Category — Economics

The US Dollar ended its rise against the Euro, as the ECB had several officials speak out in predicting future rate hikes. It is unclear if the ECB is planning a single increase (likely in July), or a series of hikes, as the officials volunteered differing opinions on the subject.

One continuing storyline is how markets worldwide are responding to central banks’ suddenly hawkish tones. Interest rate hikes have already occurred in countries such as India and Denmark, and larger players such as the ECB and the Fed are sounding like they may also raise rates in the near future. Some economists, such as Harvard’s Martin Feldstein, are worried about the possibility of minor stagflation arising from these policies.

In other news, the Swiss has rallied against the USD and the euro. Crude Oil futures are up almost 5%, and Bernanke cautioned that further price pressures could cause problems for the entire world.

Upcoming Events

USD Fed’s Beige Book

USD Advance Retail Sales (MAY)

NZD Retail Sales (APR)

JPY Bank of Japan Monthly Report

EUR German CPI (MAY)

EUR German CPI – EU Harmonised (MAY)

Calm seems to be returning to international financial markets.  US economic data released today surprised to the upside.  The US dollar is even losing its safe-haven bid with fear not as dominant in the market as in days past.  We could even see conditions set up for a normalization of credit and liquidity in the last quarter of the year.

Asian and European markets have done well for the past couple of days.  US markets have not been as resilient, but we haven’t seen major losses either (which is almost as good).  We talked about the carry yesterday, and it should continue to rebound as long as the Dow does well.  The only major negative report that we have heard regarding financial institutions is the discovery of $10 billion worth of asset-backed securities on the books of China’s national bank.  But that’s a bank that doesn’t have to worry about liquidity, so it is not something that should worry investors.

US economic data should also prove reassuring to traders at all levels.  New Home Sales came in with a dramatic 2.8% increase, registering a pace of 870,000 new purchases compared to expectations of only 820,000.  Durable Goods printed even better, rising 5.9% last month after a revised 1.9% growth the month before (check out dailyfx.com for an explanation of how you can make money trading currency on the back of the durable goods report).  Economists at Bloomberg only expected 1.0% growth in July.  What these reports mean is that the US economy was doing really well before the credit crunch this month, and if we can get passed the liquidity issue, the overall economy is on a good track.  As good news dominates the market, fewer investors feel compelled to park their assets in US dollars, and one place you can go right now is Canadian dollars.

The best case scenario in this situation is for world financial markets to settle down before the Fed’s meeting in September.  The ECB has reaffirmed its commitment to raising the overnight lending rate on the continent.  Bank of Japan Governor Fukui is determined to normalize Japan’s interest rates before too long because extremely low rates result in a misallocation of resources.  Time Magazine has a profile defining Fed Chairman Ben Bernanke as a man walking a “fine line” between inflationary pressures and threats to growth.  But Main Street looks like it may survive, and the Fed (hopefully) will be able to keep the Funds rate constant on September 18 without too much trouble.

Yesterday, we wrote that when the US sneezes, the rest of the world still gets a cold.  Now there are reports from DailFX.com comparing the Asian financial crisis of 1997-98 to the US subprime fiasco.  But while the starting points may be similar, there is reason to believe the reactions by international central banks will be different.

In 1997, traders and investors were highly leveraged in risky investments in emerging markets in Southeast Asia.  When the Thai government floated the baht, all hell broke loose.  In the current situation, traders and investors were highly leveraged into complex debt instruments backed by risky mortgages.  When foreclosures reached record highs, the credit market went into a state of panic.  If the parallels continue, then we should be looking at multiple interest rate cuts by the end of this year.

But the major difference in this case is that Fed Chairman Ben Bernanke has proven different than his predecessor Alan Greenspan.  Bernanke seems to be less inclined to bail out investors suffering in times of falling markets, especially if that bailout would include an interest rate cut.  Recent reports on Bloomberg indicate that the Fed has not decided on a course of action with regard to interest rates, instead hoping to give the increased liquidity time to work and the market time to digest the effects of the discount rate cut.  Senator Chris Dodd, Chairman of the Banking Committee, even pressed last night for more banks to take advantage of that rate cut.

That comment took place after a meeting with Secretary of the Treasury Henry Paulson and Chairman Bernanke.  The meeting was important on a number of different levels.  It occurred amid a backdrop of hawkish comments by a couple of Fed officials.  Futures traders, who had priced in a 100% chance of an interest rate cut in September, dropped their projections after the meeting to a 50% chance of a rate cut.  But one analyst for DailyFX.com still regards it as almost a certainty that the Fed will lower rates by at least 25 basis points (and maybe even 50) during their meeting on September 18.

