Zeev's Turnips Patch-No Politics (ZEEV)

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*** MS' Stephen Jen on the USD ***

Hi ml,
Are you familiar with Stephen Jen's work?
Supposedly, one of the 'best' currency analysts out there.

This was written before yesterday's huge USD rally, so, even if his views prove to be 'on the money', some (much?) of his bullish case may now be partially diluted by Friday's stong dollar advance against the basket of currencies it is measured against.


]b\Geopolitics Should Temporarily Delay the Dollar Correction

Stephen L. Jen (London)

Geopolitics versus Economics
The economic arguments for maintaining a structurally bearish outlook on the USD remain compelling to me. However, geopolitics could push the USD stronger temporarily. I make three points in this note. First, in the near-term, the ‘relief rally' that has begun much earlier than we had anticipated will likely run a bit further, until oil prices have stabilised in the low-20s, I believe. Second, we must be mindful of how North Korea (NK) responds to the developments in Iraq. A further escalation in tensions in NK would likely be positive for USD/Asia, I believe, with negative spillover effects on EUR/USD. Third, I firmly believe that, structurally, the USD will need to depreciate further (against the JPY and the EUR) over the medium term in order to help bring about a normalisation of the US external account. In sum, the USD may strengthen further in the short run due to geopolitical reasons, but should resume its structural correction once the market shifts its focus from geopolitics back to economics.

Act I: A ‘Pre-Emptive' Relief Rally (USD Positive)
This is the first post-war relief rally (RR) in history that began before the first shot was fired, in my opinion. The ‘pre-emptive' nature of this RR seems remarkable. Further, it is also worth mentioning that this so-called ‘relief rally' resulted from risk reduction rather than more risk-taking, i.e., there is nothing ‘relief' about this rally, I believe. Since it is very difficult to navigate through these geopolitical currents, the markets, evidently, have clung to the only benchmark we have: the experience of the last Iraq war, where we saw the USD and equities rally, with a collapse in oil prices. The market is, in a way, trying to front-run itself, in my view. However, I see this just as an unwinding of short-equity and short-USD positions, rather than a genuine change in the trends in these two assets.

This RR, however temporary, in my opinion, is likely to run a bit further. If the US-led military effort turns out to be as successful as the market and I expect (a matter of days rather than months), then oil prices should fall to the low-20s, which, in and of itself, would be a stimulus to the global economy and equities. With this potential fall in oil prices, another mini-rally in both equities and the USD could be likely. However, if the US-led military operation does not turn out to be as smooth and/or the post-war political transition is disruptive, the USD could suffer, in my view.

I continue to find value in the "military-might-moral-leadership" framework I proposed some weeks ago in helping me think about how geopolitics could influence the USD. Following USD-negative shocks of Turkey's first vote (constraining the US military flexibility) and Saddam Hussein's decision to destroy the Al Samoud-2 missiles (further weakening the US case for war, in my opinion) during the weekend of March 8, the US was able to reassert itself with its decision on March 16 to take action outside the UN framework. The challenges that the US faces, in my opinion, are to (1) secure an early and overwhelming military victory (validating the move up in the chart) and (2) find weapons of mass destruction in Iraq. President Bush's success on these two fronts would be indicated by a move from the top-left quadrant to the top-right quadrant in the chart, which would be very USD-positive, in my view.

