currency wars and nasty bond surprises

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    A couple of interesting articles expressing the bleeding obvious but a handy read right now when put together with equity and gold gyrations.

    AFR Saturday

    Currency wars the next front line
    Dec 14
    Jim Parker

    It is the financial markets' equivalent of beggar thy neighbour.

    In a new threat to the global economy, the economic superpowers - spooked by deflation and losing their commitment to free trade - look to be squaring up for a potentially bruising round of competitive currency devaluations.

    In one corner is Japan. Having exhausted all other palatable policy options to revive its economy, Tokyo is risking the ire of its Asian neighbours and Washington by concertedly talking down the yen.

    In the other corner, a new-look Bush administration is quietly abandoning the strong US dollar policy it inherited. This child of the 1990s boom has become a political and economic burden in the subsequent bust.

    Off on the side is Europe. Already ground down by recession and a punitive central bank, the Europeans may soon be squealing about a strong euro as well.

    Something clearly has to give. With deflation stalking much of the world and protectionist pressures rising, analysts fear an all-out brawl - a tit-for-tat round of ultimately destructive devaluations.

    "The very fabric of globalisation is being subjected to its sternest test ever," Morgan Stanley's chief global economist, Stephen Roach, says. "As the global economy continues to under-perform, cross-border tensions are mounting. As the spectre of deflation goes global, the risk of competitive currency devaluations is rising."



    Australia would be left helpless in such a showdown, hoping only that the competitive advantage provided by its cheap currency remains intact.

    "Australian policy makers would never come out and say so, but in that scenario I think they would welcome the Australian dollar not strengthening any further than it has already," ABN Amro currency strategist Peter Clay says.

    Devaluation benefits a country by making its exporters more competitive and boosting import replacement industries. As Australia has discovered in recent years, it also effectively quarantines the domestic economy when the world is weak.

    The temptation for authorities to manipulate supposedly free-floating currencies is strongest when their economies are at their weakest, like now. The risk is that this turns into a game of one-upmanship, inflaming protectionism and spreading instability in financial markets.

    "This is shaping up as the theme in foreign exchange markets over the next three to four months," Macquarie Bank's head of currency trading, Geoff Bowmer, says.

    "People will start to believe that both the US and Japan will benignly, and perhaps not so benignly, seek the depreciation of their own currencies. The Europeans can probably live with the euro where it is now, but if it goes too much higher they are going to be screaming as well."

    The temptation to devalue is being driven by the sluggish world economy. In the case of Japan, and to a lesser extent the US, the issue is arising because of the failure of traditional policy measures to stoke activity.

    "This issue is only going to intensify in 2003," Clay says. "Countries are going to realise that if the global economic pie is not going to grow, they will need to grab a bigger share of the pie for themselves. And the easiest way to do that is to allow their currencies to depreciate."

    Even the US Federal Reserve, which normally never comments on foreign exchange markets, has started to wonder aloud about devaluation as a last resort in staving off deflation (defined as a general fall in prices).

    "Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation," Fed governor Ben Bernake said in a recent speech.

    Japan is more blunt. Japan's Finance Minister, Masajuro Shiokawa, recently declared the yen should be valued at 150 to 160 to the $US, about 20 per cent weaker than now. Markets duly responded by driving the $US-yen to six-month lows at ¥125.

    Amid grumblings from Washington and China, Shiokawa tried to water down his remarks. But analysts are in no doubt that Japan, having already cut interest rates to zero, has embarked on another of its periodic attempts to export its way out of a slump.

    "Japan is clearly scraping the barrel in terms of policy. If they cannot take the pain of structural reform, then unfortunately competitive devaluation is the easy option," Westpac currency strategist Robert Rennie says.

    "We have seen this now for 10 years. They argue that devaluation is necessary while they reform. But as soon as they see any improvement in their economy via the trade accounts, their stomach for reform disappears."

    The US has acquiesced in this strategy for the past decade, happy for the Japanese to recycle their massive current account surplus by buying US stocks and bonds and funding the US external deficit in the process.

    This was the practical effect of the "strong dollar" policy, first expressed by former US treasury secretary Robert Rubin in the mid-1990s. The reaffirmation of the policy became a mantra, which every senior US official felt obliged to recite for fear of triggering a collapse in the dollar.

    What Rubin meant by a strong dollar has been hotly debated,

    but most currency traders understood the policy to be all about the absolute level of the dollar. Still, interpretation didn't matter when the US stockmarket and economy were booming.