The interesting thing about this scenario is that even in the midst of all these problems in the credit markets, the broader economy is still doing well.  Fundamentally, US growth remains on track, above the standard 2.0% level.  Unemployment remains low, and inflation seems to be relatively contained.  Even the debt market appears to be balancing itself out, as yields have begun to bounce back (the Fed is even considering accepting commercial paper a collateral for its discount loans).  Volatility is retreating, with the VIX down 30% off its 4-year highs last week.  Equities trades might cry foul, but the best decision right now might be to leave the Fed Funds rate unchanged.  And at least with regard to the foreign exchange market, that is good news for dollar bulls.

The Dow sold off below 13K yesterday, foreign purchases of US securities were mixed and the market has already priced in an interest rate cut in the United States at the Fed’s next meeting on September 18.  But the US dollar has shrugged off that data and continued to remain strong, at least against every major currency except the Japanese yen.  I am particularly bullish on US Treasuries as most of the rest of the bond market is particularly illiquid and difficult to price.  Treasuries are the surest bet for investors.

The gains against the commodity currencies are especially striking.  Commodities continue to fetch high prices in the futures markets, but the currencies themselves are feeling the effects of the recent appreciation.  Canadian production has fallen as a result of the strong Loonie, and investors are becoming more wary about bets placed in New Zealand and Australia.  Fundamentally, long positions in NZD/USD appear to be the most at risk.  With traders paring back on riskier strategies and sticking to the US dollar, look for the commodity currencies to continue their falls.

The interesting thing about the strength of the dollar is the lack of good economic data to support that strength.  The CPI report was flat, and the subprime problem seems to be contagious, rather than contained.  The New York Fed was hot, buy Housing Starts fell to a 10-year low in July.  The housing sector is mired in an 18-month recession.  If the Fed needs an excuse to lower interest rates, there’s plenty of poor data it can point to.

Speaking of interest rates, I will be very surprised if we do not see one on September 18, but just as surprised if we see one before then.  Bill Poole has come out and said that it would take a calamity for the Fed to introduce an emergency rate cut.  Mark Gilbert of Bloomberg brings up an interesting point though: the liquidity injections into the market by the Fed have already brought the 4-week Treasury bill below the target rate of 5.25%.  A temporary easing has already occurred which leaves the September 18 meeting to just make it official.  And when that happens, look for the dollar to lose its support.  But not until then.

Should the US Fed lower its overnight lending rate, and what will its decision mean for the US dollar?  The short-term strength of the greenback would surely disappear if rates were indeed lowered in September.  But just as certain is that financial markets would recover faster, and the economy might be stronger going into the end of 2007.  the danger of cutting interest rates (besides the inflationary risks) is the idea that a market bailout by the Federal Reserve would create a moral hazard in the financial industry.

Short-term support for the dollar remains strong.  The dollar is on a steady upward path against the euro and the pound.  It is absolutely killing against commodity currencies.  With risk aversion still dominating the forex market (and the carry trade likely to fall even further), the yen remains the only currency to show strength against the US dollar.  If USD/JPY touches 116.50, we will see all hell break loose; that’s the level at which many retail traders started shorting the yen and their stops will come into play.  Economic data for the greenback has been mixed.  Industrial production and producer prices surprised to the upside.  But the CPI report this morning came in particularly low, as many economists were predicting.

The last development would provide cover for the Fed if Bernanke decided to bail the financial market out with an interest rate cut.  Monetary policy makers could argue that the upside risk of inflation is abating, thereby preserving their inflation-fighting credibility.  But one thing to note is that the liquidity that has been injected into the market in recent days has not exactly been a “helicopter drop.”  The money has gone through the big banks, and there are still reports of smaller companies and mortgage lenders being mired in a liquidity crunch.  The signs of the intervention working are mixed, at best.

But then that points to an interesting question.  Should we bail out lending companies that made foolish decisions resulting in bad loans?  If the financial companies are not held accountable for their poor actions, then we could see even riskier investments and loans flourish in the new environment.  The ideal scenario would be to find some way to help those families stuck paying off impossible mortgages and keep them from losing their homes, but do that without assuming the risk of the larger corporations.  An actual helicopter drop, distributing money to those at the bottom-end of the operation, would be best.  The government would need to get involved.  However, the integrity of the Fed and the US dollar would be maintained, and US consumers would be saved.

Financial markets have stabilized in the last couple of days, but support for the US dollar has refused to wane.  Believe it or not, there are actually legitimate economic reasons to continue to bid up the ugly duckling of the foreign exchange market.  Especially with relation to the pound and the euro, the US dollar is connected to better recent data.  But if the subprime problem is contained (if the international interventions prove successful) then that will signal bad news for dollar bulls; financially, the US economy is in worse shape than its global counterparts.

