A Week of Interest Rate Decisions

Good day… The dollar has stayed in the pretty tight range it established over the weekend, gaining some strength over the weekend after losing some ground on Friday. It should be an exciting week, as it is ‘Interest Rate Decision’ week, and a number of central banks will be announcing their new rates. I think the rate announcements will reinforce my feelings that the world’s economies are heading down divergent paths, with some economies heading toward a recession while others maintain good growth rates.

As expected, the U.S. unemployment rose to the highest level in more than four years as employers cut jobs again in July. But the decrease in payrolls was slightly less than forecast, so some were saying ‘it isn’t as bad as we thought’.

But an increase in the jobless rate from 5.5% to 5.7% and stagnating manufacturing jobs certainly point to a continued recession in the United States. And those employees who are still working have seen their hours cut to a record low, as the total number of hours worked in July declined by 0.4%, indicating that the economy took a turn for the worse entering the third quarter. Payroll cuts combined with decreasing property values, stricter lending rules and near record energy prices sent personal income in the U.S. into negative territory. Reports this morning are expected to show a drop in Personal Income and a decrease in Personal Spending during the month of June.

We will also get one of the Fed’s favorite measures of inflation, the PCE Deflator. The PCE Deflator is expected to show that prices in June jumped by the most this year causing some to call for more rate hikes. This is what has caused the dollar to gain some ground this morning during early European trading. The FOMC will announce their interest rate decision tomorrow, and everyone is predicting they will hold rates steady (as if they have a choice!). As usual, the markets will be dissecting the accompanying statement to try and predict the FOMC’s next move. They continue to be stuck in the unenviable position of dealing with rising inflation and a slowing economy. Don’t expect any change from the ‘wait and see’ language which they have been feeding us.

The week ends with the weekly jobless numbers and a report which is expected to show that pending home sales here in the U.S. continue to fall.

Chuck is heading out to San Francisco for another investment conference later this week. Last night, while watching the Cardinals blow yet another game, he emailed me his thoughts on the upcoming week:

“I was reading a story in the Post this weekend, by John Berry, the former Fed Head, that pretty much stated what I’ve been telling people, especially the crowd in Vancouver… The Fed Won’t Raise Interest Rates this week… And in my mind, they probably won’t this year. Yes, inflation is rising, but it’s not wage spiraling inflation that usually pushed the Fed Heads to raise rates. And with the housing, credit, liquidity, and financial institutions’ problems running rampant, the Fed Heads just can’t raise rates, as raising them would make all those problems balloon! Yes, I know, the Fed Heads have been great at creating bubbles, but this would be worse than a bubble… It would be a Hindenburg!”

As Chuck points out, the Fed simply can’t raise rates; and with the poor data, another drop wouldn’t be too surprising. But no, Big Ben and his compatriots have been paralyzed by the combination of rising inflation and a slowing economy. As we have been saying, the FOMC will be forced to just take their seats and hold on for the ride. In the past, when the U.S. economy weakened, the rest of the world usually followed quickly and inflation eased as demand for oil and other commodities fell. But the world’s expansion barely slowed last year and the commodity cycle continued on its long term upward trend. Economies in Asia continue to expand, keeping the world on an upward growth path in spite of what is occurring here in the United States. So the Fed can’t count on a global slowdown to bring prices down, but if they raise rates to combat inflation, they will deepen the recession that the U.S. is already in. They seem to want to err on the side of growth, and hope inflation takes care of itself; not a good scenario for the U.S. dollar!

The ECB finds itself in a similar position, but has decided to err on the side of controlling inflation and risking a further slowdown in their economy. This is a much more conservative approach, and one that I believe will turn out to be correct. European producer prices increased by the most in at least 18 years in June, challenging the ECB’s mantra of providing price stability. The ECB will meet on Thursday, and most believe they will leave rates unchanged after lifting rates to a seven-year high last month. President Jean-Claude Trichet said that the ECB council “will do in the future what is appropriate to deliver price stability.”

The Bank of England has taken a path similar to the U.S. FOMC, and the pound sterling (GBP) has suffered because of it. The pound posted its biggest weekly decline against the dollar since mid-June, as U.K. manufacturing shrank last month by the most in a decade, adding to evidence of a recession. U.K. house prices fell the most in nearly two decades in July, and consumer confidence dropped to a record low, reports showed last week. The British economy is very weak, and there are currently no signs of a recovery. We expect the pound to continue to weaken, especially versus the euro (EUR) and also against the dollar.

