Currencies
Assessing the Dollar Undershoot
July 27, 2007

By Stephen Jen | London

Summary and conclusions

We are refreshing our currency forecasts.  Two key adjustments have been made.  (1) We mark to market the weakness in the dollar since mid-June, reflecting the intense sub-prime angst, as well as lingering weakness in the US housing market.  While we still believe that the dollar will re-assert itself in 2H from these under-valued levels, especially against the EUR and the GBP, we are now taking more seriously the impact of the structural diversification by US real money accounts.  (2) We now think that, in a robust global economy, AUD and NZD should do well, just as the CAD has. 

We maintain our view that USD/JPY should gradually trend lower, from a significantly overvalued level, and that the dollar should eventually re-assert itself, though it may not strengthen as much by end-2007 as we had thought was likely.  After the sub-prime dust settles, emerging market currencies should resume their upward trend against the dollar —a view we have held all year.  

Our forecast update

Our last forecast update was on June 14, 2007 (USD to Reassert; Non-G4 Currencies to Shine).  In that note, we terminated our call from the early months of the year that the dollar would experience a phase of weakness, driven by cyclical under-performance vis-à-vis the rest of the world.  Back then, we strongly argued for a robust global economy capable of de-coupling from a slowing US economy.  We believed that the divergence in growth and monetary paths would help push the dollar lower.  Indeed, the dollar did suffer in 1H.  However, in mid-June, data began to point to the possibility that 1Q marked the trough in the US business cycle and that 2Q would likely show a robust bounce-back from 1Q.  That was when we decided to terminate the weak dollar call.  In retrospect, that decision was premature. 

The dollar’s continued weakness in the last five weeks has been largely propelled by worries about how the sub-prime mortgage market in the US would further weigh on the US housing market, in particular, and unsettle the corporate credit market in general, with negative spillover effects on equities.  Persistent weakness in the US corporate credit markets has fuelled speculation that, because the Fed cut rates by 75bp in 1998 solely because of the failure of LTCM, even though growth was reasonably robust and inflation was accelerating, the Fed will have an even higher hurdle to raise rates, compared to the other central banks, as long as the sub-prime problem persists.  Thus, as long as the global economy remains robust, most of the non-US central banks will remain in motion, and that would be dollar-negative. 

Back in June, we did not anticipate this sub-prime shock, and are now marking to market our September forecasts.

There are two key sets of changes to our forecasts: 

First, though we maintain our view that the dollar will reassert itself in 2H (due to the continued recovery of the US economy, stabilisation of the sub-prime problem and a weakening in UK consumption), we are lowering our year-end targets for the dollar against the EUR, GBP and other currencies.  This reflects our recognition that the dollar weakness this year is not purely cyclical —as we had argued for most of the year —and that continued diversification out of USD assets by US real money managers may have exerted structural downward pressure on the dollar over the past few years (see The Biggest Dollar Diversifiers Are American, July 19, 2007).

Second, we are now of the view that the CAD, AUD and NZD should continue to perform well, though in 2008, NZD has more downside risk than the other two currencies.  This positive revision to two of the three commodity currencies reflects our (somewhat belated) recognition that a robust global economy will continue to support commodity prices and keep these currencies strong, despite them being over-valued on traditional measures. 

Some thoughts

We have the following thoughts: 

1. Financial globalisation, declining ‘home bias’ and currency valuation.  I believe that the ‘home bias’ will likely continue to decline in most countries, i.e., countries will reduce their collective exposure to their own assets, in order to have a broad enough exposure to a globalised world.  My theory that the US real money accounts have been diversifying out of USD assets is a part of this global trend.  The outward capital flows by Japanese retail investors should also be seen in this context.  Also, state pension funds (such as GPIF in Japan, the SPF in Korea and the Future Fund in Australia) may also be diversifying away from ‘home’ assets and into ‘foreign’ assets.

During this ‘transition phase’, as countries rebalance their collective portfolios, exchange rates could deviate significantly from their ‘fair values’ consistent with real economic fundamentals.  What this also means is that currency interventions by central banks would essentially be ‘subsidies’ for these flows, and will likely fail, as demonstrated by the RBNZ’s experience. 

