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To: Done, gone. who wrote (297)	9/18/2005 8:51:58 AM
From: Done, gone.	Respond to of 3363

Currencies: G7: USD to Remain Supported for the Rest of 2005 Stephen L Jen (Boston) Sept 16, 2005 No repeat of Q4 2003 and 2004 While the macroeconomic cross-currents have intensified, the USD will be well-supported for the remainder of this year, particularly against the JPY. A dollar sell-off in Q4 similar to that of 2003 and 2004 is quite unlikely. The Fed’s tightening posture is likely to be maintained. High oil prices and Katrina may have tempered my bullish view on the USD, but I remain USD constructive. For 2006, the key for the dollar is the supply of excess savings from the rest of the world: if Asia’s domestic demand recovers strongly, about which I am unconvinced, the USD may come under downward pressure. This is the key risk to my constructive view on the USD for 2006. S-I approach is much more appropriate The dollar is a savings-investment story, not a ‘how-low-the-dollar-must-be-to-help-shrink-the-US-trade-deficit’ story. This is the ‘excess savings’ idea I first introduced in November 2004, and is essentially the same idea Mr Bernanke proposed in March 2005, when he referred to the global ‘savings glut.’ The fate of the dollar is a function of the relative speed of the compression of the US C/A deficit and the rest of the world’s savings surplus. The recent signs of a recovery in domestic demand in Japan are important, in this context. I remain sceptical on the strength of the recovery in Japan, and think downside risks to Asia are more likely than otherwise. This is a key call not only on Japan, but also for the USD, given my S-I framework. Official interventions in Asia have declined recently It is no longer compelling to say Asian central banks have artificially propped up the USD. Interventions by Japan were immense in Q1 2004, but since then the MoF has not bought one dollar. Total Asian interventions actually decelerated this year. At the same time, USD/Asia actually drifted higher, with lower interventions. Why I think ‘the glass is half empty’ for the JPY The market is too bullish on JPY and Asian currencies. The Japanese economy may very well be on a recovery path which began in 2003. But a strong Nikkei does not mean a strong JPY. (1) Japan’s recovery is fragile; consider at what happened in 2004Q2-Q4. Further, oil prices and global demand are two key risks. (2) Japan still confronts daunting longer-term issues, such as fiscal, medical, and pension reform. (3) Japan’s ‘home bias’ may be weakening. If sentiment recovers in Japan, institutional funds could invest overseas, not in the Nikkei. (4) Ending quantitative easing is not the same as ending ZIRP. In fact, the BOJ could re-adopt ZIRP for an extended period of time. The Monetary Policy Statement from October 2003 outlined preconditions for ending quantitative easing, not when the BOJ should raise interest rates. Chinawill likely maintain CNY stability until year-end. What China does with the CNY is important for the outlook for the USD in general and USD/JPY. Our calculations show, according to the theoretical basket weights, USD/CNY should be trading at around 8.07. Having said this, it seems likely USD/CNY will be allowed to trade more flexibly in 2006, although I don’t expect any more step revaluations. The Fed will likely stay on its tightening campaign. I think the Fed should raise the FFR above what they consider ‘neutral.’ The USD is likely to react negatively if the Fed suggests it is pausing soon or if it tempers its view on inflation. But I believe such weakness will be temporary, and reverse when the Fed demonstrates its resolve in keeping inflation expectations anchored. The German election Many are comparing the upcoming election in Germany with the one in Japan. My own view is the best we can hope for is ‘Japan 2001,’ when Mr Koizumi won the general election, without support from his own or other parties. In terms of the political cycle, if the CDU/CSU coalition wins a majority, Ms Merkel would be three, four years away from replicating what Koizumi has done in Japan. My view on Euroland is negative: Euroland is not really growing. Growth from Germany is from wage cuts not productivity growth. What EUR has is liquidity: if investors want to run from the USD, they can hide as ‘USD asylum seekers,’ whereas Asia may not welcome such ‘USD asylum seekers.’ Bottom line I believe the dollar will hold up in Q4; and a repeat of the USD sell-offs of Q4 2003 and 2004 is unlikely. For 2006, the key for the dollar is how rapidly global excess savings shrink, that is, how rapidly Asia invests its own savings. I remain sceptical about Asia’s ability to do this under the weight of high oil prices and the mature investment cycle in China. ------------------ Currencies: USD: Is Reserve Diversification Negative for the Dollar? Stephen L Jen (Boston) Think Two-dimensionally, Not One-dimensionally For the past year, there has been much talk and speculation about reserve diversification and the dollar. In this note, I propose two thoughts. First, central banks may be diversifying across currencies and assets. Second, riskier assets are much more liquid in the US than anywhere else. Taken together, as central banks shift from a traditional liquidity management posture to a return-enhancing investment strategy, reserve diversification - simultaneously across currencies and assets - does not necessarily mean USD selling or USD weakness. The Year-old Debate on Reserve Diversification There has been intense debate on what the Asian central banks have been doing with their official foreign reserves. While the EUR might not yet be in a position to challenge the USD’s hegemony, its presence since 1999 may have marginally eroded the USD’s hegemony. Further, with the super-sized current account (C/A) deficit of the US, the fear of a USD crash probably encouraged some shifting of exposure from USDs to EURs by central banks and private funds. However, as foreign official reserves in Asia continue to rise, in some cases to levels no longer justified by liquidity needs of these economies, there has been an expressed desire by some central banks to increase the return on their reserve holdings. From ‘Fear’ to ‘Greed’ For lack of a better word, this is a shift from ‘fear’ to ‘greed’, in that some central banks may have sold USDs in 2004 out of fear the USD might crash, but going forward, are likely to be dictated by the desire for yield. One way to think about this change in investment posture is to consider central banks having two broad tranches of reserves: one for liquidity purposes and the second - higher - tranche for investment purposes. Diversification in Two Dimensions While this dual-tranche framework may be useful to help us think about how reserves are managed by central banks, in practice, central banks may not have explicitly separate tranches. It is clear however, many central banks consider diversification in two dimensions: (1) across currencies and (2) across assets within currencies. Central banks don’t usually keep foreign reserves on deposit. Rather, they almost always hold underlying assets. The most conservative stance is to hold sovereign (risk-free) papers. However, as central banks move up the risk-return curve, they could hold agency or other quasi-government papers as well as corporate bonds. Along the currency dimension, central banks could diversify their reserve holdings from USD to EUR and JPY; this is the diversification most investors have in mind. However, some Asian central banks are increasingly interested in diversifying into the G4-G10 space. The key point here in ‘diversification’ of reserves is not a one-dimensional concept, but a two-dimensional one. Reserves Diversification Need Not Be USD-negative · Central banks value liquidity. Conceptually speaking, the ‘liquidity tranche’ has to be in liquid assets, that is, markets deep enough to handle sudden, large size, transactions. But central banks are likely to value liquidity even for the ‘investment tranche.’ After all, these are reserves, not pension funds. · Euroland has better liquidity in the sovereign market, on paper. The US sovereign bond market (US$5.7 trillion) is smaller than Japan (US$6.9 trillion), and about the same size as Euroland (US$5.3 trillion). However, with low yields and the fiscal state in Japan, JGBs are not popular among central bank reserve managers. Further, while Euroland’s aggregate market cap is impressive, the individual national bond markets will become more fragmented, that is, meaningful credit spreads will emerge if EMU members continue to violate the Stability and Growth Pact. This fragmentation of the underlying sovereign debt markets in the EMU renders the US Treasury market as the single most liquid/relevant sovereign market in the world. If we remove Japan, the US accounts for almost half of the total market cap. · The US has much more liquidity in riskier assets. The US corporate bond market accounts for close to three times the corporate bond market in Euroland, and 3.5 times as big as in Japan. In fact, this market is bigger than the other corporate bond markets combined. Similarly, the total market cap of the US equity market is dominant, 2.5-3 times bigger than the markets in Euroland or Japan. Therefore, as central banks diversify across assets, there is greater justification to increase their exposure to USD risky assets. Bottom Line First, central banks are likely to continue to diversify across both currencies and assets. Second, risky assets in USDs are multiples bigger than those in other markets. Thus, if central banks diversify ‘two-dimensionally’, it is far from clear it will be USD-negative. morganstanley.com