Currencies
The Undervalued Dollar to Keep Weakening
November 09, 2007

By Stephen Jen | London

Summary and conclusions

The dollar is cheap, but is likely to undershoot further, particularly in light of the recent downward revisions by our US economists on the growth outlook of the US economy.  Euroland, Japan and the UK will also likely slow in the coming two quarters.  But the broad theme of economic de-coupling is likely to be preserved, with much of the rest of the world (RoW) weathering the prospective US slowdown better than in the past, making it difficult for an already significantly undervalued dollar to gain much traction in the coming two quarters. 

We are now looking for the dollar to bottom against the EUR and GBP in 4Q, at 1.51 and 2.13, respectively.  Also, with the dollar and the world’s risky assets under such intense pressure, the JPY is poised to participate, in earnest, in this dollar downtrend.  We are looking for USD/JPY to trade down to 106 by 1Q08, before recovering to 114 by end-2008.  

Our thoughts

We presented our last set of forecasts on September 13, 2007 (The US Dollar Is the Sub-prime Currency, for Now).  In that note, we argued that the dollar would remain on its back foot for two quarters, until the US housing market bottoms in 1Q08, and that the dollar should rebound with the economy.  In the coming months, a mid-cycle slowdown in the US, coupled with relative resilience in the RoW and powered in part by a robust Chinese economy, means that the dollar will remain weak for the next two quarters.  However, valuation is increasingly in favour of the dollar, and the US ‘twin deficits’ will continue to plunge rapidly to help support the dollar . 

Since then, the dollar has weakened by more than we had expected.  From a spot rate of 1.39, EUR/USD has overshot our forecast peak of 1.43 and traded above 1.47 earlier this week.  It is clear that we had underestimated the intensity of the pressures impinging on the USD and the relative impotence of valuation supporting the dollar.

We make the following points:   

• Point 1.  The US economic outlook has worsened somewhat.  To reflect the powerful contraction in the US housing market and the credit crunch that will restrain housing demand, consumption and capital expenditures, our US economists recently revised down their growth forecasts.  2008 growth is now expected to be 1.8%, from 2.1%.  The weakness will mainly be concentrated in early 2008 (0.5% in 4Q and 0.7% in 1Q).  Consumption growth is expected to slow from above 3% in the first three quarters of 2007 to 1.3% in the coming three quarters.  The angst regarding the US sub-prime market will add to fears about USD assets.  However, as long as China’s economy and asset prices hold up (i.e., a modest slowdown, nothing sharp), perceived economic de-coupling will continue to lead to downward pressures on the dollar, we believe. 
• Point 2.  The dollar is in trouble.  Market psychology regarding the dollar is deteriorating.  While we still have a structurally constructive opinion on the dollar and the US economy, we think that, if the situation is mismanaged by the US and European authorities, what has so far been an orderly descent in the dollar could easily degenerate into a more violent event.  In contrast to end-2004, when the USD also experienced a sharp correction, only to rally in the new year, the main players pushing the dollar this time around are not hedge funds or real money accounts.  Instead, central banks and SWFs from the Middle East and Asia may have been more active than they were back in 2004.  The risk here is that, if the ECB and the US Treasury don’t escalate their rhetoric, the market might interpret this as ‘benign neglect’ and could, in response, start to participate in this dollar sell-off.  The cyclical reasons for the dollar’s descent are obvious, but there are some structural justifications that investors who are watching the dollar’s decline could easily find convincing.

We will not repeat these structural factors (detailed in our previous note), but still look for the US and Euroland to gradually move into a situation whereby preconditions for coordinated interventions will gradually be met.  Since we don’t expect these preconditions to be met soon, the dollar will likely keep falling until the Euroland and UK economies are affected and the G7 are provoked into taking action (see Waiting for Coordinated Intervention? November 1, 2007). 

• Point 3.  The G7’s stance on exchange rates makes little sense now.  The G7’s focus on China’s currency policy is misplaced.  There is still the outdated notion that, without the ‘sticky’ USD/CNY and USD/Asia in general, EUR/USD would not rise so sharply.  This might have been true of the undercurrents in currency markets in recent years, but we believe that it is no longer a good description of the current situation.  Exchange rates are no longer driven by trade or concerns about trade imbalances.  We don’t remember the last time someone told us that they were selling the USD because of its C/A deficit.  Rather, more than ever, exchange rates are driven by cross-border flows, e.g., diversification flows by central banks in Asia and the Middle East, and structural portfolio adjustments in the private sector, as ‘home bias’ declines worldwide.  These flows are very powerful, and have little to do with where USD/CNY is.  In other words, we don’t find the G7’s notion on currencies compelling.  If Mr Trichet repeats the G7’s mantra, we believe that it would have a negligible effect on EUR/USD.  As the USD falls in coming weeks, the G7 will likely be pushed into re-thinking their strategy in anchoring expectations about the dollar. 
• Point 4.  What is happening in the world is very healthy.  We have previously argued that the low and declining US household savings rate could be explained by three variables – housing wealth, the long bond yield, and equity wealth, with housing wealth being, statistically, the most important determinant of this important variable, which underpins the US external imbalance (see US Savings Rate, the Housing Market, and the USD, September 22, 2005).   If we simulate the expected decline in US housing wealth, and changes in the long bond yield and equity wealth consistent with our latest US economic forecasts, the US household savings rate should start to recover by the end of this year. 