There is yet another ongoing trend that may be structurally negative for the dollar.  As emerging economies gain composure as they stabilise their economies and strengthen their external positions, their need for insurance from the IMF and the precautionary demand for US dollars may have declined.  In other words, countries and companies in some emerging economies no longer need to hold US dollars as their liquidity reserves to meet unforeseen external shocks.  This idea is the flip side of another idea I proposed in The Trilemma and De-Dollarisation (June 7, 2007).  In that note, I argued that one of the reasons why rapid monetary growth rates resulting from less-than-full sterilised interventions in many emerging economies have not led to inflation may be due to a fundamental increase in the demand for local money.  I will revisit this concept, but I believe that, in a world where there is an ‘economic power shift’ from developed to developing countries, the world’s demand for the US dollar could decline. 

2. The global economy and financial prices.  The state of the global economy bears no resemblance to that of the financial markets.  The headline growth rate of the global economy (tracking 4.9%) is as robust as it has been in the last four years, with much better sectoral and geographical balance.  Not only has the global economy evolved from ‘uni-polar’ to ‘tri-polar’, but many of the large emerging economies should no longer be considered as ‘emerging’ economies; and the strength of their domestic demand can no longer be dismissed.  Global GDP is around US$47 trillion; the G7 accounts for ‘only’ US$28 trillion.  The rest of the world has shown the ability to de-couple from the US, and we believe that the world has entered a phase in the globalisation process where these non-G7 economies will help make the global economy more resilient to shocks.  Some investors may be too fixated on the fragilities of the balance sheets of households in Anglo-Saxon countries, and have become unduly bearish on the ability of the global economy to withstand the volatility we are witnessing in the financial markets, I suspect. 

I continue to believe that the real economy should ultimately drive financial prices, not the other way around.  The storm in the credit markets, we believe, is a normalisation process.  Though violent, the widening in the credit spreads is an unwind of unusually low levels of credit spreads.  In other words, I believe that we are witnessing credit re-pricing, not a credit crunch.  The risk-reduction we have witnessed this week, in our view, is temporary.  Oil and other commodity prices will be supported, and so should equity prices. (This is the main rationale behind our bullishness on commodity currencies —CAD, AUD and NZD.)

3. Japanese yen.  USD/JPY has declined from close to 124 to 119 in the past four weeks.  This is a sharp drop.  I am not yet convinced that this is the beginning of a new trend, even though I endorse long JPY as a tactical trade during this volatile period.  The Japanese yen can do well in ‘extreme conditions’ if: (1) the world plunges into a risk-averse state or (2) Japan’s economy and/or the Nikkei outperforms the rest of the world.  We have been looking for USD/JPY to trade lower (118 and 112 by end-2007 and end-2008), and the scenario we have had in mind is (2), not (1).  For one thing, it is unlikely that scenario (1) can persist from now until the end of 2008. 

Bottom line

We have updated our currency forecasts and have revised our end-2007 forecast for EUR/USD to 1.33, from 1.28 previously.  USD/JPY’s forecast is unchanged: 118 by end-2007.  Part of this adjustment reflects the state of the sub-prime market, but we are also formally expressing our recognition that US real money diversification may be a structural negative for the dollar.  The AUD and NZD should continue to be supported, just like the CAD, as long as global demand remains robust.

Important Disclosure Information at the end of this Forum

Japan
Hot Topics for the CPI
July 27, 2007

By Takeshi Yamaguchi and Takehiro Sato | Tokyo

There has been a wave of recent news with potential implications for the CPI, most notably the announcement of plans to cut call charges from September by a leading cellular service operator (on July 19), followed by the Ministry of Internal Affairs and Communications’ (MIC’s) announcement of a plan to reshuffle component items in the CPI (July 20). Here we look briefly at the impact of these developments, and consider the market and policy implications.