Producer prices is the United States rose 0.6% last month versus an expected gain of only 0.2%.  That is a strong reversal of May’s 0.2% decline in producer prices.  Core prices registered a jump of 0.1%, bringing the yearly inflation index to 2.3%, higher than then 1-2% comfort zone.  The US trade deficit also fell in June to $58.1 billion from a revised $59.2 billion in May.  Providing further support for the health of the US dollar, the Fed funds rate opened this morning at 5.1875%, lower than the target rate of 5.25%.  The Fed is likely to see this situation and remain hawkish on inflation, with the recovering growth providing some cover for keeping interest rates steady.

Across the pond, the ECB and the Bank of England are faced with more negative immediate conditions.  UK CPI printed last night at 1.9% versus an expected gain of 2.3%.  The latest rounds of monetary tightening look to have had their effect on prices, and English monetary authorities may have to check their hawkish stances somewhat.  As for the continent, GDP data has been extremely disappointing, with US growth outpacing growth in the Eurozone for the first time since 2006 Q1.  But futures markets are still pricing in the probability of a rate hike in Great Britain and the EU and the likelihood of a rate cut in the United States all by the end of this year.  So while the dollar might be gaining now, the gains are likely to be short-term.

Even the short-term gains are dependent on how the international financial markets evaluate risk.  If risk aversion maintains its stranglehold, then the US dollar will continue to benefit from its status as a safe haven.  But economic data in the US, as a whole, is still pretty underwhelming.  So if traders can get past the housing mess (and the doldrums of August), we should see the dollar go back to being what it has been for some time now: safe, steady…and a terrible investment.

Traders and investors in financial markets around the world are preoccupied with paring back their risk exposure.  Internationally, emerging market investments are being cut back.  In the US equities market, stocks are losing attractiveness in favor of safer Treasury bonds.  With regard to the foreign exchange market, traders are shunning the risky carry trade.  The ultimate consequences of all this activity are strong support for the US dollar and the Japanese yen and a decline in the other major currencies.

The greenback’s rise is interesting.  With America at the locus of the subprime crisis, its currency is also the greatest beneficiary.  When risk rules the market, traders park their money in dollars, and that is likely to continue for some time.  EUR/USD acts as a proxy in the FX market for dollar sentiment, and the euro is on track to take a beating.  Economic data from the continent has also disappointed, while US Retail Sales surprised to the upside.  Unless the Fed surprises everyone with an immediate interest rate cut, dollar bulls should continue to smile.

The Japanese yen has been the other recipient of good fortune during this subprime mess.  All of the high yielders have taken turns falling against the yen.  Technical analysis points to now being the turning point for GBP/JPY.  But while the carry trade unwind is driving this growth in the yen, economic data in Japan is not supporting the rebound.  And so a long-term outlook in the currency cannot be positive.  The Bank of Japan does not have a basis to raise interest rates, and the yen will suffer accordingly.

Central banks are the major players in the FX market in this current environment.  Will the increased liquidity ease credit concerns?  Many analysts predict that the banks will be forced to concede inflation and lower rates to stave off a world-wide recession.  But predictions of this hard landing are wrong.  The market correction should even itself out, and the increase of money in the market should keep buying and selling going.

The People’s Bank of China may be in a position to use its $1.33 trillion currency reserves as a bargaining tool against U.S. lawmaker demands. Xia Bin, director of financial research at the State Council Development Center, believes China can use its holdings of U.S. government debt to its advantage. As the world’s second-largest holder of U.S. Treasuries of $407 billion, the selling of U.S. asset holdings would significantly lower their value. U.S. Treasuries fell yesterday after traders cited in a U.K. Daily Telegraph report that China may threaten to sell its holdings in U.S government debt if the U.S. imposed trade sanctions (see more in an article by Kathy Lien).

On July 26^th, the U.S. Senate Finance Committee approved legislation that would place higher duties on Chinese imports. These higher duties should compensate for the undervalued yuan. U.S. lawmakers since the beginning of the year have expressed concerns that an undervalued yuan is hurting U.S. companies. The People’s Bank of China has bought huge sums of U.S. government debt in order to keep its yuan artificially low.

With a high foreign currency reserve, a central bank is able to issue more than sufficient amounts of its domestic currency to stifle demand. If demand decreases when the economy bottoms out, the central bank would have plenty of foreign reserves to buy back the domestic currency. The enormous influx of capital from its incredible trade surplus is what has allowed China to maintain the world’s largest foreign currency reserve.

