Category — Interest Rates

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.

In the past week, EURUSD has lost more than 200 pips from its record highs.   But recent evidence shows signs of a retracing, with support for the euro regaining strength.  But it’s not like currency traders have fallen back in love with the euro.  Most of the movement in the currency pair in recent days has to do with softness in the US dollar, rather than any inherent strength in the European currency.

The data emanating from the continent is contradictory, to say the least.  Recent sentiment reports in Germany and France have bordered on terrible.  Retail Sales in Germany printed last night at a disappointing gain of 0.7%, versus 1.2% expected.  But unemployment fell by 45K, bringing the unemployment rate in Germany to 6.3%, the lowest level in that country in 14 years.  The forex market, understandably, is perplexed as to do what to do with this information.  And so trading in EURUSD right now consists of range trading within 40-60 points, with a market consensus of about 1.37.

The fundamental status of the US dollar is important in this situation because the euro is where the forex market likes to register its response to status changes in the greenback.  But even considering that, there’s no real direction for the currency market to follow.  The PCE deflator was released this morning, and the inflation register came in at 1.9%, excluding most food and energy costs.  This fits into the Fed’s comfort level of 1-2%, but the PCE deflator has a tendency to understate inflation.  Along with that, consumer spending met expectations with a gain of 0.1%, but the pace of growth is the slowest in nine months.  Home prices are also a concern, with the S&P/Case-Shiller index reporting that home prices in 20 US cities fell 2.8% in May—the biggest fall in more than six years.  But those negatives are tempered by the fact that disposable income in the United States rose 0.4% last month, outpacing spending for the first time in months.  The forex market did what it usually does with conflicting data like this: nothing.  The dollar barely moved at all against the yen and the euro after the release of the government report.

Currency traders may be confined to range trading in the near future, especially when it comes to EURUSD.  If you had to choose between the euro and the dollar, however, then your safer bet would be to go for the euro.  The ECB is only charged with maintaining price stability while the Fed has a dual mandate of controlling inflation and promoting growth.  Because of this, the ECB is likely to raise interest rates in September despite French President Nicolas Sarkozy’s concern for the negatives of a strong currency.  In contrast, chances are good that the US Fed will lower interest rates by the end of this year.  And so yield-hungry currency investors will abandon the dollar and flock to the euro.

One way to capitalize on this flow is to invest in a managed currency fund.  Bloomberg reported this morning on record returns achieved by these funds this year, and they are an excellent way to diversify your portfolio.  There are a number of very good funds out there right now, and one of the best in FXCM’s Sentiment Fund.

Despite last week’s small gains against the euro, the U.S. dollar fell against the European currency on speculation of further weak U.S. growth. It may seem like old news, but investors fear further losses on securities backed by subprime mortgages to weaken the U.S. economy. Today, Germany’s IKB Deutsche Industriebank AG reported losses directly linked to the U.S. subprime mortgage crisis. Along with last week’s Deutsche Bank report, this indicates corporate debt to be at risk from the weak housing market. The dollar fell to 1.3678 against the euro this morning, a 0.3 percent drop from last week.

The risk of owning corporate debt has sky-rocketed, also a factor in the euro gain. Bond buyers have been demanding higher risk premiums on corporate debt as risk-aversion has increased. According to index data by Merril Lynch, the spread that investors demand on corporate debt instead of holding U.S. Treasuries has widened 20 basis points this week to 128 basis points. Investors fear corporate debt will be taking hits from the subprime meltdown.

Currency Outlook and Strategy:
Tomorrow at 8:30 a.m. the U.S. Commerce department is due to release a report on U.S. consumer spending. Economists from a Bloomberg news survey speculate personal spending rose 0.1 percent in June, the least since September. Ever since U.S. personal spending has slowed from a 5-month high in December, the dollar has fallen 3.5 percent against the euro. Even though a weak spending forecast is already factored in the EUR/USD price, there is room for a further fall if the U.S. Federal Reserve decides to lower interest rates. Kenta Inoue, economist and currency analyst at Mitsubishi UFJ Securities in Tokyo, states: “I expect the U.S. economy to slow and the Fed to lower rates in the 4^th quarter. There is still room for rates to rise in Europe, so investors will start to favor European currencies over the dollar.”

And this brings up another question: Will the European Central Bank raise their federal funds rate above the current benchmark of 4.00 percent? There is much speculation the ECB will hold onto the current rate after its next meeting on August 4^th, but is likely to raise rates later in September. This increase may mean further appreciation in the euro, a main worry of French President Nicolas Sarkozy. But recent data has shown an appreciating euro has not hurt the euro-region as a whole. Exports from the EU rose 9 percent in 5 months through May from a year earlier, the second fastest pace in 6 years. This begs the question why an appreciating euro has not hurt exports. The reason is that against the currencies of the EU’s 25 trading partners, the euro has increased less than half as a much as against the U.S. dollar. Exports to the U.S. may have been hurting, but with Germany as the world’s largest exporter, exports to other countries have more than made up for losses.

