Dollar Continues its Year-End Climb

Good day… We got hit pretty hard over the weekend with our first winter storm. Usually the weather guys over-dramatize the forecast, predicting 6 inches and we barely get a dusting. But this time they were spot on, and we got hammered with two storms in a row, which dumped a total of between 6 and 8 inches of snow. It made for a great day yesterday, as the kids were playing in it all day long, only breaking to come in and warm up with some hot chocolate.

The currency markets also got dumped on over the weekend. The CPI number came in above expectations at 0.8% MOM and 4.3% YOY. After Thursday’s jump in PPI, the higher CPI was expected, but the markets still ran with the number and the dollar rallied. Yes, the dollar rallied on data that shows inflation is running higher than expected.

I had a reader email me with the obvious question, “Why would higher inflation cause the dollar to strengthen? Isn’t inflation, by definition, bad for the dollar?” Yes, continued high inflation in a country will eventually destroy that country’s currency, but the markets don’t bother to look long term. Today’s markets look at the short term implications of the numbers; and in the short term, higher inflation will mean the FOMC won’t be able to lower rates, and the higher rates should help support the U.S dollar.

Again, I don’t buy into this argument, but I also know you can’t fight the markets; and right now the currency markets want to take the dollar stronger. The dollar extended its gains against the euro (EUR), climbing to the highest in seven weeks. And the euro won’t get any help from a report released this morning that suggests Europe’s economy is heading for its slowest growth in three years. But while the European Central Bank cut its forecast for economic growth next year, it’s held off reducing interest rates as the inflation rate reached a six-year high.

Many very respected analysts expect the FOMC will (or at least should) get much more aggressive with rate cuts going forward. And with the ECB keeping rates steady, the euro will likely be underpinned by a narrowing interest rate differential.

John Mauldin, a very respected analyst and good friend of EverBank, wrote very eloquently on what I believe will be the next big ‘surprise’ to the markets: Stagflation. Here is an excerpt from his weekly newsletter, which I read last night:

“1% Growth plus 4.3% Inflation = Stagflation

“I wrote three years ago that the best end result of keeping interest rates so low for so long would be a mild stagflation, and here we are. This quarter will see 4% inflation with a probability of 1% growth, so what should the Fed do? Fight inflation with rate hikes or standing pat? Or fight a recession with rate cuts?

“If we are going into a recession, and I think we are, then that is by definition deflationary. When we have two asset bubbles bursting at the same time that is deflationary. Inflation will not be a problem in six months if we do not jump start the credit markets. Let’s look at what Alan Greenspan said four years ago, in one of his better speeches entitled ‘Monetary Policy under Uncertainty.’ It starts with the sentence:

“‘Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape.’

“It then goes on to tell us just how uncertain monetary policy is:

“‘Despite the extensive efforts to capture and quantify these key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and in all likelihood will always remain so. Every model, no matter how detailed or how well designed conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis. Consequently, even with large advances in computational capabilities and greater comprehension of economic linkages, our knowledge base is barely able to keep pace with the ever-increasing complexity of our global economy.’

“‘Look, guys,’ he tells us (my paraphrasing), ‘stop looking at three different trends, running them out ad infinitum and then drawing a conclusion about the wisdom or stupidity of our decisions. The factors affecting your trends are so complex that any number of significant events could change the relationships between your trends and the desired policy.’

“Further, he points out that the traditional measures of money stock are becoming increasingly meaningless. The obsession with M-2 or M-3 makes for good newsletter copy, but what do such broad aggregates mean in a world where new forms of money (SWAPs, derivatives, mortgages bonds, etc) appear every day? The implication that the old linear relationships between money supply (as measured by some arbitrary and outdated statistic like M-2) and inflation may no longer be valid.

“Recent history has also reinforced the perception that the relationships underlying the economy’s structure change over time in ways that are difficult to anticipate. This has been most apparent in the changing role of our standard measure of the money stock…in the past two decades, what constitutes money has been obscured by the introduction of technologies that have facilitated the proliferation of financial products and have altered the empirical relationship between economic activity and what we define as money, and in doing so has inhibited the keying of monetary policy to the control of the measured money stock.

