There was little in fundamental developments this week to change our generally cautious stance on the USD. Weakening consumer confidence, disappointing auto sales, soaring unemployment claims and the huge decline in non-farm payrolls highlight the downside risks to US growth, cementing, in our view, the likelihood of a 50bp rate cut at the May 15 FOMC meeting. The expected steepening of the very short-end of the US yield curve (Fed funds rate versus the 2-year Treasury yield) continues to suggest a downside risk in the USD outlook. We continue to favor long GBP/USD as means of expressing a bearish USD view, and remain reluctant to establish overweight EUR positions. The string of disappointing economic reports confirms our fears that the Euro area economy, in fact, cannot escape from the generalized global slowdown which, combined with signs of continued overweight EUR positions, leaves the EUR unable to capitalize on USD weakness. The JPY took the lead in gaining versus the USD over the week. Unjustified (in our view) optimism about the potential for meaningful reform, particularly in the banking sector, continues to spur the demand for Japanese equities from the foreign sector. These inflows have supported the JPY rebound, particularly during Golden Week. Although there are some critical technical tests ahead for USD/JPY (see p. 5), the key issue appears to be the magnitude of capital outflow from Japan. If that outflow is going to develop, as we expect, it generally takes place during the weeks immediately after Golden Week. Accordingly, Citiviews holds its long USD/JPY and GBP/JPY recommendations, signaling that we anticipate that the JPY will once again under-perform a USD undermined by economic weakness and declining short-term rates. Over recent weeks we have focused on the AUD as another candidate to take advantage of USD weakness, and here the environment appears to be even more supportive recently. The outlook for the Australian economy appears to be improving, with our economics team in Sydney forecasting a V-shaped recovery in the second half of 2001. GDP growth is forecast to accelerate to 4.4% (annualized) in H2 from 2.8% in H1 while, in the short-term, growth of 0.7% (q/q) is anticipated in IQ’01, reversing the sharp decline (-0.6%) of IVQ’00. The GDP report, due early June, should help stabilize confidence. Furthermore, fiscal policy remains moderately stimulative, and the growth outlook will be boosted by the anticipated 25 bp cut from the RBA at its June meeting. The widening of the Australian/US 10-year spread in mid-to-late April, reaching a high around 65bp (from a recent low of 15bp), resulted in solid international buying of the Australian bond market (especially out of Europe). Japanese investors may also find the bond market an attractive alternative to US Treasuries during the period ahead. The most recent data from the US Treasury on portfolio flows (for February) indicate a reversal of the long-standing trend of portfolio outflow from Australia (see chart). Specifically, US investors were net purchasers of Australian equities, while Australian investors ceased to be net purchasers of US securities. A continuation of this trend would remove a major factor driving AUD weakness over the past 12 months. Cross-border M&A announcements also appear supportive for AUD looking forward. While April’s announcements were inconsequential, the $9.7bn telecommunications deal announced in March (still pending) should serve to support the AUD (see chart). Over recent weeks our Citiflows team has reported sharply higher buying of AUD/USD from the CitiFX global client base, confirming our bullish tone towards the currency (see p. 5). While current global growth reports are still weak, the building blocks of a global recovery are falling into place. The US has been the leading economy on the downside, but because of aggressive Fed easing and prospective fiscal stimulus we remain optimistic about the outlook for later 2001. Just as the AUD weakened in anticipation of the global slowdown, it may be a leading indicator of better growth ahead. Since early April industrial commodity prices (JOC index) have posted their strongest rebound since production growth began to weaken in September 2000. A potential global rebound and very competitive AUD suggest a continued trade surplus over the next 12-18 months, reflected in today’s release of a solid $A257mn surplus for March. The AUD/USD has risen over 9% in recent weeks, indicating to us that a consolidation is likely before a further move higher. Citiviews recommends buying AUD/USD at .5160. USD/JPY began its surge higher in the 2nd week of November following a convergence of the 55- and 200-day moving averages in the 107.50 - 108 area. Since then the acceleration in USD/JPY has kept it above the 55-day moving average for all this time with not a single daily close below, until Thursday May 3rd. At the same time the momentum of the move has created a wide gap between the 55- and 200-day moving averages. This may be a cause for concern. With the close below the 55-day moving average there is a very real danger that this currency pair could revert to the 200-day moving average. As of today the 55-day moving average stands at 121.54 and the 200-day moving average stands at 113.63. This development replicates the moving average picture in August 1998 prior to a sharp fall in USD/JPY. It also suggests the potential for a further correction if USD/JPY does not quickly regain a solid foothold above the 55-day moving average after the end of Golden Week. Break Of 55-dma Could Lead Way To 200-dma The JPY has strengthened recently on foreign buying of Japanese equities and optimism regarding Koizumi’s reforms (see p.2). Indeed, the price action appears to be on the verge of creating strong USD/JPY bearish technical signals (see p.5). However, we continue to believe that portfolio outflows by Japanese investors after Golden Week, combined with the end of the market’s “honeymoon” with Koizumi, will cause USD/JPY to strengthen significantly. Below are alternatives using options that take advantage of the view that USD/JPY will appreciate sharply in the next month. Tenor: one-month Spot reference: 121.39 One-month Forward: 120.95 For reference, a one-month, 121.00 USD call / JPY put can be purchased for 1.31% USD notional and has a breakeven level of 122.59. This relatively expensive choice pays for complete protection from any decline in USD/JPY below 121. Further, it pays for unlimited appreciation, despite our view that spot will move to 125 in one month. Below is a more precisely tailored structure:
Position 1: USD/JPY Bullish Seagull
Buy: 121 USD call / JPY put
Sell: 125 USD call / JPY put
Sell: 118 USD put / JPY call
Premium: 0.56% USD
Breakeven: 121.68
This structure allows the investor to participate in USD appreciation up to 125, our one-month forecast. The premium is reduced by selling away participation above 125 and also by incurring downside risk in the event that spot falls below 118. Note that this “tailored” structure costs less than 1/2 of the plain vanilla call. Besides a cash position, one simple way to take advantage of a bullish view would be to buy a USD/JPY forward. The problem with the forward is that is unforgiving if the yen appreciates. One alternative that mitigates this risk somewhat is a forward extra:
Position 2: Forward Extra
Buy: 121.27 USD call / JPY put
Sell: 121.27 USD put / JPY call w/ 118 knock-in
Premium: zero
With this structure, so long as spot does not trade at 118 at any point in the next month, the investor is locked into a long USD position at 121.27. The yen may, however, appreciate almost three full yen without any ill effects. But should 118 trade before expiration, the position reverts to a long USD/JPY forward at 121.27.