Business Times Singapore
Making sense of the currency market turmoil

William R. Thomson
Aug 7, 2007

How far will the US$ fall? Will yen 'carry trade' positions unwind swiftly? Experts give their take on these and related concerns

OVERVIEW

THE combination of a sliding dollar, an unwinding of yen 'carry trades' (whereby yen are used to finance investment or speculation in higher- yielding currencies) and a credit crunch in US markets has sent financial markets reeling around the world. Volatility is back and global asset valuations are looking shaky.

The Business Times gathered together an impressive array of experts to discuss just how serious the situation is - and where investors should look for refuge in the storm.

PARTICIPANTS

Moderator:
Anthony Rowley, Tokyo correspondent of The Business Times

Panellists:
Mark Cutis, chief investment officer at Shinsei Bank in Tokyo.
Robert Lloyd George, chairman and CEO of Lloyd George Management, Hong Kong
Rei Masunaga, an international economist and former senior official of the Bank of Japan
Mark Mobius, president of Templeton Emerging Markets Fund and director and executive vice-president of Templeton Worldwide
Tohru Sasaki, an executive director and chief foreign exchange strategist, JPMorgan Chase Bank, Tokyo
William Thomson, chairman of Private Capital, Hong Kong

Anthony: Let me move straight to the point and ask you first, Tohru-san (since you are in the thick of currency market trading every day) - how far and how fast is the current dollar slide likely to go, and are we looking at a technical adjustment or a secular decline?

Tohru: I think the slide will stop sooner rather than later. In the past, when risk aversion heightened among investors, the dollar tended to be bought back. This is probably because (at such times) US investors repatriate their overseas assets. According to US Treasury data, the monthly average of US investors' net foreign stock and bond purchases was just US$4.7 billion in 2003. But the monthly average between January and May this year has been US$26.5 billion. US investors have increased their overseas investment and, therefore, once they start unwinding these investments, dollar-buying demand should become relatively large

Robert: There are some signs that the current dollar slide is bottoming out. Clearly, it was oversold at US$1.38 to the euro, US$2.06 to the pound and I think that the most undervalued currency was clearly the yen.

Mark C: I think the current dollar sell-off is basically over. I don't expect to see (it fall to) US$1.40 against the euro.

Rei: The dollar slide is mainly a reflection of market concern about the future of the US. The US economy will regain growth around the fourth quarter of this year. If so, the slide of the dollar will decelerate, although it may not stop because the US current account deficit will continue. Concern over the future of the American economy was primarily triggered by the sub-prime house mortgage loan problem in the US. The excess mortgage lending by banks reminds me of Japan's asset bubble in the late 1980s.

However, I do not consider that the present American problem is as serious as was the case in Japan. The Federal Reserve is not excessively worried by the sub-prime loan issue, because other parts of the economy are resilient. However, it watches market development carefully and will lower interest rates if there is a sign of recession. Fortunately, inflation is already under control and the Fed has good room for manoeuvre.

William: The dollar has been perched on a precipice. It has recently been trading at 80 on the USDX index. The trend of the dollar has been down since 2001 and most such declines end in panic selling and policy changes. There is a whiff of fear and panic. We are not, in my opinion, yet at the bottom.

Mark M: How far the dollar will go depends on the state of the current account deficit and the strength of the US economy. How fast it will slide will depend on the confidence level of the market towards the dollar. It will always be under scrutiny due to its importance as a world currency, and always susceptible to great volatility in times of market uncertainty.

Anthony: What about the impact on other major currencies - and are we seeing the beginning of a major unwinding in yen carry trade positions?

Mark C: I expect to see a savage unwinding of carry trades with higher Japanese interest) rates, although I suspect short-term you will see a new trading range of 115-125 (for the dollar against the yen). I expect to see the euro/yen rate at 135 within five months. I also expect to see an equity markets sell-off but the Japanese market will hold up, which, along with higher rates, will encourage a repatriation of funds (to Japan) and further increase volatility.

Tohru: No, I do not think so. Current yen appreciation is being caused by yen buybacks by short-term speculative accounts. However, Japanese retail investors, who are the major driver of the yen carry trade, still continue to sell yen through investment trusts and foreign exchange market margin trading. Once these short-term speculators have finished buying back their yen-short positions, yen appreciation will stop. Then, once the market settles down, yen weakness should resume.

William: Because of the carry trade, the yen has probably the largest short position against it of any currency in history. It is a matter of when, not if, that gets reversed.

Rei: The unwinding in yen carry trade positions which took place in recent days made the yen stronger. My view is that this unwinding is a healthy correction of the excess selling of yen over the past several months. At this moment, Japanese political uncertainties will persist and investors both at home and abroad will consider it unsafe to take any big position in yen either way.

Therefore, I will not be surprised, if the yen stays in a narrow range around the present level for some time. People are interested in the outcome of the Policy Board meetings of the Bank of Japan (BOJ) in coming months. Though a 0.25 per cent hike of short-term interest rates is likely to come in August-September, its effect on the yen exchange rate will not be very large, as the market has already discounted it.

Robert: In our view, the yen could easily go up to 100 and there are a number of factors which could tip the trend over that: Japanese Government Bond (JGB) yields are now around 2 per cent and may rise further; and the attractions of high-yield bond markets like the New Zealand dollar, Australian dollar and others will quickly fade with corrections in those currencies. Most Asian central banks are trying to stem the 'hot money' inflows. It is the reverse of the summer of 1997 and we have instead of a meltdown, a 'melt up' in Asian currencies.