Impacts of CPI component reshuffle and lower mobile phone call charges

The MIC has announced that it will reshuffle the items that it surveys for the CPI (to take effect from January 2008).The impact of the component reshuffle seems likely to be more or less negligible. This is because of certain adjustments that will be made at the point of indexing in order to adjust for additional items skewing the index for expensive items. Therefore, there should be no major changes on a YoY basis either when the added and non-added indices are compared. As for whether falling prices for the new items will have an effect on the rate of growth in prices overall, we do not expect their impact to be that substantial, because at this point the weighting of the items to be added is very small. Moreover, we see little probability where the added items are concerned of prices being adjusted for quality improvements (hedonic adjustments), so we do not expect prices to move very dramatically

Looking now at the possible impact of plans by a major cellular service provider to cut its call charges, we would note first that mobile phone call charges occupy a 208/10000 weighting in the CPI. If the new plan was used as a sample, the average price of the provider would see a marginal fall of about 20%, and in terms of YoY comparison the CPI would drop by about 0.1ppt. Even so, we think there is a great deal of uncertainty as to whether the new plan will be used by the MIC, and also as to the timing of inclusion. If it was not included in the index, the CPI would not be affected at all, so we think that the expected impact of call charge cuts would be small. That said, since the MIC has some discretion over what mobile call charges to include, and when, it is still possible that the market could overreact to unforeseen changes.

Market and policy implications

We have had a cautious view of the price outlook all along, and the price-depressing impact of this type of news flow is already largely built into our forecasts. Remember too that changes in individual price categories — not just in cell phone rates, but also utility charges, medical fees, etc. — simply represent relative price shifts, and are not related to changes in the overall price trend. When certain categories fluctuate widely, the impact can be excluded by using the trimmed mean indicator, which better identifies the trend.

In addition, when consumer price inflation is near zero, calculation error seems to be a more important factor than the trivial changes above. As we have reported elsewhere, there is a constant margin of calculation error of 0.1% up or down in the official YoY figures for Japan’s CPI. Furthermore, there is an upward bias in using a Laspeyres price index with a fixed base year. Given these margins for error, summing up the impact of individual changes to calculate the impact on the headline inflation number does not seem likely to be meaningful.

Inflation-indexed bonds are already reacting negatively to the above news flow, but a more important catalyst is the weekend Upper House election, since the expected inflation rate is currently low, and there are no clear factors to drive up prices other than a consumption tax hike. If expectations for an early consumption tax hike recede after the election, in the worst case the risk premium for a fiscal deficit could be applied in the bond market overall, not just for inflation-indexed bonds. However, our view is that the opposition parties’ contention that they would not raise the consumption tax is simply election talk to win favor at the polls, and that the market impact of the election result will be ephemeral. In other words, even if the ruling coalition falls short of a majority, debate on overall changes to the tax system, including the consumption tax, is inevitable. Debate might temporarily die down, but policy here would surely come under renewed focus ahead of the reports of the government’s and the ruling party’s tax council towards the year-end. Any market concerns (or hopes) prompted by the election would clearly be short-lived.

Important Disclosure Information at the end of this Forum

Currencies
Expensive, but Will Likely Overshoot Further
July 27, 2007

By Stephen Jen | London

Summary and conclusions

The RBNZ is working against a lot of ‘positives’: a robust global economy, a strong Asia, a massively positive terms-of-trade shock, a tight labour market, potential further expansion of fiscal stimulus and good weather.  While there are signs that the recent monetary tightening may have begun to affect the mortgage market, in my view, 8.25% is not likely to be enough to counter-balance the positives I mentioned above.  My sense is that the OCR could be raised to 8.50% in the coming months.  Even if the RBNZ does not lift rates to 8.50%, it will likely ease slower than the market thinks. 

NZD is already overvalued, but it could go a bit further, I suspect.  For it to sell off, we would need to see a panic in the market about a sharp slowdown in NZ’s housing market, and rate cuts are priced in (just as in spring 2006).  But this, I think, would be a NZD-buying opportunity, since the RBNZ would not ease unless inflation comes off, regardless of what happens to growth.  The other scenario for NZD to sell off is a broad-based global reduction of risk, unrelated to the state of the NZ economy.  Our forecasts for NZD/USD are 0.81 for end-3Q, 0.77 for end-2007 and 0.72 for end-2008.  In short, we believe that NZD/USD is in an overshoot, but warn against being too bearish on NZD too early. 