Australian house prices also fell in the second quarter, the first time prices have gone down in almost three years. Central bank Governor Glenn Stevens is counting on falling house prices to help cool inflation that has accelerated above his target range of 2% to 3%. Stevens raised the benchmark rate in March, and policy makers will be meeting again tomorrow to review interest rates. While no change in rates is expected, some are expecting the Reserve Bank of Australia to signal a move toward cutting borrowing costs to spur growth. It will be interesting to see what Governor Stevens has to say after the meeting. I don’t expect any shocks like what we saw out of NZD with Bollard turning extremely dovish. With the overall commodity boom cycle continuing, I disagree with those expecting a cut from the RBA, and believe Stevens will continue his ‘wait and see’ approach, with a hawkish bias.

The two best performing currencies as of late continued their assault on the dollar as both the Brazilian real (BRL) and Mexican pesos (MXN) climbed in value. The Mexican peso increased to the highest against the U.S. dollar in almost six years on speculation the central bank will boost the country’s lending rate at its meeting next week. Last week, the Mexican central bank raised its inflation forecasts through 2010, increasing speculation that policy makers will lift interest rates. The central bank has raised the key lending rate twice by a quarter point since May 16, but inflation has continued to quicken. Expect one or two more interest rate increases this year, which will likely keep the pesos increasing versus the U.S. dollar.

Brazil’s real continues to be the best performing currency, as it rose to a nine-year high on interest rate speculation. Brazil’s central bank is very hawkish and they will keep the interest rate advantage over the United States. Unlike the past, Brazilian policy makers are making a concerted effort to address inflation. The central bank is ready to act “vigorously” for as long as necessary to bring inflation back to its 4.5% target by 2009, according to the minutes of its July 22-23 meeting. The bank sees domestic demand at the heart of inflationary pressures and isn’t blaming rising commodity prices alone like other central banks in the world. They are following the ECB instead of our FOMC and frontloading their interest rate increases in an effort to stay in front of inflation. The currency markets are rewarding their efforts with a continued rally for the real.

The Icelandic krona (ISK) finally had a weekly advance versus the dollar and the euro after the nation’s trade balance moved to a surplus in June. The currency advanced 2.8% versus the U.S. dollar last week, the first sustained rally since the beginning of July. The move helped push the currency below 80 krona/US$ but the credit crisis continues to hold down the interest rates which we are able to pay investors. I still think investors should take advantage of any increase in the value of the krona to exit this very volatile currency.

Gold and silver continued their slide with the yellow metal threatening to break below $900. This sell off has mainly been due to the recent strength of the U.S. dollar. Bernanke and Paulson have been able to convince investors to put money back into the U.S. stock market after bailing out Fannie and Freddie and arranging additional liquidity for Wall Street. This dynamic duo has been able to lull investors back into a feeling of comfort, and with risk no longer in the forefront investors have turned away from the precious metals. But don’t look for this correction to last, the long-term commodity cycle remains in an upward trend. While Paulson and Bernanke have succeeded in luring investors back into the stock market temporarily, inflation will continue to increase and precious metals will gain back their luster as inflationary hedges.

Currencies today 8/4/08… A$ .9340, kiwi .7306, C$.9706, euro 1.5595, sterling 1.9676, Swiss .9544, ISK 79.54, rand 7.2072, krone 5.1211, SEK 6.0601, forint 149.30, zloty 2.0598, koruna 15.36, yen 107.99, baht 33.54, sing 1.3722, HKD 7.8042, INR 42.46, China 6.8516, pesos 9.9352, BRL 1.56, dollar index 73.40, Oil $125.00, Silver $17.40, and Gold… $906.73

That’s it for today… As I mentioned earlier, I watched last night as the Cardinals snatched another loss from the jaws of victory. Looks like we are going to have to just try and compete for the wild card now. I had a great weekend; my younger sister was in town from Alabama so I spent all day yesterday in the boat pulling all of the kids around the lake. Today the temperature is supposed to climb into the triple digits – one of those days I’m glad I work inside. Hope everyone has a great start to their week and a Marvelous Monday!!

Chris Gaffney
August 4, 2008