Another benefit from a rising euro has been lowered costs of oil, which is priced in U.S. dollars. The price of oil has risen 26 percent this year to $76.73 a barrel today. Despite hurting some European corporations like Airbus and Peugeot (charts), the overall euro-region seems to be withstanding the euro impact. The ECB is forecasting economic growth at 2.6 percent for 2007.

EUR/USD has been establishing fresh highs almost daily for the past two weeks.  The upward movement in the currency pair is due to a variety of factors pointing to both euro strength and dollar weakness.   Economic growth within the Eurozone is forecast to be 2.6% in 2007, putting the 13-country region at a pace behind only Great Britain among the industrialized world.  Also, most currency analysts expect at least one more rate hike this year, probably in October.  Money follows yield in the forex market, and that is certainly true with the euro.  And when analyzing this currency pair, it is impossible to ignore the recent comments of ECB members Stark and Papademos when they talk about the strength of the economy and the threat of inflation.

The weak dollar is also to blame for a lot of the support underneath EUR/USD.  Subprime mortgage losses and concerns in the credit market overall have scared off a lot of dollar investors.  Countrywide Financial Corp., the country’s largest mortgage lender, reported its third straight quarterly decline in profit and lowered its forecast for next year.  The price of credit has surged as traders continue to be worried about the possibility of the subprime crisis spilling over into other parts of the economy.  If the issues spread into the larger credit market, we will see a significant knock on growth, and it is this problem that has led to the significant dollar selling in the forex market.  Yesterday, we talked about how the weak dollar made US assets cheap and attractive.  But if the dollar continues to slide, then the assets being held drop in value.  Just the perception of dollar weakness can ignite a massive sell-off in dollar-denominated assets.

It is not certain, however, that we will see the bottom fall out in the US dollar.  Today’s currency trading has provided mixed signals for the future.  French consumer spending was a positive, coming in at 1.6% vs. 0.7% expected.  Italian Retail Sales was a slight disappointment, however, rising only 0.1% vs. 0.3% expected.  Even worse, the manufacturing PMI reading fell to 54.8.  Not only is that lower than the 55.5 forecast, but it is the first time the reading fell below the 55.0 level since February 2006.  The Eurozone economy is much more dependent on manufacturing and exports than either the United States or Great Britain, and this may be the first sign that the high exchange rate is dampening European growth.  The mixed bag of data threw currency traders for a loop and kept the euro trading around 1.3800.

So what can we expect from the forex markets in the future?  New French President Sarkozy is still clamoring for more political say in the decisions of the European Central Bank.  What that means for us is that he wants a larger emphasis placed on stimulating growth as opposed to containing inflation (low interest rates).  ECB President Trichet should be able to resist this intrusion, and the monetary policy makers are likely to raise rates to 4.25% by October of this year.  That is fundamentally positive for the euro, especially since the US Fed is likely to keep rates constant for the rest of 2007.  But technical analysis of the forex market does paint a different picture, as most signs point to the euro being overbought and the US dollar being oversold.  As such, instead of seeing the EUR/USD march toward 1.4000, we should instead see a correction and a rise in the value of the dollar.

Inflation has always been an important concern for currency analysts, if only because it has a direct relationship with interest rates.  Central banks have a mandate to keep inflation under control, and so signs of rising inflation indicate a strong currency.  But the new paradigm of an increasingly international economy could leave monetary policy makers impotent in the face of global inflationary surges.

Commodity prices are near record highs, and interest rates do not have the power to completely moderate supply-side inflationary pressures.  Oil is selling for almost $80/bbl, and there are market analysts who believe we are likely to see $100 oil by 2008.  That would put oil at the $100 level one full year before Goldman’s now infamous oil projections of last year.  Gold and food prices are also through the roof (they are the primary driver of high prices in Australia and New Zealand).  With growing demand for commodities from developing economies, price pressures are not in line to let up anytime soon.  In the forex market, the most prominent consequence of the commodity boom is the incredible rise of the three major commodity currencies (Canadian dollar, Australian dollar and New Zealand dollar).