More monetary tightening is needed 

Monetary policy is fighting a lot of positive factors for inflation.  Relative to the June Statement, data have generally surprised to the upside.  The upside surprise on non-tradables inflation (at 4.1% in 1Q) has pushed the RBNZ over the brink to tighten this morning (July 26).  The labour market is extremely tight, despite modest growth (2%), suggesting, importantly, that potential growth may be decelerating faster than the RBNZ had thought. 

There are three key questions the RBNZ will need to answer in order to form its monetary stance for the coming months. 

Question 1.  Will the mortgage market continue to slow enough, and therefore force the housing market to cool down enough?  The mortgage market has begun to slow, based on anecdotal observations.  As fixed-rate mortgages fall due (in contrast to Australia, some 80% of NZ’s mortgages are of the ‘fixed-rate’ type, with interest rates frozen for the first two years or so (similar to ARMs in the US).  Thus, interest rate hikes only affect the mortgage market with a delay), borrowers are rolling over their loans at interest rates that are 150bp higher (rising from 7.4% or so to 8.9%).  Within the next six months, borrowers could face interest rate jumps of 200bp.  It is, however, unclear if housing price inflation, which is still running at around 12% year on year, will fall to zero in 18 months’ time, as the RBNZ assumes. (The RBNZ assumes that housing price inflation will decline from around 8% now to zero by 2009.)  We should also be aware of the housing supply shortage in NZ, despite significant construction activities.  In short, the RBNZ has to form an opinion on how much traction its tightening campaign will have on the housing market —a difficult task, given the nascent nature of this trend and a lack of hard data supporting this view. (In NZ, properties that were built 10-20 years ago were small in size, and are not the type in demand now.  The supply being of the ‘wrong type’ has exacerbated the supply-demand imbalance.)

Question 2.  How big will the positive terms-of-trade (ToT) shock in the dairy products be?  Dairy prices have risen by close to 100% this year (13% since the release of the RBNZ’s MPS), (Overall NZ commodity prices have risen by 60% in the past year.) and will lead to a significantly positive demand shock in the next 18 months or so.  While most of the rise in dairy prices is due to strong structural demand from China and India, there are supply problems in Australia (due to the drought), the US (due to bio-fuel demand) and Euroland (due to a change in legislation) that suggest that dairy prices will likely stay high for at least the next two years before new supplies from Latin America and Eastern Europe become available.  Commodities are important for NZ: they account for 70% of total merchandise goods exports: dairy products account for 20% of goods exports, or 6% of GDP.  The RBNZ calculates that this will lead to a NZ$2 billion ToT shock in the coming year. (This estimate is likely to understate the total ToT shock to the economy.  For example, Fonterra (the co-op that sells and exports all the dairy products on behalf of the small farmers in NZ) has just raised its FY2007/08 price for powdered milk from US$4.15/kg last year to US$5.53/kg this year, and back-dated a price of US$4.35/kg for May and June 2007.  There is talk that this price could be raised further to above US$6.50/kg in the coming months.)  For various reasons (farms being small and non-incorporated), this ToT shock in NZ will likely have a bigger demand effect than a similar ToT shock would in other commodity countries like Australia.  In short, this ToT shock is very important and potentially meaningfully positive for aggregate demand.

Question 3.  How will a stronger NZD exacerbate the sectoral imbalances in the NZ economy?  The strong NZD further complicates the RBNZ’s policy, for two reasons.  First, NZ’s manufacturing sector is extremely stressed, even though the dairy farmers are doing well.  The ToT shock is a complication because manufacturing exports are struggling. (Manufacturing exports are struggling to deal with the structural pressures from global competition, and the strong NZD has exacerbated the problem.)  Second, a strong NZD is highly politicised issue in NZ, and may compromise the RBNZ’s inflation objective.  FinMin Cullen’s recent comments on revising the RBNZ’s mandate stems from the intense political pressures the FinMin himself is feeling.  In short, the RBNZ cannot totally ignore the political environment, which should keep the exchange rate as a hot issue in NZ until the election next year.  I even suspect that the RBNZ’s statement issued this morning, that the rate hikes already in place should be “sufficient to contain inflation”, is meant to hold down the exchange rate. 

