Although the dollar softened somewhat over the past few months, it remains strong. But the summer is expected to be volatile - what will this mean to investors?
April was a frustrating month for dollar bulls and investors holding large long positions in greenback. Recent forex market surveys show a less bullish outlook for the dollar as compared to its health in early January.
During May, the dollar had softened against the D-mark and hence by implication other core European Union currencies; but against the yen, the currency of an economy technically in recession, the dollar has remained firm. The IMF says the yen/dollar exchange rate appropriately reflects the strength of the US economy and the weakness of Japan's. Though the $1:Y130 level is broken and Japan's new fiscal stimulus package is inadequate to renew investors' confidence in yen-denominated assets, long-term participants, such as hedge funds and institutional investors, are reluctant to push the yen down to a Y140 rate. They fear inciting heavy coordinated central bank intervention from the G-5 (the US, Japan, Germany, the UK and France).
Besides, excessive yen depreciation could prompt a new round of East Asian devaluations. This risk is unacceptable to global financial markets. In October 1997, currency turmoils in SE Asia led to world-wide slumps in capital markets. There is also concern about a deterioration in global trade imbalances. The IMF warns that a growing US trade deficit could undermine confidence in the dollar, as was the case in the late 1980s. On the other hand, Japan may favour a weak yen to export itself out of ongoing economic stagnation.
However, a real risk for dollar-holders over the summer remains the probable turmoils in US capital markets. The stock market and the dollar have a close correlation. A rise in the US federal funds rate (currently 5.5%), perhaps by July or August, and over-stretched US equity valuations, could prompt significant corrections on both stock and bond markets, this leading to capital outflows. High interest rates will underpin the dollar after any initial shocks. Investors should take profits on long dollar positions during periods of robust economic fundamentals. The US economy will slow down by late-1998 or early 1999.
Market sentiment is slowly shifting in favour of core euro-constituent currencies, helped by improving economic fundamentals. Fears of a weaker euro have abated, as markets believe that a stringent...