Category — Interest Rates

It is not easy for many to admit that they made an error. It seems the President Trichet might finally be starting to embark on that difficult path. After raising rates in the Euro-Zone over the protests of many top figures within that continent, Trichet finally admitted what the rest of the world had realized some time ago: the Euro-Zone’s growth prospects are weak. This announcement/confession reflects that the ECB is starting to question if it did the right thing in raising rates. By hiking interest rates, the ECB indicated that it believed that growth would not be hurt too much by their inflation-targeting movements. It seems as though they were mistaken.

While admitting a mistake is a rarity for many, it seems that is even less frequent for public figures. Powerful men and women at the top of their fields have usually ended up there by making correct decisions, and so the idea of messing up can seem foreign. However, with the future health of the European economy largely riding on the ECB’s next move, it is time to these men and women to bite the bullet and cut rates. By alleviating this pressure the ECB will, among other things, send the message that they take growth very seriously and are committed to the economic prosperity of the European Union.

While inflation is very important, the ECB should currently direct its focus towards growth. Inflation targeting is not a cure-all, and if attacking inflation includes the ruin of the Euro-Zone’s economy, then that does not strike me as very helpful.

Upcoming Figures
EUR German Gross Domestic Product (2Q)
EUR German Consumer Price Index (Jul)
EUR French Gross Domestic Product (2Q)
EUR Euro-Zone Gross Domestic Product (2Q)
EUR Euro-Zone Consumer Price Index (Jul)
USD Consumer Price Index (Jul)
NZD Retail Sales (Jun)

With this week’s ECB’s decision all but official, a more important question looms: what’s next? The ECB is a bank whose primary focus – witnessed in both its charter and its past actions – is price stability. Despite poor economic performance in recent months, the ECB essentially has to raise rates this week, as the Euro-Zone’s current inflation level is double the target of 2%. While President Trichet and his peers may pray that a single, small hike will be enough to curb rising inflation, the more likely scenario is that the policy move will not have a huge effect. So, the question remains: what’s next?

What’s next is a big decision. The age old debate (or as old as central banks have existed) between pursuing policies that facilitate growth or inflation is front and center in many prominent economies around the globe, and Europe is no exception. Rising energy costs have not helped the problem, leading some analysts to publically worry about stagflation rearing its ugly head. In a perfect world, high growth rates allow central banks to raise rates in the never-ending war on inflation (e.g. Australia). However, growth is unquestionably slowing all throughout Europe, and many fear that a rate hike could severely impact many of the smaller economies in the Euro-Zone.

In the long-run, Trichet (or whoever is in charge of the ECB in the future) has no choice; the ECB must focus on price stability first and foremost. However, in the next six months, what the ECB will do is anybody’s guess. One popular school of thought is that the ECB will employ a wait-and-see attitude; they will raise rates now and then observe the resulting economic data for a few months. Others feel that the ECB’s mandated focus on inflation will lead to a series of hikes, regardless of the costs. For many years, West Germany’s Bundesbank produced astounding economic prosperity, a result that many attributed to the Bank’s dedication to price stability. The ECB is a descendent of the Bundesbank, and so in my mind, I think that the ECB will not be done raising rates for the year after this week.

Of course, they could shock the world and not raise rates. You never know what will happen in the world of foreign exchange…

Upcoming Figures
AUD Reserve Bank of Australia Rate Decision
USD ISM Manufacturing (Jun)
USD ISM Prices Paid (Jun)

The markets are closed, Wall-E is opening in theatres, and by now most people have at least a foot out the door for the weekend. After writing all week about the USD, the Fed, and about how I am a better forecaster of market movements than my colleague John, I have decided to do the second piece in the Random Country Report Series. Excluding Antarctica and its rather inactive central bank (please see below), the continent with the least amount of coverage in the world of foreign exchange is Africa. So today let’s examine a country known for its history, architecture, and lamb kabobs: Egypt.

Egypt has come a long way from the time of the pharos and the pyramids, being one of the first – and longest lasting – republics in the Muslim world. Its currency is the Egyptian Pound (EGP), which is currently trading at 5.35 EGP to 1 US Dollar and 8.4479 EGP to 1 GBP. Today the Central Bank of Egypt raised interest rates to 10.5%, and unlike many of the major banks around the world, promised to actively combat inflation. If necessary, the CBE promised to bring rates even higher in the future should price stability (inflation) continue to be a problem.