Act II: N Korea Likely to Be the Next Concern (USD Positive)
The next geopolitical focal point looks to be NK. In my view, the situation in NK has been under-appreciated by the market. Unfortunately, the NK problem will not go away just because the world ignores it. Last week, US intelligence sources reiterated their view that NK is only months away from being able to enrich uranium needed for atomic bombs. The NK situation thus has the potential to become the next focus of world attention. We have argued that, to the world, NK could be much more of a security and a financial threat than Iraq (‘Confronting N Korea -- A No-Won Situation,' March 13, 2003). In my view, the situation in NK will have to be addressed whether in a bilateral or a multilateral framework. The ultimate outcome is likely to be peace, rather than war, in my view. However, in the process of effecting such an outcome, tensions could escalate in northeast Asia. To the extent that NE Asian investors have a much higher propensity to invest in USD assets in times of geopolitical instability, USD/JPY and USD/KRW could rise, with negative spillover effects on EUR/USD. (Incidentally, this view underpins a point I've been making in the past weeks that a shift in the relative tension from Iraq to NK will likely be negative for EUR/USD.) I should note that the nature of this prospective rally in the USD should be very different from that of the RR we are witnessing now. This ‘Act II' will likely be accompanied by a negative global growth environment.

Act III: Economic Reality Sets In (USD Negative)
The underlying fundamentals of the US and the global economy remain weak. The Fed and many global investors may have put too much blame for weak economic activity on the uncertainty associated with the war and high oil prices. However, it is far from clear that a successful resolution of the situation in Iraq will lead to a meaningful improvement in consumer sentiment or capital expenditures. The fact is that the labour market, the housing sector, and retail sales continue to weaken. With capacity utilisation hovering at only 75.6% so far this year, it does not seem justified to believe that capex will recover all of a sudden. Demand in the US will likely be increasingly reliant on fiscal stimulus. With the ‘twin deficits' continuing to widen toward the 10% mark (the arithmetic sum of the two deficits in percent of GDP), it is difficult to see how the USD can stop depreciating, in my view.

The rally in equities and the sell-off in bonds also raises the question of whether ‘equity culture' is making a comeback to supplant ‘bond culture.' I do not believe this is yet the case. First, there is virtually no growth in the global economy, as mentioned above. If anything, the macro indicators are ‘flashing yellow' now. The rally in equities reflects more position unwinding, rather than a change in the trend, in my opinion. Second, the general process of re-balancing the asset-liability mismatch between equities and bonds is not yet complete. Life insurance companies and pensions funds worldwide continue to reduce their exposure to equities and move into bonds. I believe this is a structural trend that is not likely to reverse anytime soon. Third, ‘equity culture' is marked by a high investor tolerance for risk. This is clearly not the case now. If anything, I believe the RR has taken place prematurely because of risk reduction by investors. This is very different from the traditional type of RR whereby the engine of the rally comes from greater risk taking.

Other Considerations
I have the following thoughts:

* ‘Offensively defensive intervention' by Japan. As the USD enjoys a temporary RR and a safe-haven run, there is the risk that the MOF may take the opportunity to move up its intervention floor for USD/JPY, ensuring that USD/JPY remains a one-way trade. I suspect that this risk is not negligible, and that Japan will keep testing the tolerance of the US Treasury until it gets a response.

* An even more dovish BOJ. BOJ Governor Fukui's flexible stance on trying out even more unconventional methods of monetary easing could encourage the JPY-bears to put on long USD/JPY positions, in my view, supported by the MOF's intervention strategy and encouraged by the situation in NK.

* Could the USD correction be complete? I have been getting this question frequently lately. This is not a time to be dogmatic. But we do have confidence in our valuation framework, and the view that, until the US ‘twin deficits' stop rising, it is difficult to see how the structural downward pressures on the USD could abate without a strong economic recovery in the US -- which most believe is still very unlikely.

Bottom Line
Despite the structurally bearish outlook we have had on the USD, substantiated by economic fundamentals that are negative for the USD, we do believe that the USD could be supported temporarily by geopolitical factors. President Bush's decision to use force on Iraq outside the UN framework is a USD-positive, relative to the diplomatic stalemate of last week, in my opinion. Further, our view is that the situation in NK will receive far more market attention in due course. Tensions on the Korean Peninsula should be positive for USD/Asia, with negative spillover effects on EUR/USD. In sum, we think Iraq and NK will likely delay further the structural correction in the USD.

http://www.morganstanley.com/GEFdata/digests/20030321-fri.html#anchor1

Regards,
Dan