KEY POINTS:
Watching the US dollar and yen rally during the sub-prime-induced mortgage crisis, it may be tempting to conclude that the global foreign-exchange market is entering a new phase.
Don't bet on it. These two perennial weaklings are set to fall again.
Amid the liquidity squeeze that engulfed world credit markets, the yen surged against every major currency - rising to a 14-month high against the US dollar and chalking up its biggest gain against the New Zealand dollar in more than 30 years.
In one stretch during the (northern) summer, the NZ dollar plunged 26 per cent against the yen, the Australian dollar tumbled 20 per cent and the euro fell 9.7 per cent.
Propelling Japan's currency higher were speculators racing to exit what's known as the yen carry trade. The strategy, which involves borrowing low-yielding yen and investing the proceeds in higher-yielding assets, is still alive - if not particularly well.
That should be welcome news to hedge-fund managers. Many of them took a beating as they sought to exit the trade, convinced it had become the dodo bird of the foreign-exchange market.
"The carry trade is only in remission," says David Abramson, Montreal-based head of foreign-exchange strategy at BCA Research. "Yen strength is based on liquidation of bearish positioning, not bulls entering the market."
Meanwhile, the US dollar shot up 3.5 per cent against the euro in just six August trading sessions. That prompted some analysts and investors to proclaim that, for all its warts, the cellar-dwelling US currency at least still serves as a haven during periods of financial stress.
Even so, the US currency's prospects relative to its European counterpart are anything but bright. Goldman Sachs three weeks ago lowered its US dollar forecasts. It told clients the euro would rise to a record US$1.43 within the next three to six months. That compares with an earlier forecast of US$1.35 and a current level of about US$1.38.
That's bad news for European cross-border investors. Their US stock and bond holdings will be worth less when translated into euros and other European currencies.
A stronger euro, which has risen 65 per cent against the US dollar in the past seven years, will also make European companies less competitive.
Goldman's logic. "The weakness in US credit markets will lower foreign demand for US credit products, weakening the flow dynamics for the US dollar," says Jens Nordvig, a New York-based senior economist at Goldman.
Furthermore, there is potential for additional "decoupling" of growth between the euro zone and the US, he says.
Barclays Capital has a similar take on the greenback. In six months, the British bank sees the US currency at US$1.40 to the euro and 117 yen. And in a year, Bear Stearns International projects the European common currency to be changing hands at US$1.45.
Interest-rate futures show 72 per cent odds that the US Federal Reserve will lower borrowing costs by half a percentage point to 4.75 per cent next week.
Such cuts, though, might depress the US dollar, especially if the European Central Bank resumes raising rates. Last week, the ECB left its key rate unchanged at 4 per cent, pending a review of the market turmoil's impact on growth. Last month, the US central bank lowered its discount rate and bent the rules to allow some banks to channel money from the discount window to their broker-dealers.
"Adding aggressive rate cuts to these measures would make the market conclude that the Fed has created a massive capital-market safety net," says Hans Redeker, London-based global head of foreign-exchange strategy at BNP Paribas. That will lure investors into riskier investments and drive the euro above US$1.40, he says.
"Carry trades will be a theme over the next three to six months," Abramson says. Confronted with a sputtering economy, "Japan's central bank has no economic reason to normalise interest rates".
Although Asian economies are booming, Japanese consumer confidence is at almost a three-year low and deflation continues to haunt the country's economy.
Japan's gross domestic product grew at an annual 0.5 per cent rate in the second quarter, down from 3.2 per cent in the first quarter, according to preliminary data. Export growth is also slowing.
Credit Suisse economists predict the Bank of Japan will raise its benchmark interest rate 0.25 percentage points to 0.75 per cent on October 31.
But the risk is that the central bank will delay raising rates, says Andrew Garthwaite, London-based head of global equity strategy at Credit Suisse. "Thus the interest-rate differential between Japanese and US assets is set to remain abnormally high."
For years, currency traders and investors have figured the day would come when the US dollar finally rises in earnest and the carry trade fades into oblivion. They had just better hope the catalysts aren't the troubling ones of the past few weeks.
* Michael R. Sesit is a Bloomberg News columnist
