US
that resulted in a widening C/A deficit. Therefore, the argument goes, the C/A deficit itself is not a problem. According to this
argument, the value of the USD will be determined by the relative productivity growth rates, not the C/A deficit.
But this is not likely to justify a C/A deficit as large as 4.5% of GDP. We agree with the line of reasoning that,
with higher productivity growth, the sustainable level of C/A deficit may very likely be higher than in the past. However, we believe
that, in an environment where global growth is becoming more balanced, a C/A deficit of 4.5% of GDP is unsustainably large at the
current level of USD. In our view, there were both "push" and "pull" factors behind the exceptional capital flows buoying the US
dollar in the past two years. A higher productivity growth rate is no doubt an important factor pulling in capital. However, the
financial crisis plaguing emerging markets was a dominant "push" factor. The world is different now. Emerging markets have
continued to recover strongly, as pointed out by Jay Pelosky and others. And trend growth in Europe is accelerating. In fact, based on
Morgan Stanley Dean Witter’s growth forecasts, US income growth will, by Q3/Q4 of this year, fall below that of the world for the
first time since the beginning of 1997.
A key distinction between current and capital accounts. The current and the capital accounts are fundamentally different.
The current account is called the "current" account because it is an account of current transactions, that is, what matters is the current
levels of US and foreign incomes, the current exchange rate, the current interest rates, ... etc. On the other hand, the capital account is
an account of transactions that have an "expectational element." There is a "forward-looking" component in most capital flows, that
is, expectations drive capital flows, not the current fundamentals. This distinction is important because it implies that, when
expectations change, the K/A will adjust quicker than the C/A. In the case of the US, if the outlook of the US economy is
downgraded, its K/A surplus could shrink before its C/A deficit is compressed. The implication for the USD is obvious: it would fall.
Possible triggers for USD correction. While the US was unambiguously the leader of the global economy up to May/June
of this year, it may be the laggard going forward. Further downward revisions to US growth sparked by weak data, or Fed rate hikes in
response to strong data, could result in an imbalance between the current and the capital accounts of the US. Since the weak US June
labour data, the world has been quite pleased that the Fed may not act aggressively in the coming months. When the market realises
that the slowdown in the US will be sharper than that in the rest of the world, it will become much less sanguine about the outlook
of the US dollar, in our view.
Bull case for the Euro
Our bull case for the euro rests on our view that Europe has entered a long, virtuous growth cycle, in which trend growth accelerates
significantly above the dismal levels seen during the 1990s. The three underpinnings of this acceleration in trend growth are (1) corporate
restructuring, (2) structural reforms such as deregulation of product and labour markets, as well as tax reform, and (3) new technologies.
Corporate restructuring has been a key feature of Europe’s transformation over the last few years and received an additional push due to EMU —
witness the M&A boom of last year, which has extended into this year. Deregulation of product and labour markets, which also has been under
way for some time, creates new jobs and investment opportunities, especially in the service sector, and leads to a decline in the NAIRU, the
unemployment rate that is consistent with stable inflation. And, last but not least, Europe is starting to catch up on the information and
communication technology front, emulating the successful US model. Against this backdrop, the huge deficit in the euro area’s capital account
— reflecting large outflows of direct and portfolio investment — should diminish over time, and the euro should rally.
Why we are bullish on the JPY
Our reasons for being bullish on the JPY remain unchanged: (1) high domestic savings and (2) low propensity to expatriate capital. The
combination of these two features has manifested themselves in the inability of Japan to recycle its large current account earnings. Since
mid-1999, the Ministry of Finance has had to artificially pump excess USDs out by intervening in the currency markets. During the past 12
months, the MOF has bought close to US$90 billion in the market, roughly equal to two-thirds of Japan’s C/A surplus. In other words, the
Japanese economy could only manage to recycle one-third (!) of its C/A surplus, forcing the MOF to do the rest. If it weren’t for the heaviest
intervention in history, USD/JPY would have certainly fallen significantly lower than the current levels. Thus, the binding constraint on
USD/JPY has been, and will continue to be, the MOF’s intervention strategy.
The MOF’s intervention strategy
The logic behind the MOF’s intervention strategy is not totally clear to us, though the professed reason for taking on such a policy is to protect
the exporters. But, as data show, Japan’s external sector is doing better than it has ever done in history! Also, with the MOF using the
intervention proceeds to buy US Treasuries, essentially, the country with the largest fiscal deficit in the world is financing that with the largest
fiscal surplus in the world at a pace of US$90 billion a year! This intervention policy cannot last forever. We believe that the line of defence
will be lowered, below 100, when there is broad-based weakening in the US dollar.
Bottom line
The US dollar has benefited from exceptional circumstances over the past couple of years — first the emerging markets crisis and second a
re-rating of underlying productivity growth — which have buoyed capital inflows and bloated the current account deficit. With the US economy
slowing and global growth rebalancing, the financability of the C/A deficit will become the key issue for currency markets, we believe. This,
together with the specific factors underpinning the yen and the euro, should lead to a sizeable correction in the US dollar. |