The economy has already exceeded full capacity

Even before the latest positive ToT shock, the NZ economy was already operating beyond full capacity.  At 3.8%, its unemployment rate is the lowest in the OECD, and average hourly earnings continue to accelerate (its moving average has risen from under 2% in 2000 to above 5% now).  Capacity utilisation measures confirm the tightness in factor inputs(capacity utilisation has been above NZ’s long-term average for six consecutive years).

Regarding domestic demand, the latest data point to a sharp resurgence in retail spending, with its growth rate accelerating from 1.5% to over 5% in the last four quarters. 

Further, there are signs that the potential growth rate of NZ may have decelerated by more than the RBNZ has assumed in its forecasts.  In fact, this may be behind the upside surprise in the non-tradeables inflation rate.  The population growth rate has fallen and, importantly, labour productivity is declining, reflecting in part the super-tight labour market.  With the last recession having occurred in 1998, the NZ economy has been continuously absorbing its labour force for close to a decade.  While immigration and the strengthening NZD have helped keep a lid on wage and imported price inflation in the past years, the labour market is so tight now that labour productivity may have suffered as lowly skilled workers make up the primary marginal new workers joining the labour force. (Labour productivity and total factor productivity growth have decelerated materially between 1992-2000 and 2001-2006.)  If potential growth is indeed lower than the RBNZ had thought, then GDP growth would need to be lower for longer to push down inflation.  This also means that, in the short term, interest rates will probably need to be raised further and kept high for longer. 

Of course, in the long run, a lower potential growth rate should imply a lower ‘neutral’ interest rate.  In an inflation-targeting country, decelerating productivity growth should, thus, translate into a flatter (less positively sloped) yield curve, as short rates need to go higher while the long-term rates should drift lower.  While, in the old days, a lower potential growth rate and a lower long-term real interest rate meant a weaker currency, in the current environment, where nominal cash interest rates still seem to matter the most, the NZD should remain well supported.  (Uridashi and Eurokiwi issuances are likely to remain high, funding the scheduled roll-overs.  Lumpy redemptions of these coupons are, again, expected.  In August/September 2007, some NZ$3 billion a month will fall due.  But net outstanding bonds of these types continue to rise, suggesting that gross issuances of new bonds will more than fully finance the roll-overs.)

Fiscal stimulus in the coming year is yet another risk

In addition to a ToT shock adding to an already tight economy, fiscal policy will likely become even more stimulative by 2008.  Already contributing to almost 1% of GDP growth this year, and with the incumbent Labour government being 15 points behind in the polls and an election due to take place next year, it is likely that the government will be pressured to cut taxes or increase infrastructure spending.  This poses a major, but not immediate, risk for interest rates and the exchange rate.  (Incidentally, I think that the same trend will emerge in many parts of the world, forcing central banks to take more action than they would otherwise.)

Fears of RBNZ rate cuts could be easily rekindled

There could be considerable volatility in NZD/USD and NZD/JPY.  Not only are macro hedge funds bearish on the NZD, and will likely be keen to short the NZD when they have an excuse, but domestic investors in NZ are also quick to price in rate cuts as soon as they sense that the housing market may be slowing.  In spring 2006, we witnessed a drastic shift in sentiment regarding the interest rate and exchange rate outlook.  I suspect that there will be déjà-vu moments later this year.  But, given that inflation is likely to remain high in NZ, the chances of the RBNZ cutting rates are low, and these should be NZD-buying opportunities, in my view. 

Bottom line

Though NZD/USD is over-valued, it could overshoot even more as the RBNZ is likely to tighten further.  The two major caveats are (1) the NZ housing market collapses or (2) there is a sharp reduction in risk appetite in the world.

Important Disclosure Information at the end of this Forum

Currencies
AUD: A Great ‘China Play’
July 27, 2007

By Stephen Jen | London

Summary and conclusions

AUD/USD is a clean ‘China Play’, given the extraordinary symbiotic trade relationship between Australia and China.  As long as China remains strong, the terms of trade (ToT) shock for Australia will be higher for longer, which should be supportive for the AUD. 

