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When is the next currency aftershock. (includes related articles) (Cover Story)

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Futures (Cedar Falls, IA) April 1, 1994 | Nusbaum, David

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The Bundesbank cuts interest rates, the Fed raises them and politicians from Washington and Tokyo talk tough on trade -- but who will the currency markets listen to this summer? After two currency market earthquakes in the last two years, besieged traders looking for stable

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ground aren't likely to find any soon -- in fact, some have fallen through new fissures. Case in point: In mid-February, Soros Fund Management lost $600 million shorting the yen as it gained almost 6% in two days. It wasn't alone. As a group, hedge funds lost 1.43% in February (through Feb. 25) reports Micropal, a Boston firm that tracks about 130 hedge rituals. "We're at a turning point in interest rate, currency and commodity prices," says Ezra Zask, president of Ezra Zask Associates in Norfolk, Conn. "Plus the Japanese and Russian situations

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are creating a lot of tension." As such, currency volatilily should continue into summer, based on global central banks raising or cutting interest rates, and contentious trade discussions -- mainly between the United States and Japan. U.S./Japan relations neared the boiling point in mid-February, as fruitless trade talks sent the yen to 101.9 per dollar on the 15th (it ended the month a little over 104.5; the higher the yen per

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dollar, the weaker the yen and stronger the dollar). And Japan received no sympathy from European ears at February's G-7 meetings, says Pat Magill, chief corporate dealer for Daiwa (Europe) Bank Ltd. in London. That leaves the Bank of Japan to fight the battle. Magill expects a Japanese interest rate cut

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soon, followed by the yen breaking resistance at 105.8, reaching the 107 level in April, 112 by October.

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"The current level is not realistic," Magill says. "It's not in the interest of the U.S. economy to (prolong the recession in Japan)." Tom Benfer, director of foreign exchange for the Bank of Montreal in New Y ork, agrees a rate cut will happen, and he expects the yen to weaken faster, reaching 112 yen in August.

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"Everyone's assuming there's no (trade) agreement, but they'll pull it out of the hat," he says. Zask says today's strong yen is unhealthy. He expects it to trend toward 118 by August as politicians conclude a sub-110 yen does more global harm than good. www.highbeam.com/doc/1G1-15382357.html

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When is the next currency aftershock. (includes related articles) (Cover Story) - Futures (Cedar Falls, IA) | HighBeam Research

But not everyone expects the yen to weaken long-term. Some analysts say U.S. economic growth estimates now are overdone in the wake of 1993's 7.5% fourth quarter growth rate, and expect the dollar's strength to fade when the market realizes this. Jouni Kokko, international economist with S.G. Warburg Securities in London, sees another half-point discount rate cut in Japan. While he expects a near-term range of 110 to 112, he sees the yen returning to 100 to 103 later this year as the dollar loses steam. Similarly, Nick Stanenkovic, an economist with DKB International in London, says the dollar could reach 110 yen in the second quarter, but trade flows will remain firm in 1994's second half, dropping the dollar back to around 105 yen. But why wait to go long the yen? Paul Horne, Smith Barney Shearson's international economist in Paris, expects it to reach 102 by June's end, break the 100 barrier and finish 1994 around 95 or 96. The Japanese government will be too weak to combat protectionist sentiment, given a general acceptance that "endaka" -- a strong yen period -- is here to stay. A second factor, Horne says, is corrections in equities and bond markets starting in New Y ork will spread to Japan. Horne also expects Japan's economic troubles to end sooner, rather than later: "People forget how adaptable the Japanese are." Bundesbo Meanwhile, Germany's central bank, the Bundesbank, is trying to adapt to its own troubled economy. It lowered discount rates to 5.25% from 5.75% Feb. 17, the first drop since last October. Many analysts say rates will hit 4% in 1994 -- despite ballooning money supply figures in January -- as the Bundesbank focuses on other fundamentals: dropping inflation, a strong Deutsche mark (1.70 per dollar at the end of February), and an improving trade balance. Like many analysts, Horne sees the D-mark losing ground versus the U.S. dollar, falling to around 1.81 by June. "The principal gain will be in the second quarter, largely after the Bundesbank cuts rates," says Horne, who sees the U.S. Fed funds rate gaining 50 basis points, too. Stephen Flanagan, vice president at PaineWebber Inc. in New Y ork, says the U.S. economic recovery and the dollar's long-term bull trend are still in effect, with support between 1.68 and 1.69 and the 200-day moving average around 1.6825. He sees the dollar "poking its head in at the 1.80 level," at which point European central banks will start selling. Zask says the upper end of the trading range should be around 1.82 in coming months. "The (U.S.) long bond is coming up very quickly -- that will drive it." Some analysts see the dollar rising well over the 1.80 level. Victor Polce, corporate foreign exchange manager for Commerzbank in New Y ork, expects a range between 1.75 and 1.85, maybe as high as 1.90 from April to August, as German rates drop and U.S. rates hold firm as its economy improves with warmer weather. From a technical standpoint, Lisbeth Keefe, Technical Data's chief foreign exchange technical analyst in Boston, says the dollar's long-term picture is bullish and likely to repeat last year's timing against the D-mark. She expects to see the dollar between 1.78 to 1.82 D-marks by April/May, possibly reaching 1.90 to 1.95 by October. "The specter of (Germany's) October elections helps put a floor under the dollar/D-mark, preventing any sharper pullbacks," Keefe says. But once again, Stanenkovic and Kokko warn the overrated U.S. economy will drag down dollar values. Stanenkovic says the dollar could end the second quarter as low as 1.60 and continue downward as German markets have already discounted the worst domestic news. While Kokko says the D-mark could reach 1.77 to 1.78 near-term, it will return to 1.70 later in the year as German economic forecasts are revised upward, interest rates fall and inflation drops www.highbeam.com/doc/1G1-15382357.html

