Keeping Dollar Above 100 Yen Seen as Crucial

The Clinton Administration has finally decided to come to the aid of the falling dollar, partly in the name of stock and bond market stability.

Yet on Wall Street, many pros argue that the dollar wouldn't be in its current predicament if the Administration hadn't ordered a de facto devaluation earlier this year, as part of the undeclared trade war with Japan.

And some experts question whether support for the buck will mean all that much to stock and bond investors, many of whom have far bigger concerns at this point.

On Friday, at the Treasury's direction, the Federal Reserve Bank of New York jumped into the currency market to buy dollars when it appeared that the dollar would break through the 100 yen level for the first time in post-World War II history.

The dollar closed in New York at 101.50 yen Friday, up from 101.35 on Thursday and well above the low of 100.65 reached Friday just before the Fed began to buy.

The U.S. currency's weakness actually has been ongoing for months, but its decline has been almost completely overshadowed by the turmoil in stocks and bonds.

Since Jan. 1, the dollar has tumbled from 111.60 yen, a drop of 9%. Against the German mark, the dollar has slumped from 1.738 marks to 1.654, a drop of 5%. It's also down nearly 6% against the Swiss franc and the Italian lira.

Unless they've traveled overseas or bought a big-ticket foreign-made product, however, most Americans probably haven't been aware of the dollar's devaluation.

But the White House has decided that enough is enough, apparently for two reasons, analysts say:

* Already shocked by the surge in long-term bond yields this year, the Administration fears that bond traders could seize on the weak dollar to whip up more inflation hysteria and push yields even higher. A falling dollar, after all, boosts prices of goods imported to the United States.

* A slide in the dollar below the psychologically important 100-yen level could prove far too destabilizing for Japan, especially with yet another new and struggling government in place there.

In fact, the most intriguing aspect of the Administration's new approach to currency markets is that it may signal the end of the 2-month-old effort to pry open Japan's consumer and industrial markets with a dramatically weaker dollar, which automatically lowers prices of U.S. exports to Japan.

"I see this as the start of a more positive approach by the Administration to the U.S.-Japan trade dispute," says Steven Nagourney, global portfolio strategist at Lehman Bros. in New York.

Practically speaking, with the new government of Prime Minister Tsutomo Hata on extremely shaky ground, bashing Japan further with a lower dollar would seem to be a futile effort anyway, if the goal is to force a negotiated settlement of America's trade beefs.

"Japanese political unrest is endemic now," warns Donald Straszheim, chief economist at Merrill Lynch & Co. in New York. "There's nobody to negotiate a trade deal with. "

It may also have become evident to the White House, experts say, that the decision to use the dollar's value as a weapon against Japan has had unintended effects--mainly in triggering or at least abetting a slide in the buck against key European currencies.

"There's been an erosion of confidence in exactly what the Administration has in mind for the dollar," says Eric Nickerson, senior economist at Bank of America in San Francisco. That translates into "a tendency for the dollar to sag against all other currencies" as well, he says, because "the speculation (on the market's part) is that no one cares."

For foreign investors, buying assets denominated in a weak currency is a losing game: Each time the currency declines in value, their assets shrink accordingly.

The irony is that, based solely on economic fundamentals, the dollar should have been the world's strong currency this year. The U.S. economy is growing, while Japan and much of Europe remain mired in recession or close to it.

By definition, a healthy economy should beget a healthy currency by attracting investment and engendering confidence.

What's more, the Fed's decision to raise interest rates this year to moderate the economy's pace should have attracted yield-hungry foreign investors to U.S. fixed-income securities, thereby boosting demand for dollars.

But potential foreign buyers of U.S. securities may have been put off by more than the Administration's dollar policy, experts say.

The violent dumping of stocks and bonds by U.S. investors since January, as the Fed's credit-tightening unraveled years of hidden speculation in the markets, also may have caused foreigners to think twice about the true value of dollar-denominated assets.

To put it simply, if Americans are fleeing their own stocks and bonds, why should foreigners be attracted to those securities?

At the same time, Americans' appetite for foreign stocks, mostly via foreign-stock mutual funds, has remained remarkably strong this year.

After a hiccup in demand in March, many fund companies say foreign stock funds were hot products again in April. Every dollar sent overseas is a dollar sold in favor of another currency.

All told, the reasons for the dollar's weakness are obvious in retrospect, analysts say. The question now is whether the Fed and the Administration can succeed in at least stabilizing the buck, if not strengthening it.

Perhaps more important for the average investor, would a healthier dollar be bullish for U.S. markets?

Many experts say that, given the awful sentiment in the bond market--where long-term yields jumped again last week on inflation fears--a more robust dollar could be a meaningful help there.

A turnaround in the dollar would allay worries about imported inflation and could lure more foreigners to U.S. bonds, perhaps just in time for the Treasury's huge mid-May sale of notes and bonds, says Lehman Bros.' Nagourney.

A higher dollar could likewise pump up foreign demand for U.S. stocks, because an appreciating currency provides automatic gains for foreign owners of assets denominated in that currency.

The flip side, however, is that a rising dollar would make U.S. exports more expensive overseas. That could be negative for the export-dependent industrial and technology companies whose stocks have led the bull market over the past year.

And some Wall Streeters maintain that the dollar is the least of the markets' worries.

Of far greater concern is how high the Fed will ultimately raise interest rates, and whether corporate earnings will continue to grow at a pace brisk enough to support stock prices.

Even so, the dollar's moves figure into both of those equations as well, experts note.

Overall, economist Henry Gailliot at Federated Investors in Pittsburgh figures that it isn't as important for the dollar to rise here as it is for the currency to stop falling.

"The dollar going up 5% or 10% is not as good (for markets) as another drop of 5% or 10% is bad for them," he says.

*

Searching for Bond Buyers: The $7.7 billion net cash outflow from bond mutual funds in March, reported last week by the funds' trade group, is raising the specter of another long famine ahead for the funds.

The last time investors pulled so much out of bond funds in one month was in October, 1987. Then, as now, market interest rates were rising and bond fund share prices were falling.

Also, the rush of money out of bond funds in late 1987 and in 1988 followed a dramatic surge of cash in 1985-86.

As the accompanying chart shows, the cash flows into bond funds between 1991 and 1993 rivaled that 1985-86 surge.

What's also important to note is that in the last cycle, investors failed to return to bond funds in significant numbers until 1991--even though the Fed began allowing short-term interest rates to drop beginning in early 1989.

Coincidentally, long-term bond yields remained stubbornly high until 1991.

All of this suggests that, when investors begin to exit bond funds, they stay away for a long time. And without this major source of buying power to compete for bonds, long-term yields can stay higher than you'd expect for a long time as well.

Bond Fund Flows: '80s Redux?

Bond fund investors have begun to yank money out of the funds as interest rates have risen and fund share prices have eroded. After three years of huge cash inflows, a repeat of the late-1980s experience may be imminent. Cash inflows all but dried up in those years. Net new cash flow into bond funds. In billions of dollars.

1994*: $4.5

*1994 data through March

Source: Investment Company Institute

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