Sell the Euro and Yen | Forbes - 6 September 1999

This article was originally published in Forbes - 6 September 1999.

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Two months ago (FORBES GLOBAL, July 5) I advised waiting for a bounce in the euro toward 1.07 to 1.08 to position short for a move down against the dollar below parity. We've reached 1.08; I now recommend the purchase of a six-month euro put struck at 1.01 euros to the dollar for a cost of 0.6%.

There are signs of a pick-up in European economic growth, but the situation remains unstable as structural problems abound. Unemployment rates are above 10%, and growth rates will likely average well below 3% for the next several years. The continued depreciation of the euro versus the dollar is essential to help boost European demand. Ultimately the euro could trade as low as 93 to 95, so if the timing is right, this strategy could yield as much as 900% in six months.

Regarding Japan and the yen, it is clear that the Bank of Japan intervention has initially failed, as the dollar broke through support at 120 to the dollar and tumbled to just below 114. The recent yen rally has brought about a peak in dollar bearishness; that is often a sign the trend will reverse itself.

Japan's economy is in a structural depression, not a cyclical recession; and any incipient recovery is extremely sensitive to the yen's level against the dollar. As the dollar sinks, so do Japanese growth prospects; conditions get progressively worse as the dollar declines, with profit margins shrinking and deflationary forces spreading.

The most compelling aspect of the long-term bullish dollar/yen scenario is that the lower the dollar goes, the worse Japan's economic fundamentals become, making the dollar's rise more likely. Japan desperately needs to reflate, but the authorities appear frozen. A weaker currency would help to prevent the economy from tumbling into a deflationary spiral.

For many years the Japanese policy makers completely misread their economy, so they kept monetary policy excessively tight to avoid a re-emergence of the "bubble" economy. Subsequent efforts to stimulate growth have been reactive rather than proactive, so their policies have had little impact. In fact, for the past several years Japanese authorities have, mysteriously, maintained the attitude that a weak yen was tantamount to an admission of failure in the government's policies. At this point Japanese authorities should forget about saving face and take the necessary steps to turn things around.

The world would benefit from a dramatic reflation in Japan, whether by monetization or inflation-targeting. Powerful, pent-up demand would be unleashed, and big pools of capital freed up, for offshore investments as the recovery became self-sustaining and financial institutions healed. Trade imbalances with the U.S. will be reduced only when this course is followed, even though the yen would initially weaken dramatically from current levels.

The world economy looks precarious. Japan could experience a crushing economic collapse if the dollar continues its descent below 110. Europe's economic health is a long way off. China is struggling to hit its targets; pressure is mounting for the renminbi to be allowed to sink.

Ultimately, the U.S. would suffer if other economies weaken. Foreign holdings of U.S. Treasurys, under duress, could be sold and the money repatriated in a mad dash to shore up domestic balance sheets. This would drive U.S. interest rates higher, slow the U.S. economy and reinforce a very ugly trend in global deflation.

I believe that the authorities in Japan will come to their senses and forestall these developments. The current policy of zero interest rates is clearly not enough. In order to trigger a strong, consumer-led recovery, the government must instill the expectation that prices will rise. This could be done through massive personal tax cuts--including the abolition of the consumption tax-- and a strong commitment to maintain zero interest rates. The measures must be proactive, and they must induce spending. Some inflation will probably be created, but the alternative could be far worse!

In the July26 issue of FORBES GLOBAL, I recommended the purchase of a one-year call spread of 125 to 135 to the dollar for a price of 1%. I still like this trade and would consider adding another tranche if the price drops to 0.7%.