Another way of thinking about global rebalancing is that the ‘20%-balancing-down, 80%-balancing-up’ scenario we have had should help the world rebalance, with the US slowing, while the RoW catches up.  This is precisely what we are witnessing, and policy makers and investors should not be puzzled or alarmed by this development.   

• Point 5.  The JPY may finally participate in this USD sell-off.  So far, the JPY has failed to participate in the general USD sell-off.  We have long been reluctant to consider downside risks to USD/JPY, because of the extraordinarily high ‘home bias’ in Japan.  But with the recent sell-off in the dollar, and the lack of any push-back by the G7 officials, we now believe that the risk to USD/JPY is biased to the downside, as the developed world will likely slow in coming quarters and risky assets come under some downward pressure.  However, beyond this period, we are still expecting USD/JPY to drift back up, due to capital outflows.

Commodity and EM currency forecasts

As the developed world (US, Euroland and Japan) slows in the coming two quarters, there will be a bit of a wobble in the commodity currencies and the EM currencies.  Our forecasts for the AXJ currencies remain unchanged, as they had already incorporated such a scenario. 

Bottom line

Despite believing that the USD is grossly undervalued against the EUR and GBP, and may not be far from the ultimate trough against these currencies, we believe that the market will likely push the USD lower, until the G7 are provoked into threatening or conducting interventions.  As the G7 are not yet in a position to intervene, the USD will likely keep weakening, even against the JPY. 

 

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Japan
Room at the Top? Not Such an Outlandish Scenario (Part II)
November 09, 2007

By Takehiro Sato | Tokyo

Update on BoJ leadership outlook

We commented in our October 26 note (Room at the Top? Not Such an Outlandish Scenario) that the possibility of our theoretical scenario of not having a BoJ Governor and Deputy Governors actually occurring has increased. This outlook takes into account the expiration of Governor and Deputy Governors’ terms on March 19, 2008 and the possibility of the Democratic Party of Japan (DPJ), which holds a majority in the Upper House and effective veto power on personnel decisions, calling for a postponement of the selection until after a general election confirms the next administration against the backdrop of stalled conditions in the National Diet. Subsequent deliberations in the National Diet regarding this issue clarified legal provisions for dealing with top leadership vacancies. We review our position in light of the additional information.

Interpretation of the BoJ Law clarified in National Diet deliberations

Our previous note raised the possibility of Miyako Suda, a board member, temporarily handling the chairman duties. However, deliberations by the Upper House’s fiscal and monetary committee on November 1 indicate that this possibility is unlikely.

Actually, the government’s interpretation of the BoJ Law restricts the temporary assignment to an ‘absence’ of the Governor and Deputy Governors for an overseas trip or because of physical reasons. It does not apply to vacancies. The remaining six board members elect a chairman when the top leadership is vacant from a lack of National Diet approval due to an impasse in the National Diet or the National Diet not being in session according to Article 16 of the BoJ Law. There is a chance of an Executive Director being elected and handling the chairman’s duties. The Cabinet Office Legal Bureau’s opinion implies that an Executive Director without National Diet approval could theoretically participate in policy meeting discussions, exercise general control of the board as chairman, and cast policy votes. While this interpretation seems somewhat unusual to a non-legal expert, it is the government’s opinion and must be respected.

We mentioned another possibility in our previous note of the existing leadership team provisionally continuing in their positions without National Diet approval until the next team is officially confirmed, and thereby extending the terms. We think that Article 23 of the BoJ Law envisions this type of scenario and it is a more realistic outcome than electing an Executive Director. Yet the BoJ Law handles this scenario as a provisional appointment without National Diet approval rather than an extension. A pragmatic question is whether someone would provisionally accept the Governor’s position despite the risk of not receiving National Diet approval later on. The least problematic scenario would be provisional designation of the existing leadership team to fulfill this role and then voluntarily resign once the new team is finalized instead of being dismissed as prescribed by the BoJ Law.

Policy implications

However, the policy implications are the same in both cases. While the timing of Diet dissolution and a general election will play a role, it is unlikely that the board would make important policy decisions without a proper leadership team. There is hence a possibility of a monetary-policy gridlock from late March when the Governor’s term expires until April and May when Diet dissolution and a general election are expected. New leadership would also need some time before it could take real initiative even if National Diet approval comes in May or so. These factors could delay policy action until at least Jul-Sep 2008.