    Now, in the midst of the worst bear market in decades, with US unemployment rising, its manufacturers battling recessionary conditions and its exporters priced out of world markets, the strong-dollar policy has become a liability for America.

    The problem for the Bush administration - as recently departed treasury secretary Paul O'Neill quickly found out - is how to soften its commitment to a strong dollar without creating an avalanche of selling.

    "There is this huge dichotomy in America," Bowmer says. "A weaker dollar will boost their economy via exports. But they also need to attract the capital flow to fund their current account deficit and a weak dollar won't do that for them."

    While the $US has lost more than a tenth of its value since hitting 15-year highs early this year, it is still a long way from weak. In fact, it remains more than 25 per cent above its levels of the mid-1990s, when the strong-dollar policy was introduced.

    The imposition by the US Congress of steel tariffs and increased agricultural protection this year was an effective admission that the political and economic pain of the strong-dollar policy had become untenable.

    The gaffe-prone O'Neill found it almost impossible to articulate a position on the currency which kept both the markets and his political paymasters happy. But it seems unlikely that his replacement, John Snow, will prove any more coherent. "Whether there is any actual declaration of change in policy is immaterial," says Clifford Bennett, a currency strategist with FxMax. "The point is that the US will not support the dollar as it falls, and at least behind closed doors, and increasingly publicly, will be happy with a dollar 10 per cent to 20 per cent lower."

    Whether the export-dependent Japanese and other North-East Asian economies would be happy with a much weaker dollar is another matter.

    "What is going to make or break the dollar policy in the next year is Asia," Rennie says. "Asia is quite happy with the dollar where it is and is willing to put its money where its mouth is by funding a significant proportion of the US current account deficit. That willingness disappears only when the global economy recovers."

    The catch 22 is that the longer the dollar stays strong, the less likely the global economy will recover in a sustained way.

    A strong dollar lets Japan, and to a lesser extent Europe, defer structural reform but leaves the US to carry the world. This exacerbates imbalances in its economy.

    "The currency can either be a carrot or a stick in shaping structural change," Roach says. "The experience of the last 25 years tells me that the stick approach is far more effective."

    and this

    Too much bull for bourse to bear 14/12/02

    AFR News - 14.12.02 01:27

    Jump to first matched term
    Scarlet Fu

    Prudential Securities's chief investment strategist, Ed Yardeni, expects the Standard & Poor's 500 Index to end the year at 900, near Thursday's close.

    A year ago, his firm and his forecast were different.

    Yardeni, who started 2002 at Deutsche Banc Alex. Brown, projected the benchmark index for US stocks would end the year at 1260. After reducing his prediction four times, most recently in September, he may hit the target.

    Like all but one of 15 Wall Street strategists surveyed by Bloomberg News, Yardeni failed to foresee a third straight year of declines in US stocks. Only Douglas Cliggott, who quit J.P. Morgan Chase in February, forecast this year's drop.

    "They have been unambiguously wrong for so long that you wonder what the purpose is," said Ian Rogers, a money manager at Strong Capital Management, which handles $US43 billion ($76 billion) in Menomonee Falls, Wisconsin.

    "There's such enormous pressure to be early on the turn because the guy who gets it first and right wins. Everyone else loses."

    The average estimate at the start of the year was for a 12 per cent gain in the S&P 500 to 1291, as most strategists predicted the worst of the bear market had passed. The S&P 500 has lost 21 per cent so far this year.

    Four of the 15 strategists polled have made a 2003 year-end forecast; they expect the S&P 500 to climb to an average 1018, a 13 per cent rise from current levels.

    After underestimating the depth and duration of the slump, six firms abandoned publishing year-end targets altogether and switched to giving a 12-month forecast or a fair-value estimate.

    Two of the most bullish strategists, Credit Suisse First Boston's Tom Galvin and Lehman Brothers' Jeffrey Applegate, were fired amid a broader wave of job cuts at their firms.

    Of the strategists tracked by Bloomberg, UBS Warburg's Ed Kerschner was the most bullish at the start of the year. His initial target was for a 37 per cent gain to 1570.

    In July, he changed to providing a "fair market" estimate for the index. The current level is 1032.

    He recommends investors allocate 89 per cent of their assets to stocks and 11 per cent to bonds.

    "What strategist do you know of who's been right 70 per cent of the time? Or 50 per cent?" said Roy Papp, who manages $US700 million at L. Roy Papp & Associates.

