Central Bank Intervention is the Reason

Good day… I know most of you opened up the Pfennig this morning hoping to get a blast of Chuck’s witty writing style. Well the airlines arranged for Chuck to stay in San Francisco a little longer, so you’ll have to wait another day. The currency markets continued to get hammered by the U.S. dollar on Friday with the dollar index climbing all the way back above 76, a level we haven’t seen since mid-February. The dollar did sell off a bit in early European trading, but it has started to climb again as I write.

Several readers sent me an excellent opinion piece by James Turk which appeared on GoldMoney’s website. Mr. Turk points to central bank intervention as a major reason for the recent dollar strength. The article agrees with what I was saying last week – that the dollar has no fundamental reason to be rallying. The reports and news out of the United States have not been favorable to the greenback, and the twin deficits in the U.S. continue to soar out of control. I mentioned that the recent moves of the dollar smacked of intervention, as the dollar only wanted to move in one direction, ignoring any data that would typically send it back down. Turk points to some data that backs up this intervention theory:

“When central banks intervene in the currency markets, they exchange their currency for dollars. Central banks then use the dollars they acquire to buy US government debt instruments so that they can earn interest on their money. The debt instruments central banks acquire are held in custody for them at the Federal Reserve, which reports this amount weekly.

“On July 16, 2008 (the closest date of the weekly reports to the July 15th low in the Dollar Index), the Federal Reserve reported holding $2,349 million of US government paper in custody for central banks. In its report released today, this amount had grown over the past three weeks to $2,401 million, a 38.4% annual rate of growth. To put this phenomenally high growth rate into perspective, for the twelve months ending this past July 16th, assets in the Federal Reserve’s custody account grew by 17.3%, which is less than one-half the growth rate experienced over the past three weeks.

“So central banks were accumulating dollars over the past three weeks at a rate far above what one would expect as a result of the US trade deficit. The logical conclusion is that they were intervening in currency markets. They were buying dollars for the purpose of propping it up, to keep the dollar from falling off the edge of the cliff.”

You can read James Turk’s entire article here. He makes a convincing argument. As Chuck and I have pointed out in the past, intervention (even cooperative central bank intervention) can only impact the markets for the short-term. Economic fundamentals will eventually win out, so the central banks have only bought themselves a little time. Unless the economic data in the United States does an about-face (and I don’t expect it to), the U.S. dollar will remain in its long-term downward trend.

Friday saw the release of additional U.S. data that would usually have moved the dollar lower, but not in this dollar bull environment. U.S. non-farm productivity slowed, increasing at a 2.2% pace versus last month’s 2.6% rate. Unit labor costs came in just under expectations, and wholesale inventories rose by almost 2 times the expected rate. This increase in wholesale inventories is somewhat telling, as companies were unable to sell all of the goods that they were producing. Could U.S. consumers finally be slowing their spending? If so, it would mean an even more dramatic drop in GDP for the last half of 2008.

This week will bring a number of big economic reports here in the United States, none of which are expected to be dollar friendly. Tomorrow we will get the trade balance, which is expected to have ballooned back above 60 billion in June. We will also see the monthly budget statement and ABC consumer confidence. Wednesday will bring us the import price index in the U.S. along with advance retail sales and business inventories. July Consumer Prices lead off the reports on Thursday, followed by the weekly jobless claims. And we will close out the week with the empire manufacturing numbers, TIC flows, industrial production, and Chuck’s favorite, the capacity utilization numbers for July. If the reports come in where expected, the dollar bulls may start running for the hills.

The euro (EUR) has gained a bit this morning after policy makers said the ECB remains focused on inflation and that traders are beginning to realize that last week’s 3.6% drop was excessive. The euro also rebounded due to expectations that government reports released this week will show consumer price growth in Europe accelerated to a 16-year high last month, more than double the ECB’s 2% ceiling.

If the U.K. producer prices are any indication of what the Eurozone inflation numbers will look like, the ECB will have to take a serious look at moving toward a tightening bias again. U.K. producer prices increased in July at the fastest pace since records began in 1986. Prices charged by factories rose 10.2% from a year earlier. Double-digit inflation is not going to keep the BOE or the ECB on the sidelines for too long. If this rate continues, they will be forced to raise interest rates in order to combat this runaway inflation.

Danish inflation was also reported this morning, and came in at an 18-1/2 year high of 4%. These increased costs are raising concern among European central banks that employees are going to start to demand higher pay to compensate them for the lost spending power that has been eroded by inflation. Denmark’s labor shortage, with unemployment at 1.6% in June, means employers are more likely to give in to demands for pay increases. I would look for the Danish central bank to raise rates in order to combat this wage rate inflation risk. Higher rates should equate to a stronger Danish krone going forward.

Australia’s central bank is not helping out their currency, as they continue to signal that rate cuts are in store. The Reserve Bank of Australia said in its quarterly policy statement released today that it will have more room to cut interest rates because ‘significant moderation’ in domestic demand will slow inflation, cut economic growth in half and drive up unemployment. Today’s statement suggests Governor Glenn Stevens will ignore a spike in the inflation rate to prop up an economy buffeted by weaker domestic spending and falling house prices.

Doesn’t Governor Stevens see what has happened in the United Kingdom? Does he really want to take his country down this path of runaway inflation combined with a slowing economy? I hope not, but the statement does suggest that the RBA will begin to look at a possible interest rate cut as early as next month.

The Olympic opening ceremonies were quite a spectacle, it amazes me how much money and planning went into them. Much has been written about how these games are a chance for China to show the world just how far they have come in moving into the world’s economic elite. Recently, China has been slowing the pace of their currency appreciation, preparing for the global economic slowdown that is expected to deepen. The yuan (CNY) retreated in the last two weeks after government officials said supporting growth is as important as fighting inflation. Exporters had begun to complain about the pace of the renminbi’s appreciation, and with a slowing economy there will probably be less need to keep up the rate of the currencies’ rise versus the U.S dollar.

This should be an interesting week. The data in the United States shouldn’t be supportive of the dollar, so we will see if the central banks want to fight the underlying economic fundamentals and continue to prop up the greenback. I would expect us to see the dollar lose much of its recent strength, but the last two weeks have shown me just how wrong a little central bank intervention can make me look.

Currencies today 8/11/08… A$ .8903, kiwi .7040, C$.9392, euro 1.5024, sterling 1.9227, Swiss .9277, ISK 81.52, rand 7.6909, krone 5.3287, SEK 6.2521, forint 157.67, zloty 2.1754, koruna 16.05, yen 109.83, baht 33.74, sing 1.4063, HKD 7.8095, INR 42.176, China 6.8577, pesos 10.137, BRL 1.6087, dollar index 75.89, Oil $116.00, Silver $15.34, and Gold… $860.35

That’s it for today… I love watching the Olympics, not only the big name sports like swimming and gymnastics, but also the lesser known sports which typically don’t get any TV coverage. These are the athletes who aren’t going to get any multi-million dollar endorsement deals, but have still dedicated their lives to being the best at their chosen sport. With Chuck, Kristin, and Jennifer all out this morning, Christine and I will be doing the trading this morning. Monday’s are the biggest trade day for us, so I better cut it off here and get to work. Sure hope the airlines don’t decide to further delay Chuck’s flight home! Hope everyone has a Marvelous Monday and a terrific rest of the week!!

Chris Gaffney
August 11, 2008