Euro Rallies After EU Summit Sgreement

Last time I sat in for Chuck, the markets took us on quite a ride; but with the end of the year within sight, and most of the trading desks short-staffed, I don’t think we will see a lot of big positions being put on the books. Should be a fairly quiet couple of weeks to end out 2010… (Chuck would tell me I just jinxed any hopes of lower volatility!!)

Yesterday was sure quiet in the markets, as the dollar index opened and closed within a very tight range (0.00175%). This morning the euro (EUR) is gaining a bit as European Leaders announced an agreement to create a mechanism to contain future debt shocks. As Chuck suggested in yesterday’s Pfennig, EU leaders followed Germany’s lead and agreed to set up a crisis-resolution system in 2013 that would protect the euro but would also force bondholders to bear some of the costs of future rescues. This is what German Chancellor Merkel has been insisting, that those who have invested in the high yielding bonds of Greece, Ireland, and Spain will need to bear some of the costs of any rescue package. These investors have purchased the bonds at these high yields knowing of the risks, and the citizens of Germany are in no mood to “bail them out.”

After winning the EU commitment for the crisis-resolution system, Merkel seemed to soften her previous insistence that each country of the EU needs to stand on its own. According to a Bloomberg article that I read this morning, Merkel said that maintaining national fiscal discipline won’t alone put the 16-nation euro region on a sounder footing. “It is just as important that we move toward a common economic policy step by step,” Merkel told reporters in Brussels today. “It will be a long process.”

Sounds like Merkel may be warming up to the idea of a euro-wide bond offering! I agree with Chuck that this is exactly what the EU needs. All of these countries share a common currency, and therefore have to share common monetary policies, so why shouldn’t they share a common bond offering. Yes, Germany and France would initially have to pay higher interest rates on the new debt, but they continue to have to bail out the weaker members anyway!

The euro enjoyed a bit of a rally after the agreement, and continued higher as Germany’s business confidence unexpectedly rose to a record in December. The IFO institute said its business climate index increased to 109.9 from 109.3 in November. December’s figure is the highest reading since records for a unified Germany began in 1991. Germany’s economy continues to surge ahead on exports to Asia and the rest of the Eurozone.

Even some bad news from Moody’s couldn’t stop the euro’s rally. Moody’s Investor Service cut Ireland’s credit rating five levels from Aa2 to Baa1. The cut was widely expected, but the severity of the cut surprised many. The rating is still three levels above non-investment grade and is now the same as the rating of Russia. More bad news came for Ireland as Moody’s said the outlook for the rating is “negative” which is all but a guarantee of further downgrades in the future. But as usual, Moody’s is late to the game and the bond and currency markets seemed to brush this announcement aside. However, it does indicate that the European debt crisis will remain a thorn in the euro’s side for the next few years. But how does the saying go… “What doesn’t kill you only makes you stronger.” I continue to believe the euro will survive this crisis, and will actually become an even stronger competitor to the US dollar as the world’s reserve currency.

Problems in the US continue to mount, and our fearless leaders in Washington are clearly not worried about the debt that continues to pile up. The US House adopted the $858 billion tax package and will send it to the White House for Obama’s signature. This is more of the same for our lawmakers: Leveraging our future for short-term gains. Don’t get me wrong, I am all for lower taxes and smaller government. But unfortunately this new “compromise” gives us lower taxes and bigger government. Let me see if I get this right, our congressmen were against extending the tax cuts as it would be fiscally irresponsible and add too much to the debt, but these same congressmen decided to support the tax cuts after additional spending was added to the bill! Doesn’t make much sense to me, but it definitely shows you how we have run up our massive debt, and just how hard it is going to be to get anyone to do anything about it.

Chuck and I were discussing this last night on the way to the hockey game, and we were marveling at the size of the ponzi scheme which the US has been able to run. The FOMC has pumped a record amount of stimulus into the system, in order to try and drive interest rates down and stimulate our economy. But instead of lending this money out, banks have simply placed the funds on deposit with the FED, which then turns around and uses these funds to purchase US Treasury bonds, enabling us to issue more debt to pump back out into the markets. Eventually this incestuous cycle will be broken, and when that happens all bets are off regarding the fiscal “stability” of the US, and I hate to think what will happen to the US dollar.

Ty Keough sent me a note yesterday regarding something he read in The Daily Reckoning on Ron Paul and his oversight of the Federal Reserve. Dr. Paul continues to be one of the most responsible members of congress, and his new chairmanship doesn’t bode well for the folks at the Bernank.