Recent news of larger subprime-related losses at overseas financial institutions has rekindled credit worries and is leading to wider credit spreads and stock-price instability thus far in November. Japan’s GDP data for Jul-Sep and Oct-Dec face downward pressure from sharp reductions in housing and construction investments, and worsening terms of trade from upswings in energy and raw material prices are heavily impacting smaller businesses. Leading indicators, such as the Economy Watchers’ Survey, are headed lower in this environment. We think that these economic conditions significantly reduce the possibility of a policy rate hike during December 2007 to February 2008, though a slight chance remains for rate action in January 2008.

Possibility of a ‘happening’ rate hike

We discussed the possibility of a ‘happening’ rate hike during an effective absence of the leadership team in our previous note. However, the Outlook Report released at the end of October expressed uncertainty regarding the bank’s stance and suggests a loss of resolve. We think that the possibility of the ‘happening’ scenario based on a decision by the six board members without top leadership is fairly low amid growing downside risks.

 

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Japan
Japan: Oil Decoupling
November 09, 2007

By Robert Feldman | Tokyo

Hard to find good news

It is hard to find good investment news from Japan these days. Yes, earnings announcements so far have shown more than 10% growth, as expected. And valuations are low. But none of this is new news. Rather, attention has focused on disarray in politics:  The internal disruptions involving the resignation – subsequently retracted! – of opposition leader Ozawa have only strengthened the anti-reform forces in the ruling party. Moreover, the intense focus of politicians on the next election has given bureaucrats free rein. More investors are asking why they should have any money in Japan at all.

Do not overlook the obvious: Reduced oil dependence

In this gloomy atmosphere, it is easy to overlook the quiet longer-term strengths of the Japanese economy. One such strength, which deserves much more attention than it usually gets, is Japan’s immense success in reducing oil dependence. In fact, total oil imports to Japan are lower today (about 4 1/4 mbpd) than they were in 1973 (about 5 mbpd).

The story is even more interesting when oil imports are contrasted with real GDP growth. Since 1960, real GDP has risen by 200%, and oil imports are up by 207%. This suggests that the long-term income elasticity of oil imports to GDP is about 1.0. In fact, nothing could be further from the truth. In the high-growth 1960s, the income elasticity was close to 2.0; between the first and second oil crises, about zero. In the decade after the second oil crisis, the income elasticity was negative! It then reverted to a modest positive, and recently has been back near zero. In light of the movements of the real price of oil in these periods, it is obvious that the price elasticity of oil imports was quite high. When oil was cheap, imports roared. When oil was expensive, imports plunged. These reactions to price took time, but were very real.

This decoupling from oil came from a variety of sources. Conservation was extremely important, in particular the design of cities focusing on public transportation and high-density urban areas. Energy efficiency was raised through better mileage in cars, and through improved building codes. Energy saving was promoted by a host of government programs and incentives. Despite these efforts, however, the energy intensity of GDP did rise over the last 30 years, from about 61 joules per yen of real GDP in 1975 to 65 in 2004.

Thus, the real story in the decoupling of Japan from oil is diversification of energy sources, both within fossil fuel types and away from fossil fuels as a whole. Within fossil fuels, dependence on oil and oil products dropped from 72% of total energy use in 1975 to 46% in 2004. In contrast, the share of coal rose from 18% to 22%, and the share of LNG rose from 3% to 15%, in the same period. Overall, however, fossil fuel dependence dropped from 92% to 82%. Among the non-fossil energy sources, the largest increase came from nuclear power, which rose from 2% of the total to 11%.

This change in the level and composition of fossil fuel dependence has reduced the vulnerability of Japan to energy shocks. Of course, the prices of all fossil fuels tend to move together, but timing lags among the different types can give the economy significant adjustment room, and help avoid panic. Moreover, the lower dependence on fossil fuels reduces the part of the economy that is vulnerable to shocks. In addition, now that reducing carbon emissions, which largely come from fossil fuels, is much more important, Japan has somewhat less environmental homework than other countries.

Science, and social-science technology

Looking forward, the lessons from Japan’s energy policy give hints about what will happen next. First, the sense of energy crisis will still resonate in Japan. Despite the progress, Japan still depends on imports for 82% of its energy, a drop of only 5% in the last 35 years. Second, with real oil prices at historical highs, there is highly likely to be another major shift away from oil, as occurred in the 1980s. Conservation and alternative energy sources will continue to be parts of the story. Diversification of supply by region will also be part of the story, especially now that biofuels are becoming more affordable. Third, Japan is likely to outperform other countries in adjusting to high oil prices, because the successful lessons of the past can be repeated. Finally, Japanese companies and the government are likely to pursue many technology alternatives.

Investors are right, in my opinion, to be gloomy about the short-term prospects for a return to aggressive reform policies. Lack of reform today means lack of growth tomorrow. However, in this gloomy period, it is important to remember that Japan does have world-class success stories. The application of that track record to today’s energy problems does give a reasonable hope that, at a quiet, micro level, Japanese companies and Japanese society have some unappreciated strengths.

 

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