Global market angst over the US subprime mortgage crisis, among other factors, has prompted Morgan Stanley to update its currency forecasts, says Stephen Jen, the bank’s global head of currency research.
MS has revised its end-2007 forecast for the euro-dollar exchange rate from to $1.33, from $1.28 previously. The dollar-yen forecast is unchanged: Y118 by end-2007. Part of this adjustment reflects the state of the sub-prime market, but Jen says it also a formal expression of recognition “that US real money diversification may be a structural negative for the dollar”.
The Australian and New Zealand dollars should continue to be supported, just like the Canadian dollar, he says, “as long as global demand remains robust”.
In light of the continued deterioration in the US sub-prime market and widening credit spreads, economic and monetary divergence between the US and the rest of the world is likely to persist for some time, Jen predicts.
Though the US economy, and therefore the dollar, can be expected to reassert themselves later this year from the “currently undervalued” levels (“especially against the euro and the pound”) it is time now to “mark to market the weakness in the dollar in the past five weeks”, he says.
Last week, Jen proposed the idea that diversification by US real money managers may have been an important structural negative for the dollar since 2003. He predicts declining ‘home bias’ in many countries on currency trades. “State pension funds will also be diversifying”, he notes, and further, “emerging markets’ dwindling demand for the dollar for liquidity purposes could also weigh on the US currency”.
Basically, global economy and financial markets “are out of sync”, says Jen. “The two don’t bear a resemblance to each other…The global economy is as robust now as it has been in the past four years, and is more balanced,” he says, adding that he still believes “the global economy should drive financial markets, not the other way around.”
On the Japanese yen, meanwhile, subject of much market focus on Friday, concern at the Asian Development Bank and reports about the unwinding of the yen carry trade, Jen says current yen strength “reflects risk-aversion and, therefore, may be temporary”.
Against the dollar, the yen has declined from close to Y124 to Y119 in the past four weeks. “This is a sharp drop”, notes Jen. “I am not yet convinced that this is the beginning of a new trend, even though I endorse long yen as a tactical trade during this volatile period.”
The yen can do well in “extreme conditions”, concludes Jen, if: (1) the world plunges into a risk-averse state or (2) Japan’s economy and/or the Nikkei index outperforms the rest of the world.
“We have been looking for USD/JPY to trade lower (Y118 and Y112 by end-2007 and end-2008), and the scenario we have had in mind is (2), not (1). For one thing, it is unlikely that scenario (1) can persist from now until the end of 2008.”
That conclusion, however, may be of little comfort to those caught up in the present market maelstrom.