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When is the next currency aftershock. (includes related articles) (Cover Story) - Futures (Cedar Falls, IA) | HighBeam Research

below the U.S. rate. Kokko expects the dollar to generally run out of steam later in 1994 as traders finally weigh coming U.S. budget deficits -- perhaps as high as $140 billion this year, $190 billion in 1995 -into their analyses. "That's the most important thing the market has failed to take into account -- U.S. current accounts," Kokko says. "(It's) an accident-prone environment." Emergency action Bigger accidents waiting to happen in Bosnia and Russia could become big currency wildcards this summer. If full-fledged war erupts, analysts predict heavy buying in the dollar and Swiss franc, mainly at the D-mark's expense. Magill says the dollar would quickly reach 1.76 D-marks if, for example, it looked as if Y eltsin would step down. In such a scenario, Zask says the Swiss franc has too many problems to be the safe haven, but amidst inflation and instability "don't discount gold" in the flight to quality. The world's other major currencies don't seem to illicit as much excitement from analysts. April tax increases may jeopardize the U.K.'s economic recovery, and sterling has slipped slightly since the base bank rate was cut 0.25% Feb. 8. That environment, Keefe says, could make sterling/yen one of the most lucrative trades this summer, as two failed bullish divergences in early 1994 and other technical indicators are providing a textbook signal for a long-term change (see "Getting pounded," p. 25). Keefe sees the pound dropping to 1.38 to 1.41 dollars per pound by May and 1.32 by August. Eventually, the pound projects as low as 1.20 following the completion of a multi-year headand-shoulders pattern that ended in September 1992. Stanenkovic also doesn't see the pound doing much against the dollar or the D-mark, although the market's underestimating the impact of upcoming British tax increases. "If we don't see the sterling/mark consolidate around current levels (2.53 at February's end), it could hit 2.60, then begin drifting back to current levels," Stanenkovic says. The French franc is expected to mirror the D-mark, as France sticks to its "franc fort" policy despite an economy calling out for stimulus. The Bank of France's recent independence adds to the board's cautiousness. Magill says the Bank of France is still looking to replenish its reserves, but if prices approach "anything around the 3.39 signal level you'll see (them) buying D-marks." Elsewhere, Benfer says the Canadian dollar is being overlooked. It should benefit from U.S. economic success spillover. A different trade idea for this summer, Zask suggests, is long the Australian dollar/short the yen. The yen is the most overvalued currency versus the U.S. dollar, he says, while the Australian dollar is the most undervalued. Zask says: "It could get to 80 yen by August." Whole shakin' goin' on Futures traders constantly face draw-downs on invested assets. As draw-downs are related to the riskiness of trades -- and the currency market certainly is no stranger to risk -- it follows that traders should know which currencies are more likely to satisfy their risk requirements. In general, risk refers to the chance that a trader will encounter an outcome different from the expected outcome; therefore, volatility can be used to measure the riskiness of a currency. Here, volatility is interpreted as short-term fluctuation of nominal exchange rates around their longrun trends, and is measured by Daily Average Absolute Percentage Change: |Mathematical Expressions Omitted~ where T is the number of trading days in a year and x is the daily closing value of a currency. www.highbeam.com/doc/1G1-15382357.html