The US Federal Reserve, along with other prominent central banks, is confronting the problem of simultaneously rising costs and slowing growth. As a result, it left rates unchanged the other day. Fortunately for Egypt, however, growth has not been a problem. In fact, the Egyptian economy is expected to expand more in this year than in 2008. As a result, the CBE has what would be seen as a gift by many other central banks: the chance to fight inflation without worrying about growth.

There are, of course, some problems in the Egyptian economy. Inflation is right under 20%, yet this problem is at the forefront of the CBE’s conscience. Many Egyptians also live with a low standard of living – a problem that the government has not yet been able to fully remedy despite recent moves such as wage increases. Another area of worry is rising food costs, as Egypt is the worlds’ second leading wheat importer due to their inability to grow the crop in the bleak Sahara Desert. As commodity prices continue to rise, Egypt should become concerned about their need to import so much wheat.

Still, in all, the outlook seems solid for Egypt. The International Monetary Fund (IMF) has rated the country as being one of the top countries in the world undertaking economic reforms, as they have taken steps in the past decade to become more transparent and liberalized economically. Politically, despite having the largest population of any Muslim country, Egypt is a voice of moderation in an ever-volatile region. By avoiding political turmoil and pursuing sound monetary policy, Egypt has produced consistent growth, and should be seen as a model for nearby economies that also don’t have access to enormous natural oil resources.

Antarctica’s Central Bank’s most recent meeting:

As I have explained before, there are some days when there is little of note in the FOREX world, so I get the chance to research a random economy somewhere in the world. Today (and I’m sure tomorrow) is not such a day. Everyone’s favorite superpower, the United States of America, came out with important economic data today, and will have even more important data tomorrow. US Consumer Confidence was lower then expected, and the lowest it has been since 1992. While some analysts are often critical of the fickle nature of this statistic, it nevertheless measures an important aspect of the market: what consumers are thinking about the economy. Partially as a result of this data, but mostly because investors are really waiting for tomorrow’s events, the US Dollar did little today.

A day after bad news came out of Europe’s largest economy, the second largest released better then expected data. Yesterday Germany announced that a measure of business confidence was lower than expected, but today Consumer Spending results in France surprised many by showing solid results. The Euro, like the USD, moved little today relative to the other major currencies. It is very likely that the news coming out of the US tomorrow (see below) will send currency pairs flying even if the USD is not in the pair. If the announcements fall into line as expected, the EUR should enjoy a good day as investors move away from the USD.

If you have an opinion about what the FOMC will say, tonight is a great time to get in before the market moves tomorrow. If you are unsure, I encourage you to try to find out what has been announced as soon as you can, and then look to jump on board if the market seems to be moving. Good luck!

Upcoming Figures
EUR German Consumer Price Index (Jun)
EUR Italian Retail Sales (Apr)
USD Durable Goods Orders (May)
USD New Home Sales (May)
USD Federal Open Market Committee Decision @ 2:15PM EST
NZD Current Account Balance (Q1)
NZD Current Account Deficit – Gross Domestic Product Ratio (Q1)

My assignment for the day: write 200 times “Next time I will not get too excited when I write about India’s short term economic situation.” For those who have been following India in the past few days, the developments seem anything but the rosy picture I painted last time around. Sure, in the long run, India is still poised to have solid and sustainable growth. However, their current battle with inflation may be more than just a bump in the road.

The rupee has been slammed in the past few days, as many see the Reserve Bank of India (RBI) having made insufficient actions, and being too slow to respond. The rupee’s fall is testament to the economy needing more rate hikes in order to limit its rapidly rising inflation. Limiting inflation is seen as being one of the keys to fixing the myriad of problems in India’s economy: a rising budget deficit, a current account deficit, a weak rupee, rising import costs (including energy), and diminishing spending power. However, concerns exist for the RBI (similar to the worries of the U.S. Federal Reserve) when considering rate hikes: the role of energy costs and the related adverse effects of rates that are too high.

So, let me revise my earlier statements. In order to correct the problems that their country is facing, the RBI should (and most likely will) continue to raise rates. As they are very dependent on oil imports, it would be a very worthwhile long-term goal to try to utilize alternative energy sources. As the country is still becoming industrialized, by pursuing these alternative energy methods while the country is still growing, the new energy sectors could grow along with the country. Finally, most analysts are saying that India is not in the same position as it was in 1991, when it suffered another economic downturn (and rupee devaluation). In other words, though the Indian economy may suffer a downturn or even a recession, India is still well situated – as long as they utilize smarter monetary policy – to stabilize and expand in the future.

