The Dollar's Top is Nigh, and Japan's Yen Stands to Gain says Credit Agricole Strategist

Yen exchange rate

- Poor manufacturing ISM suggests contagion

- USD to fall as U.S. economy starts decline

- Global factors main cause like in 1998

The U.S. Dollar is probably peaking at the moment but its days at the top are numbered and the Japanese could stand to gain as a result according to an analyst at one of Europe's largest lenders.

“A lot of the U.S. Dollar’s strength has been due to the resilience of the U.S. economy in the face of the global downturn,” says David Forrester, a strategist at Credit Agricole.

Yet the recent slowdown in U.S. manufacturing, reflected in the ISM Manufacturing PMI’s decline below 50 - the dividing line between expansion and contraction - suggests the downturn has spread to America, adds the strategist in an interview with CNBC.

The unexpected fall in manufacturing is likely to put more pressure on the U.S. Federal Reserve (Fed) to cut interest rates to help stimulate the flagging economy.

This, in turn, will probably weigh on the U.S. Dollar since lower interest rates tend to attract less foreign capital inflows because of the lower rate of return, which in turn lowers demand for the currency.

The U.S. Dollar index had risen to 2019 highs above 99.00 on the back of a combination of weakness of most other counterparts, but especially the Euro and the Pound, and also the relative strength of the U.S. economy. If the latter weakens, however, that could result in one of the ‘chair legs’ propping up the Dollar being ‘sawn off’.

“From here on you could see some more U.S. Dollar weakness. Going forward we expect further Fed rate cuts: another one this year and another two next year,” says Forrester.

If the Fed moves into a new easing cycle on the back of a slowing economy Credit Agricole sees a ‘replay’ of 1998 for the U.S. Dollar “where global factors actually resulted in the Fed cutting rates and that actually resulted in a weaker Dollar going forward.”

Forrester’s preference for trading the effect would be via a short-trade on USD/JPY.

“We actually like the idea of selling USD/JPY. I think the Yen is going to be an outperformer going forward in general,” says the Strategist.

Part of the reason for expecting the Dollar to weaken substantially against the Yen more than other counterparts, is that the Bank of Japan (BOJ) has no room to weaken its currency using monetary policy, despite the risk the Yen is becoming overvalued (which is impacting negatively on Japanese exports).

The BOJ cannot cut interest rates without the risk of damaging its financial services sector since rates are already in negative territory, and have been for years, which has had the effect of steadily undermining their financial system. This is because banks find it harder to make profits when interest rates are low, since their margins on lending are also correspondingly smaller.

Any further rate cuts would thus be self-defeating as they could only help one area of the economy - exporters - at the expense of another area of the economy - financial services.

“The BOJ it is in the unfortunate situation of facing a global trade war which is quickly morphing into a global currency war and they don’t have much ammunition to fight that currency war. If they flatten their curve more or go further into negative rates it hurts insurance company profits, it hurts banking profits, it hurts lending. The negatives from such moves would offset the positives in terms of their impact on the economy,” says Forrester.

One option might be to buy equity ETFs which would support the stock market and also weaken the Yen, however, this too would have drawbacks.

“They could buy more equity ETFs but that would only be a temporary bounce in the Nikkei and a temporary weakness in the Yen, so we like selling USD/JPY on rallies going forward,” says the strategist.

USD/JPY could weaken as low as 100.000 on the back of newfound Dollar weakness, says Forrester, which is Credit Agricoles ‘fair value’ estimate for the pair. The time horizon for such a decline would be 6-9 months.

The Yen is not the only asset to appreciate during this period, “other safe-havens such as gold” are also likely to rise, says Forrester.

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