In addition, the Australian economy is robust and balanced, unlike that of New Zealand.  The RBA is clearly in a tightening mode.  Given the election calendar, the RBA is looking for a convincing justification/political cover (such as the high CPI figures released on July 25) for another rate hike.  Further, few in Australia seem to be bothered by the strong AUD. 

Even from its current lofty levels, AUD/USD could rally further, in my view.  If the dollar does reassert itself, as I believe it will in 2H, the AUD will likely outperform the EUR, GBP and NZD.  Our targets for AUD/USD are 91¢ by end-2007 and 86¢ by end-2008.  We expect AUD/NZD to rise from 1.11 now to 1.19 by end-2008. 

China a dominant driver for Australia

It is by now clear how dominant a force China’s economy has been in helping to generate a ‘second wind’ for Australia, after housing prices there decelerated in 2004.  China now accounts for 12.3% of Australia’s total exports (compared to 4.7% a decade ago), and is Australia’s third-largest market.  It has already become the single-largest source of Australia’s imports, accounting for 14.4% of total imports (compared to 1.4% a decade ago).  Not only has demand from China helped support base metals prices, it has also depressed Australia’s import prices.  Australia’s ToT have risen by around 40% in the past four years, reaching their highest level since the Korean War, and have been a significant support for the AUD. (The RBA’s index of commodity prices (ICP) has risen by 65% in AUD terms and 104% in USD terms in the past four years, with base metals prices — led by nickel and copper — tripling during this period.)  Given how diverse tradeable goods from China and Australia are, bilateral trade between these two countries is clearly mutually beneficial. 

The rise in the ToT since 2004 has been extraordinary.  If anything, it is surprising that the AUD is not even higher than it is.  There are several channels through which ToT could drive the AUD: 

• Channel 1: The full impact of the ToT shock not yet felt.  Reflecting persistent scepticism about the sustainability of China’s economic growth, Australia’s resources companies were late in recognising the impact of the emergence of China and, as a result, were late in embarking on a capex binge to raise their production capacity.  Thus, the gains from the positive ToT shock by Australia’s resources sector have been primarily in the form of higher export prices.  But it is expected that when the new capacity, which is still being added now, becomes operational, the volume effect will be significant.(In addition to new production/extraction capacity waiting to become available, there have been major bottlenecks in the transport infrastructure, including ports and rail lines.  In particular, coal and iron ore exports have been restrained by transport constraints.)  In other words, we have only witnessed the first part of the benefits of the ToT shock; the second part is coming.  The AUD should remain supported even if the ToT stop increasing.  
• Channel 2: M&A flows to ‘turbo-charge’ this effect.  In a world with large and fluid cross-border capital flows, ToT shocks could have a larger effect on exchange rates if they are followed by foreign direct investment (FDI) flows.  In Canada, for example, inward FDI has accelerated in recent years, helping to push USD/CAD near parity.  In 2006, FDI in Canada was USD$67 billion — more than double the amount seen in 2005, and 2007 levels look set to be significantly higher.  A similar trend has been witnessed in Australia.  Going forward, the resource industries in both Australia and Canada are likely to attract considerable interest from foreign investors, in my view.  This is currency-supportive, beyond the aforementioned economic impact from a ToT shock. 
• Channel 3: The monetary channel.  Positive ToT shocks add to aggregate demand, and bias monetary policy rates upward.  One example is the large capex (A$60 billion over the past five years) that has taken place, and the infrastructure spending that will take place, in the resources industry to expand production capacity.  To the extent that the RBA already has a tightening bias, the more sustained a large ToT shock is, the more the RBA will need to act, which should have the logical implications for the AUD. 

The AUD is still a commodity currency.  As long as China’s demand remains robust, the AUD should be expected to perform well, ceteris paribus. 