In some weeks, the news highlight in the FOREX world is an Italian report on car sales. Other weeks, the major headline is that Nigerian workers are striking against the oil companies. However, this week, there’s plenty to be excited about, especially the most important gathering since the meeting of the Five Families: the U.S. Federal Reserve Open Market Committee Meeting.

Ladies and Gentlemen, start your engines.

Ok, perhaps this is not quite as important as Don Corleone and Co., but in the FOREX world, there are few planned events that can have as much impact as this one. Ever since Fed Chairman Bernanke announced an end to rate cuts a few weeks ago, anyone and everyone has circled this week on the calendar. Most analysts, traders, and “people in the know” are not anticipating a rate change, which would be the first time that FOMC has met and not done so in some time. However, despite a general sense of confidence that rates will be held constant, everyone connected to the market will be reading between the lines to try and get a glimpse of the Fed’s future moves.

With energy costs going nowhere but up, it has been argued that the Fed’s main concern might be that issue instead of their stated focus: inflation. Should the meeting’s outcome go as forecasted (no rate change), that would be a signal that inflation is not the only problem that the Fed is attempting to solve. If inflation is rearing its ugly head, the standard call out of the Central Bank’s Playbook has been to raise rates. However, there is a general worry that such a hike would only aid energy prices in their climb. As a result, most are predicting that the Fed will stand pat for now.

Though not this week, the ECB will be meeting soon, and will face a tough decision of their own. While the Fed only said that they are done cutting rates, the ECB has stated that they plan on raising rates. The problem with President Trichet’s plan, however, is that the economic data reported since that announcement has indicated that a rate cut might not be the smart move. Growth in the Euro-zone is slowing, and unless Trichet wants to play chicken with the economy and see who backs down first, a rate cut is being seen as less and less likely. However, Trichet is considered one of the most hawkish heads of a central bank in the world, so anything is possible.

Some days, I know exactly what I’m going to write about. On days that I don’t, I usually peruse through the news, trying to find something that piques my interest. Today’s top headlines in the currency sector centering on the US Dollar not doing anything as there’s little to trade on… thanks for the help world. So, I have decided that on days such as this, a day with little of note on the economic calendar, I would focus on a country (and its currency) that rarely gets much discussion in the world of FOREX. Today, that country is India.

For those of you who were unaware, the currency in India is called the rupee. Should you be traveling to India soon, it would be in your best interest to know that the USD is currently worth about 43 rupees. The country is dealing with high inflation, rising energy costs (who isn’t?), and a weakened rupee. As a response to all three, the Reserve Bank of India recently increased its benchmark repurchase rate and raised interest rates. As a result of this responsible policy move, many analysts now expect the rupee to strengthen against the USD to around 41:1 by the end of the year.

Like many other countries around the world, India has suffered from crude oil prices. As they import about 70% of their oil, their rupee has suffered in kind. Still, not all is bad, as India has produced very impressive growth over the past decade. While that growth is crucial to India’s long term development, the Reserve Bank of India has sent a message that it is willing to sacrifice some of that growth today for improved economic indicators tomorrow. Unlike its neighbor, China, whose policies have led to – and sustained – very high inflation, India has decided to confront the problem.

As for the long term, most analysts remain optimistic. With its enormous population, the economic potential for India is still very strong. The country does sustain a sizeable current account deficit, but much of this could likely be attributed to energy costs. Personally, I applaud India’s commitment to keeping its inflation and rupee at acceptable levels. Instead of just continuing to focus on growth regardless of the long term consequences (ex. China), India is positioning itself to experience excellent growth for a long time by fixing its economic problems now.

Upcoming Figures
CHF Trade Balance (May)
CHF Swiss National Bank Rate Decision
GBP Retail Sales (May)
CAD Consumer Price Index (May)
USD Phildelphia Fed Business Survey (Jun)

Last week I mentioned that though the G8 conference would impact the US dollar in the short term, the ultimate fate of the USD will ultimately be determined more by Bernanke than by anyone else. The Group of Eight’s meeting has come and gone, offering little good news for the USD. In the FOREX market, that “little good news” led to bad news for the USD, as the greenback surrendered some of the territory it had gained last week. So with the conference in the rear-view mirror… let’s look ahead.

