Dollar's Sudden Demise to the Yen Threatens to Push Up Interest Rates
A s Hurricane Floyd hit the Eastern Seaboard last week, Wall Street waged its own battle against winds blowing in the opposite direction. The gusts to which we refer emanated from capital zooming away from U.S. shores to what investors hope are greener pastures abroad.
The destination for much of the outflows was Japan, where the rising yen is acting like a capital magnet much in the way the dollar has in recent years. So sudden and powerful was the yen's advance that the Bank of Japan again intervened in foreign-exchange markets. And while the yen's ascent slowed by week's end, many analysts see the dollar returning to October 1995 levels of below 100 yen.
The yen's rise may not be entirely supported by economic fundamentals, nor is it a good development for an economy that needs a competitive currency to recover. Also, with Japanese companies just 10 days away from their fiscal midyear, the yen's climb could make marking portfolios to market a particularly painful experience. Its strength could have a major impact on local currency valuations of foreign assets.
But the yen's upward trajectory could pose grave risks to the U.S. bond market and by extension, equities -- as investors reassess their dollar -- denominated assets. In particular, players that borrowed in low-interest-rate yen and reinvested in higher-yielding securities via the "yen-carry trade" are dumping Treasuries to avoid losses as bond prices fall. More yen-carry-play selling could be forthcoming.
Over the past year, Wall Street realized that the yen-carry trade was a force to be reckoned with. When Russia stumbled last August, it became apparent that just about every hedge fund and leveraged trader in existence had borrowed cheaply in Japan-making them effectively short the yen-and putting those funds in markets in the U.S., Europe and Russia. Once the Japanese currency showed signs of life, the rush to unwind these positions caused tremendous volatility in the capital markets.
As the crisis in the emerging markets settled down in late 1998 and the yen weakened anew, accounts established new yen-carry positions. But now that Japan's economy is on the mend and U.S growth trends are uncertain, the yen is giving the dollar competition as the global currency of choice. This could pull a key leg of support out from under the U.S. bond market, to which many investors fearing a stock-market meltdown had fled. Others abandoned corporate bonds in favor of U.S. Treasuries, thinking the public sector offered more security. Instead, shelter seekers have taken hits in a bond market experiencing its second-worst year on record after 1994. As of the first week of September, the total return of the 30-year Treasury bond was negative 12% this year, marking the worst performance since the late 1920s. Indeed, some who piled into bonds are kicking themselves today. Worse, they may be kicking themselves even harder in the months ahead if the dollar continues its slide.
With fears of inflation, another Federal Reserve rate hike and a possible current-account crisis weighing on market psychology, the dollar's problems are hardly good news. There's little dispute that the strong dollar has served the U.S. well. It attracted mountains of capital in U.S. markets, keeping interest rates lower than they'd otherwise be. It also helped the U.S. survive a global financial crisis, kept inflation at bay, enabled the Fed to avoid aggressive rate hikes, and facilitated Wall Street's historic bull market.
But is the world's largest economy too dependent on the strength of its currency? The $80.7 billion current-account gap in the second quarter means the deficit could reach $325 billion in 1999. These eye-popping data mean that the U.S. needs to attract more than $6 billion of capital from abroad, week in and week out, just to balance its books, which most likely is unsustainable. And it seems the inevitable process of allowing the dollar to slide to address the problem is already under way.
If this dynamic is an orderly one, capital markets will have less to worry about. But the dollar's sudden decline against the yen threatens to push up long-term interest rates. U.S. officials haven't said much about recent currency trends. Fed staffers have been equally reticent, though some say privately that the dollar's slide isn't a big concern so long as it's not in free fall. One silver lining, Fed officials point out, is that a softer dollar may provide some relief on the current-account front.
Recent views from the Treasury and Fed make it impossible to guess when, or if, the U.S. will join the Bank of Japan in halting the yen's climb. Markets found great significance in last week's visit to Washington by Deputy Finance Minister Haruhiko Kuroda. The question, of course, was whether Kuroda lobbied U.S. officials to intervene. Indeed, a report in Japan's Nihon Keizai Shimbun newspaper said Tokyo and Washington are moving closer to a joint intervention to strengthen the dollar.
Yet one wonders why Washington would help out when Tokyo has potent steps at its disposal, ones it's been reluctant to take. Tokyo's recent intervention efforts have been "sterilized," meaning that when selling yen, authorities siphon a proportionate amount of liquidity from the domestic money market. Because the relative quantities of yen and dollars stay the same, sterilized intervention won't do the trick, a fact markets interpret as a lack of resolve in Tokyo. The dollar's woes are weighing on bond-market psychology. It ended the week at 106.80 yen, compared with the 103 range Thursday and 108.75 a week earlier. As a result, even good news on the inflation front was met with indifference by bond investors. To some extent, bonds had a hard time rallying in the face of Hurricane Floyd; some accounts sold securities to front-run insurance companies that may have to liquidate securities to raise cash for payment of disaster claims. Municipal bonds also lost ground, as property and casualty insurers became sellers.
But the market nevertheless managed to end the week much where it began, thanks to tame news on inflation that reinforced the views that the Fed won't tighten next month. The benchmark 30year Treasury ended the week yielding 6.05%, up slightly from 6.03% a week earlier.
Consumer prices rose a modest 0.3% in August, while core prices, which exclude food and energy items, increased a scant 0.1%. With core inflation the lowest in 33 years, notes Edward Jones strategist Mario DeRose, the central bank will remain in wait-and-see mode.
Joe Giagrande, a proprietary trader at TradeLink LLC, says the bond market is pricing in only about a 25% chance of a quarter-percentage-point tightening on October 5. Giagrande's model, which he developed while working on the New York Fed's open-market trading desk, tracks the short-term futures market, including contracts based on the federal funds rate. It's unique because it strips out technical factors-like year-end rate pressures-for a more accurate reading on Fed policy expectations. And Giagrande finds that markets are pricing in a declining likelihood of a Fed action in late 1999.
Yet another Fed tightening can't be ruled out. News that retail sales jumped 1.2% in August, housing starts rose 0.4% and weekly claims for state unemployment insurance remained south of 300,000 provided yet more evidence that the economy isn't slowing. So while an October 5 rate hike doesn't seem likely, one could come on November 16 if it seems the Fed's two tightenings this year weren't enough to cool things off.
A s Hurricane Floyd hit the Eastern Seaboard last week, Wall Street waged its own battle against winds blowing in the opposite direction.