The RBA tightening campaign is not yet complete

The RBA has ample reasons, perhaps more so than the RBNZ, to tighten further.  The 2Q CPI figures released yesterday (July 25, 2007), which showed a +1.2%Q (5.0% annualised) growth, are the ‘political cover’ that the RBA needs to raise its policy rate from 6.25% to 6.50% in August.  Such an interest rate trajectory will likely be supportive of the AUD.  Here are some thoughts on the RBA’s policy stance:

• The economy is close to full employment.  The economy is very robust, with non-farm GDP growth having accelerated to 4.5% recently.  At the same time, rainfall this year has been normal, and will help to alleviate the effects of the drought in the farming sector.(The wheat harvest in November/December should be good, and is expected to double the pace seen in 2006)  The unemployment rate is at a generational low of 4.5%; capacity utilisation is very high.  Housing credit growth is decelerating (80% of Australia’s mortgages are variable rate, so monetary tightening has had more traction in Australia than NZ, where 80% of the mortgages are of the fixed rate).  The very fact that the mortgage market has already begun to react to interest rate hikes makes it less likely that the RBA will over-tighten.   (In other words, it would not run the risk that, all of a sudden, mortgage holders roll over loans at substantially higher interest rates.)  At the same time, business credit growth has accelerated.  Continued interest rate hikes are likely, and this is indeed the posture and the intention of the RBA, in my view.   Downside surprises to inflation in the last two quarters are likely to prove to be temporary. Moderation in inflation in recent quarters could also reflect a slight acceleration in potential growth.  The abatement in inflationary pressures in recent quarters has been a bit of a puzzle, though the latest release makes the inflation profile more consistent with the strength of the economy (underlying inflation decelerated from 3.25% in 2Q and 3Q06 to 2.25% in 4Q06 and 1Q07, despite an acceleration in consumption in 1Q07).  One hypothesis is that potential growth may be accelerating.  Despite the fact that the UR continues to drift lower, wage inflation has been steady at around 4%.  Rising demand for labour in the resources sector has not led to inflationary pressures in other sectors; instead, we have seen labour migration between sectors, between geographical areas within Australia, and net large immigration of skilled workers from outside Australia.  At the same time, business investment has been remarkably robust for several years, averaging 16% of GDP in the last two years — a 50-year high.  It is possible that some of this investment may soon show up in increases in productivity.  In short, the economic risks of the RBA ‘over-tightening’ by 25bp seem modest. 
• The upcoming election is an issue for the timing of the RBA’s rate hikes.  The incumbent government is under pressure.  Given that an election is likely to be called towards the end of the year, we suspect that the RBA wants to put some time between its next rate hike and the election.  Also, it would likely want a clear justification (such as the high CPI figures we saw yesterday) for the next rate hike.  This is why yesterday’s CPI is so important.  If the RBA does not hike in August, it might not be able to raise rates until early 2008. (There will likely be fiscal stimulus, arising from higher infrastructure spending by the state governments (27% increase for FY2007/08) and income tax cuts by the federal government.  However, since Australia has had a similar fiscal stimulus every year for several years, this is not likely to be as big a risk to monetary policy as in the case of New Zealand.)
• A debate on the role that the strong AUD plays in holding down inflation.  While exchange rate pass-through to import prices and overall CPI in Australia has declined substantially in recent years (consistent with the same trend observed elsewhere in the world), a strong AUD has had some restrictive effects on manufacturing exports; this, in turn, may have had some dampening effects on overall inflation.  Thus, from the perspective of inflation containment, a strong AUD is consistent with the monetary objective.  This explains why the RBA is not concerned about the strong AUD. 
• There is little sensitivity —both in the private sector and among the policy makers —towards the strong AUD.  In fact, the more interesting question, as I mentioned above, is why the AUD is not even stronger.  Merchandise exporters have not complained much, possibly because domestic demand is so strong that they have been able to sell much of their production within Australia.  Also, much of the low value-added manufacturing exports sector was destroyed back in the 1980s and, therefore, there are no exporters of this type to complain about the strong AUD. 

Bottom line

AUD/USD is a clean ‘China Play’.  As long as demand in China remains robust, the AUD should be a major beneficiary.  I expect the AUD to be well supported and outperform the EUR, GBP and NZD, even when the dollar reasserts itself.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.