From a Daily Reckoning essay titled “Ron Paul: The Fed Spends ‘More Money Than the Congress Does’”:

Dr. Ron Paul (R-TX) held his first interview since being appointed chair of the House Monetary Policy Subcommittee. He says he’s going “to think things through and not overdo things too soon,” but ultimately plans to stick to his guns, and “emphasize the oversight of the Federal Reserve.”

He also points out why he views his new role as important in these times…

“Obviously, it is very popular with the American people to audit the Fed and know what they’re doing when they can spend trillions of dollars and we don’t know where it goes. They have a bigger budget; they spend more money than the Congress does. Yet, we have no oversight. It was never intended that a secret body like this could create money out of thin air spend to take care of some banks and big business and foreign banks and the American people struggle? We have to look into it and we have to start to consider reforms.”

Today, we will get just one piece of data: the leading indicators, which are expected to show an increase of 1.1% for the next three to six months. I don’t expect this number to move the markets one way or the other, so it will probably be a pretty quiet day in the markets.

Chuck left me a bit of information he wanted me to share with everyone concerning data that was released yesterday:

Canada’s international securities transactions data for the month of October reflected an international investor community apparently comfortable with Canadian risk. Over the course of the month, foreign investors digested a net C$9.5 billion in Canadian securities, primarily corporate bonds and equity.

So… Foreigners felt safer buying Canadian assets than US assets (recall October’s total was $7.5 billion in the US)!!!

OK… Yesterday, the Philly Fed Index (manufacturing for that region) showed a HUGE jump in activity versus the consensus… The consensus was for the index to fall from an index number of 22.5 to 15… But instead it jumped to 24.3. So manufacturing in the Philly region must be doing quite well… But let me tell you a little secret that you won’t hear on TV… And it plays very well with my tirade yesterday about the coming inflation in the US…

You see… There was a surge in the prices paid sub index, which rose to the highest since June of 2008. And we all know what happened after June of 2008… But that’s not the point here… The point is simply that if these manufacturers are seeing these pricing pressures, why aren’t they passing them on to the consumer? Well… Probably because with the unemployment problem in the US, the manufacturers just don’t see it as viable… But… There are stories beginning to circulate around the rumors that manufacturers are looking to pass on these price increases…

And when they do… here comes the inflation!

Thanks to Chuck for that information, and with higher inflation expectations, the commodity currencies will probably be the belles of the ball. Australia’s dollar (AUD) headed for another weekly gain versus the US dollar and traded near a seven-month high versus the Japanese yen (JPY). New Zealand’s dollar (NZD) also rallied yesterday as Standard & Poor’s raised China’s credit rating. Both Australia and New Zealand are dependent on China where a majority of their exports are shipped, so a strong China is good news for the currencies “down under.”

China allowed their currency to rise slightly last night for the first time in three days. We continue to think China will maintain its low and slow appreciation policy for the renminbi. Those that are betting on a large overnight appreciation will be disappointed, as the Chinese leaders understand that a dramatic increase in the currency would be too destabilizing on their economy. But a slow 7%-8% annual rise will accomplish the necessary 40%-50% adjustment over the next 5 or 6 years. China has a long history, and 5 or 6 years is really not that long of a time period for what is the globe’s oldest civilization.

And to close out this morning’s Pfennig, I will refer back to something Chuck left me late yesterday on the Indian rupee (INR). “After raising rates 6 times in 2010… The Reserve Bank of India (RBI) left rates unchanged yesterday… I don’t see that as an end to their rate hike cycle. The RBI will be back to the rate hike table in 2011… Things are going well in India, and before the economy gets a chance to overheat, the RBI will hike rates…” So for those looking to benefit from an expanding global economy, but want a bit of interest, the Indian rupee may be an excellent alternative to the Chinese Renminbi.

To recap: The EU followed the German Chancellor’s suggestions (no surprise there) and will create a crisis resolution system in 2013. US lawmakers passed the extensions of the Bush-era tax cuts, tacking on even more debt to the bill. The boys over at the Bernank have to be shaking in their shoes as Dr. Ron Paul will be starting his oversight in 2011. China will allow a slow appreciation, and India announced they will leave rates unchanged but will be back to the rate hike table in 2011.

Chris Gaffney
for The Daily Reckoning