As <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />United States approaches its Congressional elections in November, political change is occurring in all of the G-3 currencies and its impact on foreign exchange trading may be far more powerful than the market appreciates. Here is a quick look at key players and possible political scenarios that may affect currency movements in the near future.<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
Japan New Face Same Policies?
Despite the fact that Shinzo Abe Japans newly elected prime minister - has never had ministerial experience and has only been in politics for 13 years former Prime Minister Junichiro Koizumi personally groomed him to take the helm of the worlds second largest economy. Mr. Abe is Japans youngest serving prime minister since World War II and its first to have been born after war. Yet, Mr. Abes careful, sober temperament stands in sharp contrast to that of his charismatic predecessor whose reform minded agenda guided Japan out of decade long struggle with deflation and generated five consecutive years of economic expansion..
While former Japanese prime minister Junichiro Koizumi impressed investors the world over with his dedicated focus to economic reform, Mr. Abe whose father and grandfather were both career politicians appears far more interested in foreign relations rather than economics. His primary focus is on establishing better relations with China and South Korea. These relations have been sorely tested by Mr. Kozumis repeated visits to the Yasukuni shrine which both Koreans and Chinese view with great distaste because along with 2.5 million war dead the shrine honors fourteen generals convicted of war crimes. Although Mr. Abe refused to rule out a visit to shrine in the future, he stated that any such decision should be personal rather than official in nature. His conciliatory tone on this issue should ease the conflict and create a more productive relationship with Japans neighbors. If Mr. Abe vision of peaceful, friction free cooperation between South Asias three most important economies comes to pass the regions power and economic might should expand as it continues to command an ever larger share of global capital relative to both Europe and United States. Certainly if Mr. Abe is able to forge cooperation amongst Japans most important neighbors he would be able to neutralize the destabilizing influence of North Korea and therefore minimize the regions single greatest geo-political threat, a development that is likely to help the yen in the long term
On the economic front Mr. Abe ambitions appear decidedly more modest as he tries to continue Mr. Koizumis reforms while at the same time attempting to address the growing disparity between urban and rural areas in Japan. According to Hiromichi Shirakawa, chief economist for Japan at Credit Suisse First Boston, His economic reform ideas are quite simple -- to delay tax hikes and in the meantime try to reduce spending. To that end, the departure of Mr. Abes main rival former Finance Minister Sadakazu Tanigaki a passionate advocate of tax increases to balance the budget - should be seen as positive sign by the currency market. If Mr. Abe is able delay any additional tax on consumption, he will be able to provide more time for Japanese consumers to alter their frugal spending habits shaped by ten years of relentless deflation. In the meantime Japans central bankers will not move on rates until they see clear, unambiguous evidence that Japanese consumers have finally abandoned their deflationary mindset and started to increase spending. With Mr. Abe now firmly in place, Japans monetary authorities may feel more free to pursue a monetary policy unhampered by political considerations and may increase the pace of tightening in 2007, all of which should prove positive for the yen which has suffered disproportionately from carry trade fueled selling.
Euro-Zone Trouble in the Heartland?
Taxes, look to be a key issue in Germany as well where after nearly a decade of moribund growth Euro-zones most important country is finally enjoying an economic revival. In fact in the last quarter Euro-zone GDP growth exceeded US growth for the first time since 2000. However, Germany faces the prospect of an increase in Value Added Taxes which are expected to rise from 16% to 19% at the start of 2007. So far the center-right government of Angela Merkel has resisted any attempts to delay the tax hike, arguing that it is necessary to prop up Germanys fiscal finances. The increase in VAT which translates to a whopping 19% jump in the cost of goods is services is likely to have a very depressive effect on consumer spending in 2007 which may short circuit ECBs attempt to tighten monetary policy much beyond the 3.25%- 3.50% level and may stifle the nascent recovery in the 12 member region.
