As is customary, end-of–year preparations have deterred many investors from actively participating in bond markets, so trading volumes have shrunk and trading ranges have narrowed. Foreign exchange markets, on the other hand, have been moving in to distinctly new territories. The US dollar has continued its downward trajectory, as the see-saw pushes the euro to all-time highs. Though this might feel not that dramatic, given the single currency’s short life-to-date and its own depressing downward path after it was launched, the dollar really is low. Its trade-weighted index is now down close to its lowest ever levels.
Does it have further to fall? Yes, according to the analysts at Deutsche Bank Research who suggest that the dollar could indeed breach and sail through historic lows. They comment: “The trade-weighted US dollar is now only 10% above its all-time low seen in April 1995, and the odds are looking increasingly good for a new low to be reached in 2004.” Deutsche Bank point to a recent poll (by Reuters) of foreign exchange analysts which shows an average forecast of EUR/USD 1.22 in three, six and 12 months, with UDS/JPY levels of 107,105 and 104 over the same time horizons. Because of the homogeneity of sanguine FX views – in the analyst community at least – the Deutsche Bank team have taken a contrarian view and suggest that the reality may well turn out to be rather more dramatic.
For Heinz Fesser, head of fixed income at DWS in Frankfurt, the possibility of a larger fall in the US dollar is a risk factor which he and his team are considering. “Although our central scenario is for general weakness in the US currency to be maintained – our forecast is for USD/EUR 1.25 or a bit higher by year end – one risk scenario features a significantly weaker dollar,” he argues.
“There is not much support for the dollar just now, at least not from yields differentials. The external imbalances are huge, especially in relation to Asia. If there were to be a revaluation of the Chinese currency this would almost certainly set off a similar move for the Japanese Yen as the authorities would be unable to halt the tide. And if we have a change in the present situation of the Asian economies recycling their current account balances into US dollar assets then that could be harmful for the US dollar.”
New York-based FX Concepts offer another angle on the USD/EUR debate. Chairman and founder John Taylor recently published an article entitled ‘Has Ecofin given the world a strong euro?’ Taylor comments, “One of the most fundamental relationships in economics states that if a country’s government increases its deficit and the credit quality is deemed to be maintained, then that country’s currency will appreciate.
“It was certainly true of the Reagan years in the early 1980s with the hawkish Paul Volcker at the Federal Reserve. So if we have Ecofin allowing France and Germany to increase their budget deficits, those governments will have to fund them by borrowing more money. And on the other side sits the ECB, guardian of low inflation, who will tend to become even more hawkish and keep interest rates higher than they otherwise might have been. Result? More support for the currency.”
Taylor’s ideas have not yet found much credibility amongst many European fund managers who tend to argue that Ecofin’s decision should instead be viewed as a destabilising event for the Euro. But some, like Roland Lescure at CDC Ixis Asset Management in Paris agrees that it ought, in theory at least, to be a positive factor when evaluating the euro.
Lescure, however, adds: “The (US dollar) weakening we have seen over the latter part of 2003 was mostly a dollar weakness event rather than the euro’s popularity increasing, but indirectly it does not hurt the euro that we will see more funding in the zone and higher real interest rates. If we focus on the dollar, we can see how its large external imbalances weigh so heavily. The US dollar’s depreciation registered so far against all the major currencies should translate in an improvement in the US current external deficit of about 1 to 1.5% of GDP. To see more improvement, an even weaker dollar clearly helps.”
“There have not been that many sellers in this last phase of dollar weakness,” says Taylor. “But there are still plenty of holders, not least because of the high weightings to US$ in the MSCI weightings for example.” Taylor tells of his view of a world on the brink of huge change in the global order. He states “We are seeing the birth of a new historical relationship that will define the new millennium: the battle between China and the US for dominance in the 21st century. China will be the biggest country in the developed world and the US will have to find itself a different role, as indeed was Britain’s ‘fate’ after 1776.”
Capital markets of course have some much more immediate and pressing matters at hand which will certainly need close attention. Global imbalances, geo-political event risks and nervousness over growth expectations each have the capacity cause more volatility, argues Heinz Fesser. He is readying his team for more volatility in capital markets. “Basically we expect yields to creep up somewhat over the course of 2004, but the risks outside could certainly cause volatility, but may put downward pressure on yields in a flight-to-quality move,” he states.
In spite of any of the possibility of any or all of these factors having the capacity to shatter the calm in the world’s capital markets, Fesser is reasonably sanguine about the course of government bond yields themselves, suggesting that although they will rise over the year, the rise is unlikely to be that dramatic.
CDC Ixis’ Roland Lescure is also quite cheerful about 2004. “Things look OK now. Central banks have more time on their hands. Back at the start of 2003 the spectre of deflation was clearly scaring the Fed, but now that threat has gone and there is surely no sign of inflation returning.
“As for the ECB, their outlook and policy direction are much easier to gauge and markets always appreciate moves towards greater transparency, certainly when it comes to Central bank expectations.”