    "I've never believed in market timers. If you want to gamble and speculate, you do market timing."

    Cliggott, who correctly predicted a stock market decline in early 2000, forecast the benchmark index would fall 17 per cent this year to 950. In his years at JP Morgan, Cliggott, 46, advised clients to keep no more than 60 per cent - and as little as 50 per cent - of their assets in equities.

    His successor, Carlos Asilis, said the index may fall to as low as 800 by the end of next year.

    "On the one hand, there's pressure to be bullish. On the other, there's a pressure to get honest - you have those two forces at work," said Richard Russell, editor of the Dow Theory Letter.

    "Ultimately, the public is going to get disgusted with someone who's just touting the market," he said. As for Yardeni, he lowered his target the first time upon moving to Prudential in April, cutting it to 1250.

    Many strategists themselves have given up on making a year-end forecast. Banc of America Securities, CIBC World Markets, Goldman Sachs, Merrill Lynch and Morgan Stanley all changed to 12-month forecasts.

    Their average consensus is for the S&P 500 to rise to 1062.

    JP Morgan's Mr Asilis said the value of making year-end price targets lies "in the context of the overall model and assumptions as opposed to the specific numbers".

    "People like to hear about that sort of thing," said Kevin Johnson, who helps to oversee $US7.1 billion at Aronson & Partners in Philadelphia, PA.

    "It makes good cocktail party chatter and it can sometimes move markets," he said.

    but more importantly this

    Bias to bonds could leave investors in a fix
    Dec 14
    Alison Kahler

    Retail investors have developed a dangerous addiction to fixed interest that could cause as much damage to savings as the bear stockmarket, regardless of the bond market's reputation as a safe haven from economic uncertainty.

    Worldwide, investors have poured money into fixed-interest funds in an attempt to avoid capital losses on the sharemarket. In the United States, investors poured $US22.7 billion ($40.6 billion) into a bond fund run by global indexing giant Vanguard Group in the first nine months of 2002 alone.

    But Vanguard's chairman and chief executive, John Brennan, did not celebrate the new business, even though it means the Pennsylvania-based manager is likely to top annual US inflow tables.

    Brennan told BusinessWeek magazine last month that he had personally warned investors to be wary of the bond market. His website warning says investors who had moved entirely into bonds since 2002 were "looking in a rear-view mirror, and probably moved to bonds too late to get the returns they were seeking".

    "It's no different than stocks in 1999. The risk is disappointment and surprise," Brennan told BusinessWeek.

    Australians have adopted the same tack as US retail investors, although to a lesser degree. Inflows into retail fixed-interest funds available to locals were $2.4 billion in the year to September 30, compared to negative $1 billion in the previous corresponding period.

    The sector appeared attractive because it is not as volatile as the stockmarket and has produced impressive returns at the same time as share prices have slumped.

    The median Australian fixed-interest pooled superannuation trust produced a 4.46 per cent return in the year to October 31, compared to the negative 3.68 per cent return from the median Australian equity PST, according to InTech Financial Services.



    But many investors appear to suffer from the misconception that it is impossible for bonds to produce a capital loss. Indeed, retail investors all over the world seem to misunderstand most aspects of the fixed-interest market.

    Vanguard surveyed its US investors and found that 70 per cent didn't know that if interest rates rise, bond prices fall, and vice versa.

    This fundamental aspect of bond investing explains why bond prices have rallied in the past year, and why the fixed-interest cycle may be about to turn in the opposite direction.

    Bonds tend to do well in a sluggish economy because interest rates and inflation tend to be low. But an expanding economy has a negative effect on bond markets because expansion is often inflationary.

    "It's reasonable to say capital gains from bonds may fall as we move into the new year. Bonds have produced good returns over the past year because yields have fallen," says AMP Henderson Global Investors' chief economist and head of investment strategy, Shane Oliver.

    "For every 1 per cent decline in the yield from local bonds, there is roughly a 4 per cent capital gain. The yield from 10-year bonds was 6 per cent at the start of the year but is now around 5.5 per cent", Dr Oliver says.

    He forecasts a very different scenario for next year and says the only return from fixed interest in 2003 may be the running yield. "Bond yields are likely to go sideways next year, or drift upwards when confidence in the world economy grows. The decent [capital gains] from bonds may fade."

    This means investors chasing the immediate past performance of bonds may get the same shock delivered to people who bought shares at the peak of the bull stockmarket. They may think they have bought into the best investment in the world, only to find it soon drops in value.

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