In his most recent column, Robert Novak wrote that despite his publically hawkish stance, Bernanke is more concerned with growth rates. Furthermore, Bernanke feels that oil and gasoline prices, if they continue to rise, could lead to the dreaded state of halted growth in addition to rising inflation. Assuming that what Novak is reporting is accurate, it would seem that Bernanke’s pronouncements last week were a charade. In other words, Bernanke isn’t likely to walk the walk. However, this might not be a bad thing. Many see the economy as not yet ready for a rate hike, and so perhaps holding rates constant for the next several months would be the best thing for the US economy.

The USD has ended the rally it began last week, and while the short term prospects are dimmer than they were several days ago, the jury is still out regarding the long term. On the one hand, disappointing economic data that keeps coming out (most recently in the US: poor manufacturing results) would indicate that the USD is in for more stormy seas. However, analysts are noting that it has been years since people have held such bullish opinions about the USD. Many feel that the dollar is “due,” meaning that after taking its lumps for years, it is poised to finally recover. With the Saudis agreeing to pump more oil, perhaps the stars are aligning for a USD recovery. However, it’s hard to know the future for certain. As it is written in one of the Harry Potter books, we humans are not very good at reading the stars.

Upcoming Figures

AUD Reserve Bank of Australia’s Board Minutes (Jun)

EUR Italian Trade Balance (Euros) (Apr)

GBP Consumer Price Index (May)

EUR Euro-Zone Trade Balance (Euros) (Apr)

USD Current Account Balance (Q1)

USD Housing Starts (May)

JPY BoJ to Publish Minutes of Board Meetings

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.

Financial markets look to be rebounding after their huge drops in the last couple of weeks. Markets have seen an uptick in value and, and recent news only seems to support that trend. The primary effects of this movement on the foreign exchange market have been twofold: providing the Fed with justification to slow down the easing process and giving Mrs. Watananbe the ability to resume the carry trade.

Let’s look first at how the financial markets have returned to a relative state of calm. The four biggest US banks borrowed $500 million each from the Fed’s discount window yesterday. None of the four actually need the money, but the act is a symbol of trust in and acceptance of the Fed’s recent decision to lower the discount rate. Bank of America also took a new $2 billion stake in Countrywide Financial, the nation’s biggest lender of home loans, a catalyst that drove down corporate bond risk and drove up stocks. Once thought to be on the verge of bankruptcy, Countrywide appears to have survived the crisis, signaling hope for the larger economy. Looking at the broader equities market, the VIX index feel even more yesterday, now sitting more than 40% lower than the highs hit last week.

All this good news might indicate that the Fed doesn’t have to ease rates to the extent that futures traders have priced in. And indications from US central bankers point to the Fed not really wanting to lower rates just now (the moral hazard problem). The Fed has a number of different options as to what it could do in September and October, but it has to realize that the credit problems are still far from over. Commercial paper is still being ignored to a ridiculous degree, and if a wide scale easing program is not implemented, then we could see the problems of Wall Street spread to Main Street.

A spread to the wider economy is not out of the realm of possibility. Layoffs in mortgage companies are coming, and the big banks are already shutting down their subprime units. More troubling is what happens to mortgage rates if the Fed keeps rates steady. Adjustable rate mortgages are set to be re-priced next month, and with credit conditions as they are now, we will see consumers swamped with enormous debt service bills. Consumers are the engine of the US economy, and any slowdown in that sector because of higher bills could be disastrous. That said, if the Fed keeps rates steady, it would also be bullish for the US dollar in the short-term. As corporate profits shrink and equities markets decline, we would see a strengthening of the dollar’s safe-have bid, and USD/JPY, especially, would see the bottom fall out.

But with the stock market reasonably strong and most market participants sure of a Fed funds interest rate cut, the US dollar is seeing some capital outflow and so is the Japanese yen. The dollar-yen hit 117 last night, and the carry trade seems to be returning. Mrs. Watanabe saw in the recent drops the same buying opportunity that hedge funds proclaimed (and quantitative funds have made back most of their losses this week). We should see at least two rate cuts this year in the United States and that should generally prove bullish for the carry trade. But as always, be careful.