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When is the next currency aftershock. (includes related articles) (Cover Story) - Futures (Cedar Falls, IA) | HighBeam Research

The table at right compares the volatility of bilateral exchange rates for major currencies from 1985 to 1993. As the table shows, short-term exchange rate volatility increased in conjunction with European exchange rate mechanism (ERM) problems beginning in 1992. Overall, the dollar index consistently shows the lowest short-term volatility; the yen has the second lowest. The European Monetary System (EMS) countries and finally the Swiss franc have the highest volatility. (Note the volatility measures of French franc, Deutsche mark, Italian lira and pound sterling are very close to each other, as expected in view of their EMS membership.) Volatility of bilateral nominal exchange rates against U.S. dollar Volatility is measured by daily average absolute percentage change

Dollar France

Germany

Italy

UK

Japan

Swiss

Index

85

0.64

0.66

0.60

0.79

0.40

0.69

.57

86

0.58

0.57

0.56

0.51

0.52

0.66

.45

87

0.58

0.49

0.46

0.47

0.54

0.55

.41

88

0.43

0.47

0.43

0.49

0.45

0.52

.39

89

0.51

0.52

0.47

0.53

0.49

0.59

.44

90

0.43

0.46

0.45

0.45

0.50

0.65

.37

91

0.63

0.66

0.62

0.58

0.47

0.66

.53

92

0.65

0.67

0.70

0.65

0.40

0.76

.52

93

0.50

0.55

0.54

0.58

0.51

0.59

.41

85-91

0.53

0.53

0.50

0.54

0.48

0.61

.44

92-93

0.58

0.61

0.62

0.62

0.46

0.68

.47

Dollar Index is a weighted average of U.S. dollar against currencies of other G-10 countries.

Source: Federal Reserve System

Given that higher volatility levels heighten the risk of losing invested assets, these results could help both experienced and novice short-term traders choose the appropriate currency for a given level of risk. Massoud Metghalchi is an assistant professor at the University of Houston-Victoria. All the king's horses The ERM hasn't been in the limelight much since its members bowed to speculative strain last August and dramatically widened the fluctuation bands. The move to 15% bands on either side of a central rate from a previous 2.25% band for most members has relieved speculative pressure on the ERM and its umbrella, the EMS. But the ERM's emasculation has clouded the EMS' longer-term goal of monetary union. The Organization for Economic Cooperation and Development (OECD) says the new-look ERM has not been as impotent as some had envisioned. "Further convergence of long-term interest rates and the move back of exchange rates within their pre-crisis ranges point to a satisfactory performance of the modified system," the OECD said in its February "Financial Market Trends." The OECD said ERM European currencies have fluctuated more markedly but "currency fluctuations failed to lead to sharp depreciation against the D-mark and the Dutch guilder. Instead, the French franc, the Belgian franc and the Danish krone are now back within their pre-crisis range against the D-mark." The waning possibility of a quick return to narrow bands has raised doubts about the future of monetary union and an eventual single currency.

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When is the next currency aftershock. (includes related articles) (Cover Story) - Futures (Cedar Falls, IA) | HighBeam Research

There's little doubt the first target date for the final phase of monetary union -- 1997 -- is out; some question whether the second target date of 1999 will be met. The more skeptical don't see monetary union until well into the next century, if ever. Gerald Holtham, international economist with Lehman Brothers in London, says although the "spirit of the ERM lives on in France, Holland and Belgium, there (aren't) any early prospects to return to the narrow flotation bands." He says there has been a loss of enthusiasm in Germany "and Germany is the key to (monetary union)." German political developments have put a cloud over the ERM and monetary union. "Although the spirit (of monetary union) lives on, there is no move to formalize it," he says. COPYRIGHT 2009 Summit Business Media. This material is published under license from the publisher through the Gale Group, Farmington Hills, Michigan. All inquiries regarding rights or concerns about this content should be directed to Customer Service. For permission to reuse this article, contact Copyright Clearance Center.

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Futures, April 1, 1994

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