Don't Be Fooled by the U.S. GDP

Good day… And welcome to the last day of July. The dollar held its ground through most of the trading day but started to sell off as the day wound down. The currency markets seem to be stuck in a summer doldrums, with few dramatic moves. With many of the head traders enjoying a summer break (ours included), currency desks are reluctant to take on large positions. And who can blame them as the recent global economic data has left investors wondering where to turn.

As I have explained to several recent callers, the global economy is experiencing a slowdown, as the high commodity prices and a slumping U.S. economy have both hurt growth. The economic releases have shown an overall slowdown in growth, and rising global inflation. But the overall slowdown will have differing effects on the currencies. Asia is slowing, but a slowdown from double-digit growth in China and India is much different than a slowdown in the United States where growth is around 2%. Also, the Asian countries have kept interest rates low to try and keep their currencies from appreciating too quickly. These countries are therefore in a much better position to combat inflation, and can allow currency appreciation to help combat rising prices.

Some economists have predicted a fall in commodity prices because of the global slowdown, but China and India will still have very healthy growth rates, albeit below 10%. The growth of a consuming middle class in China and the increase in disposable income in India will allow these new consumers to pick up some of the drop in consumption by the United States and Europe. The world’s economic engine will continue to be based in Asia, and the countries that are positioned to feed this engine the raw materials it needs, will continue to perform. Australia, Canada, Brazil, and the emerging countries in Africa should continue to benefit from a commodity bull market, which I believe will continue.

But back to today’s markets. The euro (EUR) rose overnight, moving back above the 1.56 handle, snapping two days of losses. Data showed that inflation in Europe accelerated to the fastest pace in more than 16 years in July. This jump in inflation will put pressure on the ECB to continue to raise interest rates, as inflation holds at a level that is double the target rate. In spite of dire predictions for economic growth in Europe, German unemployment continues to fall with the rate holding at a 16-year low. Higher interest rates in Europe, while negative for growth prospects, will keep the euro well bid.

But data released this morning in the United States could send the dollar back up again. Economists are expecting the second quarter GDP numbers released in the U.S. later this morning to show an increase of 2.3% compared to the first quarter growth of just 1%. This positive number is largely due to the one-time effects of the fiscal stimulus package and about $78 billion in tax rebates which went out during the quarter. I believe this will be another one-time positive number, which the markets will likely run with. I’m sure we will have the stock jockeys coming out of the woodwork talking about how the ‘worst is over’ and the equity market and dollar will likely rally.

But don’t get caught up in the suckers rally, as numbers released tomorrow will probably show a further decline in non-farm payrolls for the month of July, and an increase in the unemployment rate. The gains in economic growth will be in stark contrast to the recession signal sent by the loss of jobs. While the GDP number has benefited from the one-time stimulus package and tax rebates, employment numbers show a truer picture of the current state of our economy. Bernanke himself is urging caution. There are “significant downside risks to the outlook for growth,” and, “upside risks to the inflation outlook have intensified,” he told the Senate Banking Committee in Washington. I have to believe the FOMC will continue to be forced to sit on the sidelines, keeping interest rates unchanged through the end of the year. Not a good scenario for the U.S. dollar.

While the Federal Reserve is unable to move interest rates, they continue to help their friends on Wall Street with government-backed loans. The Fed extended its emergency lending programs to Wall Street firms through January after policy makers judged that markets are still too weak to operate without a backstop from the central bank. This move illustrates just how fragile the U.S. banking system remains, as losses from mortgage backed securities and the credit crunch continue to shake Wall Street’s balance sheets. As expected, the extension of the credit facilities had the desired effect, as stocks rallied on Wall Street.

A small rise in the price of oil helped rally the Canadian dollar (CAD) for the first time in seven days. Recently the markets had started to predict a free fall in the price of oil, which put selling pressure on both the Norwegian krone (NOK) and Canadian dollar. But the stabilization in the price of oil had a positive impact on the loonie. I read where Alberta holds the largest crude oil reserves outside the Middle East, so the Canadian dollar will certainly be influenced by energy prices. I don’t expect the Canadian buck to rally much past parity though, as it is heavily reliant on the U.S. economy, which will continue to slow.

The Mexican peso (MXN) was another currency that advanced yesterday. Mexico’s peso advanced to a near six-year high, and is now the second best performing currency YTD, behind the Brazilian real (BRL). The peso has benefited from two interest rate increases by the central bank since June, widening the gap between the Mexican and U.S. benchmark lending rates to 6%, the most in almost three years. And with the central bank raising their inflation forecast through 2010, there is a good chance of another rate increase in August. With another rate increase, we will likely see the peso trade below 10 pesos/dollar.

As I mentioned above, the Brazilian real continues to be the best performing currency versus the U.S. dollar this year. With untold riches of commodities, and a more stable political situation than in the past, Brazil continues to attract investors. But investors should continue to look at the Brazilian real as a speculative investment; it shouldn’t be seen as a core currency holding. We offer a 3-month CD in real at an APY of 6.4%, with a $20,000 minimum investment. Also, due to the speculative nature of this currency, investors have to complete an emerging markets risk disclosure prior to investing.

Some bad news out of Australia caused the Aussie dollar (AUD) to fall to a six-week low. A government report showed that retail sales dropped the most in six years, adding to signs that the economy is slowing. The currency markets are now predicting that the Reserve Bank of Australia may now cut rates this year instead of next. A housing recession similar to those of the United States and United Kingdom is also putting pressure on the Aussie dollar. On the positive side, the Australian government said the trade balance turned to a surplus in June after coal and meat exports jumped. I continue to believe that commodity demand will pull the Australian economy through their housing slowdown, with the currency actually rallying by the end of the year.

Japanese investors also continue to support the Aussie dollar and kiwi (NZD). The Japanese bought record amounts of Australian and New Zealand dollars on the Tokyo Financial Exchange yesterday, as gains in the yen (JPY) made the higher-yielding currencies cheaper. So the carry trade lives on! The Bank of Japan is expected to keep rates on hold, as Japan’s economy heads for a ‘soft landing’. In its annual evaluation of the Japanese economy, the IMF forecast economic growth of 1.5% this year, a pace that is slightly below the economy’s potential. The report said the Bank of Japan’s ‘wait and see’ approach to monetary policy was appropriate. With the BOJ keeping rates down, the carry trade will continue.

Currencies today 7/31/08… A$ .9448, kiwi .7337, C$.9779, euro 1.5615, sterling 1.9817, Swiss .9546, ISK 79.30, rand 7.3835, krone 5.1356, SEK 6.055, forint 147.83, zloty 2.0518, koruna 15.35, yen 108.18, baht 33.51, sing 1.3663, HKD 7.8027, INR 42.55, China 6.8318, pesos 10.02, BRL 1.5620, dollar index 73.19, Oil $128.15, Silver $17.49, and Gold… $910.21

That’s it for today… It is food day here today, as we celebrate the birthday of Ann Hopkins. Ann is one of the individuals who’s taken it upon herself to bake a cake for each of us on our birthdays. In addition to being a terrific cook, Ann is just a great girl with a very quick wit. So today is our opportunity to pay back Ann for all of her late night baking endeavors. I think I actually smell someone cooking up pancakes for breakfast! Got to go see if I can grab a few. Hope everyone has a terrific Thursday, and Happy Birthday to Ann!

Chris Gaffney
July 31, 2008