“Not only are past relationships not always linear, but past relationships may change over time. This is the old principle of ‘past performance is not indicative of future results.’ Just because things worked in the past does not mean they will in the future, as the world is changing rapidly.

“This is now more true than ever. We are in an entirely brave new world. The primary order of business is to get the credit markets back in operation and restore confidence to the markets. And this may take more than a 25 basis point cut every 6-7 weeks. If the markets get the sense that the Fed does not get it, things could get out of hand very rapidly. The Fed needs to [get] out in front of this problem. This is not an academic issue. This is a very real world crisis.

“The Fed should cut rates at a fairly aggressive pace. If things turn out not to be as bad as they look, they can take the cuts back fairly quickly. It seems to me that the risk of a recession in the midst of a credit crunch is not something to ‘play chicken’ with.

“And if they are not going to cut rates, then they need to tell the markets why and what they are going to do to help alleviate the problem. It is time for Helicopter Ben to become Transparent Ben.

“If we have more than a mild recession, it will be because the Fed does not get it and did not act in time. I think they will, but this week makes me nervous.”

Chuck tells all of us on the desk to make sure we read Mr. Mauldin’s “Thoughts from the Frontline Weekly Newsletter” on a regular basis. John Mauldin is a very good analyst, and excellent writer. You can read all of his latest newsletter here. I appreciate John letting us reprint part of his letter here, as he does an excellent job presenting a pretty complex subject in a pretty clear manner.

Today we will see the current account balance, Empire Manufacturing, NAHB housing market index, and the very important TIC Flow data. The current account balance is expected to show some narrowing during the third quarter, but the more interesting data will be the TIC flow numbers, which are expected to show a dramatic pick up in the amount of U.S. Treasury purchases by foreigners. You will recall that this number actually showed foreigners had purchased 14.7 billion LESS Treasuries last month, but today’s numbers are expected to reflect a dramatic turn around. Net Long-term TIC flows are expected to be 50 billion in October, with Total Net TIC flows showing an increase of 30 billion. As Chuck has pointed out several times in the past, this number is important, as we are dependent on foreigners to finance our current account deficits. Without foreign purchasing of our Treasuries, interest rates will move up and the dollar will fall.

We will have to wait and see if this number rebounds as expected. If not, we could see the December dollar rally start to falter. Trade desks are all short staffed from now until the end of the year, so we could see some pretty erratic markets. Those that have been waiting for a good time to get their portfolios diversified may want to take advantage of these erratic markets to buy into some currencies or metals at what look like good prices.

Finally, the metals fell again over the weekend. Gold fell for a third day in London as the dollar gained, eroding the metal’s appeal as a hedge against a weaker U.S. currency. Silver also declined. Again, these moves were largely driven by the strength of the U.S. dollar. I don’t think the dollar will hold its value, nor do I think gold and silver have peaked. Inflation will be up, and both gold and silver are the perfect hedge against runaway prices.

This has gone on a little long this morning, and we have a new addition starting on the desk this morning, so I will wrap it up.

Currencies today: A$ .8587, kiwi .7562, C$ .9868, euro 1.4386, sterling 2.0158, Swiss .8664, ISK 63.18, rand 6.9138, krone 5.545, SEK 6.5704, forint 177.08, zloty 2.52, koruna 18.3941, yen 113.43, baht 30.53, sing 1.4597, HKD 7.7990, INR 39.545, China 7.385, pesos 10.837, BRL 1.8122, dollar index 77.546, Oil $90.81, Silver $13.73, and Gold… $789.61

That’s it for today… Happy Birthday to Jennifer who is responsible for all of the currency trading while Chuck is out. As I said earlier, we have some help arriving on the desk today as one of our top guys from the mortgage side Tim Smith, decided to come up to St. Louis to help us out. I just hope he stays after being greeted by 13 degree weather and 6 inches of snow!!

Chris Gaffney
December 17, 2007