Ms. Merkel also faces political challenges from the far-right after the rise of National Democratic Party (a fringe political party sympathetic to the Nazi doctrine) in the rural region of Mecklenburg which includes her home constituency. In the most recent election NDP received 7.3% of the vote up from less than 1% in the previous state vote. "That's the most depressing result," said Erwin Sellering, deputy leader in Mecklenburg of the Social Democratic Party, which lost ground in the vote. "Depressing for us all because it was our common goal to prevent it." While NDP s win is hardly indicative of Germanys move to far right it does suggest wide spread frustration with the slow pace of Ms. Merkels economic reform which continues to leave the eastern part of the country with high double digit unemployment. If Germanys growth slows markedly as a result of the VAT increases, the unrest is likely to only become more intense creating a possible political crisis in Euro-zone most important economic member.
US Watch the Pump
On the surface President Bush and the Republican party appear to be in trouble as United States approaches its biennial Congressional elections. The Presidents approval rating is mired in the lows 40s, the Senate - long thought to be a lock for GOP - may now be vulnerable to a Democratic take over and the latest Reuters/Zogby survey of potential voters gives preference to Democrats over Republicans by 42% to 33% margin. One fear expressed by some currency analysts is the potential ascendancy of New York Congressman Charles Rangel to the chairmanship of the powerful Ways and Means committee should Democrats win the House. The Ways and Means committee controls the tax code of the United States and Congressman Rangel is a well known proponent of rollbacks of President Bushs tax cuts. Many market players fear that a new spate of tax legislation would exacerbate the current US economic slowdown caused by the recent contraction in the housing sector.
In the Senate the situation appears even more precarious for the ruling Republican party. Democratic challengers are either ahead or close in races in five states held by the Republicans: Missouri, Montana, Ohio, Pennsylvania and Rhode Island. Furthermore the state of Virginia which only a month ago appeared to be a solid Republican strong hold may be slipping to Democratic control after incumbent Senator George Allen stumbled badly in his contest against a former Republican Jim Webb a Vietnam vet and former Secretary of the Navy under President Reagan. Mr. Allens campaign has been dogged by accusations of racial insensitivity caused by Mr. Allens off the cuff remarks, and even possible commitment of a bias crime by his former college classmates.
Yet, despite the seeming bleakness of the Republican cause, the Democrats have not been able to close the deal. "The president and the Republicans are still on the ropes, but they certainly seem to have hit bottom and bounced back," said John Zogby the pollster. "This is still very competitive." One surprising source of support for the President and the GOP may come from the gas pump. Gas prices and Presidential approval ratings have a near perfect inverse correlation. Mr. Bushs rating hit a nadir when gas prices skyrocketed above $3.25 per gallon but have improved considerably since the rapid decline in the cost of gasoline to an average of $2.45 per gallon. Furthermore, the recent problems of the Amaranth hedge fund which have led to much lower natural gas prices may inadvertently contribute to additional Republican strength by keeping heating bills in the coming fall and winter season far lower than expected. In short, as the saying goes, in politics a day is a lifetime and with more than month to the US election the dynamic can easily change.
Conclusions for FX
Overall, however, the political landscape in all three primarily economic regions of the world suggests that the range bound standstill trading of the currency market may continue a while longer as each block faces its own unique set of political problems that may impinge on growth in 2007. In Europe the prospect of increasing VAT in Germany may sabotage the regions budding recovery and cut short any further rate hikes by the ECB leaving euro with a considerable interest rate disadvantage to the dollar, In US, the coming Congressional election may sweep Democrats into power and could create a temporary outflow of capital, as the natural instinct of currency speculators with respect to any political change is to flee first and ask questions later. However, if Republicans manage to hold on to the House while Democrats overtake the Senate the market could react positively as this would create the speculators favorite outcome political deadlock which should restrain fiscal spending while at the same time maintaining current capital friendly tax policy. Finally, in Japan where the political change is the most minimal a lot will depend on Mr. Abe ability to continue the reform policies of the far more charismatic Mr. Koizumi. If Mr. Abe is able to delay any additional tax increases while Ms. Merkel proceeds with hers, perhaps the clearest trade in FX in 2007 would be the EUR/JPY short which at present continues to hover near all time highs of 150.78. However, the risk to that scenario stems from the possibility that the ECB maintains its hawkish stance despite any slowdown in EZ growth while the BOJ following Mr. Abes cautious stance maintains rates near zero percent. In that case the yen will continue to be vulnerable to carry trade flows as capital will seek yield amidst slowing global growth.
