Germany marks time as the dollar finds its level

ECONOMIC VIEW

Normalisation is one of those English words used only by people to whom English is not a first language, but you can see why Hans Tietmeyer, president of the Bundesbank, was employing it at the weekend to describe the recent decline of the mark. For the surge in the mark over the last year has been quite abnormal and recent declines have gone only some way to restoring it to a level German exporters find acceptable. Indeed, if you wanted to find one single reason for the new recession in Germany the strength of the mark must be at the top of the pile.

Yesterday the currency fell further, breaking through key chart levels against the dollar of DM1.5075 and DM1.5065, leading to suggestions that "normalisation" still has a long way to run.

When currencies refuse to do what they ought rationally to be doing, the obvious questions are: how long can they behave in this way, and how much damage will they cause meanwhile? When currencies behave as they ought to, the questions are: will they continue to correct, will they stop, or will they overshoot; and how quickly will previous damage be repaired?

It is time now to start applying these second set of questions to the key tripartate currency relationship of the world, that between the dollar, the mark and the yen.

The background to these question is set out in the left-hand graph: as you can see there has been a sharp and sustained recovery of the dollar against the yen since April of last year, taking place in two phases. There was a bounce from June/July through to September, then a steady consolidation to the present.

Against the mark, however, while the trough of the dollar was less pronounced, there has been only the most muted of recoveries: we are not yet back to the level of the beginning of last year.

Determining the "right" level for currencies is always a black art, and the dollar rate is in any case a crude proxy for any currency's value. But there is a common-sense case to be made that the dollar/yen rate of close to 110 gives the Japanese economy a chance to stage a recovery, whereas the DM1.50 rate is still damaging to the German one.

That would square with what seems to be happening. A Japanese recovery, still desperately fragile, at last seems to be taking place; but the German economy has been pushed back into recession. Theo Waigel, the German finance minister, told his EU colleagues at the Verona meeting last weekend that "there is very little chance of 1.5 per cent growth this year" and the latest market forecasts put growth at less than 1 per cent.

So the first question: will the currencies continue to correct?

The technical analysts - the people who draw patterns from the charts - are now looking for the dollar to climb to around DM1.60 and Y120. There are two further arguments to support this, at least as far as the mark is concerned. One is interest rate differentials.

The implied forward market forecast for US interest rates, set out in the right-hand chart, shows a climb to 6 per cent by the end of next year, which would certainly underpin any such move.

German interest rates, projected on the same basis, are flat through most of this year, maybe rising a bit towards the end. (Interest rate differentials are by no means the only force governing currencies, but they do have a strong influence on them.)

The other is momentum. It is an observable fact that once currencies head solidly in one direction, it takes quite a lot to stop them. The dollar is in an upswing, so anyone who has bought it in recent months will have made money. Human nature being what it is, dealers have to have quite a strong view to want to bet against it until new information comes along. That is why currencies frequently overshoot.

If the normal long-term cyclical pattern of the past were repeated, one might therefore expect a sustained, if bumpy, climb of the dollar for the next couple of years before it became obvious that a new downtrend would have to begin. My own view is that just such a bumpy upswing will be sustained, though I would hate to be tied down to a statement of its likely duration. But there are reasonable doubts.

Some of these come from future interest rate movements. Aside from showing the forward market projects, the right-hand graph also shows some other forecasts of dollar and mark interest rates from HSBC Markets. Other City forecasters would also accept that the rise in rates implied by the forward markets is too sharp.

These show a very different pattern: steady US rates through the summer of this year, and then falling rates from the autumn onwards; and more slowly falling mark rates.

Leave aside the mark forecast and focus on the US one, for if that is right, it would knock away the interest rate support for the dollar. That would not necessarily reverse the dollar's recovery, but it would knock it on the head.

Other doubts come from the policy-markers: whether officialdom in the US, German and Japan wants a continued dollar recovery. The yen is more affected by Japanese policy than the mark by German, and while both the ministry of finance and the Bank of Japan have been firmly in favour of the movement over the last year a rate somewhere between 110 and 120 may be deemed appropriate. As for the mark, while the remarks of Dr Tietmeyer suggest that a further fall in the mark is welcomed there, the Bundesbank certainly does not want a weak currency.

As for the US, this is an election year, so anything (like an overly- strong dollar) which undermined economic growth would be particularly unwelcome.

In any case the whole American policy machine has noted with some pride the way in which the soft dollar has helped sustain a low-inflation economic recovery which is the envy of Europe and Japan. America will not want the surge in the dollar to be sustained if it starts hitting US jobs.

What one can say with reasonable assurance is that if the dollar does push up to those chart points noted above, the officials will start to try to cap the dollar, with words, if nothing more. Is the present rise enough to support the Japanese recovery and recreate the Continental European one? Yes, but only in the sense that the dollar is not really the core problem in either case.

In Japan, that remains one of corporate and banking weakness, coupled with the need for deregulation and tax reform. In France and Germany problems of unemployment are, in part at least, structural. A lower mark and franc are helpful in that they make structural reforms more acceptable politically - it is much easier to push through unpleasant policies if the economy is growing well - but that is all.

The moral here is surely threefold. First, that "normalisation" is immensely welcome, and that it will be even more welcome it if continues awhile yet. Second, that some further dollar rise is likely (which, incidentally, could mean a pound back in the $1.40 region).

And third, that if this rise does occur it merely creates a set of circumstances which make it easier for Japan and Europe to make the structural changes to their economy which they know they have to do; it will not of itself solve their problem.