Land of the Rising Currency
The financial press speaks of "the dollar" as though it had a single price. But it doesn't, it's priced against every other currency according to how traders feel about the United States and its economic condition, as well as the conditions in the other country.
The euro-dollar exchange rate gets the most publicity, but the movements in this currency pair don‚t necessarily reflect movements in other currencies, such as the Japanese yen-dollar pair. Indeed, I‚m projecting a sharp drop in the dollar against the yen in the months ahead.
But before I elaborate on my prediction, I need to address some common misconceptions about the relative value of currencies. I think this will help you understand why the U.S. dollar refuses to fall against the euro, as some of the "fundamentals" say it should. It will also help you understand why I‚m now recommending the yen.
The value of a currency is closely related to the strength of its underlying economy. In the case of the United States, despite staggering budget and current account (trade) deficits, a deteriorating geopolitical situation and many other imponderables, it still has the world‚s biggest and strongest economy.
What is economic strength, anyway? Let's define it as adaptability, meaning the flexibility to change with changing conditions, including the ability to recover from external shocks. And that‚s the key to understanding why the dollar has actually climbed against the euro for most of 2004. Europe‚s GDP growth this year will be 1.6% this year at best, compared to 4.5% or so in the United States. Even if the Middle East explodes and oil prices spike higher, the euro is unlikely to gain against the dollar and might even fall, as the United States is much further away from the trouble, geographically, and less dependent on imported oil than Europe.
An economy perceived as "strong" attracts inbound investment. And that‚s the key to understanding the euro‚s February-April 2004 correction from near $1.30 to $1.176. Each month, the United States needs an influx of $40-45 billion to fund its current account deficit. But a great deal more money than that actually flows in, it's more like $70-90 billion per month.
In contrast, while Europe is running a current account surplus of around $15 billion per month - it is losing almost twice as much in combined direct investment and portfolio outflows. In March 2004, a monstrous 23.9 billion euros flowed out of Europe. The month before, Europe drew IN •27.7 billion euros. That's a net reversal of $60 billion.
The folks who decide how to allocate capital on a global basis don‚t miss information like this, and it makes them wary of investing in Europe, or more specifically, the euro. So now they are turning their attention to another strengthening economy ˜ Japan. While the capital inflow into Japan is miniscule in comparison to the United States and Europe, it‚s rapidly increasing. And that bodes well for both the Japanese equity markets and the Japanese yen.
Make no mistake ˜ Japan is a "heavyweight." Japan is the world‚s second-largest economy, after the United States. Since global capital allocations are roughly in line with a country‚s share of world GDP, or its equity market‚s share of world stock markets, Japan should be attracting a sizeable share of global capital. But for the last 15 years, investment inflows into Japan have been tiny.
One big reason is that the Japanese economy is only now pulling out of a tailspin that began in 1989, when the Japanese stock market crashed. Ever since, most international investment houses have "underweighted" Japan.
Another reason investors persistently snubbed Japan came about because of structural problems in the financial sector and excessive government debt, which caused ratings agencies to rank Japan in the same class as Botswana.You can question whether rating agencies have their heads screwed on straight ˜ the willingness and ability to repay government debt is quite different in an advanced society like Japan than it is in a developing country like Botswana ˜ but never mind. Tokyo was simply not an important destination for global capital.
And just over a year ago, the most widely followed Japanese stock market index, the Nikkei 225, fell to 7,600 ˜ down from nearly 40,000 at its 1989 peak. However, experienced traders knew that this was the best time to buy - sensing a historic low ˜ and money has been pouring into Japan ever since.
Over the last two decades, the median level for the Nikkei has been about 20,000. Today, it stands around 11,000, so a return to "normal" means it could double. Foreign buyers are helping it along. In the year to March 2004, the latest figures available, net foreign purchases of Japanese stocks totaled a record $125 million.
Now, $125 million is not a huge sum of money, particularly in relation to the multibillion-dollar capital flows flowing in and out of Europe and the United States. But this relatively small money flow could be only the beginning of a delicious trend. Profits at many Japanese corporations are soaring into the double digits, especially for exporters like Honda and Sony. And they are selling into Asia, not just the United States, where imports from Japan are falling back.
The big question is whether the recovery will be sustainable. While most banks are operating profitably, one or two large banks are still hemorrhaging money, and their collapse could spook investors. Another concern is that after a decade of deflation, prices are starting to inch up. The Bank of Japan has already started to prepare the markets for a rate hike, sometime in the next 12-24 months. That seems awfully far away today and is not a serious concern for investors.
It will be a historic moment when the inflation level passes 0. No other country has experienced deflation since the Great Depression, and as a nation of savers, the Japanese were particularly reluctant to be goosed into a spending spree that can help end a deflationary cycle. As economist John Maynard Keynes said, opening the money spigot in this situation was like "pushing on a string." The government even gave away money vouchers and put a time limit on them to get consumers to spend ˜ but even then, not all of them were used! But now employment is rising, disposable income is rising and the propensity to consume is rising.
It may be too soon to say Japan is back, but the probability is high. In fact, Japan‚s GDP in the latest quarter surpassed even the U.S. GDP at 5.4% annualized, although the year won‚t come in that good. Money follows growth - not only portfolio investment, but also direct foreign investment (e.g., foreigners buying real estate, setting up new plants and buying companies). The Japanese frown on foreign ownership of Japanese assets, but even that is beginning to change.
In sum, fortune favors the yen right now. But until very recently, the Japanese government didn‚t want a stronger yen...they feared it could choke the recovery. Indeed, to avoid the strengthening currency, the central bank spent $220 billion between September 2003 and April 2004, mostly selling yen and buying dollars. In some months, Japanese citizens were, in effect, subsidizing the U.S. trade and budget deficits combined.Finally, just three months ago, Japan abandoned its interventionist policy. The official explanation was that the economy was strong enough that exporters no longer needed the protection of an artificially weak yen. Another possibility is that the United States and Europe pressured Japan to end the policy, which artificially strengthened the euro and the dollar.
Whatever the explanation, the Japanese have, at least for now, sworn off intervention. However, the Japanese finance minister has warned that Japan has the sovereign right to intervene in its own self-interest, and we should believe him. Were the dollar to fall against the yen from today‚s 110 to 80, as it did in 1995, the Bank of Japan would hardly be silent. But a more modest fall, say to 100, would probably be acceptable.
Indeed, the dollar is already falling against the yen. From the dollar‚s peak against the yen at 135 in February 2002, it has fallen 18.5%, to 110. If the yen continues to move to the same extent and at the same pace, it will reach 100 by year-end 2004. Currently, the dollar has been rallying and has pushed the yen up beyond 111. It is my assertion, therefore, that this represents an excellent buying opportunity in anticipation of a yen blast upward.
P.S. On two occasions recently ˜ 1994 and 1997 ˜ the yen did precisely that...it blasted higher. And interestingly, both times, liftoff occurred in the September-October period. Don‚t miss the space shuttle!
Note: Barbara Rockefeller is an international economist with over
25 years experience in the currency markets. She is also the co-editor
of The Money Trader, the first currency and bond options trading
service for individual investors.