But more troubling for fans of domestic monetary policy is that inflation is also being stoked by rising prices for finished goods and services.  This phenomenon has surprised many observers because it seems counterintuitive to the idea of globalization.  Free trade was supposed to lead to higher efficiency and lower prices.  But with emerging markets all over the world on the rise, we are seeing more and more wealth in the developing world.  A booming economy naturally leads to higher prices, and the Chinese yuan, Indian rupee and other emerging market currencies have appreciated significantly this year.  Goods from these countries are now more expensive, and so as we buy imports from the rest of the world, we see China and India and Brazil exporting inflation.

Growing wealth in the world’s developing areas has other consequences of inflation as well.  Rich foreigners buy assets in the developed economies, and more buyers drives up the price of these assets.  This is partly the cause of exploding real estate prices in London.  For those concerned about the US dollar, we should note that the weak dollar makes US assets especially attractive.  It is as if US products were being sold at a discount relative to prices in the past.  This is why foreign ownership of US securities reached record levels last May.  But forex traders should still keep track of the current state of the US dollar.  Traders like to invest in markets that are growing (and economies that are healthy.  So while a weak dollar might be good for the US economy, a weakening dollar is bad.  And with central banks less powerful in the face of the new global economy, we might not be able to do anything about it.

The Chinese economy has grown at its fastest rate in 12 years during the second quarter. China’s GDP growth has increased to 11.9 percent from a year ago. This figure has exceeded all expectations from 23 economists at Bloomberg. Inflation has risen to 4.4 percent in June, the fastest rate since September 2004. The Chinese economy is on fire and needs cooling. The most obvious is a change in monetary policy. There is much speculation the Chinese central bank will increase interest rates and in turn this will strengthen the yuan. But is revaluation by direct policy of the yuan needed?

According to Glen Maguire, chief Asia economist at Societe Generale SA, a strict revaluation by the central bank is needed in order to quell the surge. He indicates the yuan may even need to appreciate as much as 3.5 percent in a single day. A stronger yuan would slow down the economy by making exports more expensive and thereby reducing China’s enormous trade surplus. U.S. lawmakers have been very keen on a strengthened yuan, claiming that U.S. companies have been taking hits by its artificially low value. Senator Charles Grassly has spoken on the issue extensively stating the Chinese currency has not risen fast enough.

Despite U.S. and Chinese economists having met and agreeing on the same direction for the yuan, the Chinese central bank does not want a fast acceleration. Bank of China Governor Zhou Xiaochuan has stated he does not want the yuan to accelerate nearly as fast as the U.S. would prefer. Other currency analysts do not see the yuan appreciating to unprecedented levels anytime soon. According to Tim Shea, a currency analyst in the Sales and Trading Department at FXCM, “China has shown since the initial dropping of the peg in 2005 that the strengthening of the yuan would happen gradually and at their own pace.” He points out, “…that a 3 percent change in one day would be a move of 2200 pips, the equivalent of all the movement made since January. This would not be in line with past policy.”

We have also seen changes in Chinese fiscal policy to help the cooling process. Inflation has actually outpaced the return on bank deposits spurring investments in the equities market. The benchmark CSI 300 stock index for the Chinese market has gained 87 percent this year. In response, fiscal measures have included legislation allowing the 20 percent tax on interest income to be reduced or even taken away. As a result, fixed-income investments have increased to 26.7 percent in the first half of the year from a year ago. Even though this increase in savings is modest in comparison to the spurring equity run, a future meltdown of the Chinese economy is unlikely. With the right fiscal and monetary policy the Chinese economy will continue to grow at a controllable pace. The yuan will strengthen, but most likely at a pace unsuitable to U.S. lawmakers.

Commodity currencies have been beating up on the US dollar and the Japanese yen recently and yesterday was no different.  The Canadian dollar, the New Zealand dollar and the Australian dollar all hit new highs, an occurrence so common in that last couple of weeks that’s most traders simply yawned.  Some of the underlying support for these currencies comes from high commodity prices, especially oil and gold, of course.  But much of the gains should also be attributed to weakness in the US dollar and the yen carry trade.

It is pretty easy to spot the strength the commodity currencies have derived from greenback bears.  The data released in the respective countries has not been really great.  Canada’s inflation numbers yesterday printed lower than expected.  Australia and New Zealand have not released much data recently, and what has been released has been worse than expected.   But the rise of the Loonie, Aussie and Kiwi cannot be stopped.  And that can be traced back to the sluggishness of the US dollar.  And the market consensus after Fed Chairman Bernanke’s speech is that US interest rates are likely to stay the same for some time.  Bernanke also seemed more concerned about the slumping housing market than he has been in earlier speeches.  And so the commodity currencies should continue to benefit from the weak dollar.

