FIRST QUARTILE ECONOMICS |
European indices are also flashing warning signs as the German DAX index fell 4.4 percent from its early week record high while the Swiss Market Index fell 3.0 percent on the week and is down a distressing 8.3 percent from its peak two weeks earlier.The Japanese Index rose 2.0 percent on the week in respect for the new fiscal stimulus package.
U.S. DOLLAR: The big dollar is either at a cross roads (end of its three-year bull run versus the DM and Yen) or just biding time until it begins rising again. Three weeks ago, the Yen looked to be in serious trouble after Moody’s put a negative bias on Japanese sovereign debt. However, some pretty serious support by the Bank of Japan (as high as USD $20 billion was believed to have been sold for Yen) has only delayed the demise of the Yen.
To be fair, financial market participants have been neutralized somewhat by the details of the latest economic rescue package which includes hefty tax cuts among other economic stimuli. With the details now in hand, the Yen has weakened again to the 131.50 area (versus 127.55 just last week) and this is probably the beginning of follow through weakness.
While Japanese financial officials continue to imply renewed intervention to avert undue Yen weakness, the market is becoming less and less timid. The same Japanese officials are now openly talking about the probability of large bank failures. This is a reminder that no economic stimulus package will do anything over the near term and that the worst is yet to come for the Japanese economy. It still seems likely that the Yen is headed towards something in excess of 140 during 1998.
The DM meanwhile has strengthened with the Yen but has held on to most of its gains versus the dollar. Obviously, the European currencies are not in the same economic boat with Japan and Asia and have relatively better prospects than the Yen. However, the prize for the strongest economy and the one viewed as closest to raising interest rates, remains in the hands of the U.S. Accordingly, the DM will ultimately see new weaker levels versus the dollar in 1998. A re-test of the 1997 level of 1.90 DM still appears likely in 1998 while my peak target of 2.0 DM may ultimately prove a touch grandiose.
U.S. BONDS: Bonds no longer look very good technically as the one-year old uptrend channel has given way during the past two weeks. However, the 6 percent level has held again on the 30-year Treasury and the case for a breakdown in bond prices is not very solid.
The past week produced some hawkish comments from Fed governor/president types and more members of the street smell the groundwork being laid for a Fed tightening in May or at the July FOMC meeting, at the latest. At a minimum, dissension over steady Fed policy is probably escalating as the Asian impact is still largely immaterial on the U.S. economy.
On the positive front, new estimates put the U.S. budget surplus in the $40 billion zone this year. To be sure, the street is more often than not always expecting an imminent Fed tightening but who knows what the sequence is going to look like. Will the Fed tighten once or twice over a twelve month period, as occurred in March 1997, or will something more deliberate, such as 1994 prove to be the case?
My bet is that a Fed tightening for the usual reason of actually rising inflation is not necessary in 1998. But in the world of pre-emptive monetary policy, from now on no FOMC meeting will be taken lightly by the markets. But unlike 1994 when inflation was 3 percent and widely believed to be on its way to 4 or 5 percent, nobody really believes U.S. inflation will get out of hand any time soon. The more likely case is that the next Fed tightening phase will be regarded as consolidating inflation in the 2 percent range which bodes well for long bond yields.
A look at the U.S. yield curve ( a relatively flat 56 basis points from 1 to 30-year Treasuries) paints a relatively tame picture for the imminent dawn of a Fed tightening cycle. My expectation is for an even flatter curve if and when the Fed does tighten, if not sooner.
Over the near term, there is some concern the U.S. dollar may weaken and this may be bearish for fixed income markets. There is also concern future Bank of Japan selling of U.S. dollars will entail liquidation of U.S. Treasuries. Some think the moderation in the March employment report will reverse for April and lead to solid economic data across the board. I think, as long as the core inflation rate stays at 2 percent, long bonds are about as high in yield as they are going to get over the next several months. The long end remains a buy anywhere near 6 percent.
KEY ECONOMIC DATA: A relatively heavy U.S. data slate is on tap next week, including March durable goods orders on Tuesday and Q1 GDP on Thursday. Other data of note include the Chicago and National Purchasing Managers’ Indices. As such there is plenty of scope for markets to re-assess the prospects of tighter monetary policy in the months ahead.
CANADIAN EQUITIES: The TSE 300 fell by 0.8 percent on the week led by the 5.0 percent reversal in Financial services stocks. With heavy profit taking after the latest bank merger announcement and with still no certainty mergers will ultimately be allowed at all, there is scope for some sector rotation. The past week saw more decent gains in the Golds index, up 6.2 percent, in line with a 1.6 percent rise in the price of Gold.
CANADIAN DOLLAR: The currency continues to disturb as the late March consolidation has turned into a resumed bear market. Although relatively subtle so far, the C$ erosion has given back over half of the rally from late January to March. A minimum technical objective would now be a 62 percent retracement which better hold, otherwise a full retracement to January lows starts to take on validity.
Trading action this week saw a range of 1.4255 to 1.4367 versus 1.4240 to 1.4405 last week. Going on the likelihood that 62 percent retracement is coming, this takes the currency to the 1.4450-70 level which also corresponds to the top of a key trading channel. On the possibility of near term strength in the week ahead, CAD could rally to about 1.4285 which corresponds to 70 cents.
Presently, there is plenty of talk that the Bank of Canada has to raise interest rates to stem further currency declines but this is doubtful. While there is little basis for the currency to sustain a rally as long as interest rate spreads to the U.S. remain negative, who says the Bank of Canada wants the C$ to rise anyway? With a still unfavorable current account environment, the currency is “lucky” to be as strong as it is.
At a minimum, the negative spread argument (versus the U.S.) is drastically less relevant now, after several rate increases, than in late 1997. As well, the domestic economy is strong enough to take several more rate hikes, if necessary, to defend the currency and this is generally a factor in keeping the sentiment on CAD only mildly negative.
We are perhaps all too accustomed to expecting high drama on the domestic currency front while in reality the actual periods of currency turbulence have been relatively brief and far between. We just experienced what now passes for a C$ crisis through January, and whatever happens over the next few months it is too early to see another phase of currency defense via rising interest rates.
CANADIAN BONDS: Domestic bonds closely mirrored the mild rate increases in the U.S. during the past week. There is still no ingrained expectation of higher administered interest rates (according to the moderately sloped money market yield curve) hence C$ concerns are more a creation of the media than the market.
The upcoming week will see a strong GDP gain reported for February following weather related weakness in January. However, if the expectations of a 0.8 percent GDP gain materialize, this will only reverse the 0.7 percent decline in January. By most calculations, the domestic economy has definitely lost momentum in early 1998 and the tone of the media and the buoyant economy camp will soon begin to catch up to the reality of a now average performing Canadian economy.
By my reasoning, the prospects of a Canadian interest rate hike over the next several months are about zero. With the CPI trend back below 1.0 percent in March there are no strong forces working to push it meaningfully higher over the next several months. Long term bond prices appear well supported in this environment and yields should continue to track the U.S. market very closely.
April 27, 1998
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