Despite numbers for April and May this year showing cuts in PCB U.S. Treasury holdings after 17-months of purchases, the central bank has indicated it would cut holdings anytime soon. President Bush and Henry Paulson agree it would be “foolhardy” for China to cut holdings in U.S. debt. Selling off these assets would strengthen the yuan significantly and thereby lower export value. Both have indicated that a mutual trade flow without penalties on imports should persist. Yet, with its true actions always a secret to the public, it remains to be seen what the PCB will decide if U.S. import duties do come into play. The PCB could use its huge foreign reserves to put a dent into the U.S. economy. The situation has turned from a question of economic policy into a potential political showdown.  

After modest gains this week, the U.S. dollar fell against the yen and euro on news of poor U.S. jobs growth. A government report today showed 92,000 jobs added for July, falling well below expectations as 126,000 jobs were added in June. Economists at Bloomberg predicted 127,000 new jobs for the past month. In addition, the unemployment rate rose unexpectedly to 4.6 percent up from 4.5. These are signs the U.S. economy is still hurting from the subprime crisis as investors are losing this week’s earlier appetite for risk. The dollar fell to $1.3727 against the euro this morning in New York, down from $1.3703 yesterday. The increase in risk aversion has also caused the dollar to fall against the yen from 119.21 yesterday to 118.93 this morning.

Poor U.S. job growth and resulting increase in unemployment may prompt the U.S. Federal Reserve to lower interest rates this year to reboot growth. This may be a sharp change in monetary policy as rates have been kept strictly at 5.25 percent for 2007. Mathew Strauss, a senior currency strategist at RBC Capital Markets Inc. in Toronto, comments: “The payroll number raised concern that the slowdown in housing may start to affect growth. It seems one supporting factor for U.S. consumers may start to lose ground—a strong labor market.” Investors betting on futures contracts on the fed fund rate due in December changed forecasts on the yield to 5.02 percent, down from 5.21 percent from a month ago. The Fed will next meet on August 7^th.

Currency Outlook and Forecast:
The decisive factor for the future U.S. dollar movement is the subprime crisis. The big question bothering investors is whether the U.S. housing slump will spill over into the rest of the U.S. economy. Speaking on this issue, Jim Rogers, co-founder along with George Soros of the Quantum Fund, believes losses from the subprime-market have a long way to go. According to Rogers: “This [subprime defaults] was one of the biggest bubbles we’ve ever had in credit.” He forecasts U.S. investment banks and homebuilders will take further hits. Bear Stearns stock fell 13 percent last week. Shares in other investment banks such as Merrill Lynch and Lehman Brothers also fell this week.

Kathy Lien, chief currency strategist at FXCM, forecasts August to be a tough month for the U.S. dollar. She believes tighter credit and the housing blowup will have significant negative effects on the U.S. economy this month (see her article at dailyfx.com). Don’t expect steady long term gains in the dollar anytime soon, especially as the Fed may be lowering the borrowing rate later this year.

The US Non-Farm Payrolls report disappointed the forex market this morning, listing only 92K new jobs.  We should have expected this based on the dreadful ADP survey, but ADP has a history of missing the mark on Non-Farm Payrolls.  And so economists were actually expecting 127K new jobs, and the US labor market did not deliver.  With less than 100K new jobs, the NFP puts the Fed on track to cut interest rates in early 2008, which may benefit the equities market when it happens but it kills the US dollar in the meantime.

The US dollar has benefited from risk aversion recently (or at least been sheltered from the turmoil in the equities markets) by its status at a store of value.  People find US assets safe, and so those traders invested in riskier environments (the carry trade) have parked their money in dollar-denominated assets for the time being.  But the euro is also safe, and right now there is great opportunity to trade EURUSD with this morning’s jobs report.  A general description of how that trading should be done can be found on DailyFX.com.

The important thing to consider is that most currency traders had already priced in high expectations for US payrolls.  Had the economy met those expectations (or even exceeded them) the market would have just yawned.  But the downside disappointment is surprising and so the negative FX reaction to the NFP should be steep.

The foreign exchange market should not destroy the US dollar, at least in the short-term, because of the inherent value that many traders place in the stability of the US currency.  But the American economy is reeling from the housing and mortgage crisis (exacerbated by the falling stock market), and the news will provide impetus for many traders to move out of dollar-denominated assets.  One place to move into is Europe, because as Kathy Lien of FXCM notes, the surprise press conference for the ECB yesterday almost certainly confirms an interest rate hike in September.

Jim Rogers, the man who made billions with George Soros in the 1980s and correctly predicted the commodity boom in 1999, calls the US housing market one of the biggest credit bubbles ever.  The US economy may not be able to just absorb the shock and move on.  Manufacturing will not be able to sustain its strength forever.  There are even reports in Bloomberg that risk appetite is returning to the market.  If this continues, then the US dollar will fall even more, as the ability of US Treasuries to store value will no longer be as prized.  There does not seem to be much good news for dollar bulls in the current FX environment, and the future does not look much brighter.