The other factor fueling the fresh highs in this area of the forex market is the yen-based carry trade.  The interest rate advantage for Australia and New Zealand compared to Japan is enormous, and currency traders just cannot seem to get away from the high yields.  And that differential is likely to get higher as the futures market lists a 66% probability that the Reserve Bank of New Zealand will raise the country’s interest rates, already the highest in the industrialized world, at its next meeting.  Most currency analysts are pricing in another rate hike this year for the Royal Bank of Australia as well.

The appetite for risk (as well as the hunger for yield) in the market is tremendous, and the surging carry trade is reflective of that.  AUD/USD is at an 18-year high and NZD/USD is at its highest level since the currency was floated in 1985.  While the amazing rate of appreciation might be hurting the country’s exporters, the situation is only exacerbated by the weak greenback.  It is because of this phenomenon that the Canadian dollar is up 12% already this year, with the USD/CAD hitting 1.0416 this morning, its highest level since 1977.  But the latter pressure is not likely to go away anytime soon as many analysts are touting the weak US dollar as good for the American economy.

It seems like every day the euro hits another high.  At least, that’s been the story of the forex markets for the last five days.  A combination of dollar weakness and the market’s belief in the Eurozone economy has pushed the euro to new heights.  Yesterday was no different.  Bear Sterns officially warned their hedge fund investors that there was no value left in the fund.  With fears of the subprime crisis already strong in their minds, traders were worried that foreign investors would seek to move away from US assets.  Especially after the recent diversification of foreign exchange portfolios (basically, the selling-off of US Treasuries), the Bear Sterns news triggered a dollar decline.  Even the poor German ZEW survey released yesterday did little to stem US losses.

But today’s news may signal a top in the EUR/USD pair.  Consumer prices in the United States rose 0.2% in June. It is the smallest gain in five months but still a reversal from the drop in headline PPI seen yesterday.  Core prices also rose 0.2% versus an expected increase of 0.1%.  Housing starts also rose 2.3% this morning, providing further support for the greenback.  Lastly, Fed Chairman Bernanke is scheduled to give his semiannual report to Congress at 10:30 AM.  Today’s data probably eliminate the possibility of interest rate hikes in the near future, leaving Bernanke free to remain hawkish on inflation.  That’s why DailyFX.com reports that his speech is likely to be dollar bullish.  EUR/USD has been trading within a range of 80 points for the last five days, but if Bernanke’s speech goes as expected, we could see a dollar-positive breakout.

Euro bulls should also be concerned about recent developments regarding the European Central Bank.  New French President Nicolas Sarkozy has called for European finance ministers to be granted more influence in monetary policy decision-making.  The most direct consequence of such a move would be a loss of political independence for the ECB, and that would not be good news for the euro.  German policy makers have traditionally been for an independent central bank, but a recent Bloomberg.com report suggests that German Chancellor Angela Merkel may be coming around to Sarkozy’s viewpoint.  ECB President Jean-Claude Trichet has warned against the disastrous consequences of such a development, even suggesting that it may violate the European Commission Treaty.  This is an important situation for traders to stay on top of because if Sarkozy is successful in imposing political control upon the ECB, we could see the bottom fall out of the euro soon afterward.

In the highly volatile forex market the dollar rebounded slightly from a previous falling trend. A government report today unexpectedly showed a record level of U.S. securities bought by foreign investors in May. Holdings in U.S. stocks, bonds, and notes rose to a net $126.1 billion in May, up from a net $80.3 billion in April. This surge is an indication that confidence in the U.S. economy has not diminished. Economic data in May suggested that the housing slump did not necessarily spill into other sectors as had been feared. Economists had predicted that international investors would buy a net $72.5 billion in U.S. long-term securities for June, but in fact a net $105.9 billion was bought.

The dollar traded at 122.30 yen at 9:42 a.m. in New York up from 121.89 yen yesterday. Against the euro the U.S. currency traded at $1.3783, a significant increase from the July 13^th record low level of $1.3814. Earlier gains in the dollar were due to a report showing an increase core prices for May. Core prices, which exclude energy and food, rose 0.3 percent giving investors reason to speculate that the Fed will not be cutting interest rates. However, it remains to be seen what Fed Chairman Ben Bernanke will report during tomorrow’s testimony before Congress.

The gains made by the dollar are only short term. Investors should be careful and not overly optimistic as both the European and England Central Banks are about to raise interest rates. European Central Bank Council Member Nicholas Garganas is wary of inflation pressures from stronger than expected economic growth. This would prompt the ECB to raise the interest rate above the six-year benchmark of 4 percent. Likewise, inflation in England exceeded the central bank’s 2 percent target level for a 14^th month in June. Interest rates will likely be increased to cool the economy.