Dollar Declines as Investors Move Out of Safe Havens

Currency investors started to move back out of their ‘safe havens’ yesterday with most of the currencies moving higher versus the US dollar. The Japanese yen (JPY) was the biggest mover, setting a post-World War II high as money was repatriated back into the country. The biggest losers were the other side of the carry trades, the New Zealand dollar (NZD) and Australian dollar (AUD). The kiwi was down over 1%, and the Aussie dollar was down just .2% versus the US dollar. Things are still a bit dicey in Japan, and it looks as if at least one of the damaged reactors is going to meltdown. The Japanese are doing everything they can to cool the reactor complex, but radiation levels continue to hamper their efforts.

The Japanese continue to try and address the financial problems caused by the catastrophe by dumping huge amounts of liquidity into the Japanese markets. One reader asked how the yen could be appreciating when Japan is in the midst of creating so much new currency. Japan has (or had) one of the largest currency reserves in the world, and it has used these reserves in years past to intervene in the markets. So the injections of capital that the BOJ is currently making is not ‘new’ money, but is reserves which they had been holding. The yen is appreciating because Japanese individuals, corporations, and even the major insurance companies have been buying up yen in preparation for the re-building which will begin soon. This repatriation has triggered other investors to exit ‘carry trades’ which traditionally involved investors selling yen and buying Australian or New Zealand dollars. Carry trade reversals are making the yen even more expensive.

And the Japanese catastrophe looks to impact more than just the currency markets. I touched briefly on the falling TIC numbers yesterday, and suggested that the TIC data would likely increase this month due to safe haven buying. But these safe haven flows are usually short term, and one of the world’s largest holders of US Treasuries (Japan) has a real need to raise cash. Obviously the Japanese are going to be sellers of their US Treasuries in the aftermath of the earthquake and tsunami. I came across an excellent article by Jeff Opdyke, editor of the Emerging Market Strategist, who addressed this possibility:

If Japan Disappears from the Treasury Market…Then What?

All told, Japan owns an estimated $3 trillion of US securities, both stocks and bonds. With $886 billion of US Treasuries, Japan is the world’s #2-holder of US debt. In the past year it’s bought, on average, $10 billion worth of Treasuries every month.

You don’t easily replace the second-largest buyer of Treasury bills, bonds and notes. Not many countries have pockets deep enough to step up with that kind of financial firepower.

China does, but it already owns more US debt than it needs, and has been putting its cash into other currencies and gold out of a sense of financial prudence. Some of the Middle East nations could pick up some of the slack…but they have their own uprisings to quiet. They’re throwing bags of cash at protestors to quash the dissent, or at security personnel to quash the protestors.

The US Will Have Little Choice But to Raise Interest Rates

A more likely scenario is that Japan largely disappears from the Treasury market, with China and a few others filling in some of that vacuum. And the Federal Reserve, which is slated to end it QE2 campaign in June, will likely extend the remainder of its $600 billion buying program over several more months.

But it doesn’t seem likely that the willpower exists in Washington for the Fed to increase the size of QE2. And that means there will be some shortfall. And shortfalls are bad for the US government because the government has a certain amount of debt it has to sell every month to fund all of its bloated spending commitments.

When the world is already stuffed with American paper, though, there’s only one way to bring buyers to the table: Higher yields.

Thanks to Jeff and the folks over at the Emerging Market Strategist for letting me include this in today’s Pfennig.

Chuck has been one of the loudest voices warning investors about the US Treasury bubble, and what will eventually happen when foreign investors start to sell. As Jeff suggests, the Japanese catastrophe could be the catalyst which begins the slide in the US treasury market. Speaking of Chuck, he sent me a note from down in Jupiter yesterday regarding the commodity sell-off we have seen of late:

Here is my thought on commodities and their falling prices… I don’t believe that the situation in Japan is damping the demand for commodities… I think it’s merely a case of “risk off”. It’s my long time belief that commodities overreact to these kinds of disasters. Thoughts from the ocean’s edge… -Chuck

Both Chuck and I are fans of Jim Rogers, and believe we are still in a long term commodity bull market. Those countries that are rich in commodities will have currencies that maintain value in the long run.

Moving over to Europe, the Swiss franc (CHF) increased again overnight as investors continued to seek safety. The Swiss National Bank left their interest rates near zero yesterday as they did not see a need for monetary tightening in the current environment. Policymakers at SNB did raise their forecasts for economic growth and inflation in 2011, so a rate increase sometime this year seems to still be possible. The recent run-up in the value of the Swiss franc is helping to keep inflation down, but safe haven buying will eventually reverse, and the SNB will have to step in with an interest rate increase in order to keep inflation at bay.

The euro (EUR) appreciated back above $1.40 as Spain sold 4.1 billion euros of 30-year debt and 10-year securities. This was the first major test of whether Europe’s recent efforts to buttress the rescue fund was convincing to investors. The success of the auction was a positive sign for the euro. Demand rose versus the last time securities were offered and Spanish bonds were steady after the sale. Data released this morning showed that European construction output rose 1.8% in January from December. That was the first increase since June of last year.

The Norwegian krone (NOK) has been a popular choice with investors seeking an alternative ‘safe haven’, and Norway’s central bank is allowing the krone to appreciate. Deputy Governor Jan F. Qvigstad of the Norges Bank said the krone “is strong, but we are not worried especially.” Earlier the Norges bank official had announced that tightening may start earlier than the bank had previously indicated. There is “a 50/50 chance in May or June” of a rate increase, he said.

And finally, India’s central bank increased interest rates for the eighth time in a year as it fights against higher inflation. The Reserve Bank of India raised rates 0.25% as the Indian economy continued to grow. The monetary authority increased its inflation forecast to 8%, nearly double their ‘tolerance’ level. With inflation well above the RBI’s tolerance level, interest rates will probably continue to rise. “Based on the current and evolving growth and inflation scenario, the Reserve Bank is likely to persist with the current anti-inflationary stance,” the central bank said in the statement. Reports showed wholesale price inflation quickened to 8.31 percent in February, and another report showed that exports jumped 50%.

Turning to the US, data released yesterday showed that the current-account deficit narrowed 9.7% to $113.3 billion in the fourth quarter, reflecting an increase in exports. The deficit for the full year of 2010 widened to $470.2 billion, or 3.2% of GDP, up from 2.7% of GDP in 2009. This deficit is worrisome, as it combines with a budget shortfall of a record $1.5 trillion dollars to form the twin deficits. As the article from Jeff Opdyke suggests, we are absolutely reliant on foreign investors to fund this debt.

We have a big data day today here in the US, with all of the Consumer Price Index numbers along with the weekly jobs data. On top of all that we will get the Industrial production numbers along with Capacity Utilization and the Leading indicators for February. The Inflation data is expected to show a small increase, and the jobs data is expected to show further rot on the employment vine. Should be a busy morning in the markets, so I will end this morning’s Pfennig here.

Recap: The dollar slid lower as investors abandoned the ‘safe haven’ of US treasuries. Japan will also be selling US treasuries as they raise capital for rebuilding, and future purchases of US treasuries are questionable. The Swiss franc continues to move higher, and the euro withstood a major test as the Spanish bond auction was successful. India’s central bank raised rates to combat rising inflation. And finally, the twin deficits here in the US continue to increase, and we will have a plethora of data releases this morning here in the US.

Chris Gaffney
for The Daily Reckoning