As for the dollar, its retreat has had geopolitical as well as economic consequences. Opec countries seem to be willing to sell oil in euro and perhaps move towards a commodity based 'dinar', which would leave them less at the mercy of a falling dollar, in which oil is priced at present. Since we believe that we are in the midst of a 20-year bull market in commodities - not only energy and minerals but also food and other soft commodities - it is clearly a critical element to decide what course the dollar will take.

I tend to believe that the Federal Reserve and (US Treasurer) Henry Paulson will be responsible and take pre-emptive action to prevent a sudden slide. The Americans are not going to give up their primary role in the world monetary system easily or quickly. It is always a mistake to underestimate the resilience and creative energy of the US economy, and I think that both the trade deficit and the budget deficit will tend to improve over the next two years, particularly if
there is a retreat from Iraq.

Anthony: Which currencies look safest to you, in the light of widespread market turbulence?

Mark C: In Asia I think the Singapore dollar and probably the Malaysian ringgit and probably the Thai baht, but they will all depreciate during a US dollar rebound. In Europe, probably the Swiss franc (is the safest).

Rei: Maybe the euro is safest, because at present the euro area does not have big uncertainties both on the economic and political front in comparison to the US and Japan.

Mark M: There could be a move into emerging market currencies that offer higher yields - (those of) countries with strong foreign exchange reserves and current account balances, mainly in Asia.

William: Asian currencies as a group are still inviting. The Singapore dollar is in some ways the new Swiss franc. The Malaysian ringgit should move in line with the Chinese yuan but it is easier to buy. Both on a value and a technical basis, the Japanese yen is very undervalued.

Robert: Emerging market currencies have already made huge gains - that is, the Brazilian real and others. I would not counsel investors to chase them now

Anthony: Do you expect to see credit markets and stock markets stabilise soon, and likewise equity markets. What about bond markets and gold (or other commodities)?

Robert: My prediction is for equities to stabilise in the next three months. Gold will continue towards US$1,000 an ounce in the next two years and oil will very likely break up to US$100 over two years.

Mark C: No, I don't expect short-term stability. Maybe in the month of August but when the 'boys' come back from the beach, they will have to deal with the undigested LBO financings and the continued spate of hedge fund mini blow-ups. Not only were there sub-prime mortgage exposures in Australia but now they have cropped up in Paris-based hedge funds. So, I expect to see big turbulence - probably in October. Turbulence means a 10 per cent plus sell- off.

The bull market is probably intact as it is more of a global phenomenon than a localised event or driven by something like a hi-tech boom. Interest rates can fall periodically on some flight-to-quality concerns but in general we are on an upward trajectory for rates. Many financial strategies will come unglued with higher rates. This will precipitate another crisis which essentially means that, with time, risk gets re-priced. What does that imply? Credit spreads will normalise. Gold should take out US$700 in the next three months and take out the old 1980 high of US$800 plus. This repricing or normalisation in credit spreads is not necessarily bad. It means simply that many frivolous investments that have been powered by leverage will no longer be viable.

William: The markets are getting an overdue wake-up call. Risk is everywhere and it has been way under priced. The risks of contagion from the sub-prime fiasco in the US are just one example of the reckless use and misuse of leverage in the ongoing financial bubble that dates back to late 2002/early 2003. If this situation unwinds further, as I expect, there will shortly be increased pressure on the Fed to lower short-term rates, the first 10 per cent correction in the Dow or the S&P 500 since the bull began in 2003 - an almost unprecedented interval.

Anthony: Is the decline in the dollar likely to result in a significant shift of investment into emerging market currencies and which ones are likely to be most favoured? How great is their capacity to absorb potential large outflows from the dollar?

William: As the euro appreciates above US$1.40, we will be hearing louder and louder voices calling for intervention and a curbing of the European Central Bank's independence. Total reserves of developing economies, including those of sovereign wealth funds, total around US$6 trillion - about equal to outstanding US government debt. These reserves are growing at about US$700-800 billion a year and the US dollar element is disproportionate to its share of global GDP. A relatively small diversion of new flows (not stock) has the capability to move emerging market currencies disproportionately as well.

Tohru: Considering the size of US dollar markets, the impact from flows into emerging markets should be minimal for the entire dollar market.

Rei: My forecast is that the magnitude of the decline of the dollar value will be rather limited. Under these conditions, I don't expect any big shift of investment into emerging market currencies from dollar assets. Even when volatility in the world stock market starts again from New York, the 'safe haven' role of the dollar will not be lost easily.

Anthony: Which are the best vehicles for investing in emerging market currencies - equity or bond investment trusts in the appropriate currencies, or specialised currency funds?

Mark M: Equity investment trusts that are well diversified.

Robert: I would say that the best vehicles are general emerging market (GEM) funds. They have exposure to emerging market currencies and the best stock selection as well as high earnings growth. They normally diversify risk by owning 12-15 different markets. There are (also) some interesting new asset classes, like Asian Reits and other property funds which have good yields and may be appealing for private investors. Plus, buying property in an area of appreciating currency achieves a double gain - investors in Singapore know this better than anyone else.

6 August 2007
Business Times Singapore

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