Think Yen Strength, Not Dollar Weakness

The dollar dips below the lowest level since September 1996.
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The dominant feature of the global capital markets today is the continued strength of the Japanese yen.

If there was some dispute last week whether the 110 yen level was legitimately broken, today's price action leaves no doubt. The dollar dipped below the 109 yen level to reach its lowest level since September 1996. Some technical support is thought to exist near the 108 yen level, where more barrier options are rumored to have been struck. However, the greenback's losses could extend toward the 105.70 yen level, which corresponds to a 61.8% retracement of the dollar's rally off the historic lows against the yen set in the spring of 1995.

Because of the yen's gains across the board, it is probably more accurate to interpret the price action as yen strength rather than dollar weakness. In fact, some observers argue that the main impetus for the yen's gains has been Japanese institutional investors hedging part of their euro holdings, which were significantly amassed over the past six months. The strength of the yen weighs on Japanese equity prices, and the

Nikkei

continued its soft start of the New Year, down already 3.25%.

Japanese government bonds were among the best performers on the global stage last week, but will struggle to duplicate this feat. Yields will likely back up again, back toward 2.00% on the benchmark 10 year bond, ahead of the next 10 year auction later this month. Meanwhile, Japanese trust banks were hit amid reports that new capital adequacy rules will require greater reserves be set aside.

The dollar is flattish against the euro, holding on to the lion's share of the gains scored following the much stronger than expected U.S. jobs report before the weekend.

The euro-dollar axis is pivoting on swings in market expectations over who will be the first to reduce interest rates this year. The strength of the recent string of U.S. economic data and the booming stock market has reduced the likelihood of a rate cut in the U.S. for the next several months at least.

Eurozone data are pointing to a loss of economic momentum as last year wound down. This is evident not only in "lead" indicators like business confidence and purchasing managers surveys, but also in real sector data as well. The unexpected large rise in German unemployment reported before the weekend has been followed by a much weaker-than-expected manufacturing orders, which fell a sharp 1.5% in November compared to a consensus expectation for a 0.2% rise. The report found weakness in both domestic and foreign orders.

German and French finance officials continue to argue the case for lower

European Central Bank

(ECB) interest rates. This is important. Many of the arguments in favor of a strong euro were based on ideas that the eurozone would pursue a tight monetary policy and loose fiscal policy. However, the center-left governments throughout the eurozone grasp the political and economic realities. They are holding the line on fiscal policy and hope this will encourage the ECB to pursue a more accommodative monetary policy.

Lastly the selloff in U.S. Treasuries and the rally in European bonds have pushed the spread between the 10-year U.S. and German (the eurozone benchmark) interest rates out to 122 basis points, the widest in almost a decade. Some money managers will begin finding U.S. Treasuries more appealing on a spread basis.

The combination of weak output and subdued price pressures in the U.K. encourages expectations that the Bank of England will continue cutting interest rates.

In November, industrial output fell 0.1% for a 0.9% year-over-year increase. The narrower measure of manufacturing production, however, tells the more important story. It was down 0.2% on the month for its fourth consecutive decline. On a year-over-year basis, U.K. manufacturing is also contracting.

Meanwhile, producer prices continued to slip. Input prices were off 8.9% in December on a year-over-year basis, while output prices are down 0.6%. Short-sterling futures contracts were a bit firmer in reaction to the news. Both the March and June contracts probably need another piece of weak data to get them above chart-based resistance seen near 94.50 and 95.00, respectively. The British pound itself is steady against the dollar today as it consolidates last week's nearly 2% decline.

Brazil retains its status as the emerging market du jour.

The government has denied market rumors that Finance Minister Malan was going to resign, but the effects continue to linger. While federal officials tried containing the political squabble that erupted last week when a couple of states indicated they would not service their debt, the market remains concerned that Brazil lacks the will to implement the harsh reform measures necessary to put the economy on more sound footing. Some observers have suggested that this is at least part of the reason the dollar has been sold.

Color me skeptical. Because the dollar is generally steady to firm, what is needed is not a broad explanation of the dollar's weakness, but rather its specific weakness against the yen. Also, money fleeing Latin America tends to find a home in the U.S. asset markets.

Lastly the Australian dollar continues its merry ways -- extending last week's 4% rally.

Higher commodity prices and foreign demand for Australian stocks and bonds appear to be the driving force. Australian bonds were among the best-performing bond markets last week. Today the equity market is bucking the profit-taking trend and closed higher. The Australian dollar is testing resistance near 0.6400 and a convincing break could prompt a quick test on 0.6485.

Marc Chandler is an independent currency strategist whose column appears Mondays and Thursdays.